CH: We should remember, too, that China's economy is not static. In those sectors where they are competitive, as they grow and become more productive, there will be an increase in wages. You see that already in the coastal regions, which are becoming, relatively speaking, quite wealthy. The seemingly endless supply of low-wage workers is, in large measure, in the interior of the country; but what is being produced there is not in competition with, for example, what is made by a comparable factory in South Korea. South Korea's industry is way up the value-added chain from that.

I tell my friends in Southeast Asia that, were they to band together in an effective ASEAN Free Trade Agreement, they would do themselves a big favor. With 500 million people, they would be a much more attractive target for investment and a much more efficient region for combined production--both for regional markets and for export beyond. The point is that they should not just stand still and whine about China; they should take positive action to enhance their competitive edge.

Atlantic Static

TNI: I've been talking lately with a lot of Europeans, and every time we discuss American policy, they raise the steel tariffs and the farm bill and commence to lecture me, as their token captive-audience American, about the specter of American protectionism. I find these chidings a little odd, for two reasons. First, because I remember reading an article by Mickey Kantor--one of your Democratic successors, Carla--just after the steel tariffs were announced saying that the tariffs were a good idea, and that worried me. Second, in terms of protectionism aimed against poorer countries, aren't the EU-member states worse than the United States in many respects?

CH: I take your point. I have trouble defending the decision on steel--and the farm bill, too--on economic grounds. But politically, I understand the tremendous pressure put by Congress on the administration to do something about steel. You know, it's remarkable that after we declared that we would take a safeguard action--which is provided for in the rules of the World Trade Organization--we actually ran into short supply for our own users. So, it hasn't worked to our nation's overall economic interests.

The good news is that a safeguard is temporary--three years maximum. And, we will be forced to explain our rationale in a case that is being brought to the WTO by a number of countries. Were a panel to set it aside then, of course, we would abide by the ruling. Then the administration could say to the steel industry that it tried.

TNI: Do you think the administration expects an adverse WTO ruling?

CH: Well, let's just say that there are many trade experts who have written on this subject, and they are not confident that we will prevail.

TNI: I see. Well, let's not leave the Europeans quite yet. Of the many substantive deficiencies of journal editors in this field, economic literacy seems to be prominent among them. I certainly include myself. I cannot understand how the euro zone will work in the future. If there are such significant differences among the countries that are part of the euro zone, how can a single interest rate and a homogenous monetary policy make sense?

MF: Adam, you may not be an economist, but your difficulty in this respect is widely shared. There will be essentially one interest rate in the euro zone, since there is only one currency. There will be only one monetary policy. There will also be, therefore, only one exchange rate. And especially as the number of countries in the EU increases, it becomes more and more difficult to see how the same policy can be appropriate for all of them.

My European friends immediately reply: "You Americans have fifty states with economies as different as Alaska and Florida, and yet you have a single currency; so why can't we, with a smaller number of states, have a single currency, too?" To them, I say that the U.S. economy is very different from the European economy. One of the things we have going for us is that we all speak the same language, so that when demands slump in my own home state of Massachusetts, for example, people stop coming to Massachusetts, and people in Massachusetts start moving to places where the jobs are plentiful. But Europeans will not as readily move from Portugal to Germany, even if the Germans were willing to let them come. So, that's a major difference that is a real handicap for them.

A second difference is that our labor market is much more flexible than the European market. When a region in the United States sees a slump in demand for its product, instead of a large rise of unemployment locally, we see wages adjusting in that part of the country relative to what they are elsewhere. That provides a basis for employers to stay in production in that area.

And there's a third factor, which is that we have a centralized fiscal system. What that means in practice is that if demand falls and incomes fall in Massachusetts, say, then the taxes that flow from Massachusetts to Washington go down and the benefits that come from Washington to Massachusetts go up. As it happens, it's about forty cents on the dollar; that is to say, if the GDP in Massachusetts declines by a dollar, the net transfer to Washington declines by forty cents. That's a big stimulus to the Massachusetts economy. There's nothing like such a system at this point in Europe.

So while they have at least as much of a potential problem with a "one-size-fits-all" monetary policy as we do, they lack these three advantages that we have to help us cope: a common language; flexible wage-adjustment capabilities; and a centralized redistributive fiscal system. So, I think, as you do, that at some point they will get into trouble. At a minimum they will see more cyclical unemployment than would otherwise be the case. I suspect also that the European Central Bank, in the long run, will have a different attitude about inflation than the Bundesbank. The creation of the euro zone may have been good politically for moving forward with the European Union ...

TNI: ... and they did derive some one-time advantages from it, I think.

MF: That's right; but from a strictly economic point of view, they are liable to run into some fairly serious problems ahead.

CH: Yes, and I think it's worth pointing out that each country also gave up, to a certain extent, its own independent fiscal policy. Take Germany. Not only did it give up its independent monetary policy, but as it bumps up against the three percent EU deficit limit, it cannot use fiscal measures to stimulate growth. Usually, a country uses either monetary or fiscal policy to stimulate flagging economic growth. Moreover, the countries that need the stimulation usually have a debt burden that works as an additional inhibitor. So national governments in Euroland are pretty much without a tried and true economic policy to help them through rough waters.

TNI: Marty, you mentioned the fact of a single exchange rate. This also baffled me. Obviously, some economies in Europe are more export-dependent than others. A relatively weak euro would tend to help exporters, while a relatively strong euro would make imports cheaper and help consumers. The exchange rate, then, has a certain political quotient. So it matters who gets to decide the rate, doesn't it?

MF: I don't think any particular country is going to get control of the rate. The market will set the exchange rate between the euro and the dollar and the yen. But it's still true that fluctuations in that exchange rate are going to be more significant in some countries than in others, and that does have political implications. Countries in Europe that have extensive trade outside the euro zone will be much more affected than countries that trade mostly within Europe.

Dollarization and the Western Hemisphere

TNI: Since we're speaking of a new currency bloc, let's turn now to our own hemisphere where the question of dollarization has been much discussed in recent years. Given what's happened in Argentina lately, these formerly theoretical discussions seem to have been reshaped by events. How would you characterize the problems in Buenos Aires, and what connection do they have to the dollarization debate?

MF: Argentina is really an example of a country that fixed its exchange rate relative to the dollar, but without actually adopting the dollar as its currency. That was also a problem in Southeast Asia in 1997-98; it contributed fundamentally to the Thai problem and to a certain extent to Korea's problem. But those countries wised up and shifted to a floating exchange rate, as has Brazil, as has Mexico. By 2001, therefore, Argentina was odd man out in sticking to a policy that was very helpful a decade ago in bringing inflation under control, but it lacked an exit strategy back to a floating exchange rate--which they probably should have done five years ago when things were going well.