The euro is Eight Years Old

23^rd February 2006

The Malta Independent - Friday Wisdom

The euro’s eighth birthday passed largely unnoticed on 1 January, despite the announcement a few days earlier by the European Central Bank that there are now more euro bills in circulation than US dollars.

Six out of 10 Germans want their deutschemark back and shopkeepers in Spain routinely display prices in pesetas as if they are taking precautions for their national currency to come back in circulation. The Italians blame their economic stagnation on euro adoption which has taken away the past safety valve of devaluing their currency back to international competitiveness.

Monetary union depends for its success on a commitment for a political union. History shows that monetary unions that were not under-pinned by a political union proved short-lived. The Latin Monetary Union involving Italy, France, Belgium, Switzerland and Greece collapsed in 1920 after 60 years because of lack of fiscal discipline among its members. A Scandinavian monetary union in 1873 proved short-lived as political circumstances pulled countries apart rather than closer together.

The German Central Bank used to argue in the 1980s that monetary union was to be the end result of a political union. Eventually this view changed and the Germans accepted that monetary union could be a catalyst to bring about a political union. The official view is that monetary union can survive and function well without a political union if three conditions prevail: fiscal discipline, central bank independence and a high degree of product and labour market flexibility.

Two of these three basic conditions are currently unobtainable and the one which seems to prevail, at least nominally, that is, the independence of the central banks, is often challenged by national politicians who seem willing to put pressure on the ECB to avoid measures that could produce negative political ripples within national boundaries, even if these would be justified on a supranational basis. Furthermore the independence of central banks can only be effective if set in context of a shared identity embedded in common political institutions.

One could therefore be tempted to argue that the euro is still too young to guarantee its perpetual existence and that if the EU itself does not evolve into a political union over the next decades the long-term sustainability of the single currency could be brought into question.

This thesis begs a proper definition of political union. If it is understood as the establishment of an entity resembling the traditional member states I doubt if we will ever get there even over several decades. If it is understood as a dense network of integrated policies, common rules and established procedures with strong and active supranational institutions, common symbols and common identity, then the EU already exhibits many of these features.

After all, growth differentials between regions, even states, of the US are just as big as those between member states. The political bond between US states is much stronger and makes a monetary breakdown unthinkable and impossible. Within the EU, the political bond may not be strong enough to resolve the tensions and arguments that at times emerge. It follows that this may result in member states exiting the monetary union and still remaining as EU members gaining the same status as member states that opted to stay out of the monetary union, that is, the UK, Denmark and Sweden.

This argument is false. UK, Denmark and Sweden opted to stay out because they have a strong and highly competitive economy. They did not need the discipline of monetary union to check chronic fiscal deficits, excessive public debts and out-of-control inflation. In all three cases unemployment is low and international competitiveness is high.
Italy is the exact opposite. Since 2000, unit labour costs in Italy rose by 21.4 per cent while unit labour costs in Germany have fallen 5.9 per cent. Blaming the euro for it is easy but unreal. Leaving the euro would make Italy’s problem worse, much worse.

Competitive exchange rate devaluation of the re-adopted lira would raise the value of private and public debt through “the balance sheet effect”. Interest rates on the re-adopted currency would be significantly higher causing the public deficit to reach dramatic proportions leading to emergency monetary tightening which could choke off any growth generated by the devaluation. Inflation would increase significantly entailing a sharp drop in real wages which is often the contra effect desired by those militating for Italy’s exit from the euro monetary system.

In short, the real option to leave the monetary union is for the strong not for the weak. It is more likely that the Netherlands can handle an orderly exit rather than Italy.

Whether the euro is forever or not, it is a safe bet that it will be with us for a very long time and that we can only benefit from it if we do not harbour any expectations that it can sort out all our problems without further internal discipline. What the euro can and should do is to discipline our politicians to run a sustainable fiscal position as close to neutral as possible over an economic cycle. This would ensure that economic restructuring at the base continues without relapse to short-term fiscal extravagance for partisan political advantage.