Opinion pieces and speeches by EPI staff and associates.

THIS SPEECH WAS ORIGINALLY DELIVERED AT A MEETING OF THE INTERNATIONAL METALWORKERS FEDERATION MEETING IN HELSINKI, FINLAND ON JUNE 24, 1999.  

The Euro, the Dollar, and Their Impact on Global Manufacturing

by Jeff Faux

The introduction of the euro is the most important event for the global financial markets since the United States abandoned the gold backing for the dollar in 1971.

Although it is a major topic in the European media, the drop in the value of the euro against the dollar since its introduction is not necessarily an indication of its future course. Much of its recent behavior has been driven by market speculators testing the new currency and by continued faster economic growth in the United States as compared with Europe.

Ultimately, the fate of the euro will mirror the fate of the European economy. Based on the economic fundamentals, the euro certainly has the potential to become a second reserve currency for the world’s financial system. Together, the eleven economies of the EMU are almost as large as the United States. If and when all the nations of the European Union join, it will be larger. In some key indicators of international strength, the euro nations already are stronger. Collectively, they now enjoy a trade and current account surplus and are net creditors to the rest of the world.

Imagine that the dollar and the euro are two banks, and you are deciding in which bank to put the savings for your children. One bank (euro) is making a profit (has a surplus with the rest of the economic world) and is a net creditor — more money is owed to it than it owes. The other bank (dollar) has been running a loss for 20 years, owes a net of $1.5 trillion to the rest of the world. Where would you put your children’s savings?

Still, it will take quite a while for the euro to become widely used as a reserve currency. People accept dollars for the same reason they accept gold — because they believe that other people will always accept them. There are several reasons for this belief:

• The size of the U.S. market and its ability to grow larger, which gives people confidence that they will always be able to buy with dollars valuable things that America produces.
• Faith, based on U.S. political stability and on the relative transparency of American political and financial institutions, that there will always be a U.S. government willing and able to redeem its dollar-denominated securities.
• A large enough supply of dollars in the world so that one can always buy and sell them. In part, there are so many dollars available because the United States has been running trade deficits for so long.

For the single currency euro to come anywhere near matching the dollar as a reserve currency, the world will have to be convinced of the durability and success of the single economy upon which it is based.

One key question, therefore, is whether the euro will encourage faster European growth or will reinforce the austere macroeconomic policies that have resulted in high levels of unemployment. The answer, in turn, depends on whether the European Central Bank (ECB) can absorb the lesson of the recent American experience, which is that non-inflationary full employment can be achieved through sustained low interest rates.

This is not just an issue for Europeans. If Europe cannot grow faster, the global economy may not be able to avoid another crisis – this one caused by the inevitable drop in the value of the dollar.

Being able to print 80 percent of the world’s hard currency reserves is an advantage. Because of it, the United States has had the unique capacity to run chronic trade deficits and still maintain a strong currency. U.S. consumers benefit. As do U.S. tourists, U.S. investors in overseas markets, and the U.S. military that can maintain foreign bases more cheaply. The costs go to U.S. workers engaged in tradable goods industries – primarily manufacturing.

In the aftermath of the world financial crisis, with depressed nations forced to export their way out of their slump, the burden has grown. Roughly, one half of all of the growth in the world economy last year was represented by the increase in exports to the United States. The direct impact of the Asia crisis has cost so far 410,000 U.S. jobs in steel, auto, aircraft, machinery, electronics and other manufacturing industries.

But, while the U.S. dollar has special advantages, it cannot operate outside economic laws forever. The dollar can maintain its value, and the U.S. economy can grow at a healthy rate and run large trade deficits for only so long. There are few things that economists can be certain about, but one of them is that the dollar must decline relative to the other major currencies of the world or America will face an economic slowdown. America’s chronic trade deficits and its rising debt guarantee it.

