Hans-Werner Sinn says the long wait for notes and coins is driving many in Eastern Europe to change their D-Marks into dollars

Once again, the euro is languishing below 90 US cents. Neither intervention by the European Central Bank nor the still benign prospects of the euro-zone economies has halted the currency's decline.

More surprisingly, perhaps, the weakening euro and strengthening dollar have occured in spite of economic slowdown in the US, big interest rate cuts, vanishing US savings and a huge current account deficit. So what is the explanation?

There are two reasons, both related to the fact that the euro is still only a virtual currency. First, many people are afraid of the transition to the euro because they hold money made on the black market and do not want to declare it. To prevent money laundering, Europe's banks are required to register the exchange of larger sums by name. As a result, some people are avoiding detection by exchanging their European cash holdings for dollars.

Second, many people outside the euro-zone who hold European currencies do not realize that the currency union is already a reality. They hear rumours that European currencies will be abolished, supposedly to be replaced by a new currency. But because they do not know how the mechanism will work, they are afraid of sustaining a loss. So, again, they prefer to convert their money into a tangible currency such as the dollar.

Before the US slowdown, the argument was often heard that the euro/dollar exchange rate reflected the poor earnings expectations of European stocks and Europe's inability to carry out structural reforms. This is not convincing. Expectations about future real earnings were already reflected in equity prices, and these did not move in the same direction as the exchange rate. US share prices have declined relative to European share prices over the last year while the dollar has strengthened. When investors reshuffle or change their portfolio of equities, it is primarily the share prices that reflect that change. The dollar exchange rate does not necessarily change.

Exchange rate adjustment does occur, however, when investors reshuffle or change their holdings of cash and short-term securities whose values in terms of dollars or euros are fixed and whose interest rates are controlled by the respective central banks. That is exactly what has happened as people who were once happy to hold old European currencies have exchanged them for dollars because the euro is not available in physical form.

The sums of money involved are huge. The European black-market economy has been estimated at 16 per cent of the euro-zone's official gross domestic product. The share of black market European cash stocks would be 14 per cent if the black-market economy used the same proportions of bank and cash transactions as the regular one. In fact, however, it uses only cash. This puts the currency share used for black-market activities way above 14 per cent, or about €50bn ($44bn).

In addition, there are old European currencies circulating in eastern Europe. When the euro was officially introduced in 1999, between DM60bn and DM90bn were circulating outside Germany. The thousand-D-Mark notes stuffed in Turkish mattresses were as significant as the D-Mark holdings in Croatia, Slovenia and other eastern European countries. The outstanding D-Mark holdings amounted to between 20 and 30 per cent of the German monetary base - between 8 per cent and 12 per cent of the joint monetary base of the 11 euro-zone countries excluding Greece. That amounts to between €30bn and €45bn - again, significant sums.

Indeed, these figures are multiples of the quantities the ECB used for its interventions last year or the amount George Soros, the financier, needed to topple the European Monetary System in 1992.

There is indirect evidence to support this argument. In the years following the fall of the Iron Curtain it was possible to expand the German monetary base much faster than German GDP without causing stability problems because the excess money supply was absorbed by foreigners, primarily eastern Europeans. This process is now being reversed. Since the introduction of the euro there has been a sharp decline in money demand relative to GDP; and, recently, a decline even in absolute terms.

The fading interest in European currency holdings could largely have been avoided if the ECB had abolished uncertainty by introducing the euro notes and coins at the currency's launch on January 1, 1999. The three-year delay has proved a design fault. Today it is too late to speed up the process but the ECB could at least announce clear exchange procedures for foreigners.

Once the transition to the euro is complete, the uncertainty of foreign money users will vanish and the new currency will begin to penetrate the black markets. With time - or earlier if investors anticipate this - it will strengthen again without the ECB's interventions.

The writer is president of the Ifo Institute for Economic Research

Find more on this topic in:
"The Levitating Dollar" by Paul Krugman, The New York Times, 01 April 2001.