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IS THE EURO DOOMED?

Coauthored by Laurent Jacque and Anthony Gribe
Reprinted from Le Monde
Jan. 15, 2004
Translation of op-ed by co-author Prof. Laurent Jacque

The recent rejection of the Euro by a skeptical Sweden along with Britain’s decision to postpone sine die her referendum on joining the Euro raises questions about the future of the currency. Since its launch almost five years ago the Euro-zone has shown deepening sign of malaise. Economic growth has been anemic, unemployment has continued to creep up and its two largest economies are breaking the 3% GDP ceiling on their budget deficit, thereby defaulting on the Growth Stabilization Pact. Indeed France and Germany are liable for fines of up to 0.5% of GDP or Euro 7.8 billion and Euro11 billion. Only last week did Brussels agreed very reluctantly to waive the French fine . By contrast the “Euro- skeptics” – The United Kingdom, Sweden and Denmark – share substantially lower rates of unemployment, higher growth rates and very low budget deficits (when they are not surpluses). Clearly the Euro has not delivered any significant benefits to the Euro-zone yet: is it part of the problem?

 

The politically-motivated launch of the Euro in 1999 never met the acid-test of what economists call an optimal currency area. A group of countries (or regions) is deemed to constitute an optimal currency area when their economies are closely interwoven by trade in goods and services and mobility of factors of production. The United States is the longest surviving and most successful example of a well functioning currency area. Is the EU an optimal currency area? Intra-EU trade hovers around 15% of the Euro-zone GDP, which is significant but considerably lower than in the United States. Also, labor mobility across Europe is only a small fraction of what it is in the United States (not to mention that for socio-cultural reasons among others it remains very low within each of the national economies).

Ignoring these quintessential problems, the Euro created a single monetary policy with the establishment of a European Central Bank thereby depriving each country of two (out of three) critical economic policy tools: an independent monetary policy and the flexibility of altering its exchange rate. Furthermore, the third critical tool, fiscal policy, was sharply constrained by the Growth Stabilization Pact. Given the obvious structural and cyclical differences between EU members, the much reduced economic policy deftness is of particular concern should a given member country suffer from a particular shock that does not affect the rest of the euro-zone. If the Euro-zone were indeed an optimal currency area the economically impaired country would be able to adjust because of 1) the mobility of its labor with the rest of the Euro-zone, 2) flexibility of wages and prices and/or 3) a stabilizing transfer of fiscal resources from Brussels. None of these conditions were met when the Euro was first hatched in 1999 nor is there any sign that member countries are putting in motion structural reforms to bring the euro-zone any closer to being an optimal currency area. The third condition - which happens to be easier to meet – calls for a hefty dose of fiscal federalism but remains as elusive as ever. Indeed the European Union – which itself has very limited taxing power (no more than 1.27% of GNP) – cannot make stabilizing fiscal transfer to smooth out national shocks. The brunt of fiscal policy remains in the hands of national governments with Brussels accounting for less than 3% of Euro-government expenditures. This stands in stark contrast to the United States where more than 60% of government expenditures occur at the federal level. The US also enjoys a significant degree of labor mobility and greater wage flexibility than Europe.

To make matters worse, the European electoral calendar continues to be asynchronous with each country holding elections at the presidential, parliamentary or municipal level on their own schedule. For example, Spain and Greece held parliamentary elections in 2000; Italy, the United Kingdom and Denmark did the same in 2001; while Germany, France and the Netherlands held their ballots in 2002. These mismatched electoral timelines exacerbate cyclical discrepancies across the Euro-zone because the run-up to an election is often accompanied by expansionary fiscal policy. Unfortunately the combination of centralized monetary policy and decentralized fiscal policy is resulting into localized differences in inflation, which are in turn leading to national over/under-valuation of the Euro. Under national exchange rate policy this is easily corrected through monetary policy and “competitive” depreciation/appreciation of the national currency. However this is no longer a possibility, the straight jacket of the euro has killed the exchange rate policy tool and frozen monetary policy. Because of this inability to respond flexibly to inflation, the purchasing power of the Euro in several countries is rapidly eroding compared to the German and Euro-zone averages. Indeed on the basis of inflation rates in Greece and Germany over the period 1/1/01/99-31/06/03 the Euro in Greece is already overvalued by 25% against the Euro in Germany: if national inflation rates are extrapolated into 2006 there will be at least three countries in which the Euro is overvalued on the basis of purchasing power to the tune of 25% and one country approaching 50%.  

Inflation-based overvaluation in European Countries

We are reminded of the painful odyssey of the Argentine peso locked throughout the ‘90s in a one-to-one peg with the US dollar – de facto creating a monetary union with the United States through a currency board. In so doing Argentina abdicated its monetary policy to the United States and gave up its exchange rate policy without the possibility of compensating fiscal transfers from the United States or labor mobility. The peso became grossly overvalued (by approximately 30% in Purchasing Power Parity terms) while the Argentine economy wilted, unemployment skyrocketed and – in spite of some price and wages flexibility - the currency board ultimately collapsed and the peso plunged. Admittedly this was an extreme case of monetary union (Argentina doesn’t trade nearly as much with the US as Euro-zone member nations do with each other ) but the many similarities with the Euro-zone are ominous.

Should countries like Spain, Greece or Finland (with unemployment rates of 11.3%, 10%, and 9.1% respectively in 2002) find themselves becoming grossly uncompetitive with unbearable levels of unemployment the temptation to secede unilaterally from the Euro-zone may become overwhelming (some European central banks are rumored to have stockpiled national currency banknotes in their vaults just in case…! Ultimately much will depend on how the European Union fares economically. An optimistic scenario of renewed economic growth will keep the Euro afloat and if prosperity emboldens politicians to make hard structural reforms especially in the labor market (and in ceding further fiscal autonomy to Brussels) the Euro is here to stay. A deepening recession on the other hand with structural unemployment reaching 11-13 % will exercise unbearable pressure on the Euro-zone member countries. Politicians will seek an easy fix: the temptation of an independent (downward) currency float will be hard to resist. Ten eastern European countries joining en masse will only weaken an already rickety “equipage”. However traumatic reinstating national currencies may be, some – not necessarily all – countries may decide to exit the Euro. Smaller economies would probably be the first candidates to secede. It is unthinkable or is it ?

Laurent L. Jacque
Walter B. Wriston Professor of International Finance and Banking
The Fletcher School of Law & Diplomacy (Tufts University)
And HEC School of Management (France)