WHY NON-EUROPEANS SHOULD CARE ABOUT EMU.

If you live in Europe, economic and monetary union is an impossible sub­ject to avoid. Debates about its timing, membership and prospects make head­lines almost daily. Yet outside Europe EMU is scarcely mentioned. That is a pity. For EMU, if and when it goes ahead, will have global economic implications.

The creation of the euro will be the biggest change in the world’s monetary arrangements since the Bretton Woods system of fixed exchange rates broke down in the early 1970s. How EMU will affect the rest of the world depends largely on two related questions. First, will the euro challenge the American dol­lar as the world’s main reserve currency? And second, is EMU likely to make the global monetary system more or less stable?

Most economists and policymakers agree that the euro, if backed by a credible monetary policy, will eventually play a more important global role than its con­stituent European currencies do today. Central banks will want to hold some of their reserves in euros, and financial mar­kets will conduct more transactions in the new currency. Both changes will occur mainly at the expense of the dollar. But pundits disagree about how fast they will happen, and whether the euro will ever topple the dollar.

Fred Bergsten, director of the Institute for International Economics, a Washing­ton think-tank, says that at a minimum the euro will quickly become the world’s second key currency. The reason, he says, is that the principal influences on a cur­rency’s potential as an international cur­rency are the relative size of the underly­ing economy and that economy’s share of global trade. On both counts, EMU’s likely members score well.

The European Union ac­counts for just over 30% of world output, slightly more than America’s 27%. Even when intra-European trade flows are excluded, the EU exports more than the United States. The “core” European countries that are most likely to join EMU at the outset ac­count for a slightly bigger share of global trade than America. All this suggests that the euro should become an important international currency.

However, other arguments point strongly in the dollar’s favour. Part of the dollar’s international attraction is the size, depth and liquidity of America’s cap­ital markets. America’s market for domes­tic securities, for instance, is twice as large as the combined markets of EU countries. Even with rapidly increasing European financial integration, America’s suprem­acy in capital markets is unlikely to be challenged. The dollar is also the incum­bent: investors’ inertia  may slow change.

Even so, economists expect that be­tween зо% and 40% of global financial as­sets will end up denominated in euros (with between 40% and 50% in dollars, and the rest in yen and a few other curren­cies). This would imply a shift of between $500 billion and $1 trillion into euros, primarily out of dollars, as investors and central banks reshuffled their portfolios.

How much currency instability such a portfolio shift may cause depends on how quickly it takes place.A sudden surge in demand for the euro would cause it to appreciate rapidly. George Alogoskoufis, an economist at the Athens School of Eco­nomics, and Richard Portes, of the Lon­don Business School, argue that shifts in portfolios could push the euro temporar­ily above its long-run equilibrium level. Eventually this “overshooting” would be corrected as the EU’s current-account defi­cit widened, real interest rates fell and the euro depreciated.

Policy decisions within Europe could make the euro more volatile still. Mr Bergsten believes that EMU governments, having given up monetary policy, might pursue an expansionary fiscal policy - in spite of their “stability pact”, which is in­tended to prevent such laxity. Meanwhile the European Central Bank will be deter­mined to establish its credibility with a tight monetary policy. The combination of the two, he argues, could mirror the im­pact of Reaganomics on the dollar in the early 1980s. The euro would soar. Its global role would increase as assets were shifted into euros, but global exchange-rate volatility would rise.

It is true that other factors may dampen the effect of the shift into euros. For instance, much of the demand for euros would come from central banks ad­justing their reserves. To avoid exchange-rate instability, central bankers might do this gradually. Nonetheless, some tempo­rary rise in volatility is probable.

Monetary union might even make currencies more volatile permanently. Because trade among EMU members will be transacted in a common currency, and “international” trade will be smaller, Eu­ropean policymakers might pay less at­tention to exchange rates than they now do. More instability might result.

One popular idea for minimising such instability is a more formal system of currency co-operation between the world’s major economies. The problem, however, is that policymakers may not want to make their domestic monetary policies subject to formal exchange-rate targets for the sake of global currency-market stability. For instance, having tied their national currencies together for all time, Europeans may not want to fix the euro against the dollar and the yen.

An additional concern within Europe will be the uncertainty of who should co­operate. At its start, EMU will not include all EU members. The relationship be­tween the “ins” and “outs” will affect the potential for broader co-ordination, as well as currency stability within Europe.

Moreover, the technicalities of policy co-operation will not be simple. The Eu­ropean Central Bank will control monetary policy; EMU’s finance ministers will have a say on exchange-rate policy; and fiscal policy will (within limits) stay in the hands of individual Euro­pean governments. Policy co­ordination, at least initially, will be far from straightfor­ward. That alone may make the international monetary system less stable.

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