Future looks uncertain for the euro

The rejection by France and the Netherlands of the new EU constitution was a blow to unity, and now questions are being asked about the long-term viability of Europe\'s single currency.

Following the rejection of the new European Union constitution by France and the Netherlands, doubts have been cast over the willingness of politicians to support the European single currency. For the first time since its inception on January 1, 1999, commentators have begun to question the long-term viability of the euro. In Italy, two government ministers have recently called for the reintroduction of the lira.

There were high hopes that the euro would boost economic growth through stronger trade. This has not materialised and the past six years have seen the eurozone lag other parts of the world in growth and employment. The contrast is particularly striking with Britain, which opted out of the single currency and has outperformed the eurozone with stronger growth and lower inflation and unemployment. Despite the recession of 2001, America has also outperformed (see table 1).

Not all eurozone countries have underperformed, however. Ireland, Greece, Finland and Spain have all experienced faster-than-average growth, while Germany and Italy have been considerably weaker. The problem is that Germany and Italy account for about a third of eurozone GDP, while the fast-growing periphery is less than 5%.

While this divergence shows there have been successes within the region, it also highlights the problem facing the European Central Bank of setting an interest rate for the whole area. In real terms interest rates in Ireland have averaged less than 1% in recent years, while in low-inflation Germany the figure is over 3%.

This mismatch has had a significant impact on housing markets – a house in Ireland has doubled in value over the past eight years, while houses in Germany have fallen slightly in price. Spain has seen house prices rise by 150% over the period.

So where does the blame lie for the current uncertainty surrounding the euro? One explanation is that the weakness of the eurozone is a structural problem. European labour markets are notoriously inflexible, because of a raft of employment regulations. For a given increase in output, the eurozone will create a fraction of the jobs created by America. This has prevented it from generating a self-sustaining phase of growth as the effects of expansion are extinguished by a rigid labour market.

There is also an argument that the region has been particularly badly hit by globalisation, as it has a high concentration of industries affected by relocation to the low-cost emerging economies of Asia and Eastern Europe.

From a corporate perspective this presents an opportunity to produce goods more cheaply. However, at the macro level it creates a challenge if those made unemployed by the relocation have difficulty finding alternative work.

A further explanation is the stalling German economy – a major contributor to eurozone GDP. The reunification of Germany in 1990 initially led to an economic boom as the former communist state was rebuilt. However, the economy failed to build on this momentum and growth faded. Today one in 10 west Germans are unemployed, rising to one in five in the east, placing a huge burden on the German government. As a result, the economy has fallen into a downward spiral of rising taxes and declining growth. Blaming Germany does not give a full explanation of the eurozone’s malaise, but it goes a little way and effectively exonerates the euro from any blame.

Looking at current trends, the eurozone faces further economic weakness – we are expecting below-consensus growth (see table 2). In the absence of a pick-up in domestic demand, an economy like the eurozone does not thrive when global activity is cooling. An interest rate cut would improve sentiment, but a move to a less restrictive inflation target (say 2.5% with plus or minus 0.5%) is a longer-term solution.

We are optimistic that we will see further structural reform: a possible change of government in Germany may be the catalyst for more serious reform efforts across the continent. For all its problems, Germany has made tremendous efforts to control costs and become more competitive. The greater worry is perhaps Italy, which has not reformed and, while in the past the government would simply restore competitiveness by devaluing the lira, that is no longer an option.

So what is the likelihood of a break-up of the euro? History shows that multi-national currency unions always break down. This was the case for the Latin and Scandinavian unions1 in the late 19th/early 20th century. However, they did last a long time and produce periods of stable growth. Arguably, European Monetary Union is different; it has only one central bank, so it ultimately resembles a national currency union such as America or Canada. In this case political unity is the key to its survival. Economic divergence can persist for a long time, as the cost of leaving the euro would be huge for a country like Italy.

The eurozone is unusual in that monetary union was not preceded by political union. Ultimately, the survival of the euro will depend on political unity, and the rejection of the constitution could be seen as a reminder to Europe’s politicians that the electorate is some way from sharing this goal.

1The Latin currency union was established in 1865 and despite its name consisted of France, Belgium, Switzerland and Italy. The Scandinavian union was created in 1873 and contained Sweden, Denmark and Norway.