When the euro was introduced in 1999 the creators of the brave new single currency declared the monetary union of 12 nations irrevocable. The euro, they said, could not be unmade. So it is striking that, just six short years later, the possibility of a rupture or even collapse of the currency is being contemplated in at least semi-seriousness.
Even before last week’s polls on the constitution, the fate of the euro had been thrust on to financial markets’ agenda by a report in Germany’s Stern magazine. This claimed that Hans Eichel, the German Finance Minister, and Axel Weber, President of the Bundesbank, had participated in a discussion on prospects for a dissolution of monetary union.
Although Herr Eichel and Herr Weber have since declared their devotion to the single currency, some sort of meeting does appear to have taken place. And the Stern report found a resonance in the markets, where the currency was already under pressure.
If there was ever any doubt that the survival of the single currency was in question, it was quickly dispelled by two further events last week. First, the proeuro, European Commission-funded think-tank the Centre for European Policy Studies (CEPS), published a report arguing that monetary union was about to face a “stress test”, and gave warning that the very future of the euro was at risk. Then, Italy’s future membership of the eurozone was called into question by Roberto Maroni, a member of the Italian Government. Although Signor Maroni was not expressing government policy, his observation that the euro had “proved inadequate”, prompting speculation over a return to the lira, scarcely left it looking impregnable.
But how real is the prospect of the euro fracturing, or even imploding?
What remains apparent is that, more than six years on from the launch of the most ambitious project of its kind, monetary union has yet to produce anything like the hoped for economic convergence among its 12 member countries.
It was clear from 1999 that this disparate group of economies could hardly be more divergent. As even Otmar Issing, the ECB’s chief economist, admitted last week, the 12 nations “did not form anything close” to what in the jargon is called an “optimal currency area” — a relatively uniform zone across which a single interest rate can effectively address economic conditions.
It should hardly be surprising, then, that the “one size fits all” monetary policy of the ECB has in practice fitted none, inflicting an inappropriate nominal interest rate (and inappropriate real rates) across the eurozone, leading unavoidably to stresses. Some economies, such as Portugal’s, have run too hot, with inflationary booms; others, especially Germany’s, have run much too cold, enduring near-deflationary conditions. Few have enjoyed policy settings that are just right.
Last week’s polls on the constitution have intensified the strains on monetary union over structural reform, fiscal policy and monetary policy. Yet it is not clear whether these tensions will be sufficient to lead to some form of break-up of the single currency.
The French voters’ “non” to desperately needed EU structural reform was a rejection of liberalising, pro-market measures within the EU. The apparent consequence is a swing by the Government towards an insistence that France’s traditional “social model” can and will be preserved at all costs. This stance has already been clearly articulated by President Chirac. and epitomised in his choice of Dominique de Villepin as his new Prime Minister.
While the same anti-reform tendencies and populist pressures are evident elsewhere in the eurozone, the reform agenda cannot be written off. In Germany, for example, economists are acknowledging that painful years of wage moderation and cost-cutting have done much to restore national competitiveness. And institutions such as Goldman Sachs are hopeful that Chancellor Schröder’s move to call an early election in Germany will pave the way for a second wave of reform. In turn, this could be a spur to change in other eurozone states.
On fiscal policy, too, there are two sides to the unfolding story. The “no” votes may encourage eurozone governments to run larger deficits in the next few years. But even if unsustainable in the long run, such tactics might at least have the virtue of helping to fend off an emerging cyclical downturn. In the longer term, the extra discipline that markets are likely to impose on governments as a result of nervousness over the eurozone’s resilience should forestall excessive profligacy by its indebted member states.
In monetary policy, the “no” votes will inevitably put the ECB in the firing line, leading to more powerful demands for looser policy to bolster growth. The hardline monetarists’ assessment of last week’s CEPS report — that any capitulation by the ECB to such pressures would put the euro on the road to destruction — is surely misconceived.
The opposite argument is more persuasive. What the eurozone desperately needs is more stimulus to domestic demand to boost growth; it needs to allow countries such as Germany to capitalise on existing reforms; and it needs to provide the context for further action. In none of these three areas does last week’s votes put the euro on a one-way road to ruin.
But the biggest counter- argument to suggestions that the single currency might fall apart is more pragmatic: unravelling monetary union would be hugely difficult and costly.
For any one state, such as Italy, to break from monetary union would entail immense, if not insuperable, difficulties and disruption that would far outweigh any perceived benefits.
As UBS points out in a report this week, forcible attempts to redenominate bank accounts in a relaunched national currency would risk triggering a run on a country’s banking system as individuals or institutions tried to retain their euros in cash.
Worse still, a breakaway state would probably have to redenominate its government bonds in the new national currency, leading to a technical default and thus soaring interest bills on government borrowing. Alternatively, a government’s bonds could remain denominated in the euro (now a foreign currency), again implying a credit downgrade and much higher borrowing costs.
None of this looks very practicable, let alone attractive. And while what UBS calls “a collective disintegration” of monetary union, by agreement among all the members, would be somewhat less costly, it would still be extremely painful. Moreover, it is, for now at least, hard to imagine such a collective scenario emerging. The conclusion, therefore, can only be that while the euro may well wobble, it will not, at least for now, collapse.
