Main page content:
The crushing reality of making the eurozone work
By Martin Wolf
Published: June 8 2005 03:00 | Last updated: June 8 2005 03:00

Which part of the word "no" do Gerhard Schröder, Germany's chancellor, and Jacques Chirac, the French president, fail to understand? France and the Netherlands have rejected the constitutional treaty: it is dead. But the rejection of the treaty by two of the original six members raises profound questions about the future of Europe and, above all, about the monetary union. A rising tide of integrationist ambition swept the single currency on to the European shore in the 1990s. Now, it is in danger of becoming a beached whale.

Economists argue about the necessary and sufficient conditions for a successful single currency. But the majority would agree that it helps if the area in question is subject to common shocks, markets for goods, services, capital and labour are flexible, the overall economy is dynamic and, not least, there is a shared identity embedded in common political institutions. Not one of these conditions is either necessary or sufficient. But the absence of all four creates a huge challenge. Yet this is precisely where the eurozone now finds itself: economies have diverged; growth is disappointing; markets are proving dysfunctional; and the movement towards further political integration is now in peril.

Why do these conditions matter?

First, if a currency area is subject to common shocks, the scale of needed adjustments by any individual economy is likely to be smaller.

Second, if markets are flexible and factors of production mobile, it is easier for the central bank to achieve its objectives. In its latest Economic Outlook, the Organisation for Economic Co-operation and Development notes, for example, that headline inflation has remained at or just above 2 per cent in the eurozone, with remarkably little variation. "This," it adds, "has been the case even as growth has slowed and a sizeable negative output gap emerged in 2003 and persisted into 2004."

Third, if the overall economy of a currency union is growing rapidly, adjustments within the zone are more likely to involve lower, but still positive, growth in the affected countries, rather than, as has recently happened in Germany and Italy, a long period of stagnation (see charts).

Finally, a sense of participation in a political community makes it easier to develop fiscal mechanisms that assist adjustment to shocks and to impose fiscal discipline on member states. Moreover, the stronger the sense of a shared destiny, the less likely is use by national politicians of anti-European rhetoric as a route to power.

The link between the votes and the plight of the eurozone does not only go via the impact of the former on political integration. It also goes via the economics. Poor economic performance was one of the principal reasons for the No votes. But in France the vote was also one against openness to market forces and in favour of onerous taxes and regulation. It was, therefore, a vote against political integration and economic flexibility.

Yet, whatever the difficulties in sustaining the union, the costs of exit look far worse. Suppose that a country wished to exit from the euro and recreate its national currency, in order to depreciate, as suggested by Roberto Maroni, the maverick Italian welfare minister. Any such depreciation would raise the cost of the stock of debt. A highly indebted government would have a choice between redenominating its euro debt in a new national currency or defaulting. Either possibility would create a financial crisis and be tantamount to a withdrawal from the European legal order. As soon as this possibility became real, the interest rate spreads would become prohibitive, thereby triggering the crisis.

What, then, is going to happen? That this has now become a question is being noticed in the markets, where the currency has tumbled and interest rate spreads on bonds have widened. And what should happen? I venture the following suggestions.

First and most important, the political leadership of the existing members of the eurozone must explain the realities of a currency union. Market-led flexibility is not an option but a necessity.

Second, these leaders must stop trying to impose reform on their countries via the backdoor of the European institutions, only to blame the latter. This malign practice has undermined the legitimacy of both reform and Europe.

Third, members of the eurozone need to find a way to convince the European Central Bank they are serious about reform. A reduction in ECB interest rates is past due. But the more credible is reform, the easier it becomes for the ECB to make the needed changes.

Fourth, further expansion of the eurozone is undesirable until its core economies have demonstrated their ability to make the system work, both economically and politically.

Fifth, countries that are not within the eurozone - notably (and happily) the UK - should recognise the implications of their semi-detached status. It is not for them to try to impose reform on other European states. They should concentrate, instead, on resisting the imposition of costly and unnecessary regulations emanating from the EU upon themselves.

Finally, if there is to be further political integration, it should logically be within the eurozone. For here is a group of countries that have tied themselves together in the most intimate way. If they are unable to bind themselves more closely, above all, by creating an effective fiscal union, their project may yet founder.

In an article published on December 3 1991, just before the Maastricht treaty was negotiated, I argued that "the effort to bind states together may lead, instead, to a huge increase in frictions among them. If so the event would meet the classical definition of tragedy: hubris (arrogance), ate (folly); nemesis (destruction)." That judgment remains relevant. The euro was a heroic project. Its members cannot now afford to let it fail. But the attitudes shown over the past week make such failure more likely.

If the members of the eurozone - above all, the big countries - are unwilling to promote reform, their project may yet founder, however great the costs they would suffer. No currency union is likely to survive without either the economic or the political conditions of success. The struggle for the constitutional treaty is over. The battle for a successful currency union has begun.

Email articleEMAIL ARTICLEPrint articlePRINT ARTICLEMost popularMOST POPULAR