EPA

Watch out for free-riders

MANY predicted chaos when the euro was launched on January 1st 2002. Withdrawing 12 national currencies simultaneously and replacing them with a new single currency was fraught with logistical and political risks. In the event, the transition to the euro went like clockwork. Watched over by its guardian, the European Central Bank (ECB), the new currency swiftly established itself with consumers and the international money markets. It has become the single most powerful symbol of European unity.

But as the old joke goes, whereas the euro clearly works in practice, there are still question marks over whether it works in theory. Theoretical doubts about the euro have almost always centred on the long-term problem of maintaining a single currency without a single government behind it. The early years of the euro have not yet answered these questions: if anything, they have made them more intriguing—and troubling.

When an individual country runs into financial problems, it may be faced with high interest rates, a threat of inflation and a run on its currency. But when a number of independent countries share a currency, the risks are spread, so some countries may become “free-riders”. Even if they fail to tackle their own fiscal problems, they may escape the full consequences of their lack of action—but only because other, more responsible countries pick up some of the tab.

It was this prospect that persuaded the EU to draw up a “stability and growth pact” which required all euro countries to keep their budget deficits below 3% of GDP at all times, on pain of huge fines for repeat offenders. Unfortunately the pact proved unworkable. Portugal, the first country to exceed the 3% deficit, obediently slashed public spending, thus deepening its recession and pushing up unemployment. But when France and Germany broke the 3% barrier, they leant on the other EU members not to enforce the pact. In effect, despite a ruling by the European Court of Justice, the stability and growth pact is now in abeyance.

But the “free-rider” problem remains unresolved. Indeed, it is likely to become increasingly troublesome as the ticking of the demographic time-bomb becomes louder. It may not be entirely coincidental that the three EU countries that have chosen to stand aside from the single currency for now—Britain, Sweden and Denmark—have gone further than most to put their pensions systems on a sound financial basis.

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