1. Unit Four United We Stand?—S. Eric Wang TEXT IN DECEMBER 1991, 12 EUROPEAN nations signed the historic Maastricht Treaty and, in so doing, created the single currency trading region now known as the European Monetary Union (EMU). The Maastricht Treaty outlines the process by which the EMU nations will replace their individual currencies with a single currency, the euro, that will be controlled by a single European central bank.

2. Unit Four United We Stand?—S. Eric Wang While current problems center on controlling government deficits to meet Maastricht conditions, the exchange rate crises of the recent past call into question the basic desirability of the project. The current delays in monetary unification are necessary; more caution would be in the best interest of the people of Europe.

3. Unit Four United We Stand?—S. Eric Wang Why Monetary Union In order to properly evaluate the dilemmas facing the EMU, the current system must be carefully analyzed with particular attention to its economic costs and benefits. Currency fluctuations occur for a number of reasons, the most important being that nations often expand or reduce the amount of currency in circulation.

4. Unit Four United We Stand?—S. Eric Wang The benefits of EMU come from eliminating the economic costs associated with having multiple currencies. The most apparent cost of different currencies involves the resources that must be spent converting from one currency to another. A second cost of numerous currencies comes about when nations allow the relative values of their currencies to fluctuate freely. The uncertainty created by varying exchange rates creates a barrier to trade because the value of the money that people will receive changes when exchange rates change.

5. Unit Four United We Stand?—S. Eric Wang However, under the system in place before the beginning of the present monetary unification process, this cost was also quite small.

6. Unit Four United We Stand?—S. Eric Wang With small exchange rate fluctuations and only occasional exchange rate realignments, firms were able to use futures and swaps, among other financial instruments, to hedge against the risk. This system, however, also created an economic cost because regulations on capital flow made capital markets inefficient. However, removal of regulations would have resulted in intolerably volatile exchange rates. The best solution to this dilemma appeared to be the adoption of a single European currency.

7. Unit Four United We Stand?—S. Eric Wang Maastricht and Modifications The Maastricht Treaty, in detailing the path towards monetary unification, included an important exchange rate condition which takes advantage of the European Exchange Rate Mechanism (ERM). However, a number of crises soon forced the ERM to change.

8. Unit Four United We Stand?—S. Eric Wang These crises raise questions as to how a monetarily integrated Europe would function. Clearly, nations currently rely tremendously on monetary flexibility to reign in inflation and to boost sagging economies.

9. Unit Four United We Stand?—S. Eric Wang Unification and the United States With limited fiscal freedom, the lack of national monetary policy will create enormous dissent and controversy within the Union at times of asymmetric recession.

10. Unit Four United We Stand?—S. Eric Wang The economic consequences of such a situation have already been demonstrated in the crises of 1992 and 1993. The political ramifications of such a situation after unification are clearly disturbing.

11. Unit Four United We Stand?—S. Eric Wang To add to the potential for trouble, Europe may see an increase in economic specialization along geographic and political boundaries, a phenomenon that would make Europe even more at risk for asymmetric recessions.

12. Unit Four United We Stand?—S. Eric Wang Similar specialization can occur in Europe as well. To prevent such harmful specialization, European nations may choose to erect artificial barriers through tariffs and regulations. However, such a move would be in direct contradiction to the goals of monetary unification.

13. Unit Four United We Stand?—S. Eric Wang The full effects of an asymmetric recession on a specialized Europe would be quite complicated. A rough estimate of the economic ramifications can be done, though, using the United States economy as an example.

14. Unit Four United We Stand?—S. Eric Wang According to economist Paul Krugman, US regions in recession tend to lose labor population; wages tend not to fall and few new industries are attracted to the depressed area. This means that a post-recession region in the United States may have lower total output than it did before it went into recession, even though the unemployment rate of the region may be back at the natural rate.

15. Unit Four United We Stand?—S. Eric Wang For Europe, this implies that once a nation goes into a recession, it should refrain from deficit spending because its GDP may stay low even after its unemployment rate is back to its natural level. However, the population loss problem is mitigated by the fact that European labor mobility is much lower than US labor mobility.

16. Unit Four United We Stand?—S. Eric Wang There is another crucial difference between the United States single currency area and the EMU.

17. Unit Four United We Stand?—S. Eric Wang The Need for Caution The experience of large, monetarily unified economies, such as that of the United States, and the obstacles that have intervened in Europe’s monetary unification process to date present a strong argument for caution.

18. Unit Four United We Stand?—S. Eric Wang This does not mean that Europe should not eventually have a single currency. It is merely an indication that the process towards unification, and indeed the characteristics of the unified Europe, need to be revised. The solutions to Europe’s dilemmas just need time to be found. Without these solutions, though, the current move towards unification appears to be unnecessarily rushed and could potentially harm the European economy and people. (from Harvard International Review, Winter 1996/1997)