What we do not know is when the drop will occur. Many economists predicted that the U.S. stock market bubble would burst and the dollar would drop by now. It has not yet happened because of the willingness of U.S. consumers to borrow and spend in excess of their income, and the willingness of foreigners to finance them. Simple arithmetic tells us that this cannot go on forever. At some point, consumers will exhaust their ability to expand their borrowing. When that happens, the dollar will drop, the cost of U.S. exports will fall, and the American trade imbalance will reverse.

The second key question, therefore, is when the U.S. dollar falls, will it have a “hard” landing and depress the world economy or a “soft” one, in which Europe and others compensate by raising their own growth rates?

We do not know the answer. But we do know that among the most important factors determining the impact of the euro on the global economy over the next few years are whether the euro helps or impedes growth in Europe, and how soon and how fast the dollar declines.

On the basis of these two critical factors, let us look at two different economic scenarios, or stories, about the future paths the euro and the dollar might take.

We will start with the story with the unhappy ending.

On the euro side, the European Central Bank keeps interest rates higher than justified by unemployment in order to maintain credibility and investor “confidence” in the euro. Maastricht budget constraints also keep growth low. The ECB remains secretive so investors do not understand how it works and are, therefore, suspicious about the stability of the euro. Disagreements create dissension within the ECB. The UK does not join.

As a result:

• Unemployment continues to be high in Europe,
• The Euro stagnates at par with U.S. dollar, or below,
• The European trade surplus with United States grows,
• European investment in United States is strong as European firms move to take advantage of growing U.S. market,
• Social welfare erodes as slow growth reduces revenues and governments attempt to stimulate private sector growth by further reducing the public sector.

European manufacturin
g workers gain from the continued trade surplus, but lose from the general downward pressure on European wages and benefits as European governments attempt to fight slow growth with structural readjustment. They also lose from the increasing willingness of European companies to invest in the United States. Unions are forced to make more concessions.

On the dollar side, U.S. growth continues for a while. But debt service becomes more of a burden — especially for American consumers.

At some point, U.S. consumers reduce their borrowing and spending. This may happen because debt burdens become too high and/or interest rates rise – in response to real or imagined inflation. Retail sales drop in the United States. Production follows downward and the unemployment rate increases. Foreign investors who have been heavily investing the American stock market fear that a slowdown will depreciate the dollar. They sell off U.S. stocks, forcing the value of U.S. dollar to fall. The Federal Reserve reacts by raising interest rates.

The drop in the dollar against the euro hurts the European trade balance. And because of years of slow growth, European firms are not in a good position to grow on the basis of domestic sales. Unemployment rises and pressure builds for European workers to accept lower wages to stay competitive.

Without any major consumer market in the world able to take up the slack of shrinking U.S. imports, the rest of world also goes into an economic slump. Canada and Mexico begin to have rising trade deficits with the United States and industrial employment falls in both countries. Both currencies fall with the dollar. Inflation and higher interest rates follow. Real manufacturing wages decline.

Moreover, the markets “overshoot” – the herd instinct of investors drives down the Canadian dollar and the peso more than is justified by the economic fundamentals. Mexico is especially vulnerable, because its debt is so high and its economy now depends on continuous refinancing. This could lead to a flight of capital and another financial crisis, which the new IMF line of credit cannot overcome. But unlike 1994, the United States, with its own problems might not be willing to help with more loans and may, because of a rising domestic unemployment rate, react negatively to a further acceleration of imports from Mexico.

Support grows in Mexico and Canada to dollarize their economies. Promoters of dollarization have argued that the United States is their biggest market and accepting the dollar would eliminate uncertainties about currency movements. In addition, they now argue that dollarization would protect them from the “overshooting” market. Opponents reply that they lose what is left of national control over their economies and that monetary policy will be run for the benefit of the United States. This could lead to some major political conflict in both nations.

