In 1999, the euro started life at $1.17, its supporters full of high hopes that Europe's economy would be a rival to U.S. dominance. Four years later, the currency wallows below parity with the dollar, reflecting the lack of progress in the European Union's promised economic and market reforms. Without improvement on this front, costly plans for an even bigger Europe could do more harm to the euro -- and the Continent's economy -- than good.
Monetary union was expected to be a catalyst for reforms that would encourage foreign investment in Europe, while creating larger, more liquid markets to absorb the increased demand for euro assets. But the euro's chronic weakness against the dollar has been a result of investment flowing out of Europe and into the U.S. More restrictive and costly labor markets, relatively high inflation, and sluggish growth have turned investors off. Progress on improving European competitiveness is unlikely to speed up when 10 emerging-market economies join EU.
A CONTINUED DRAG. While observers debate the impact of the new East European members, the experience of German reunification, involving the integration of a developed economy with a post-communist one, could be useful in shedding light on the likely costs of enlargement. West Germany was Europe's growth engine, and rejoining with its eastern counterpart made the country the Continent's largest economy.
Although more than a decade has passed since reunification, it continues to be a drag on the German economy, which is currently Europe's weakest. Unemployment remains a very high 20% in eastern Germany. For the country as a whole, it hovers around a stubborn 10%, only briefly dipping below this during the late-'90s economic boom. The jobless rate, along with a lack of demand in the East, has cost the German government dearly: Berlin has transfered about 500 billion euros to the East over the past decade to pay for public services.
MMS International forecasts that the German economy will grow at a tepid 0.2% annual rate in 2002, compared with estimates for 0.8% growth in the euro zone as a whole (and vs. a 3.1% forecast for the "struggling" U.S. economy). Berlin has gone from being the model of fiscal rectitude to one of a growing number of EMU members violating government-spending limits set out in the very Growth & Stability Pact it helped engineer.
BICKERING CLUB. With the German example in mind, it's not surprising that observers turn a wary eye on the EU's plan to add 10 poorer economies to a bickering club of 11. Though the political will exists to move ahead with EU enlargement, the thorny and complex issues of how to pay for it remain unresolved. That's business as usual, since European officials have enough trouble resolving their existing problems, with central bankers and politicians continuously blaming each other for a stagnant economy.
European budgets, like Germany's after reunification, are going to take a hit. Already straining to keep below limits set out in the Growth & Stability Pact, an EMU cornerstone, budgets will be stretched even further by the costs of integrating 10 poorer and less developed economies.
Supporters of expansion point out that this assimilation will be more gradual than Germany's experience. Economic development in the new EU members will have progressed much further than it did in East Germany at the time of reunification. Exchange rates are also much more in line with what are considered equilibrium levels, compared with an overvalued East German currency then. Furthermore, new EU members will be subject to continued monitoring to ensure economic convergence with the rest of Europe before being admitted to the single-currency club.
HOG-TIED BANKERS. True, the 10 new member countries should add some 400 billion euros to overall gross domestic product in the EU, an increase of about 5%. In theory, costs will go down as industrial production moves east to take advantage of cheaper labor, and Europe will become more competitive in the global marketplace. However, this hasn't been the case in Germany. After reunification, wages in the East shot up, and unemployment remains stubbornly high. And while EU expansion will add a modest 5% to GDP, population will jump a hefty 20%.
Meanwhile, European Central Bank officials are seen as slow to react to signs of economic weakness, having to reconcile the views of 11 different central bank governors who make up the policy committee. Some countries with sagging growth are complaining about recoveries choked by the bank's relatively high interest rates, the result of the ECB's restrictive inflation-targeting mandate and cumbersome decision-making process. The question of how the latter will be streamlined to accommodate 10 more countries' views remains unanswered.
Expansion will likely retard other reforms -- which are already lagging -- as well. The ECB has been asking governments to liberalize labor markets and remove barriers to foreign investment -- to scant effect. Finance Ministers, for their part, would prefer to have a central bank with a less restrictive policy mandate.
A WEAKER EURO? With Europea's problems weighing on investors' minds, they haven't changed their preference for America, despite terrorism, Enron and WorldCom going bankrupt amid unparalleled accounting fraud, and fears about the U.S. economy dipping back into recession. This bodes ill for the euro.
The currency has managed to climb above parity this year, but the gains are merely a byproduct of a weaker dollar in general. Expectations of an exodus of investment from the U.S., which have fed speculative selling of dollars, have so far not materialized.
A U.S. recovery that could remain shaky into next year may keep the dollar on the defensive. But once a rebound takes hold, growth is expected to outpace Europe by a sizeable margin once again (MMS predicts 1.4% EMU growth in 2003 vs. more than 3.5% in the U.S.). If these forecasts prove accurate, the euro would sink, possibly even challenging its record low of 82.25 cents over the next couple of years. Europe's slower growth would likely be reinforced by the economic burden of EU enlargement.
With many of the promises of Europe's experiment in monetary union still unfulfilled, Europe's appetite for expansion may prove much bigger than what investors can stomach. Though more gradual than German reunification, EU expansion could be a costly burden. Unless the existing members can put their houses in order, investor confidence in the euro zone could worsen as Europe muddles through enlargement.
By Will Rugg, MMS International's managing currency analyst
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