With the euro finally becoming a tangible currency on January 1, 2002, it is time for a preliminary assessment. Is the euro working? Do people like it? And will it last? The answer to all three questions appears to be yes. So far, so good.
Until January 1, 2002, the euro had led a demi-life merely as a book entry currency. If anybody wanted to feel or touch a euro, they had to draw out one of the twelve national currencies in the euro-area, each of which were fixed denominations of the underlying and intangible euro. No wonder the British -- always ill at ease with abstract concepts, and liking the physical and real -- felt ill at ease with this ghostly currency. But somehow, the new currency came to life on New Year's Day 2002.
The changeover was rather remarkable. The logistics went better than anyone had expected, which was a shock to many who predicted whole regions of the euro-area in turmoil at their inability to handle the new currency. What was even more surprising was the genuine enthusiasm that the new currency engendered. Policy-makers had, before the event, hoped that there would at least be sullen acquiescence. After all, it is pretty inconvenient having to use two currencies at the same time even for a few weeks. Instead, the 301 million people in the euro-area changed over far more quickly than anticipated. There were queues at cash machines late into the night of the changeover. The opinion polls suggested a sharp shift in favour of the new currency even in suspicious parts of the euro-area like Germany, which had objectively most to lose from the final disappearance of the Deutschemark, a worthy and long-standing store of value. The whole cash changeover went far faster than had been predicted.
The cash changeover was important in the eyes of the public, who for the first time actually had daily contact with a symbol of their European Union membership. But the economic effects of the euro had already begun three (or arguably even more) years before, casting their shadow forward from the cash changeover. However one measures the euro, it is hard to see the new currency as other than a success in its own terms. It was designed to provide its members with a currency area in which the buffetings of international capital flows would finally be banished, in which businesses could plan ahead without fear of sudden exchange rate volatility, and in which a single competitive market could become as much of a reality as it is in the United States. After all, how effective would the US single market be if there were separate Californian, Texan and New York dollars?
First, as a tool of the single market, the new currency is clearly delivering. Prices are converging within the euro-area, as the recent Dresdner Kleinwort Wasserstein study showed. And they tend to converge on the lower prices in the existing countries, because those are the prices set in the most competitive markets. To raise them would be to lose market share. There is therefore a steady downwards pressure on inflation from the introduction of the euro, even though the short-term one or two month impact of the physical currency changeover was a rounding-up of some prices (though by no more overall than perhaps 0.2% on the consumer price index). Economists are for once unanimous in predicting that the medium run effects of the euro will be to increase downwards pressures on inflation.
This increased competitive pressure is very significant if some studies are to be believed. In North America, the volatility of the Canadian and US dollars against each other has acted as a very important barrier to trade. One study estimated that the price differences found when you cross just one kilometre across the US--Canada border were the same as the price differences created within the United States or Canada only by transport costs over a distance of 1,780 miles. If that study is right, then the effect of the introduction of the euro was to bring many European companies suddenly 1,780 miles closer to each other than they were at the end of 2001. This does not, of course, mean that prices will be the same throughout the euro-area. They vary according to transport costs and the different market positions of the outlet: Harrods will always be more expensive than Asda for the same goods. But the euro spells the end of the phenomenon that has repeatedly been found in Europe, namely that price differences between member states are three to five times greater than price differences within member states.
The end to currency volatility also means an increase in trade and investment between the euro-area members, and there is growing evidence of this as well. When I think of this effect, I always remember a conversation that I had not so long ago with a businessman who said that he would be able to export for the first time in the euro-area. He was in the electro-plating business, and worked on very small margins of some 2 to 3% of turnover (though with a perfectly respectable return on capital). He could not export from Britain today because currency volatility could wipe out his potential profit, and nor could he hedge (by locking in a return in sterling from euro revenues) because the cost of hedging would often exceed his likely profit margin. For that sort of business, the euro is a free hedge.
