Inflationomics

An Uncertain Euro

The euro, the single European currency, has fallen almost 20 percent against the U.S. dollar since its launch on January 1, 1999. It has slumped against other international currencies as well, in particular, the British pound and the Japanese yen. Yet, the members of the European Central Bank (ECB), whose duty it is to administer the euro, seek to reassure us that it is undervalued and, therefore, bound to recover soon. The markets, unfortunately, don't seem to listen to such statements of confidence as the euro continues to disappoint. From an exchange rate of 1.17 U.S. dollars to the euro at the beginning of the year it fell below parity with the dollar in December and to 95 cents at the end of March 2000. And while ECB officials wax eloquent about potential strength and "proper" exchange rates, their prognoses visibly differ from reality. The impression arises that something is seriously wrong.

In Britain, Denmark, and Sweden the critics who had opposed adoption of the euro congratulate themselves on their foresight. But as some economists had predicted, the weaker euro stimulated exports from the eleven-member euro-zone by reducing export prices without significantly affecting the low inflation rate. In Germany the low euro sparked an export-led recovery; Spain, Portugal, and Ireland achieved dramatic economic growth. Even France, attempting to solve its high unemployment problem by introducing a 35-hour workweek, felt the stimulating effects of a low euro. Few structural reforms were undertaken throughout the euro area to attack the 10.3 percent unemployment rate.

The low euro enables several euro countries to show large current account surpluses. Exporters sell more goods and services abroad than importers buy, which boosts the foreign demand for the euro and lends support to its exchange rate. Yet the trade surpluses are dwarfed by the magnitude of capital outflows which drive the euro irresistibly lower. Economic considerations move many Europeans to desert their own capital markets and move to the U.S., especially the high-tech "new economy." They help to offset spectacular U.S. trade deficits and thus keep the dollar strong. In 1999 the euro area suffered an estimated outflow of some 120 billion euros in direct investments and a net outflow of some 60 billion of portfolio investment, compared with a current account surplus of some 45 billion euros. Such flows render ECB efforts to turn the euro around rather ineffectual and cast dark shadows on its future.

Many European investment funds find their way to Wall Street. Investors apparently view the American current account deficit, which amounts to some 4 percent of GDP, as an indication of extraordinary economic dynamism. Conversely, the large current account surpluses of the euro-zone are viewed as lack of profitable investment opportunities. The American economy is said to be humming, business taxes are believed to be low, labor is mobile, labor unions are rather tame when compared with their kin in Europe, and venture capital is abundant. Many Europeans eagerly partake of the euphoria, blithely ignoring that the U.S. indebtedness to the world is growing incessantly, and that the personal and corporate indebtedness in the U.S. has reached astronomic proportions. Their enthusiasm is sustaining the dollar and weakening the euro.

The European Central Bank has an unenviable task of maintaining stable goods prices. Such a task calls for stability not only in the quantity of money but also in the productivity of goods and services. The three large economies of the euro area – Germany, France, and Italy – are showing narrow productivity improvements after a lengthy slump but, when compared with the record-breaking dynamism of the U.S. economy, still seem sluggish. Wim Duisenberg, the ECB's president, therefore advises: "What we desperately need in Europe is structural reform ... and when it happens it is a very slow process." Tony Blair, Britain's Prime Minister, proposes to "retain the values of the European social model but change their application radically for the modern world." (Financial Times, London, 1/31/2000). Worries about the political direction of governments in Germany, France, and Italy and about the ever-lurking danger of possible government intervention tend to scare investors off and keep the euro weak. A strong euro presupposes strong economic activity and investor confidence that the political climate for business will be favorable.

Germany is by far the largest economy in the euro area. If we were to judge the euro by German economic expectations, the euro could hardly be strong. Ever since 1970 the German government has managed to reduce the percentage of investments of gross domestic product and thus German production potentials. In order to achieve the highest standard of social welfare the government relentlessly raised business costs and priced much production out of international competition. Both domestic and foreign investment have fallen sharply, especially since the reunification in 1991. Business capital tends to avoid a country where the costs of labor and government cast doubt on the returns to capital. In Germany the hourly costs of labor, more than one- half of which are mandated fringe costs, are by far the highest in the world, even higher than in Japan and the United States. As in ages past, industry-wide labor unions practice ugly confrontation without any consideration for the unemployment they create. Guided by old-time doctrines of labor exploitation and class warfare, they stultify whole industries and thereby signal to the world that the trend toward labor-saving production and high unemployment will continue. Under such conditions foreign and domestic investment capital is fleeing Germany, and mobile real capital is moving to foreign countries, especially Poland and the Czech Republic.

The new Red-Green government coalition led by Chancellor Gerhard Schröder made a few stabs at economic reform most of which were soon abandoned. An "Alliance for Jobs," a national association of labor unions, government officials, and employers, was to promote employment through training programs for young people and earlier retirement of older people. Then followed an "austerity package," a list of across-the-board cuts in government expenditures, which caused a general uproar and divided and paralyzed the governing coalition. It gave new strength and support to the die-hard socialist opposition within the Red-Green coalition itself.

