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If Not the Euro, Then What?

John Rekenthaler

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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Rekenthaler: One thing that you mentioned that was news to a lot of the people in the audience was that the U.S. dollar wasn’t created overnight, or the U.S. dollar wasn't a success overnight. I wonder if you could briefly touch upon the history of the U.S. dollar and how one could say it went through its progress or its evolution as well?

Adams: So people look at the euro today, and they say, you know this currency doesn't satisfy a checklist of criteria that we need in order to have a single currency, and so it might be interesting to look at the American economy when we adopted the dollar and asked, did we satisfy those criteria here? And the short answer is, we probably didn't. We adopted our dollar as we know it more or less today in the context of the Civil War in 1864, but we really did not satisfy the checklist for a single currency until the 1930s.

And we went through a period of substantial economic turbulence that was associated with having a single currency with different economic needs in different parts of country. In fact, the campaign of 1896, when William Jennings Bryan was running for president, included his famous acceptance speech at the Democratic Convention, where he said, "I will not crucify the American worker on a cross of gold," and in many ways that cross of gold is what Greece is bearing today.

Rekenthaler: William Jennings Bryan was ... ahead of his time.

Adams: He only didn't know it.

Rekenthaler: Exactly. So, if the euro is going to survive, which it sounds like it will because there is no other choice, and the Germans would want it to survive as well, compared to the other alternatives. How is it going to fare relative to the dollar? Is it inevitable that the euro is going to become weaker relative to the dollar?

Adams: Well, of course, an exchange rate is the relative strengths of two currencies, and so it depends a little bit on what happens in the United States, and on the health of both the American economy and the health of the American polity.

We are very aware in the United States of some of the economic and some of the political problems that Europe is facing today, but I think we're also very aware of some of the economic problems and political dysfunctions that we face in the United States. So who is going to appear relatively strong as opposed to just absolutely strong is, shall we say, by no means obvious over the longer term. It's going to depend a little bit on who gets his house in order faster.

Rekenthaler: So to summarize, the euro will survive, albeit perhaps with slightly fewer members, or a little different grouping of countries. And it's not so clear that, as the euro has its problems or a couple of countries drop out, that it will necessarily drop down on price relative to the dollar, because we shouldn't just point at Europe, and say, you are the one with problems, and we don't have them--that the U.S. in many ways is an analogous situation economically.

Adams: That sounds sensible to me.

Rekenthaler: All right. Thank you very much, Jim Adams, Thurnau Professor of Economics at the University of Michigan, and thank you for coming to our conference.

Adams: My pleasure.