Sean O’Grady: Will the euroland centre hold?

Two years after the onset of the credit crunch, and a decade on from its
establishment as a single (though not universal) currency for the European
Union, it has survived in better shape than most of its critics predicted.

Its biggest economies ? Germany and France ? are already out of recession. It
is humiliating the dollar. It covers the biggest economic zone in the world.
Yet, when it started out it was labelled, by some typically indelicate
London forex traders, as a “toilet currency”, compromised by
fundamental weaknesses in the sclerotic European economies. Even the
bank-notes were derided as being too easy to forge. A wave of counterfeits
was predicted ? that never arrived.

To many even five years ago, the dynamic Anglo-Saxon model still looked a
better bet, and the euro languished against sterling and the dollar for a
long time. Today, the euro is being talked up as possible replacement for
the greenback as a reserve currency for the world.

Nor has the governance of the euro been noticeably inferior to that of its
principal rivals. The European Central Bank was designed on the highly
successful template provided by the German Bundesbank, a central bank that,
alone in the G7 powers, enjoyed a reputation for monetary rectitude. It has
not yet been chaired by a German, but the Dutch Wim Duisenberg and, still
more conspicuously, the former French central bank governor Jean-Claude
Trichet have shown themselves Germanic in mind-set.

The ECB, almost alone among the institutions of the European Union, has a
proper job to do and gets on with it unfussily. Indeed many critics say,
with the benefit of hindsight, that at least the ECB managed the early
stages of the credit crunch more effectively than the Federal Reserve or the
Bank of England. Leastways, nothing was done to damage the euro itself, even
though the anchor of the Maastricht criteria ? low budget deficits and
modest national debts ? has had to be jettisoned.

Sooner or later, as with our own “golden” fiscal rules, the
governments of the eurozone will have to reinstate some sort of credible
fiscal framework. The German constitutional amendment to restrict structural
annual budget deficits to 0.35 per cent of GDP might be a good pointer.

But those euro successes are only part of the story. One of its main, if often
undeclared, aims was to accelerate convergence among European economies. Let
us recall here that after half a century of free trade, and another 10 years
or so of a single market, the eurozone economies were already pretty
integrated ? or at least seemed to be. Some of the smaller nations around
Germany had been Deutschemark satellite zones long before the euro was
dreamt up. The euro should have followed the usual economic logic and made
the eurozone nations economies still more integrated and convergent. So did

Crude as it is, I’ve tried to test this by looking at the course of two broad
indicators: inflation and unemployment. (Only some nations are shown in the
charts, for the sake of clarity). The evidence is a little surprising.

First, as the charts suggest and simple measures of standard deviation
confirm, the eurozone economies didn’t converge that much even in the good
years, when intra-zone trade was expanding. Let’s take inflation.

Looking at the difference between the best and worst performers, and the
variability of the economies from each other, they did indeed broadly get
closer over the first seven years of the euro’s existence. Indeed the
maximum convergence occurred, eerily, in July 2007, just when the credit
crunch was about to bite: the difference between the best and worst
inflation performances among the original members of the euro was 1.2 per
cent. Spooky. Now the divergence is more severe ? around 4 per cent, close
to where the eurozone started out.

More telling still, and more dangerous because of its far more destructive
impact on social cohesion and politics, is the increasingly alarming
disparity in the eurozone’s “real” economies. Nowhere is this more
apparent than in the unemployment numbers, with Spain in particular
registering a disastrous increase. Almost always the worst performer in the
western European Union, Spain is now even further from away from the
mainstream, with youth unemployment now in excess of 30 per cent. Ireland
has joined Spain as an outlier, but the rest of the pack is more spread out
than ever before in the euro’s history. A decade ago there were 10
percentage points separating the best and worst performers ? the Netherlands
and Spain. Now there are 15, and between the same two states. So what does
this tell us?

Well, it does underline that, although we occupy such a tiny corner of the
globe, trading so much with one another, we Europeans have far less in
common than we might think. We are very structurally divergent, and it has
taken this crisis to show us quite how much.

The reasons are obvious: differences in property, labour, product and capital
markets, all far from uniform. The real-estate scenes in Ireland and
Germany, for example, might as well be on different planets. The labour
markets of the Netherlands and Belgium are bizarrely different, and the
differential impact of the credit crunch on different countries’ banking
systems has also exaggerated differences (though in that respect the Spanish
have come off relatively well).

Add to that the many languages, and separate political cultures, and you can
see why the eurosceptic case is so persistent. Had the UK joined the euro in
1999, the chances are that we would have converged with the rest of the
eurozone no more than Spain has done. This might well have left us too with
the wrong level of interest rates for the state of our domestic economy ?
and the Exchange Rate Mechanism (ERM) experience writ large. Indeed it is
perfectly possible that sterling might have dropped out of the euro by now.

Still, the euro is hanging together. The higher yields demanded by the markets
on government bonds issued by weaker brethren such as Portugal are evidence
enough that the central political problem of the euro has not been expunged.

It is still possible ? although the moment of greatest peril has prob-ably
passed ? for one of the eurozone’s members to re-establish its national
currency. When some nations manage to control costs more effectively than
others, and unemployment and social pain mount elsewhere, the traditional
method of adjustment has been currency deprecation. With that safety valve
removed, it is difficult to see how nations such as Italy will be able to
solve their growth problem, or Spain to dissolve its jobless queues. That
isn’t an argument for them to leave the euro: merely to note that, as long
as they retain their own governments, that option will always exist.

Additional research by Beth Admanson

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