CAMBRIDGE: For several years Europe has held its breath wondering whether European Monetary Union would actually happen. After traversing a minefield of obstacles, EMU is on the threshold of realization. The question is no longer whether EMU will happen, but what it will mean for Europe. I predict that EMU will be launched with an initial success that will confound its worst critics, but that the success will be followed by years of difficult challenges that will confound EMU’s most optimistic supporters. In short, EMU will happen; it will survive; and it will disappoint those with ardent hopes that monetary union will create a new European economic miracle.

Upon the launch of fixed rates -- which will formally occur in early 1999, but in fact will begin in mid-1998 -- EMU will lead to efficiency gains in financial markets. The social costs of managing exchange rate fluctuations and uncertainty within Europe will fall (but not be entirely eliminated for a few years, since backsliding will still be a possibility). The chances for increased scale and competitiveness of key financial sectors, such as insurance, pension funds, and equity markets, will be real. Cross-border production, trade, and tourism will become less costly, if only slightly in most cases. In short, there is a good chance that the start of EMU will be comfortable and economically successful.

The problems will come after the first phase of euphoria and relief. Most economists concur that Europe is not an “optimal currency area,” in which the various regions in EMU will share the same needs of monetary policy. Some regions will be hit by negative shocks that in other times and places would call for monetary ease or currency depreciation. Other regions within EMU will need monetary tightening or currency appreciation. In fact, all will now be straitjacketed by a one-size-fits-all monetary policy. These misalignments are small today, but they will grow over time.

These so-called “asymmetric shocks” and “asymmetric structural problems” would be manageable if Europe otherwise had a flexible and dynamic economy. It does not. Europe is over-taxed and over-regulated in the labor market. Unemployment remains high because Europe cannot afford the job guarantees, heavy payroll taxation, short work weeks, and high-take-home pay (especially for lower skilled workers) that it aspires to. Moreover, Europe neither has the means nor the political cohesion to make up for shortfalls in one region by massive fiscal transfers from other regions (nor would such large transfers generally be a good idea).

EMU will face a different kind of problem almost not discussed so far. One of the normal roles of a central bank is to be a “lender of last resort” when bank failures threaten to destabilize the banking system and the economy. As depositors flee from a weak bank, they can destroy the bank’s liquidity. A panic can arise, which brings down other banks as well. Thus, central banks wisely stand ready to give credits to weakened banks to prevent panics and bank runs, and to allow an orderly period of closing or merging weak banks. Before EMU, each central bank looked after its own banking system. When Swedish, Finish, Spanish, and French banks faced crises in the past decade, their respective central banks exercised the function of lenders of last resort. To be effective, they had to move fast.

Under EMU, there will be no longer be Spanish or Swedish central banks with the credit-granting authority to be lender of last resort. There is also a good chance that the new European Central Bank (ECB) will be stymied in carrying out that role for the region as a whole. There are sure to be political disagreements within the ECB about saving one country’s banks through emergency EURO credits issued by the ECB. What looks like a political and economic imperative to Spaniards may look like a waste of money to Germans. My guess is that the ECB is not an effective lender of last resort, because it will face too many internal obstacles to quick action. Banking crises may therefore simmer or explode without adequate attention.

This is not merely a hypothetical problem. Europe’s banking sector is already weaker than it looks, since there is an uncompetitive portion of banks that needs to be merged or closed. The competitive pressures on European banks resulting from currency union will almost surely force the issue, by pushing weak banks towards bankruptcy. The combination of a banking sector squeeze with a paralyzed or ineffective lender of last resort is a potentially very dangerous combination.

In the final analysis, I believe that EMU will survive, but not necessarily flourish. The ECB is likely to preside over a weakening EURO currency that brings frustration rather than satisfaction to a significant part of the new “Euroland.” The Bundesbank’s monetary rigor will be just one voice among many in the monetary union; other voices will press for monetary expansion and a weakening currency in midst of continuing frustrations with unemployment, and new frustrations with financial sector crisis. While some observers believe that even closer political union will follow EMU, and thereby solve the economic problems exacerbated by EMU, such hopes are even more hypothetical, and may run counter to powerful forces which now push many of Europe’s regions to demand more, not less, political sovereignty.

Read more