On January 1, 1999, the euro comes into existence. And for the first time since World War II–with far-reaching consequences for American monetary and fiscal policy–countries looking for somewhere to turn with their currency reserves will have a choice beyond the US dollar.
Between early 1994 and April 1995 the dollar’s value plunged from 115 yen to nearly 80 yen. Countries holding dollar reserves–that is, most of the world–were hammered financially, losing a third of their purchasing power. But there wasn’t a stampede to get out, a Mexican- or Asian-style run on the dollar.
Why not? Well, because getting out wasn’t really an option. European currencies were too small-scale to accommodate the influx and outflow of large sums of money (about $5 trillion is held as currency reserves). Such movements would have had too great an effect on the value of European currencies, and in turn would have placed the reserves at risk. The yen wouldn’t have worked, either: No one wants to put their reserves in a country with financial market regulations that allow the government to deprive them of the use of that money when they want it.
Of course, the United States has hardly been an ideal candidate. Those looking for the best place to hold their international reserves are not looking for good investment opportunities. They are looking for the safest place to hold their funds until they need to use them. The United States runs a trade deficit in excess of $200 billion and is a net debtor owing foreigners $1.5 trillion. Europe, by contrast, runs a trade surplus with the rest of the world, and is owed about $1 trillion. Clearly, with advantages of stability and comparable size, the euro will be a more appealing choice. And with that choice comes the possibility of a run on the dollar.
There will soon be less demand for dollar reserves for other reasons, too. European countries and companies may have been buying and selling German marks or French francs, but the reserves held to finance those transactions were in dollars. Now, with ten fewer currency transactions to make, they will require fewer reserves. Countries like Saudi Arabia now hold all their reserves and price all their oil in dollars. But since they engage in significant commerce with Europe, it will make sense for them to shift some of their funds from dollars to euros.
Until now, the dollar’s role as the world’s reserve currency has provided the United States with a special advantage–the ability to run a large trade deficit year after year. It is an axiom of international economics that no country can run such deficits forever. In year one the foreign funds necessary to pay for the first year’s trade deficit must be borrowed. In year two funds to pay for the second year’s trade deficits must be borrowed, and additional funds have to be borrowed to pay the interest on the loans that financed the previous year’s trade deficit. In year three, funds are being borrowed to pay interest on interest–and so on. This is called compound interest, and compound interest always wins. Eventually the amounts that must be borrowed get so big that the rest of the world either will not, or cannot, finance them.
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However, because the United States has been able to borrow in dollars and can print new dollars if the need arises, there are no questions about it being able to repay loans. In financial terms America isn’t really an international borrower, because it does not have debts denominated in other currencies. As a result, the United States has been able to run very large trade deficits for a very long time.
With the introduction of the euro this limitless ability to borrow ends. Soon enough it will become more difficult to obtain loans in dollars, as more countries convert their reserves to euros. And while no one can say exactly what the limits are, a run will occur if the United States’ creditors decide that it is not such a good risk anymore. Unfortunately, this shift is occurring just as the world is expecting the United States to run large trade deficits to prevent the Asian meltdown from causing a global recession.
The euro also means big changes for Alan Greenspan and the Federal Reserve Board. Greenspan has enjoyed a freedom unique among central bankers: Because he has not been compelled to keep interest rates high to hold the value of the currency constant, he has been able to lower them to stimulate the economy when it seems to be slowing down or appears in danger of falling into a credit crunch. We saw this flexibility in action between September and November, when three quick interest rate reductions stabilized American and global financial markets and gave the US economy an upward boost.
But after January, the Federal Reserve Board may need to raise interest rates to prevent a run on the dollar just when it should be lowering them to prevent the economy from slipping into a recession. This is what’s been happening in East Asia. Asian nations have had to raise their interest rates to prevent currency outflows, which makes their recessions worse. Central banks around the world face a Hobson’s choice–watch the currency plunge or watch the economy plunge.
To escape this predicament fiscal policies have to be reinvented. But the United States hasn’t used its fiscal policy instruments–that is, raised or lowered either spending or taxes to slow down or speed up the economy–since President Reagan last did it to boost growth in the early eighties. Reagan called it supply-side economics–a big cut in taxes and a big increase in defense spending without offsetting cuts in domestic spending–but in reality it was simply old-fashioned Keynesian economics in drag. It worked: The economy pulled out of its recession and started expanding.
Since that time all the focus has been on cutting spending and raising taxes to close the budget deficit and get the national debt (the Reagan Administration’s gift to the future) under control. Now that the budget has been balanced, fiscal policies have been taken out of jail.
But for fiscal policies to be effective, they need to be speedy–like those three quick cuts in interest rates in four weeks last fall. The President and Congress cannot afford to dawdle in agreeing on tax cuts or spending increases. Yet to say the least, quick agreements are not their forte. Every tax and every spending program takes months, if not years, to change. As long as this is true, fiscal policies are like a firetruck that is too far away to stop your house from burning down when you call in an alarm.
The solution is to have an emergency package of tax reductions or spending increases (or the reverse) on the shelf, pre-approved by both the President and Congress, so that it can be implemented immediately if the economy seems headed into a deflationary recession or an inflationary boom. This system could easily be established, but at the moment the need for responsive fiscal policies isn’t even being discussed.
The euro, by forcing the United States to occupy a more normal position in the world, where it is constrained by balance-of-payments considerations, will change a central dynamic in the global economy. It means that the United States will lose much of its power to be a locomotive for the rest of the world. At the moment exports are sustaining the East Asian economies and allowing Europe to withstand the deflationary pressures that are flowing from Asia. But those exports can only thrive as long as the United States can freely buy much more than it sells, running up large trade deficits–which is about to end.
While America must reinvigorate fiscal policies to remain prosperous, the world is going to have to build a new economic locomotive for itself. That can only be done with close cross-country coordination of monetary and fiscal policies among Europe, Japan and the United States, a project they have thus far demonstrated no ability to undertake. But the euro signals the end of the post-World War II American era and the onset of a new economic era, which demands new monetary and fiscal policies throughout the world.
