‘Get ready for a shock’

Date: 19/06/1997

IT IS a commonplace to say that Americans are not prepared for what will hit them when the euro comes, but US economics guru Fred Bergsten goes further.

“Both sides are going to get a shock,” says the director of the Washington-based Institute for International Economics. “Americans are going to be shocked by the impact and Europeans are going to get a shock if I am right and the euro appreciates substantially. Even though they go on about wanting a hard currency, they do not want anything like the degree of appreciation that I expect to happen.”

Even though he now works in the private sector, Bergsten was formerly President Richard Nixon's chief adviser on international economics before moving to the treasury under Jimmy Carter to run the international department.

This, along with his skill as a populariser of complex ideas, has given Bergsten's currency crystal-gazing an unusual kudos.

His soothsaying on the single currency is original and, if he turns out to be even half right, the monetary world is poised to undergo a change of seismic proportions.

At the moment, the world's most traded currencies are the dollar, the deutschemark and the yen, but it is the dollar which is overwhelmingly dominant in trade and invoicing. Fifty percent of global financial transactions are carried out in dollars compared with 15&percent; in marks.

Simply increasing the size of Europe's dominant trading area from Germany to a bigger euro-zone including France, and maybe even Italy and Spain, would boost the European currency's share of world trade.

At the same time, international investors would have a new large-scale capital market in which to park their cash as an alternative to the US. Bergsten believes that the mass emigration of these funds - a process known as 'portfolio diversification' - will double or triple the euro's share of financial transactions compared with that of the mark.

It will mean a new bipolar currency world, with the euro and the dollar each accounting for 40&percent; of all financial transactions and the remaining 20&percent; shared by the yen, the Swiss franc and other smaller currencies.

If, as Bergsten forecasts, the total portfolio diversification amounts to as much as 900 billion ecu, this will feel like an earthquake.

The ramifications would be huge. For a start, he thinks that the dollar could lose between 25&percent; and 50&percent; of its exchange rate value against the euro compared with its level against the mark as the portfolio shift goes through.

The precise size of this appreciation of the euro will depend on where it starts and, here again, Bergsten speaks heresy. “I believe that the Europeans are going to want to start the euro at an undervalued rate,” he says.

While policy-makers want a strong single currency, they do not want it to price their goods out of world markets. After all, this is one of the key reasons why German heavy industry favours bringing an end to the often overvalued mark.

“The only way out of the dilemma is to try and weaken the national currencies before the start-up of the euro, thereby beginning the euro at a competitively undervalued exchange rate from which it could rise at least modestly,” says Bergsten. “This would characterise the euro as a strong currency, but without getting to a level that hurts member states' competitive position.”

Nevertheless, the euro is going to be a hard beast to tame. Even if the 'stability pact' aimed at keeping tight fiscal discipline in the monetary union fails to work, this should not lead to a weakening of the currency. On the contrary.

“If they go easy on fiscal policy, that just means the European Central Bank [ECB] will react with a tighter monetary policy,” says Bergsten. “This would lead to the sort of mix of looser fiscal policy and tighter money that we had here under Reaganomics.”

In the early Eighties, a massive increase in the US budget deficit was matched by a ratcheting-up of interest rates by the Federal Reserve as it tried to offset any inflationary impact from the extra public spending. What is more likely is that the stability pact will hold and that the ECB will seek to maintain a strong euro exchange rate anyway, says Bergsten.

“Early on, for better or for worse, they are going to view the exchange rate as one of the best indicators of whether they are doing their job right - which is to create a hard currency and run a responsible monetary policy. They would be leery about letting it depreciate, simply because that might generate the image of a weak currency.”

Whatever the scenario may be, the American economist believes that the new world order is going to require a return to some form of managed exchange rates to prevent Europe from acquiring a taste for the kind of 'benign neglect' of its currency's external value long practised by US policy-makers.

Since trade will take up a much smaller share of the euro-zone's economy than it did for the individual countries, the chances of importing inflation through a depreciation of the exchange rate will recede.

Moreover, the size and depth of the European capital markets will make it less likely that international investors will race for the door every time the euro loses its value abroad. The temptation to do nothing if it gyrates on the foreign exchange markets would grow.

“There will be a tendency for much greater fluctuation and prolonged misalignment between the dollar and the euro than there has ever been between the dollar and the mark,” says Bergsten.

“In fact, it will be more like the historical relationship between the dollar and the yen, which has fluctuated much more, led to much more prolonged misalignments and had much more important effects on trade policy.”

The early years of the Clinton administration were marked by a series of trade battles between the US and Japan as the Americans sought to boost the value of the yen against the dollar. At the time, Bergsten came up with a number of proposed 'target zones' for the dollar/yen exchange rate aimed at achieving greater trading equilibrium.

Once the euro is well established as a global currency, he would like to see such zones established and policed by a new Group of Three - the US, Europe and Japan - to replace the old G7, which also includes Canada, the UK, Italy, Germany and France.

“Once we get to a more or less 'steady' state, then we will need new and much more structured forms of EU-US cooperation - not to manage the exchange market in the day-to-day sense of having a fixed rate, but something to limit the degree of flexibility and keep it from diverging too far from the underlying fundamentals.”

This would mean establishing a central rate between the currencies and allowing them to fluctuate plus or minus 10&percent; on either side of that rate - the kind of global, managed exchange rate policy that has not been seen since the early Seventies.

Since the French elections brought a slightly less euro-enthusiastic government to power, people are asking more fundamental questions about the EMU project. Can it start on time in January 1999? Should it, even?

Bergsten still believes it will come and, once that is assumed, politicians and the markets should be ready for the consequences it will bring. “The design for a new international system obviously does not have to be decided now,” he says. “But people will have to start thinking about it fast.”