Originally published in the BOSTON GLOBE

Tuesday, December 9, 1997

Currency union likely to have subtle effects on US

A new Old World

by Martin and Kathleen Feldstein

"The European political union could lead to increased conflicts in Europe and to confrontations with the United States."

The dominant economic subject in Europe these days is the Economic and Monetary Union, which is scheduled to begin in January 1999. What's it all about? And what does it mean for the United States?

EMU is basically an agreement among a dozen European countries to substitute a new single European currency, the euro, for their own national currencies. Instead of German marks, French francs, Italian lira, and the like, all business will be done in euros. Using a single currency instead of 12 separate currencies should make cross-border buying and selling of goods and services and of such assets as stocks and bonds both cheaper and easier.

If that were all that EMU meant, it would be a minor issue for Europe and even less significant for the United States. Although some trade and investment that is now done in dollars might shift to euros, the impact of that on the American economy would be too small to notice.

But the shift to a single currency means much more than just increased convenience in trade and investment. A single currency is likely to lead to higher cyclical unemployment in Europe because it would deny countries the ability to use their own monetary policy and lower interest rates to offset~t temporary declines in demand. Now there can be different interest rates in Spain and Germany as national financial markets and national central banks respond to differences in cyclical conditions. A single currency would mean a single set of interest rates for all of Europe and a single monetary policy made by a new European Central Bank.

Even if unemployment is high in one country while labor markets are tight in another, the European Central Bank must set a single monetary policy and a single basic interest rate for all of Europe. Because monetary policy and interest rates would no longer be tailored to national differences in economic conditions, the average rate of unemployment in Europe will generally be higher. Europeans often note that the United States operates with a single currency even though economic conditions often differ substantially among the major regions of the country. They ask why a single currency wouldn't be as benign in Europe as it appears to be in the United States.

There are three important reasons why the single currency in the United States does not cause the higher unemployment here that economists predict would happen in Europe. First, Americans are much more geographically mobile than Europeans are. When jobs are scarce in Michigan or Massachusetts, Americans move to where the jobs are in Arizona or Florida. In contrast, Europeans are blocked by language and custom from leaving Spain or France to move to the Netherlands or Britain.

Second, American wages are much more flexible than European wages, an important reason why Europe now has unemployment rates that are more than twice that in the United States. An economic downturn in one region of the United States causes wages to decline there relative to wages in other parts of the country, thereby stimulating local employment by making locally produced products more competitive.

And third, our federal system of government means that a $100 million decline of output in Massachusetts brings a net transfer from Washington -- through lower taxes paid and more benefits received -of about $40 million, That acts as a fiscal stimulus that dampens the downturn in the Massachusetts economy. Since European taxes and transfers are matters for national governments, and are expected to stay that way, there are no corresponding cross-border transfers to reduce national fluctuations in unemployment.

The higher European unemployment that will follow EMU will be a problem for the Europeans, but will hardly affect the United States. The same is true for the higher inflation rate that might occur as a European Central Bank replaces the current system, in which the very tough anti-inflationary German central bank sets the standard that other countries in Europe follow.

The potentially important effects on the United States are more subtle and more difficult to predict. The EMU is likely to lead to a more uniform set of European labor market rules based on European social policy norms. Those rules are likely to make Europe less able to compete in global markets and that could prompt the Europeans to construct trade barriers to keep out US products.

Even more serious, the European political union that will follow the establishment of the EMU will change the political character of Europe in ways that could lead to increased conflicts in Europe and to confrontations with the United States. The recent debates in Europe about the future of monetary policy and the conflicts between France and the United States over policy toward Iraq are a small sample of things to come. If EMU goes forward, as now looks increasingly likely, the United States will need to rethink carefully our relations with Western Europe.

Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist., write frequently together on economics.