This helps to explain why another authoritative study found that a Canadian province does twenty times as much trade with another Canadian province as it does with an equidistant US state. This extraordinary result is despite a long-standing Canada--US free trade agreement that predates the well-known North American Free Trade Agreement (NAFTA); serious mechanisms for eliminating non-tariff barriers between Canada and the United States; and even a common language (with the exception of Quebec). If this study is right, then there is going to be an enormous increase in trade between the member states of the euro-area, and that of course will tend to lead to an increase in their national income of perhaps a third of the increase in trade.
This effect on trade is beginning to occur within the euro-area. Since the euro was introduced on January 1, 1999, Germany's trade with the EU (exports plus imports) has leapt from 27.2% of GDP in 1998 to 31.4% in 2000. France's trade with the EU has risen from 28.0% to 32.0%. Italy's from 23.0% to 24.4%. If we apply the rule of thumb that about a third of any increase in trade actually increases national income, then the 4 per centage point rise in the share of their GDP that France and Germany have enjoyed has boosted their economies by around 1 3% compared with what would otherwise have happened. Over the same period, Britain's trade with the EU has edged down from 23.4% of GDP in 1998 to 23% in 2000, slightly damping growth. Separate and volatile currencies are a real obstacle to trade. In effect, they are a tariff barrier.
The euro-area also means that businesses can invest in another member state within the currency area without fear that the exchange rate will suddenly move and deprive them of part of their capital or their revenue flow. This too is having the expected effect of increasing investment, and particularly in those parts of the euro-area that have attractive labour costs. Portugal, one of the two poorest countries in the euro-area, is attracting foreign investment on an unprecedented scale. Its inflows of capital have amounted to around 10% of GDP for three years. If that had occurred when Portugal still had an escudo, it would have suffered a demoralising collapse of confidence, a sharp decline in the exchange rate, and a rise in interest rates. No such thing can now occur. As with the Gold Standard before the first world war, during which capital flows were larger than at any time since, the euro has established the conditions for a sharp rise in cross-border investment. Not surprisingly, investment has been growing more quickly in the euro-area countries than in the non-euro area EU countries for each of the last four years.
The impact of currency certainty and increased competition has also caused a sharp rise in the amount of cross-border mergers and acquisitions activity since the launch of the euro in 1999. The euro has been a major contributory factor in what is becoming a vast restructuring of the European economy. Businesses need to produce on a bigger scale, and in more efficient ways, to maintain their profitability in the face of tougher competition. And they can now distribute different parts of the business across the euro-area without any fear of currency volatility making them uneconomic. In the last three years since the launch of the euro in January 1999, the total value of European company mergers has exceeded USD3.7tr, more than in the cumulative total of the previous decade. Indeed, both 1999 and 2000 saw merger volume at more than six times the annual rate of the peak year of the previous European merger boom in 1990.
This merger boom has been helped by a sudden integration of the euro-area's financial markets. Because investors now have much wider choice within the euro-area than they had in their segmented national financial markets, and because they no longer have any currency risk when investing in another part of the euro-area, they now have the ability to put together portfolios of bonds and shares on a much broader basis than before, offsetting the risk of individual securities within the larger portfolio. The result has been a large investor demand for corporate bonds, which have taken off as a market as never before. The birth of a real corporate bond market in the euro-area has also helped to fuel the mergers boom, since finance has been easier to arrange.
All of this has dangers for Britain. Some of the biggest British businesses, often participating in the mergers boom, may slowly emigrate to their biggest market in the euro-area, effectively becoming euro-area companies. But medium sized British businesses will not have that option: they will continue to suffer the disadvantage of incurring costs in a currency different from the currency of their biggest export market. Although these businesses can hedge their revenue -- selling future euro revenue for sterling -- they cannot hedge their costs. If sterling rises, they become less competitive even if they make a profit on their forward contract. It still makes sense for them to sack workers, which is why we have lost more than 400,000 jobs in manufacturing in four years. Far from being a useful policy lever, sterling is buffeted by footloose capital flows that make the currency more like a wrecking ball.
