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Euro on Top

Five years ago, Europe embarked on one of the more audacious economic experiments in modern times: taking 11 competing currencies and turning them into one. The introduction of the euro was seen as a herald of a unified European economy, and wise men promised that it would challenge the dollar's status as the world's currency of choice. Things didn't go exactly as planned—the euro's value was dismally low for its first couple of years. But since 2002, as American travelers have discovered to their dismay, the euro has grown valuable and the dollar has become cheap.

The idea of the euro is an intuitively appealing one, easily grasped by any traveler who no longer needs to change money every time he crosses a border. Economies work best when there is as little sand as possible in the gears of buying and selling, and myriad currencies represent a lot of unnecessary sand. Euro advocates believed that people in France would do business more easily with people in Italy or Finland if they were all using the same currency, and on this count, the euro has performed as promised. Trade among the euro countries jumped 30 percent in the currency's first year, and has continued to grow since.

Economies, though, do not live by trade alone. Interest rates and government policy are also important. And here the euro has hurt Europe. The major economies on the Continent have been stuck in a slow-growth, high-unemployment pattern for years. The traditional way to get an economy out of that kind of rut is to use two tools: monetary policy (cutting interest rates) and fiscal policy (boosting government spending and/or cutting taxes). The United States, for instance, relied on both in the wake of the 2001 recession. But the euro has made it harder for Europe to use those tools effectively.

Although the euro treats Europe as if it were one economy, it really isn't. Instead, it's made up of very different kinds of economies: fast-growing smaller ones, such as Ireland's, and big, slower-growing ones, such as Germany's. The best strategy would be to have higher interest rates in growing economies (when inflation is a risk) and lower rates in ones that need a kick in the pants. But the euro means that

Europe has to use a one-size-fits-all approach to monetary policy. And since European central bankers are obsessed with keeping inflation low, the higher interest rates they've set for all members have been a straitjacket. As for government spending and tax cuts, in order to adopt the euro, countries had to promise to keep their annual budget deficits and their government debt below certain levels. This was, in principle, a good idea—in general, the more government debt an economy has, the less productive it will be. But when an economy is stagnating, deficits can be useful. The euro has made it harder for governments to use them.

So why, if the European economy is in the doldrums, is the euro so strong?The biggest reason is probably America, and specifically the current behavior of the U.S. government and U.S. consumers. Since 2001, the United States has been running massive budget deficits. Someone has to fund them by buying government bonds, and since Americans save almost nothing, it's foreigners who are footing the bill.

At the same time, we are buying furiously from the rest of the world, creating a trade deficit that also needs to be funded. Withforeign investors hesitant, and more skeptical about the value of a dollar, American assets have to be cheaper to attract them, which means the dollar has to fall.

It isn't, then, that the euro is really so strong, so much as it is that the dollar is weak. With neither the European nor the American economy running the way economies should (Europe too conservative, the United States too profligate), it's more a matter of which of them looks less bad. And unfortunately for Europe, the strong euro has actually made it harder to create jobs, since European goods are now more expensive in the rest of the world, hurting European businesses.

This doesn't mean that the introduction of the euro was necessarily a mistake. For all the high-flown rhetoric about its potential economic benefits, the driving force behind the euro's introduction was not economic. It was political. The abiding concern of European politicians since World War II has been the desire to ensure that there would never be any serious conflict on the Continent again. Economic unity, the thinking went, would breed political unity. The euro, whatever its economic effects, is an integral part of the process of forming a true European state. Whether that process is a realistic one remains to be seen, especially since some EU members, including Britain and Sweden, have refused to become members of the euro zone, while Germany and France have been violating the euro treaty with their fiscal policies. But certainly the idea of a unified Europe remains a powerful one. So the next time you trade in your dollars for euros, you can at least comfort yourself with the thought that you're making a small contribution to the cause of peace in Europe.

JAMES SUROWIECKI is the financial columnist of The New Yorker; his book The Wisdom of Crowds will be published this month (Doubleday).

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