Why the Euro Is Sinking

Wall Street Journal, June 9, 1999

By Melvyn Krauss, a senior fellow at the Hoover Institution and a professor emeritus of economics at New York University.

When Europe launched its new currency, the euro, in January, its cheerleaders predicted a strong beginning. The currency of the world's premier welfare states would teach the currency of the world's largest free-market economy a thing or two. But since hitting a high of $1.1877 on Jan. 4, the euro has lost 10% of its value against the dollar in a mere five months, and current sentiment in foreign-exchange markets is that it will trade at parity to the dollar in the near future.

In fact, despite a slight rally yesterday, the euro may be going much lower than that. Asked recently about the euro's decline, European Central Bank President Wim Duisenberg said, "The euro, after an initial bout of appreciation, has done, in my mind, rather well." One wonders: if a 10% decline in five months is doing "rather well," what would Mr. Duisenberg consider doing poorly?

At a minimum, the ECB president's remarks reflect a benign neglect for the foreign-exchange value of the euro. They also suggest that key European monetary officials actually may want the euro lower, so long as the decline is gradual.

The reason is not hard to understand. The European Union is now the world's largest and most expensive welfare state. Though this is a blight on economic growth, Europe's domestic politics prevent a major scale-back. In these circumstances, European monetary authorities have chosen the palliative of pumping up the economy by lowering interest rates and devaluing the currency. When Mr. Duisenberg predicts that "the worst is over in Europe" and that growth will rise about 2.5% next year, he is telegraphing his intention to continue lowering interest rates and not fight further declines in the euro.

The tumbling euro illustrates an important relationship--overlooked by conventional monetary analysis--between the size of a nation's welfare state and the foreign-exchange value of its currency. Because welfare states are low-growth economies, policy makers often resort to keeping their currencies cheap in the hopes of achieving a modicum of growth. Moreover, because welfare-state economies are never dynamic, capital tends to flow out of them to high-growth countries not burdened by excessive social programs and government regulations. This bids up the currencies of the high-growth economies relative to the low-growth ones.

The U.S. is a leading example of a country characterized by a relatively small welfare state, high growth, capital inflow, a strong currency and a sizable trade deficit. (It is clear from this analysis that the U.S. trade deficit reflects a healthy economic situation, not a sick one.)

Europe, on the other hand, has a huge welfare state, low growth, capital outflow, a weak currency and a trade surplus.

While the declining euro does not by itself indicate the infant currency is about to be abandoned, it does raise "stability pact" problems. For traditionally low-inflation

countries like Germany to have entered into a monetary union with traditionally high-inflation countries like Italy, all countries had to make guarantees of fiscal discipline.

But fiscal discipline is now being seriously undermined by European economic weakness. For example, only five months after the euro was introduced, Italy asked for, and received, permission to raise its 1999 fiscal-deficit target to 2.4% of its gross domestic product from 2% if severe economic conditions warrant.

It's not that Italy is recklessly jacking up its public expenditures. Instead, anemic Italian growth is generating lower than expected tax revenues.

Italy's backtracking on fiscal discipline is causing real concern for the euro's long-term viability. "If it were to become a general trend," warned Mr. Duisenberg, "it wouldn't do the euro any good." By undermining the European Monetary Union's fiscal-discipline standards, Europe's present economic weakness poses a mortal threat to its fledgling currency. This is why Mr. Duisenberg is keeping - and will continue to keep - Europe's monetary pedal to the metal.

The actions of Europe's monetary authorities will come to naught, however, if European politicians do not act quickly to scale back the welfare state. ECB chief economist Otmar Issing recognizes this better than most.

After warning that "Germany risked becoming the 'sick man of Europe' unless it reformed its expensive welfare state," Mr. Issing went on to declare that "Germany and other European Union countries shared the blame with Italy for the euro's weakness because they had failed to make their economies more flexible."

Europe's welfare state and the euro are mortal enemies.

Unless the former can be scaled back in a meaningful way - and soon - the prognosis for Europe's new currency is not good.

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