Even if sterling now falls to a sustainable level -- at or below EUR1.50 in my judgement -- there will be another problem. British business will not face the gradually intensifying pressure of competition within the euro-area as the twelve economies integrate fully. When sterling is stable, it acts like a tariff barrier. That is comfortable in the short term, but in the long term it is disastrous. Remember the price we paid in accumulated inefficiency when we stayed outside the liberalising European Union from 1958 to 1973. Any American or Japanese company, examining the advantages of investing in Britain or the euro-area, is going to assess many factors such a labour flexibility, skills and language. But if they are producing for the whole European market -- as most in manufacturing do -- the euro-area now has an enormous advantage as a location. Costs are in the same currency as revenues. For many, this will tip the balance. This is why the recent Ernst & Young investment survey showed a decline in Britain's proportion of investment in the EU, and why non-EU manufacturers intend to invest more in France than in Britain for the first time.
But is the euro credible, the euro-sceptics ask? After all, it may have delivered internal price stability, but it has sunk sharply against the dollar compared with its launch rate when it bought USD1.17. This, though, misses the point. After all, there is nothing new in currency volalitility. The Deutsche mark was much lower in 1985 than at any time recently: if we confect a euro going back into the eighties, the low point in 1985 was 67 cents whereas the low point in this business cycle has been 82 cents. And there is no sign that this is other than the usual currency volatility that has been such a feature of the post-Bretton Woods period.
After all, if the markets had lost confidence in the euro, you would expect that ten year bond yields -- the interest rates paid by euro-area governments -- would have risen sharply. You would also expect the weaker members of the euro-area (in terms of their public finances) to suffer an even bigger risk premium in their ten year bond yields to compensate investors for the risk that they may drop out of the euro. In fact, ten year bond yields have tended to be a little lower than in the United States, and that has applied even to the Italian governments' long-term interest rates. No sign of a lack of market confidence in the future of the euro in those figures.
The euro has also been a success in protecting its member states against the vagaries of international financial and economic shocks. Remember that over the last few years there have been two substantial shocks: first, there was a rise in crude oil prices from USD13.1 a barrel in 1998 ( the year before the launch of the euro) to USD28.90 in 2000. That was a substantial external shock. In addition, there has been the weakness of the euro against the dollar (or strength of the dollar against the euro, which comes to the same thing). If such shocks had occurred through most of the period from 1971 to 1999, there would have been many crises within Europe as finance ministers tried to align their exchange rates with something that the markets thought to be sustainable. Midnight meetings would have been de rigueur. There would have been a definite sense of crisis. Instead, the euro-area finance ministers have been able to ignore the whole shooting match. The euro has delivered the insulation from external shocks that was an important objective of its foundation.
Nor to my mind is all the criticism of the European Central Bank justified. True, it has not opened up as much as its rivals at the US Federal Reserve or the Bank of Japan, because it does not yet publish its votes or summary minutes. However, it has responded to the pressure of the European Parliament by publishing projections, making available its own econometric models, and by sending its Governing Council members to appear before the European Parliament's economic and monetary affairs committee on no fewer than 19 occasions in the last full reporting year. This is real progress. Its decisions are also hard to fault except with the wisdom of hindsight. One German academic -- Professor Peter Bofinger -- has shown that the ECB interest rate decisions reflected a judgement of the state of the economy quite consistently, since he has been able to explain their decisions in terms of the economic data.
Nor has the so-called 'one size fits all' problem proved problematic. Inflation rates are bound to differ in a monetary union (as no doubt they would do in Britain, if we published regional inflation figures). But the differences are within the bounds to be found in the United States, and the scare stories have proved to have no foundation. For example, Professor Patrick Minford, a leading 'no' campaigner in Britain, predicted that Irish inflation would rise from its then 6% to 10% and would stay there for three years. Fortunately, Irish inflation has subsided below 4% in short order. Equally, the 'no' campaign's projections that the changeover cost in Britain would be more than GBP30bn now look ludicrous given that no euro-area country spent an eighth as much.
So far, so good with the euro. Of course, it is early days. But the euro is delivering helpful economic results, liberalising markets, and bringing greater choice of quality and price to consumers.
Chris Huhne MEP is a former economist, author of two books on the euro (most recently Both sides of the coin, in which he argued in favour), and head of one of the City of London's largest teams of private sector economists. He is now economic spokesman of the European Liberal Democratic and Reformist Group.
