At the time the Euro was introduced in 1999, its opponents prophesied a dark future of increasing currency strains within the euro zone, as disparate economies struggled together in a single currency. Later, in 2002-03, the fears appeared to have been ill-founded, and the euro was hailed as a stunning success. However, today it seems that the pessimists may have been right, just a little early.
Recent economic statistics demonstrate this. Italy is expected to grow at only 0.6 percent in 2005, and to run a budget deficit approaching 5 percent of Gross Domestic Product in 2006. Portugal is expected to run a budget deficit of 7 percent of GDP in 2005. Theoretically, both countries could be subject to EU sanctions for exceeding the 3 percent budget deficit limit established under the Maastricht Criteria for the euro’s inception, in practice such sanctions are unlikely since France and Germany have already broken the criteria repeatedly.
Italy’s unit labor costs have risen 40 percent compared with Germany’s since the institution of the euro, according to the OECD. Spain is expected to run a current account deficit of around 5 percent of GDP in both 2005 and 2006, according to the Economist; again, declining relative competitiveness is to blame.
In a perfectly adjusted, apolitical free market economy, Italy, Portugal and Spain would adjust their economies to the euro’s requirements relatively easily. Italy and Spain would force down wage rates, probably through periods of high unemployment, while Italy and Portugal would undertake savage cuts in public spending to bring their budgets into balance.
In the real world, it’s not so simple. Spain already has an unemployment rate of 10.2 percent, and Italy one of 8 percent, while on the budget front Portugal has a Socialist government and Italy faces elections next year. Normal free market adjustment, therefore, would be exceptionally inconvenient if not impossible in all three countries.
This type of difficulty was forecast by the euro’s opponents at the time it was devised. Historically, Italy, Spain and Portugal have run sloppier economic policies than Germany, which was hemmed in by the Bundesbank and by the long-standing German fear of inflation. Inflation in all three countries was higher, budget deficits were generally higher and public debt was higher and – not coincidentally – tax evasion and interest rates were much higher. The overall size of the public sector was similar to Germany’s, or even somewhat smaller, but the political and economic environment was quite different. When exchange rate parity between the Mediterranean and Germany was maintained over a long period, Mediterranean sloppiness caused those countries to become progressively less competitive, and eventually a currency realignment occurred.
Opponents of the euro pointed out that if existing policies remained in place in the Mediterranean once the euro was adopted, those countries’ costs would gradually become out of line with those of Germany and Northern Europe. This would particularly be the case because of the initially lower interest rates that a common currency would bring, which would cause an inflationary economic boom, with accompanying real estate speculation, in Mediterranean countries whose domestic interest rates had dramatically fallen.
When disaster didn’t ensue by 2001-02, and full currency union took place smoothly, euro proponents were quick to proclaim that the doomsayers had been wrong. Even though there had been a boom in the Mediterranean countries, and budget deficits in several countries had crept above the Maastricht limit, disaster had not occurred and the lower transaction costs of a common currency would raise everybody’s growth rate sufficiently to compensate for any transitional difficulties.
It didn’t happen. For one thing, the reduction in transaction costs from a common currency was overstated. As an Englishman or American traveling around Europe, I find it very convenient that almost the entire continent has one currency: no more francs, deutschemarks or lire but just one generic “foreign money.” For local businesses, the gains are much less.
On the one hand, payments between countries are cheaper (though since clearing house systems are not yet unified, and banks’ costs remain higher than on a domestic transaction, your bank will only absorb the costs if you get the payment details exactly right, which many small businesses don’t.)
On the other hand, considerable barriers remain to a seamless European market, as is demonstrated by the continuing lack of strong cross border mergers between retailers and commercial banks, the institutions with most day to day contact with the public. If you try to sell a German product in France, there’s still a lot more to be done than for an Indiana manufacturer selling in Ohio. For Indiana/Ohio, the seller just loads up a truck and visits Ohio branches of retailers with whom he is already dealing – only in a few cases does he have to provide different labeling information or vary his product, while his advertising campaign can simply be extended to the Cleveland, Columbus and Cincinnati media. Financing can be done from his Indiana bank, which these days probably has branches in Ohio.
On the other hand a German selling in France is dealing with different retailers, in a different language, hence different labels, with different margin and credit requirements, and selling through a different advertising campaign in a different language and probably using a different appeal. Thus the saving from a common currency is only a minor part of his overall distribution costs.
Whereas the benefits of the euro accrue almost immediately, and do not thereafter increase much (unless such infrastructure as clearing systems are unified) its costs do not appear immediately. If Italy tends to have labor costs that rise 5 percent per annum faster than Germany’s, it does not suffer much in the first year, since the original exchange rate parity was selected at a level that made Italian goods competitive, or even slightly cheaper than German goods of the same quality. On the other hand, the indirect benefit to Italy, of a cheap money boom, rising house prices, and increased industrial investment, does occur immediately and produces a substantial feel-good factor. Thus in its early years a common currency such as the euro is likely to be popular.
After the initial boost, the problems of a common currency start appearing, and intensify steadily. If there is an inflation differential, prices get more and more out of line. If one country has a budget deficit, both its public debt and its borrowing costs increase, in turn increasing the deficit. If it adopts restrictive taxation policies to attack the deficit, its economy goes into recession. If a country has high unemployment, the cost of unemployment payments itself weakens the economy relative to its partners.
The solution is to have fiscal and other policies set centrally, with free movement of goods, services and labor. If Ohio runs into a recession, transfer payments come from the rest of the United States to bail it out. If Ohio prices and wages rise, goods and labor flow to Ohio and tend to deflate them. If Ohio runs a budget deficit, its officials turn to Washington for help. In the early United States, these mechanisms did not work very well (which is why Pennsylvania defaulted in 1841 and notes of back-country banks traded at a discount.) In today’s United States, they do. In the EU, they are not yet available, so many of the corrective mechanisms for currency-union imbalances don’t exist.
In the mind of EU policymakers, the solution to all this is simple. Once problems appear, they will be solved by increasing centralization of decision making, particularly on fiscal policy. Hence a currency union will lead to a common fiscal policy set by Brussels, and in particular to tax harmonization, a key EU bureaucrat wish for 20 years now.
The stage is thus set for a vast Manichean struggle, which will dwarf the current battle over the EU constitution. As imbalances worsen within the Euro zone, national governments will attempt to correct them but will fail, since any national government that follows policies draconian enough to succeed will be thrown out by its electorate. The EU bureaucracy will correctly assert the inevitability of tax and other policy harmonization, and increased central direction from Brussels. Even in the EU however, democracy is not entirely without a say, and the forces that have struggled (whether successfully or not) against the EU constitution will push for a much less painful solution to the problems caused by the euro: leaving the euro and re-establishing a national currency.
The struggle will be a bitter one; which side wins will determine the future of Europe.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.