Jun 6th 2005
From The Economist Global Agenda
The French and Dutch referendums have dashed hopes of political union in Europe. As criticism of the euro grows louder, there are fears that monetary union, too, might be in peril
VARIOUS countries have been called “the sick man of Europe” at one time or another, but never before has the competition for the title proved so fierce. Italy entered its second recession in two years in the first quarter of 2005. Germany, despite tentative stabs at structural reform, is struggling with glacial growth rates and double-digit unemployment. And Portugal, also battling recession, just announced that its budget deficit will top 6.8% of GDP this year, more than twice the 3% limit set by the stability and growth pact agreed in Maastricht.
Portugal is not the only one running up deficits. France, Germany and Italy, the euro area's three biggest economies, have all breached the Maastricht criteria repeatedly without triggering the supposedly automatic sanctions. In March, the European Union acknowledged reality by relaxing the requirements, filling the rules with enough loopholes to render them toothless.
The deficits do not seem to be big enough to stimulate economic growth. Governments that have exhausted fiscal stimulus generally rely on monetary policy to soften downturns, but euro-area governments have surrendered control over their money supply to the European Central Bank. The ECB has left interest rates at 2% for two years now, and despite slow or negative growth in its three biggest economies, has been talking of a rate increase later in the year. This has been unpopular, and not just with governments looking for a shot in the arm. In its latest economic outlook, released in late May, the OECD called on the ECB to lower interest rates.
The European Commission has information on the stability and growth pact. The OECD posts its latest economic outlook and its economic survey of Italy. See also the European Central Bank.Tight monetary policy isn’t the only reason people are grumbling about the euro, however. It has erased the financing advantages that firms in stable Germany once enjoyed, for instance, and its appreciation against the dollar has slowed exports, and economic growth, in many euro-area countries.
The rejection of the European constitution by France and the Netherlands has given new voice to the euro’s critics. On Wednesday June 1st reports surfaced that Hans Eichel, the German finance minister, had been present at meetings where the possible collapse of the euro was discussed—and that the German government, which has suffered recent electoral defeats thanks to economic woes, may be planning to blame the euro for the country’s problems in the run-up to the coming general election. On Friday, an Italian newspaper published remarks by Roberto Maroni, a government minister from a populist northern party, in which he excoriated the euro for causing Italy’s poor economic performance and advocated reintroducing the lira. Currency markets twitched, as a euro-area implosion began to look distinctly possible, if not imminent. On Monday, euro-area finance ministers will meet in Luxembourg. They are expected to discuss ways to stem the growing problems of the euro, including its recent decline against the dollar.
One union, many growth rates
Even before the euro was adopted, in 1999, it was clear that neither the EU nor the 12-member subset that has joined the monetary union was an optimal currency area. Ideally, currency zones should be compact and homogenous enough to show little regional variation in business cycles—otherwise a one-size-fits-all monetary policy will leave some regions lingering in recession, while others grow so fast they overheat. Many argue that this is what is happening in Europe, where a few countries, like Ireland, are experiencing rapid growth while big economies, like Germany and Italy, stagnate.
There are ways to mitigate imbalances within big currency areas. Even America is not an optimal currency zone; its regions sometimes boom or shrink out of sync with the rest of the economy. But America has important features that temper the problems of unified monetary policy. Federal programmes act as automatic fiscal stabilisers, siphoning off tax revenues from booming areas and transferring them to ailing regions as unemployment insurance or health benefits for the poor. America’s labour market is also highly flexible. This allows wages and prices to adjust downward, giving depressed regions a competitive advantage that can attract new companies and thus smooth out regional disparities. And workers in declining industrial towns frequently pack up and move across the country to find work; capital flows freely as well. Without these mitigating factors, people in depressed areas could easily be trapped in a cycle of stagnation.
In Europe, by contrast, few mechanisms exist to bring the euro area’s widely divergent business cycles into sync. The ECB has been trying to chart a middle course between slow- and fast-growing countries while establishing its credibility as an inflation-fighter. The result has been a monetary policy that is too “hot” for some, too “cold” for others, and “just right” for almost no one.
The lack of adjustment mechanisms means that “ever closer union” is not just a glowing ideal; it is a matter of survival. Language and cultural barriers—not to mention wide differences in social insurance and retirement programmes—encourage workers to stay in their own country, no matter how bad the economy, closing off one of the easiest avenues of convergence. If Europe’s economies do not drive forward towards a single market, with labour markets that are more flexible (and international), there is a growing risk that some of its members will eventually find the gulf between their economies and their monetary policies too wide to endure.
Unfortunately for euro-boosters, recent policy moves have all been in the wrong direction. Not only has the stability and growth pact, which was supposed to help force fiscal policies into rough alignment, been weakened. Progress has also stalled on measures to widen market access, such as the EU’s services directive. And fierce public resistance to eroding generous worker and consumer protections has made governments unwilling, or unable, to implement the kinds of deep structural reforms that could help.
Without these changes, the euro will probably be able to limp along, at least for a while—particularly if the ECB cuts interest rates, as it has begun to hint it might do: politicians have an easier time enduring a monetary policy that is too loose than one that is too tight. But if nothing is done, the instability will mount. Already Italy is being compared to Argentina, where a currency peg to the dollar made exports uncompetitive, sparking a recession and, ultimately, a fiscal crisis that forced the country to ditch the peg and devalue the peso. At this point such comparisons are scary possibilities, not likely outcomes. But it is only one of many plausible scenarios in which the economic ills of its members prove fatal for the euro.