THE EUROPEAN CURRENCY UNION COULD SLOW U.S. ECONOMIC GROWTH IF THE DOLLAR HAS TO GIVE UP ITS STARRING ROLE ON THE WORLD TRADE STAGE: GAMBLING IN THE EURO CASINO

This month’s main event, the selection of the member countries of the European Currency Union, was more than a bit anticlimactic, with every country that wished to enter (except for Greece) more or less meeting the requirements of the Maastricht Treaty. In fact, for months, the only tension has been which country would pull the rawest work in the accounting department in order to qualify. Italy, which assumed changes in pension payments that its own Parliament has in fact rejected three times, was generally conceded to have won that particular race, though Belgium, which has a national debt that can only be met by selling the entire country into slavery, had its adherents as well.

The main exception, the United Kingdom, will not participate at the outset, but will inevitably join sooner or later — in my opinion, much sooner than the consensus in the British press of some time after the next election in 2001 or 2002. The U.K. has been a favored destination for locating everything from Japanese auto plants to American software firms, but all on the premise that it would remain an integral part of the European Community.

Further, almost one-quarter of Britain’s aggregate gross national product comes from financial services, which are likely to suffer if kept for too long out of the euro currency bloc. (Even if economic logic says there should be no effect on the City of London from remaining outside Europe, discriminatory legislation in favor of Paris and Frankfurt is inevitable if the U.K. does not join the single currency — France has already drafted preliminary legislation.)

Conservative Party opposition to joining the common currency, which did so much political harm to the Thatcher and Major governments, can, in the end, only damage both the manufacturing and service sectors of the British economy. Twenty years of diddling and waiting, and the country will be well on its way back to what it was in danger of becoming before the Thatcher Revolution — a sort of Bangladesh with castles.

So, for the foreseeable future, some 300 million people, the largest economic bloc in the world, will have coordinated economic and monetary policies and a common currency. From the standpoint of a dollar-based investor, this raises two intriguing questions. One, is it likely to lead to continued gains in European markets? And two, is it good or bad for the United States and its competitive position in the world? I’d like to take a stab at the second question first, and then come around to the micro issues.

european counterweight

It’s possible to view the economic history of the past decade as a huge trick played by the United States on the rest of the world. The French, for whom such intellectual bed-wetting is second nature, clearly believe in an Anglo-Saxon conspiracy. Put simply, this conspiracy is “globalization” and its darkest demon the loss of national control over economic policy to “bond-market vigilantes” (i.e., the idea that a country that veers from the economic orthodoxy favored by the participants in the global bond markets will soon find itself with a currency and stock market crisis on its hands).

Even more disturbing is the insistent drumbeat of efficiency — downsizing, tax cuts, privatization — overwhelming such principles as social justice and state power as traditionally understood. Both factors radically favor the most flexible economies, and those with the least interventionist governments — namely, the United States. From the standpoint of less flexible societies in Japan and Europe, globalization looks like less of an even playing field than one expressly designed by the United States to take advantage of its particular strengths.

While the political and emotional impetus for European union is, particularly from the German point of view, primarily to avoid the repetition of the warfare that has twice leveled the Continent in this century, the economic rationale has always been much more overtly the creation of a counterweight to U.S. economic power. I’d argue that the creation of a common market and common currency is likely to pose a medium-term economic challenge to the United States, but for very different reasons than those envisioned by the founders of the European economic project.

The United States has traditionally had several major advantages in terms of its economic position. One, of course, is a huge unified home market for its manufactured goods. Japan’s tendency to have its consumers pay far more for Japanese goods than the cost of those goods abroad and the European Common Market are both attempts to mitigate this particular advantage on the part of the United States.

The other advantage, and the one that the least attention has been paid to, is that the United States has been the major economy least dependent on trade while at the same time having its currency used as the medium for the overwhelming majority of world trade. This advantage is likely to be eroded seriously with the advent of the euro — though again, for reasons not anticipated by its founders.

Since World War I, world trade has expanded at roughly twice the rate of world gross domestic product growth, and aggregate international capital flows have increased six times as fast. The United States, as the dominant economy for much of this period, has inevitably benefited from this huge growth, and trade now accounts for more than 26% of GDP — up from as little as 11% in 1975.

dependence will increase

As part of this growth in economic interdependence, the United States has joined groups like the World Trade Organization, which have effectively created a world market for many industrial products. While this has made the original rationale for the European Common Market less relevant (production must now concentrate on global rather than regional targets) it will over time seriously erode the importance of the size of any particular home market. The United States will still benefit substantially from the size of its capital markets and the sheer scale of its tertiary education sector, but nevertheless, an important historical advantage of the country will have been eroded to a significant extent.

