Resident Fellow Desmond Lachman

There are certainly many things to celebrate about the Euro's first ten years of existence. As Harvard Professor Jeffrey Frankel has recently noted, the transition to a European monetary union among 11 countries in 1999 went smoothly, the Euro immediately became the world's number two international reserve currency, and ECB officials have worked as European citizens rather than as home country representatives. In addition, in recent years the Euro has increased considerably in value, it has gained a strong reputation, and it has expanded to 15 member countries with many more countries knocking at the door for Euro-membership.

While the Euro's many achievements are not to be gainsaid, the Eurozone has developed serious imbalances that could prove to be the Euro's eventual undoing. This would be particularly the case were the present European recession allowed to deepen and to be prolonged. Among the more fundamental imbalances threatening the Euro's longer-run durability are the marked divergences between Eurozone members in international competitiveness and in external current account balance positions. Further threatening the Euro are the ongoing bursting of major housing market bubbles in Spain and Ireland, as well as the lack of serious progress in addressing fiscal imbalances and excessive public indebtedness in Greece and Italy.

Over the past few years, the ECB's one size-fits-all monetary policy has resulted in very different price and wage inflation performance between individual Eurozone members. As a result, since 2000, Greece, Spain and Portugal have all lost between 15 and 30 percentage points in cost competitiveness with respect to Germany. This loss in competitiveness has contributed importantly to the marked widening in the external current account deficits of these three Mediterranean countries to between 10 and 12 percentage points of their respective GDPs. That widening has occurred at a time that Germany is now running an external current account surplus of 7 percentage points of its GDP.

History all too sadly attests to the fact that external current account deficits of the size now being experienced by Europe's Mediterranean members are simply not sustainable. For even though these countries might largely be borrowing in Euros, these continuous large external current account deficits necessarily require ongoing financing from abroad that results in ever-increasing external debt burdens. The recent widening in spreads on the Mediterranean countries' sovereign debt to over 100 basis points with respect to Germany would seem to be a warning shot from the markets as to the un-sustainability of present external borrowing trends in Greece, Portugal,and Spain.

Within the constraints of a currency union, individual member countries cannot restore competitiveness through currency devaluation. Rather competitiveness has to be regained either by consistently having lower wage and price inflation than their neighbors or else by having consistently better productivity performance. At the best of times, regaining competitiveness in this manner implies political sacrifices that are difficult to bear as recent events in Athens would attest. It is all the more difficult to regain competitiveness at a time when most countries are in deep recession and when they are on the cusp of experiencing price and wage deflation.

Recessionary conditions in Europe would also highly complicate the solution to the particular problems presently plaguing major Eurozone countries like Italy and Spain. During the boom years, Italy made very little progress in addressing its public finance problem as is all too vividly evidenced in a public debt to GDP ratio still in excess of 100 percent and a public debt maturity of less than seven years. The present downturn is bound to aggravate Italy's already precarious public finances since, lacking an independent monetary or exchange rate policy, any attempts at fiscal consolidation by Italy in the midst of a recession are all too likely to prove counterproductive.

Similarly, an unfavorable external environment will exacerbate the vicious housing-led downturns in Ireland and in Spain, which are now experiencing the early phase of the bursting of their outsized housing market bubbles. Lacking independent monetary and exchange rate policies, as well as having lost a substantial amount of international competitiveness, it is difficult to see how the economies of these two countries will not severely challenge their longer-run political stability.

The potential unraveling of the Euro in its present form constitutes a major risk not only for the Mediterranean member countries but rather for the Eurozone as a whole, with which they are so closely intertwined. This risk would seem to make it all the more imperative for European policymakers to respond very much more aggressively to the current European economic downturn than has been the case to date.

Desmond Lachman is a resident fellow at AEI.