For many decades Germany played a leading role in European political and economic affairs. The sad fate of the euro clearly indicates that this is no longer the case. The economy is stag- nating and Berlin is playing party politics rather than pointing the way. Surely there are hints of reform for the distant future, but there is no intention to reverse the course. The coalition in power which pursues social justice through redistribution of income and wealth has no appeal to investors, domestic as well as foreign. The political opposition, the Christian Democratic Party of Chancellor Helmut Kohl which led the country into economic stagnation and massive unemployment, is enmeshed in spending scandals; it is unlikely to play a constructive role in the near future. In short, Germany does not bolster and buttress the euro.

The weak euro ignited an export boom also in France, which is instilling in the French new self-confidence after many years of pessimism and self-doubt. A recovering economy with declining unemployment is imparting new optimism and giving new strength to the Socialists, Greens, and Communists who make up the ruling coalition. Unemployment has declined no less than 10 percent since the coalition came to power in June 1997, specifically from 12.6 percent of working population to only 11 percent at the end of 1999. Prime Minister Lionel Jospin confidently predicts that he foresees a full employment economy within a decade.

Much of the coalition's popularity springs from the government's drive to reduce the workweek from 39 hours to 35 without an accompanying cut in pay. This new restriction, which is a key element in the Socialist platform, is said to create some 100,000 new jobs by forcing employers to hire new labor for the four hours lost per worker and to give employees a raise of some 10 percent per hour of work. Companies with more than 20 employees had to comply by January 2000 and the rest must comply by January 2002. Despite such sweeping legislation, the strongest critics of the government are the Greens and Communists who are quick to accuse the Prime Minister of pursuing free-market liberal ideas at the expense of Socialist ideals. If a four-hour reduction of the workweek and a ten-percent raise in wages are viewed as compromises and betrayals of Socialist ideals, it is difficult to fathom what a full realization of Socialist ideals would entail.

With the rate of unemployment at only 11 percent, labor unions in France felt encouraged to call several strikes and demon- strations during 1999 over such issues as benefits and worker safety. A work stoppage by transit employees in June caused traffic jams in Paris and much economic disruption. And while a militant farm union targeted the McDonald fast-food chain for disruption, the government confronted Britain and the European Union about British beef exports. Neither the French government nor French unions meant to inspire confidence in the euro.

Observers of the European scene are bound to notice the great similarity of the French and German political and economic scenes. Both countries welcome a weak euro and its effects, rising exports and declining imports, which promote a feeling of cyclical recovery. Politically, the French people led the way when, in 1997, a majority chose a Socialist, Green, and Communist coalition over the center-right parties that had governed France in the past. In 1998 the German people followed suit by electing a Red-Green coalition. Both the French and German governments are torn and paralyzed by internal ideological conflict; both benefit from the lack of a united opposition. In France, Socialist Prime Minister Lionel Jospin struggles continually with his coalition partners who pose a bigger risk to his administration than external opposition. In Germany, the Schröder administration is split along ideological lines, the Greens between the realists and fundamentalists and the Reds between the modernizers on the one hand and the die-hard socialist ideologues on the other. In short, both governments have their own built-in multifold oppositions which limit their power and capability to impose new restrictions or embark upon structural reforms. Neither inspires much confidence in the future of the euro.

The two major economic issues of Italy, the third-largest member of the currency union, are high taxes and the high cost of social programs causing huge budget deficit. In 1998 a center-left coalition government led by Romano Prodi managed to halve the country's deficit to 2.7 percent of GDP, thereby fulfilling the requirement for joining the single European currency of no more than a 3 percent deficit. It met the conditions by achieving a spectacular turnaround, cutting spending, privatizing public enterprises, and levying a onetime "Euro tax." But such unpopular policies led to the collapse of the Prodi administration as the Communist members of Parliament withdrew their support. They joined a heterogeneous coalition of seven leftist parties under Massimo D'Alema who had spent his entire political career serving the former Communist Party and its successor, the Democratic Party of the Left. D'Alema was to be the first former Communist to head the government of a major Western country.

The Democratic Party of the Left is the mainstay of the D'Alema administration. It opposes a radical overhaul of Italy's costly pension system, but seeks to abolish abuses. Radical reform is said to amount to a betrayal of the working classes and placation of globalized capitalism. Italians can retire at age 53, provided they have made insurance contributions for 35 years. The Party program also envisions a reduction of the workweek from 40 hours to 35 hours by the year 2001. Such a shortening is to lead to an instant reduction in the double-rate of unemployment. Indeed, D'Alema insists that it may add a million new jobs to the economy.

The coalition government lacks a clear parliamentary majority and, therefore, depends for survival on deputies of other far-left parties who may bring it down for any reason. Yet, in 1999, it did succeed in getting Parliament to approve a four-year program designed to cut the budget deficit by $8.2 billion. Spending cuts are to be followed by an income tax reduction for low-income Italians from 27 percent to 26 percent.


European politicians and ECB officials may wax eloquent about the potential strength of the euro. They may try to talk the euro up, or even intervene in the money markets. They may hold out the hope that European economic expansion will continue and inflationary fears will recede. They may even hint that the shining star of the U.S. is bound to fade soon, making Europe a more attractive investment area. Yet a cursory look at the three large countries of the euro area today is not very encouraging. And although we may not be able to foresee the intellectual power or vigor that may bring early improvements, we must always be mindful that an old social and economic order changes continually, yielding place to new. Time brings change for better or worse.


http://www.statistic-bund.de/home.htm;
http://www.insee.fr/vf/products/pub/ecostat/index.htm;
http://www.istat.it.

Hans F. Sennholz
www.sennholz.com

For comments, suggestions, or replies to the author, please e-mail