The creation of Europe's single currency is a watershed event in international finance and economics. The crucial test of the Euro's success is not the willingness of nations to give up their own brand of currency, but rather their willingness to abide by a common monetary policy. This article explores the tradeoffs inherent in that decision.

After endless blather about it, the Euro has arrived, at least as a matter of accounting. This raises the question posed in my title. So what's the answer?

The Euro's birth is the most significant event in international finance since the 1973 breakdown of the Bretton Woods system of fixed exchange rates between the major industrialized countries, which in turn was the most significant event since the Bretton Woods formation in the wake of WWII. This is a "three-sigma" economic event at least. No group of sovereign nations has ever embarked on a single currency program of this magnitude. The common currency is a huge step toward complete integration of the European economies. Currency fluctuations will no longer increase the risk of trade between countries.

As a political event, the Euro ranks below the convulsions of the former Soviet Union and the East Bloc, but above most everything else that has happened in Europe in recent decades. The significance of the Euro is a bit more subtle than many people think. While it is nice that these countries will have a common currency, and it may have been extremely hard for many Europeans to give up their own flavor of currency, the real difficulties of monetary union don't stem from a common currency per se. Instead, the complexities and challenges will arise because "Euroland" will have a common monetary policy.

Rightly or wrongly, the citizenry in most countries considers management of the economy to be one of the most important functions of the national government. And monetary policy is the principle means of managing the economy's ups and downs. Think back to the 1992 U.S. Presidential election. It was the economy, stupid. And it was arguably within the grasp of the Fed to determine the outcome of the election. If the Fed had lowered interest rates sooner or more aggressively when the economy slowed in 1990 and 1991, the economy wouldn't have been a liability for Bush. Whilst savvy politicians seldom chastise the Fed in public, they lean on the Fed in private all the time.

So now Europe will have 11 national governments with different economic fundamentals and different wishes for monetary policy, all guided by the same European Central Bank (ECB). I try to envision happiness and harmony, but it is not easy. There are two problems with a common monetary policy. First, countries' economic circumstances will change over time, often in different ways. Second, even in the same circumstances, countries may have different preferences over monetary policy.

Proponents of the Euro frequently point to the U.S. as a model. After all, a single monetary policy has worked reasonably well for the U.S. all these years, and the U.S. is comparable in economic size to Euroland. But even within the U.S., there can be large disparities in regional economic performance which create differences of opinion about the desired monetary policy. In the last "national" recession in the U.S. (1990-91), California and other defense-dependent states were particularly hard hit. Midwest states were virtually unscathed. California would have preferred a much more expansionary monetary policy with lower interest rates to stimulate spending. Of course, this desire faded relatively quickly as California's performance converged toward overall U.S. performance within a couple of years. The main mechanism for this convergence in U.S. states is migration of the labor force. When things got bad in Southern California, people stopped moving there and many started moving out. This alleviated the regional excess supply of labor and smoothed out national performance.

Euroland is likely to experience even greater disparities in regional performance than the U.S. The economic base of Finland (lumber, paper, and vodka) is extremely different from that of France or Spain. When Finland has a recession because timber prices collapse but the rest of Euroland is cruising along, what happens? Euroland monetary policy won't react to the Finns plight for sure. Will people stop moving to Finland? OK, moot question. Will Finns head for greener pastures in….France? Probably not. The populations of Euroland are not nearly as mobile as U.S. residents within their own nations, let alone across national borders.

The point is, some countries may endure protracted downturns with no monetary policy response. And the way those regional downturns are resolved in the U.S. seems unlikely to work well for Euroland. When this kind of scenario unfolds, Euroland will meet a real test. It will be a political, as well as an economic, test.

How will Europe fare? It depends where the cleavage arises. If it arises between Finland and the rest of Europe, it's not going to tear Euroland apart. The ECB is unlikely to let policy be dictated by events in Finland. And the Finns have too much to gain from being a part of Euroland to opt out. It is those countries on the economic periphery (e.g. Spain, Portugal, Finland, and Ireland) that are most likely to benefit from monetary union through lower inflation and real interest rates and greater currency stability and capital inflows. If the cleavage arises because of different monetary policy needs in France vs. Germany, or Italy vs. France, then Euroland will face more serious problems. But this scenario seems far less likely. The core countries have tended to exhibit much more synchronous behavior over recent years.

The other tension that will arise concerns the general stance of monetary policy as regards the tradeoff between short-term growth and long term price stability. The ECB's Charter clearly stipulates that price stability is the goal of monetary policy. There is no mention of promoting employment or economic growth in hard times, as there is in the Federal Reserve's Charter in the U.S. Newly elected governments across Europe seem to feel differently about this matter than did their predecessors who helped frame the ECB Charter. Whether the Central Bank will adhere to its Charter or accommodate the wishes of national government officials remains to be seen. But this could be the juggling act that turns out to be key to the success of the Euro.

Would a successful Euro come at the expense of the U.S. dollar? Many people ask this question, but it is not always clear what they have in mind. The only logical issue here is whether the existence of the Euro might eventually reduce the demand for dollars and dollar assets in international capital markets. There are two important sources of demand for dollars and dollar assets that could be threatened. First, many residents of unstable foreign economies use dollars as a currency for doing business. In fact, over half of all U.S. currency in circulation is held by foreigners. Second, many central banks around the world hold dollar-denominated assets to back up their liabilities. This is particularly important in countries that fix their currency's value to the dollar.

If the Euro started to compete with the dollar as the world's currency of choice in these regards, it would have a small effect on the United States. There is some value to the U.S. of having foreign residents willing to hold U.S. dollars. We are able to trade those pieces of paper for real goods and services. If they simply hold onto the paper, that's a pretty good deal for us. Even if we assume that at some point those countries will stabilize and residents will no longer need dollars, we still have the equivalent of an interest free loan from them while they use our currency. The value of this benefit today is estimated to be about $13 billion dollars per year by the Council of Economic Advisers. Similarly, when central banks hold our assets as reserves, it increases demand for our government debt, which lowers the rate of interest somewhat. The precise magnitude of this benefit is harder to determine. But in any case, in a $7 trillion economy, the added benefit of being the reserve currency of choice is not huge. And the Euro certainly won't completely replace the dollar anytime soon.

Although there is no reason to be worried about a competition between the Euro and the dollar, the Euro really is a high-stakes gamble. This is a continent that has repeatedly experienced the worst kind of upheaval imaginable. Little wonder people find the idea of cementing a relationship between the nations of Europe an attractive idea. Will the marriage of these mercurial partners create stability? By raising the costs of opting out of the relationship, it just might. On the other hand (economists are required to have two), if those costs are breached, the divorce could get very messy.