The Euro, Part 1

When I consider the Euro as a currency, I still think of it as a brand new institution. I still remember the rough conversion from French Francs to US Dollars, as well as the Italian Lira conversion to US Dollars. In fact, the transition to the Euro as a currency began in 1993, with the ratification of the Treaty on European Monetary Union - almost 13 years ago.

Since then, several important events have taken place in the evolution of the Euro. On January 1, 1998, the name "Euro" was officially adopted. On the same day in 1999, exchange rates for the various involved currencies were irrevocably set - that is, 6.55 French Francs forever equal one Euro. From 1999 to 2002, corporations and businesses were allowed to (and later required to) conduct business in both currencies. Finally, in 2002, the switch to paper currency was made, and the population of the 11 member nations was required to begin using the Euro for all transactions. Remnants of the old currencies remained for a few months to help people adjust to the new system, but now have largely disappeared.

The European System of Central Banks closely mirrors the system in the United States. Just as the Fed uses two tools to conduct monetary policy (adjustment of the discount rate, and conduction of open market operations), so too is the European Central Bank responsible for monetary policy. In addition to this responsibility, the ECB must conduct foreign exchange operations and monitor the efficacy of payment systems across all Euro-using countries. Just as there are several regional central banks in the US, each country (of which there are currently 12) has their own central bank that is responsible for monitoring economic activity in that country. These banks also have a similar role to the regional banks in the US - they monitor the activities of foreign banks as well as private banks in that country.

I am somewhat capable in French, so I often choose to look at information about France when it is available. The site for the French Central Bank is here. The current news article is a letter from the current Governor of the French Central Bank, Christian Noyer, to the president of France, Jacques Chirac. In it, he discusses recent trends in France's economy - it is, in fact, an extremely interesting read. It contains information about everything one could possibly hope to know about the current developments. One thing that becomes obvious when reading this is that the French (or at least Noyer) is extremely aware of the US budget deficit (more accurately, the current account deficit). In this document, it is listed as 666 billion dollars in 2004. This means that the United States borrows almost 2 billion dollars A DAY to keep the economy afloat. The US is now nearly $8 billion in debt - each US citizen's share of this is roughly $27,000.

Let us compare this to the budget deficits of the European Monetary Union countries to determine relative economic strength (or at least stability). Consider these requirements:

"The Maastricht treaty sets four economic criteria for membership in the monetary union. A country's rate of inflation must be no more than 1.5 per cent above "that of, at most, the three best performing Member States," usually interpreted as the average of the three lowest-inflation countries. Long-term interest rates must be held at no more than 2 per cent above the average of the long-term interest rates of the three countries with the lowest inflation. Member states must not be found by the Council of Ministers to be running an "excessive" budget deficit, which could be triggered by deficits above 3 per cent of gross domestic product (GDP) and ratios of debt-to-GDP above 60 per cent. Finally, a government must keep its currency within the "normal" bands of the EMS and not devalue it during the two years prior to entry."

So now I pose the question - would the US qualify to join the EMU?

1. Eurostat, the entity in charge of monitoring economic data in the Eurozone, indicates that the annualized inflation rate for May 2005 was 1.9% for the Euro. For Q2 of 2005, the estimated annualized inflation rate in the US has been between 3.2% and 3.5%. In this case, then, the United States seems to be very close to an unacceptable level of inflation.

The US must be within 1.5 percentage points of the average of the best three performers. If the current average for all 12 EU countries is 1.9%, then the three best performers probably have an average inflation somewhat lower than this - perhaps 1.6% or even lower. Thus, the United States has current inflation that is too high. On this point, we could not possibly join the EMU.

2. On the point of interest rates, it is my understanding that the European Central Bank now sets interest rates for all 12 member countires. This article backs up that understanding. The current interest rate set by the ECU is 4.75%. In the US, the current yield on 30-year bonds is 4.34%. So it seems like the US and the EU are basically on the same track here, and we'd probably fit in.

3. The current US GDP was $11.75 trillion in 2004. The deficit in 2004 was $666 billion. That means that the deficit was 5.67% of US GDP last year. That's too high according to the requirement - we would only be allowed to run deficits of 3% or less.

I'm not entirely sure what it means to have a debt-to-GDP ratio of greater than 60%. This math isn't entirely clear to me. However, I will try. Our current debt is about $8 trillion. Again, last year's GDP was about $11.75 trillion. That means that the debt-to-GDP ratio in the US is 68% - again, too high for membership in the EMU.

As a separate investigation, how does the growth rate of the US GDP compare to the growth rate of the EU GDP?

The CIA factbook indicates that the real growth rate for the US in 2004 was about 4.4%. Eurostat reports that the 2004 EU GDP growth rate was 2.4%. That's only two percentage points, but anyone familiar with growth equations can tell you that over a period of just a few years, a small difference in growth can add up quickly to a big difference.

So the US has higher inflation and runs a greater deficit than the EU, but we demonstrate a higher growth rate. Can this rate of growth be sustained?

The IMF says no. They write, "The U.S. current account deficit and its counterparts elsewhere in the world are widely viewed as unsustainable. A gradual adjustment of the U.S. external position and exchange rate remains the most likely scenario, especially if it involves stronger growth in the rest of the world. The challenge is to support the adjustment by stronger U.S. national saving to avoid the burden falling on investment and growth, both in the United States and abroad. Moreover, there will be limits to the global demand for U.S. assets, and there is a risk that an abrupt and disorderly shift in investor preferences could have a significant adverse effect on interest rates and global capital markets."

I am very interested to discover how the relationship between the Euro and the dollar will develop over time. Currently, a Euro is worth 1.21 US dollars. If one looks at the graphs available here, one sees that the EU gained an enormous amount of value against the dollar as soon as it was brought into play - nearly doubling in value from its lowest point (.84 to 1.35). However, since last year around September, the Euro has been losing value against the dollar. I would like to investigate next why this has taken place and what market forces are in effect that impact the swing of the Euro's value against the dollar.