What The Euro Means

The dramatic debut of the euro comes as something of a shock to many American academics, policymakers, and pundits, who have tended to view Europe's effort to create a single currency skeptically, if not scornfully. Yet the smooth launch, initial strength, and intense investor interest in euro-denominated securities are a clear wake-up call. The euro is changing the financial and economic playing field. Those who underestimate its impact and the potential problems it could pose to the U.S. may find themselves in the company of those who said the euro would never see the light of day.

What does the euro mean for the U.S.? Start with capital markets. BE, or Before the Euro, European companies financed their growth mainly by borrowing from banks, rather than issuing stock or bonds. Thus, its securities markets were small and underdeveloped; the total value of equities equaled about 40% of gross domestic product, vs. 130% for the U.S. But the euro will unify Europe's stock and bond markets and Americanize its financial practices. Enormous sums of portfolio investments will shift out of 11 narrow national markets into a single, euro-denominated one. As it grows, global investors will seek out euro stocks and bonds as a safe haven and good investment for their cash. Liquid capital markets could attract a tidal wave of international money--pulling some of it away from the U.S. Much of America's investment boom in recent years came from foreign financing. Now, there will be greater competition for global capital.

The dollar could trend down for some time. Up to 30% of all world trade will soon be denominated in euros. This could encourage central bankers to put a similar proportion of their reserves in the new currency. To do so, they will have to sell dollars. There's no way around it.

Those who believe that the dollar will continue its total dominance are dreaming. The euro will almost certainly become a reserve currency. It may take 5 or 10 years, but our best guess is 2 or 3. The euro will join the dollar as a numeraire against which other currencies are measured and in which other monies are held. And it is by no means assured that the euro will be junior to the dollar in the long run.

That depends on Washington policy. The U.S. has been running large trade deficits for decades. With Asia in the dumps, America's current account deficit could hit 4% of GDP in 1999. Before the euro, the U.S. could finance this deficit cheaply, because overseas trading partners were willing to hold dollars or dollar-denominated debt. They didn't have much choice.

Now, they do. The U.S. may have to raise interest rates to entice foreign investors to buy Treasury bonds or corporate paper. Long-term rates have already started to rise. A weaker dollar could drive them higher by yearend, surprising the markets.

The good news is that a lower dollar translates into more exports and higher repatriated earnings from abroad. The dollar strengthened from 1995 to 1998, hurting top-line growth. This year, a weaker dollar could add 2% to 3% to earnings growth. The euro will also smooth transnational mergers between European and U.S. companies and improve corporate efficiencies inside Europe. All this is good for corporate performance and economic growth.

The bad news is that the U.S. can no longer play "consumer of last resort" and absorb imports from Asia without limit. The deficits with China and Japan may finally be reaching intolerable levels. Indeed, the dollar increasingly looms as the big financial question mark for 1999. Already weak against the yen, a supereuro that soars by 20% could trigger a dollar crisis. It probably won't happen, but it could. America can no longer take its dollar for granted. The euro has arrived.

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