By Laura D'Andrea Tyson
Should Britain, already a member of the European Union, join the euro zone, too? Britain's Chancellor of the Exchequer is about to issue what will be a highly controversial report indicating that the answer is "no -- not at this time." His verdict will be based on extensive economic analysis concluding that under current conditions, a decision to adopt the euro will not promote Britain's macroeconomic stability and growth. His report is sure to disappoint both British multinationals, whose European transactions would be facilitated by a common currency with the Continent, and British politicians, who want Britain to assume a leadership role in a more unified Europe. But with Germany slipping into deflation, France not far behind, and recession overtaking the euro zone economies, the conclusion makes excellent economic sense.
The experience of Germany is a cautionary tale of the pitfalls of joining a common currency regime that precludes exchange-rate adjustments and constrains monetary and fiscal policy choices. The German economy is in serious trouble, with a growth rate of less than 1%, an unemployment rate of over 10%, an economy that chronically underperforms its potential, and the highest manufacturing costs in the world. In the past, when Germany controlled its own monetary and fiscal policy, it could have responded to such conditions by lowering interest rates, reducing taxes, and increasing government spending to stimulate demand. Lower interest rates combined with weak domestic demand in Germany would have caused the mark to fall, reducing the world prices of German products and increasing exports. But thanks to the euro, such countercyclical exchange-rate and policy adjustments are impossible.
The European Central Bank's misguided adherence to an average inflation target of less than 2% for the entire euro zone creates excessively tight monetary conditions in Germany. The ECB claims that this target provides a sufficient safety margin to guard against the risks of deflation. But that's not true for Germany, whose core inflation rate is only 0.5%, perilously close to deflation, and headed downward.
The EU's Stability & Growth Pact, designed to limit budget deficits and curb inflation, constrains Germany's ability to use countercyclical fiscal policy to stimulate domestic demand. Indeed, by the pact's flawed logic, Germany should be increasing taxes or cutting spending because it has breached the 3% cap on deficits as a share of gross domestic product. This is the reverse of what should be happening. The European Commission is even threatening to impose steep fines on Germany if it violates the cap for the third year in a row.
Since January, 2002, the euro has appreciated by 16% on a trade-weighted basis. A euro appreciation of this size is estimated to have the same impact on growth and inflation as an increase of three percentage points in nominal interest rates. Most analysts expect the euro to rise further throughout 2003.
Deflation in Germany, once the economic powerhouse of Europe, is a frightening prospect for both Europe and the global economy. There is now a real danger that Germany, Japan, and perhaps the U.S. will slip into deflation by the end of this year. Deflation increases the real burden of debt, and total private sector debt in Europe -- as in the U.S. -- is much larger as a share of GDP now than it was in the 1930s, when deflation last haunted the world economy. More important, since nominal interest rates cannot fall below zero, deflation renders traditional monetary policy useless and yields positive real interest rates that thwart growth.
Once deflation takes hold, it's difficult to reverse. Success is uncertain and depends on "unconventional" macroeconomic policies, including the central bank's purchasing government debt and printing money to finance tax cuts or higher government spending. In either case, a high degree of cooperation between monetary and fiscal authorities is essential.
As Japan's recent experience demonstrates, this kind of cooperation is hard to achieve even in one nation with one independent central bank and one government. It's almost impossible to imagine in the euro zone. Even if the ECB finally recognizes the imperative to fight deflation rather than to curb inflation, how would it coordinate with 12 governments representing 12 economies with different growth rates and deflation risks, different debt and deficit situations, and different priorities? In particular, how would the ECB apportion its purchases of government debt or its monetization of government deficits among the euro member countries?
Motivated by a bold political vision of a unified Europe and confident of its enduring economic strengths, Germany unwittingly designed a common currency system that is now undermining its economic performance. Britain does not have to make the same mistake. The political logic for joining the euro zone may be compelling, but the economic evidence argues for caution and delay.
Laura D'Andrea Tyson is dean of London Business School.