EMU on the rocks and all exits closed

The euro was created to bring economic stability to Europe. However, the politicians who promoted European Monetary Union ignored inherent flaws in the project. The credit crisis has exposed these flaws. As a result, a number of the weaker eurozone members are facing severe deflation and a quite desperate economic outlook.

The leading European politicians behind the euro project, such as former French president Francois Mitterand, weren’t much interested in economics. In a new book, The Euro: The Politics of the New Global Currency (Yale) David Marsh shows how these politicians brushed aside the concerns of their advisers as they rushed eagerly towards monetary union. Mr Mitterand’s vision for the single currency, says Mr Marsh, was “based on emotion, psychology and wishful thinking” rather than rational economics.

It was hoped that the euro would bring faster and more stable economic growth, while exporting Germany’s record of price stability to other members of the single currency. But many potential economic problems with European Monetary Union were identified decades ago. In 1973 Derek Mitchell, a British Treasury official, observed that the loss of exchange rate flexibility would remove a simple method for rectifying imbalances between Europe’s economies. Without the option of exchange rate depreciation, once imbalances appeared “equilibrium could only then be restored”, declared Mr Mitchell, “by inflation in the ‘high performance’ countries and unemployment and stagnation in the ‘low performance’ countries, unless central provision is made for the imbalances to be offset by massive and speedy resource transfers”.

Economists at the Bundesbank wanted to delay monetary union until the performance of Europe’s various economies had converged around similar inflation and growth rates. They were defeated by French bureaucrats, who believed that the euro would bring about convergence. Former Bundesbank (and later chief European Central Bank) economist Otmar Issing questioned whether Europe could move to a single currency without parallel moves to political union. Eddie George, then governor of the Bank of England, warned that Europe needed to improve its labour market flexibility before entering into a monetary union. His counterpart at the Bank of Italy, governor Antonio Fazio, questioned whether Italy would make a suitable member of EMU given that the country had a history of periodically devaluing the lira in order to regain competitiveness.

Despite these reservations, the single currency was created without effective controls on the ability of member governments to issue debt and with no formal arrangements for fiscal transfers to aid stricken countries through hard times. A high level of cross-border labour mobility, which anyhow would have required a common language, was never achieved. There were no ground rules for dealing with divergent economic competitiveness among member countries produced by differing rates of inflation and productivity over time.

Europeans are paying the price for the oversights of their former political masters. Since the euro came into existence a decade ago, consumer prices in Portugal, Ireland, Italy, Greece and Spain have risen by an average of about 20 percentage points more than in Germany. They have also experienced lower productivity growth. In addition, they have run large current account deficits and, with the exception of Italy, have experienced tremendous housing bubbles and credit booms. The ECB inadvertently contributed to the credit booms by setting an excessively low interest rate for fast-growing economies, such as Ireland.

In the past, the weaker European economies faced with the current crisis would have simply devalued their currencies. With that option closed by monetary union, their economic outlook appears dire. Spain’s unit labour costs are currently about 20 per cent higher than Germany’s, according to Andrew Hunt Economics. Unemployment is rapidly approaching 15 per cent of the workforce. To regain competitiveness, Spain would have to cut costs sharply, including wages.

Ireland’s problems are even more acute. Irish exports amount to about 90 per cent of GDP and roughly a third of these exports go to the UK. Ireland also competes with Britain for foreign direct investment. Yet over the past year, the euro has appreciated by 20 per cent against sterling, rendering Ireland even less competitive at its moment of crisis.

As the credit ratings for the peripheral members of the eurozone are downgraded and their borrowing costs rise relative to Germany, there has been speculation that some countries may choose to ditch the euro. The trouble is that EMU is an economic roach motel – it’s easier to check in than it is to quit. Leaving the euro would be a painful and messy business. It would require breaking supposedly “irreversible” treaty commitments and disentangling a web of euro-denominated financial obligations. As former German Chancellor Helmut Schmidt says “the great strength of the euro [is] that nobody can leave it without damaging his own country and his own economy in a very severe way”.

However, the alternatives aren’t pleasant. Germany might be forced to make reluctantly huge fiscal transfers to eurozone countries with large current account deficits, such as Spain. But this wouldn’t make them more competitive. As former Bundesbank president Karl-Otto Poehl says: “The other European countries have no choice [but] to . . . embark on a course of cost-cutting.”

A decade after its birth, the euro is playing a similar deflationary role in the current credit crisis as the gold standard performed in the Great Depression. The Europeans of the 1930s had certain advantages. For a start, they were less leveraged and when the crisis arrived, they had no trouble casting off their golden fetters.


Edward Chancellor is a member of GMO’s asset allocation team