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Resident Fellow Desmond Lachman
As the euro rides high, an unhealthy sense of complacency pervades European capitals about the currency’s long-run viability. For while cracks in the euro’s very foundations are widening, European policymakers all too often blindly trumpet its moment in the sun without paying any regard to its longer-run weaknesses. By so doing, they make it all the more likely that too little will be done too late to put the euro on a more sustainable footing that might ensure its survival.
One can well understand the pride that European policymakers are taking in their currency some seven years after it was launched in 1999. After all, European long-term interest rates are now considerably lower than those in the US, inflation in the eurozone is well anchored and the euro is now very much stronger in the international currency market than it was at the time of its launch. If that were not sufficient reason for pride, the euro has now comfortably displaced the dollar as the world’s pre-eminent currency in the international bond market.
A closer examination of the euro’s eroding fundamentals reveals, however, that European policymakers’ pride in their currency today might be yet another example of pride before a fall, for developments in the individual countries comprising the eurozone have hardly evolved in the direction that the euro’s founders had envisaged. Nor have they evolved in the direction necessary for the currency’s survival.
At the time of the euro’s launch, it was hoped that the adoption of a single currency would force all member countries to become more disciplined in their public finances and more competitive in their labour and product markets. By depriving countries of the easy way out of restoring lost competitiveness through exchange rate devaluation, it was hoped that countries would be forced to reform their labour markets and to undertake sweeping market reform with a keen eye on their relative competitive position.
Looking at the continued wayward wage and price performance of Greece, Italy, Portugal and Spain since 1999, one might be forgiven for thinking that little has changed in these countries in spite of their having joined the euro. In the short space of seven years, these countries have managed to lose between 30 and 45 per cent of international competitiveness to Germany. This is already exerting a serious toll on Italian growth performance, and it does not bode well for growth prospects in Mediterranean Europe, especially if Spain’s housing market bubble bursts.
A further symptom that something is amiss in the working of the single currency system is the divergent external current account positions of individual countries. Whereas Germany now runs an external current account surplus of around 4 per cent of gross domestic product, Greece, Spain and Portugal all run external current account deficits of between 8 and 10 per cent of GDP. These current account imbalances are the highest among the Organisation for Economic Co-operation and Development countries and show no immediate sign of narrowing.
The opening up of divergences in relative trade performance between individual European countries would be of little moment if the eurozone were a properly functioning currency union with real labour market mobility and true wage and price flexibility. After all, large differences in trade performance between individual states in the US do not lead to great unemployment variations between states as wages adjust and as labour moves.
Sadly, however, most studies reveal that the eurozone is as lacking today in those essential qualities for a successful currency union as it was at the time of the euro’s initial launch. As a result, one must expect unemployment to rise to socially unacceptable levels in those countries that lag behind, which in time could seriously erode political support for the euro.
It has to be of particular concern that the past loss in competitiveness will weigh most heavily on the future growth prospects of Greece, Italy and Portugal, which all desperately need more rapid growth to address the parlous state of their public finances. In this respect, by virtue of its relative economic importance, Italy stands out in terms of the risk that its public finances pose to the long-run survival of the euro in its present form.
Despite the favourable global environment and the dramatic drop in Italy’s borrowing costs since joining the euro, Italy has not managed to rein in its public deficit. Given its political instability, it is unlikely to do so any time soon. As a result, Italy’s public debt has remained above 100 per cent of GDP. More worrying still is the fact that its public debt to GDP ratio is again on a rising path. This has to raise serious questions about the long-run sustainability of Italy’s public finances, especially if one considers that markets are unlikely to remain forever forbearing in the way they price Italy’s public debt.
Over the past five years, the unusually favourable global environment has papered over the cracks in the euro’s foundations. History cautions that it would be a grave mistake for European policymakers to assume that those supportive conditions will persist indefinitely. Instead of crowing about the euro’s success, they would be better advised to embrace real labour and product market reform that might provide a firmer foundation for the single currency.
Desmond Lachman is a resident fellow at AEI.
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