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 fter
three years in the making (and many more on the drawing board),
the euro is finally circulating and has replaced over a dozen European
currencies. This is a positive for Europe overall, with some minor
drawbacks. Yet, as many articles on the euro have appeared in the
past few weeks — and during the entire period the euro has
been in use — several critics of the common currency have surfaced,
each of whom misses the salient aspects of the changeover.
Apparently,
there's a great ignorance of monetary systems out there, and it's
interesting that some long-time critics of the euro have not seen
their original forecasts of hyper-inflation, cultural ruin, or whatever
materialize.
Many of the
problematic views of the euro have their origins in a faulty world
view. Many critics, for instance, point to the 1970s when the dollar
was falling relative to the rest of the world's currencies and U.S.
inflation rose both in absolute and relative terms. They cite this
period as an example of what can (and in some cases, will) happen
with the new common currency.
Monetary shocks
dominated the landscape during the 1970s and purchasing power parity
(PPP) was the relevant framework of analysis. In the PPP world,
differences in inflation rates across countries are matched by currency
depreciation. For example, the euro has depreciated more than 30%
from its peak. According to some critics, this depreciation would
produce a corresponding increase in EMU (Economic Monetary Union)
consumer prices relative to U.S. (or other countries') prices. Yet,
U.S. inflation has been slightly higher than the EMU's — the
opposite of what some "knowledgeable" critics forecasted.
An obvious
but important point is that neither region's inflation is out of
control. Yet the PPP critics argue that European central bankers
have mishandled the implementation of the euro. In fact, they suggest
that what the European Central Bank (ECB) needs is a Paul Volker
or Alan Greenspan — someone who can restore confidence in the
currency and take it to new heights. We do owe a great deal
to these two gentlemen, however that is not to say that there is
no other or better way.
Better, perhaps,
would be to frame the issue in terms of rules versus discretion.
Volker and Greenspan have been great. However, as the past few years
have shown, and as some of the Volker/Greenspan proponents have
correctly pointed out, the Fed overdid and provided too much liquidity
in anticipation of Y2K, and then overdid it again in the aftermath
by withdrawing too much liquidity too fast. It seems that, in these
instances, discretion failed us. The Fed did not adhere to a price
rule. Instead it followed the Greenspan rule. The domestic price
rule would have worked better.
It's ironic
that the euro critics fault ECB Chairman Duisenberg for his supposed
disregard of the falling euro. He is criticized for focusing on
European prices. But that is precisely what a domestic price rule
does. It focuses on stabilizing domestic prices.
Yes, there
were euro-implementation mistakes. But the bulk of the mistakes
were on the real side. One only need to recall the brouhaha over
Ireland having a two-tiered tax-rate system. The EMU pressured them
to harmonize, hoping that they would raise the lower rates —
instead Ireland lowered its top rate. In Germany, the budgetary
static analysis got the better of the Schroeder government. Germany
enacted a major tax-rate reduction that could leave the EMU with
lower corporate tax rates than the U.S. However, in their infinite
wisdom, and based on a static analysis, the legislature postponed
the rate cut to this January. A phased-in personal income tax rate
reduction is also included. The top rate will decline to 45% by
2005 from the original 53%.
The German
tax-rate cuts have had an impact on German asset values and the
pace of economic activity. The personal income-tax rates were phased
in, and that introduced an incentive to delay income recognition
from last year to this year. As a result, the rate of economic expansion
slowed during the transition.
Nearly a year
ago I had suggested that the euro would begin its rise in 2001 with
the expectation that the cap-gains tax on corporate holdings would
disappear. But bureaucrats have a way of keeping taxes alive. When
the law was passed, the Germans imposed a one-year holding period
beginning January of this year. Corporations had a strong incentive
to postpone realizing capital gains until January 2002. In part,
this explained the weakness in the euro since its inception.
And the recent
strength of the euro is easily explained if one believes in forward-looking
markets. The future is now. German businesses have a strong incentive
to divest themselves of these holdings and realize the gains. The
surprising thing to us is that the press made very little of this.
It was only very recently that the Wall Street Journal touted
the tax law changes. The unlocking of capital will make Germany
a very dynamic place.
Italy has announced
that they will not let the budget deficit get in the way of personal
income-tax rate reduction. The European community has a strong urge
to harmonize. With Germany, Italy, and to some extent Ireland, leading
the way, the harmonization will result in lower tax rates. The euro
should be fairly strong the next few years and it will be because
real rates of return will increase in Euroland relative to the rest
of the world.
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