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By John Rekenthaler | 06-22-2012 01:00 PM

If Not the Euro, Then What?

A euro, even with its problems, is still better than the alternatives, says Thurnau Professor of Economics Jim Adams.

John Rekenthaler: I'm John Rekenthaler for Morningstar.

I'm here with Jim Adams, Thurnau Professor of Economics at the University of Michigan. And Professor Adams just recently finished the keynote presentation on "Fragility of the Euro" on a Friday session. And it's quite entertaining. Thank you very much.

William James Adams: And it is my pleasure.

Rekenthaler: One would generally not think of discussion of the euro as being entertaining, but you made it so.

I think our viewers are fairly familiar now with the reasons why the euro should break up or why the euro is a problem. We run into that a lot in the American media, in particular of the notion that fiscal transfers can happen in the state. So, in the U.S., if one state is in trouble, monies effectively flow through the Federal government to another state. And that doesn't happen in Europe.

But what's the positive case for the existence of the euro? You gave that to our audience, and I'd like to share that here.

Adams: Well, I think the place to begin an answer to your question is to ask the question, what's the alternative? If we were to have the euro break up, we would need to replace it with some kind of relationship that links one country to another in currency terms. So, what would that be?

So, there are two other options that we might think of. One possibility would be that we just have freely floating exchange rates. The difficulty with freely floating exchange rates is that some countries in Europe rely very heavily on other countries for exports and also for imports--far more than the American economy relies on other economies for their consumption or for their production, their sales.

And so, if you think, for example, about the United States, maybe 10% to 15% of what we produce is exported, and 10% to 15% of what we consume is imported. So, if exchange rates vary a little bit, it doesn't have a decisive impact on the American economy.

But if you live in Belgium or the Netherlands, more like 70% of what you produce is sold abroad, and more like 70% of what you consume is produced abroad. So, every time exchange rates change, that creates a lot of problems for them.

Rekenthaler: So, a euro with its problems is still better than a floating system when people are so dependent upon international trade.

Adams: Quite so. So the other possibility is to go to something that would be something like a Bretton-Woods system for Europe, which is similar to what we had in the international monetary system before the mid-1970s. And there you would have fixed exchange rates rather than floating exchange rates, and that solves the problem of this day-to-day, minute-to-minute uncertainty.

But the problem with fixed exchange rates, then, is that if money can move freely from one country to another country, there are no impediments to that, then money is always going to flow to where the interest rate is highest, which means those countries that don't want as high an interest rate as the others that are part of the group will not be able to conduct their own monetary policy.

Rekenthaler: Germany is not signing on for this one, I don’t think.

Adams: Well, Germany likes it because it likes a high interest rate.

Rekenthaler: OK.

Adams: So, in fact, everyone's forced to match the German interest rate.

Rekenthaler: I see. So, they would like it, but the others wouldn’t. The point is, somebody doesn’t like it.

Adams: That’s right. It's those who would prefer a lower interest rate would not. So, in short, neither floating rates nor fixed rates, national currencies solves the problem. So you can't leap from the frying pan into the fire.

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