China and other emerging markets in Asia dependent upon exports to the United States for hard currency also find their trade balances deteriorating. Japan reacts by trying to keep the yen low against the dollar in order to regain falling exports. Efforts to reorganize the Japanese banking system stall, because slower growth makes it harder to absorb the short term unemployment that will accompany such reorganization.

Countries with less trade with the United States — e.g. Argentina, Brazil, African countries — are less immediately affected. But lower growth and higher interest rates demanded by International Monetary Fund and U.S. Treasury advisors are counterproductive, and generally undercut investor confidence all around the world. Central banks finally move to lower interest rates, but it is too late. The absence of a new source of demand and investor confidence to offset the drop in the dollar and shrinking American the growth throws world into general depression.

Now let’s turn to the “soft-landing” scenario with a happier ending.

On the euro side, the European Central Bank learns the lesson of the U.S. recovery and lowers interest rates to the point where growth accelerates. This signals investors and consumers that European governments and the Central Bank intend to produce faster growth. Maastricht rules are bent to allow budget deficits to grow in countries of particularly high unemployment.

Consumer spending rises and inflation is held in check – reproducing the recent American experience. Confidence grows. Economic growth forecasts are adjusted upward. Manufacturing employment expands. Imports grow along with the general economy. The euro begins to rise against the dollar as investment moves back to Europe.

European and U.S. authorities cooperate to manage the gradual decline of the U.S. dollar. They intervene in the markets when the two currencies diverge beyond an agreed-upon range. The range is announced publicly.

On the dollar side, the U.S. trade deficit improves slowly as dollar declines. The stock market also drops slowly as foreign investment in U.S. equity portfolios shrinks. But stocks in U.S. manufacturing companies strengthen in expectation of increasing exports. U.S. interest rates fall slowly, following European rates.

The slow decline of U.S. dollar and lower interest rates give Mexico some breathing room. The peso and the Canadian dollar fall against the euro, but do not overshoot the dollar. Both Canadian and Mexican exports slowly diversify to other markets.

Japan makes a determined effort to jump-start its economy with a combination of expansionary policies and a determination to restructure its banking system. Sustained government spending takes hold. Consumer spending rises on regained confidence in the future. Confidence spreads to China.

International financial institutions stop demanding domestic austerity, and economies in the rest of Asia and Latin America – such as Argentina and Brazil – expand.

This demonstration that the euro nations and the United States are able to agree on policies that promote growth, gradually raises long-term confidence in the euro and becomes the basis for its wider acceptance as a reserve currency.

Two final questions. First, would a strong euro undercut the U.S. Treasury’s influence in global finance? The answer is yes. But the U.S. Treasury has usually reflected the interests of U.S. investors, not U.S. workers. The typical American manufacturing worker would gain from an expanded role for the euro. And over the long run, manufacturing workers everywhere would benefit if a gradual sharing of the responsibility for being the world’s reserve currency avoids a major financial crisis.

The second question is whether the development of a strong euro would encourage the division of the world into warring “currency” blocs – the euro in Europe and Africa, a dollar bloc in the Western Hemisphere and eventually a similar single currency bloc in Asia.

This is a possibility. But such a scenario will not be the result of a single European currency. It will be the result of near-sighted policies. If European authorities do not encourage a strong and sustainable internal growth within Europe, if the U.S. policy makers see the euro as a rival to their current hegemonic influence, rather than as a potential partner in the task of maintaining global stability, and if both do not work together to produce a “soft landing” for the dollar, then stagnant growth will aggravate the competition for foreign markets and increase tensions between them.

As these scenarios suggest, the stakes for workers in manufacturing industries are very high. In a global economy, workers in your industries will pay a high price for slow global growth. But they will also be among the greatest beneficiaries of a world in which the euro can be an instrument of faster growth, higher wages, and rising living standards for all.

[ POSTED TO VIEWPOINTS ON AUGUST 12 ]

Jeff Faux is the president of the Economic Policy Institute. He is the author of The Party’s Not Over.