The other factor that needs to be considered is that the advent of the common currency in Europe means that it is now the U. S. that is more dependent on the level of world trade than Europe and most affected by shifts in currency exchange rates. How could this be possible when trade still accounts for roughly twice the percentage of GDP for the average European country as it does for the United States? Simple — to a very large extent Europeans trade with each other, which makes the aggregate trade figures meaningless once currency union is in place. It is Europe now, rather than the United States, which can be said to be the least dependent on external trade. It is Europe that will, at the margin, have the greatest control over its internal monetary policy — the traditional prerogative of the United States.

The problem for the United States, and for the world economy, is that the design of the common currency is deeply flawed in economic terms and will inevitably lead to a weak European currency vis-a-vis the dollar and further severe economic problems for Asia.

The general tendency towards a weaker euro is likely to negatively impact the United States in two ways. First, and most obvious, is that it is likely to tip the balance of the terms of trade in favor of a depreciating Europe. And the effect of that change is unlikely to be offset by greater economic flexibility on the part of the United States.

If the sole question of global economic competition was to see who could downsize all economic organizations, governmental and private, to the greatest possible extent while keeping rioting to a minimum, there is no doubt that the incredible social and economic flexibility of the United States would keep us in the pole position indefinitely.

Unfortunately for the United States, the move towards efficiency is only likely to give a comparative advantage at the earliest stages of the process and for a relatively brief period of time. The amount of downsizing an economy requires is a function of capital utilization — that is, how hard each dollar of industrial investment has to sweat to produce a dollar of profit. Thus, the level of efficiency required depends to a certain extent on the level of capital available as a percentage of GDP — i.e., the savings rate. The United States has a savings rate less than half that of the average European country. Hence, Europe must endure quite a bit less restructuring to achieve roughly the same economic results — and I can guarantee you, in 90% of the relevant areas, it has already happened.

sound the alarm

A side effect of increased European competitiveness is even more potentially alarming in the medium term. The United States could become the largest creditor nation and continue to run up huge current account surpluses only because the dollar was the medium of exchange for world trade and the leading reserve currency. To the extent that the euro replaces the dollar — and the change in the terms of trade guarantee it will to some extent — the U.S. must either increase its exports, decrease its imports, increase its savings rate substantially or face a currency crisis.

Any of the choices is likely to lead to a severe dip in consumption and an extended recession. It is also likely to trash the economic assumptions of Japan and much of Asia — namely, the existence of the United States as the buyer of last resort for Asia’s export-led economies. None of this is going to happen overnight, but it does suggest that the U.S. had better skip the victory lap and get back to work. And Japan and Asia in general need to start figuring out Plan B. Mercantilism is an economic dead end for the foreseeable future.

Is euro-euphoria a reason to keep buying these markets? The improvement in the outlook for European competitiveness and growth has not exactly gone unnoticed by European stock markets, almost all of which reached new highs in the first quarter of 1998. In a fashion very similar to the situation in the U. S., low interest rates and fears over retirement savings have led to a flood of money pouring into mutual funds and equity markets.

The most obvious implication of the euro — the convergence of interest rates between such traditionally high interest-rate countries as Spain and Italy and such traditionally low interest-rate countries as Germany and the Netherlands — has caused massive upward moves in the stock markets of the former group.

Despite the fact that rates have pretty much converged, there is probably room for these markets to continue to outperform. There is a huge disparity in wealth between various European countries, which is likely to continue to be arbitraged away over time.

change is going to come

Similarly, providers of goods in which there is a great price disparity between countries are likely to be significantly disadvantaged. This is particularly true of retailers and makers of pharmaceuticals. Within practical levels of the cost of transport, prices are likely to fall for most items to the lowest currently prevailing level. Outright price deflation in the richer countries is not out of the question.

The magnitude of these changes is unlikely to have been fully discounted into markets, particularly those such as France and Germany, which are in the early phases of economic recovery and are still undergoing significant restructuring. But the best performers are likely to fall within two fairly tight groups: domestic producers and retailers of goods in countries such as Italy, Spain, Portugal and Finland, which has seen sharp falls in interest rates, and economically sensitive companies throughout Europe

Financial stocks and retailers in Northern Europe, the stars of the last 12 months, seem to be at best fairly priced at historic levels of price-to-book value and entering what is likely to prove a period in which competition increases significantly. Europe still looks enormously attractive from a bottom-up view, but it is probably time for most active stock pickers, hugely overweight in financial stocks, to consider changing horses.

There’s little question that the creation of the Euro is a historic event. And like most historic events, it is difficult to calculate all the implications in advance. But serious upside remains in Europe if governments move towards the greater economic flexibility that having a common currency implies. In the medium term that may prove to be a development that the United States finds much more uncomfortable than it can now imagine.

Mr. Tyson is chief investment officer and managing director of Mastholm Asset Management, an institutional international money management firm in Bellevue, Wash. This article is adapted from the May issue of Mastholm’s View from the Mast newsletter.