Mises Daily

Is the Euro Forever?

Leaders of European Union member states have been reeling from the double rejection of the proposed European Constitution by two of the six founding members, the Netherlands and France. Given a chance to express their opinion on “ever closer union,” for the first time in over a decade and ever, respectively, French and Dutch voters spurned the controversial text against the wishes of their countries’ political, media and commercial elite. 

The reasons for rejection were varied and contradictory, but at its roots was dissatisfaction with present economic conditions –foremost persistently high unemployment- and perceived indifference and arrogance with which national politicians subordinate domestic concerns to busy themselves with constructing a supranational entity.

One particular object of derision and scrutiny is the euro, the currency adopted in 1999 by 12 of the 15 member states that comprised the EU before the admission of 10 Central and Eastern European states in 2004.  Three ministers in  Italy’s governing coalition have augured for a reconstituted lira tied to the dollar and leaders of the German Finance Ministry have at least been privy to pessimistic discussions among private banks concerning the euro’s future.  Since the referendums the value of the euro has dropped. As of June 21, the euro was nearing a nine-month low against the very shaky dollar.

Saddled with slowing economic growth, chronic unemployment and threatened by competition from East Asia and Central and Eastern Europe, eurozone member states, particularly the core governments and economies of France, Germany and Italy, are becoming increasingly disenchanted with the common currency.  As much a political as economic project, the euro faces grave peril as the impetus, conditions, and justifications underpinning monetary union are beginning to unravel. 

From Werner to EMU

The euro was the successor of approximately two decades of a formal, though adjustable, system of mutually pegged exchange rates led by Germany’s central bank, the Bundesbank.  The gradual abolition of exchange controls in Western Europe throughout the 1980s paved the way for EU member states to embark upon economic and monetary union (EMU), as enshrined in the 1992 Maastricht treaty.  As envisioned in the European Community approved but shelved 1971 Werner report that advocated a European monetary policy, Maastricht called for a three-stage sequence of macroeconomic convergence between member states’ inflation and exchange rates, which culminated in a common currency directed by the European Central Bank in Frankfurt. 

Designed to entrench and symbolise European unity internally and augment the EU’s influence abroad, the euro also makes economic sense to EU leaders.  It obviated further speculative attacks on Europe’s vulnerable system of pegged currencies, reduced the uncertainty of inter-European trade and substituted the increasingly insular Bundesbank’s de facto control of the EU’s monetary policy for the community-minded ECB.  For many of Europe’s more indebted, inflationary and devaluation-prone governments (Portugal, Italy, and Greece) monetary union reduced government borrowing and debt-servicing costs and attenuated the threat of insolvency.

For all of the advantages of a currency union, the opportunity costs can be dear to national politicians and voters erroneously wedded to the notion that government can and must “manage” the economy to promote growth.  The existence of the ECB precludes individual member states from inflating their way out of trouble, a self-defeating prescription that merely serves to distort investment and production patterns and covertly redistributes income, ultimately aggravating economic problems. 

Nevertheless, politicians from France, Germany and Italy-countries comprising 70% of the eurozone’s output- all have railed against the ECB’s supposedly restrictive monetary policy and demanded rate cuts to ease their plight.  Much to their chagrin, the Maastricht Treaty states that the ECB must chiefly pursue price stability followed by limiting money growth. 

While the bank does acknowledge a link between money creation and inflation, its reputation as an inflation hawk fails to hold water.  The ECB’s 2% borrowing rate-unchanged for two years- is exceptionally accommodating, on par with the Fed according to some studies.  As Stefan Karlsson notes1 , the ECB’s 4.5% reference value for annual M3 money growth has been serially overshot throughout the bank’s six-year existence, averaging 6.7%.  Since last year the rate of borrowing in many eurozone economies has accelerated, stoking a housing bubble in at least a quarter of the eurozone states that portends a hard landing should money growth persist.

One currency, but one union?

Economic participants in an optimal currency union reap efficiency gains at the expense of governments’ loss of discretion over national economic policy tools.  In particular, potential members must weigh the reduction of uncertainty and transaction costs from pegging to another currency against relinquishing the ability to print fiat money to get out of jams. 

Monetary union sustainability is predicated on several factors, principally the volume of intra-union trade as well as the integration and mobility of factors of production between constituent members.  For its part, intra-EU exchange between its members is small as a proportion of European output.  Although the removal of barriers to travel and employment between EU countries has been largely completed throughout the 15 Western European members of the EU, labour mobility is much more stilted than in America, another currency union.  A bevy of different cultures, lack of a universal tongue and varying schemes of social services eligibility all staunch the movement of labour. 

What is more, the pervasive role of the state in European countries, with its stringent rules regarding job protection, collective bargaining, minimum wages, onerous tax and spending patterns and entitlement programmes ensconce sclerosis where flexibility is needed for currency union members to adjust to ever-evolving markets. 

Based on the market and factor integration justification for EMU -the fiscal and political aspects will be analysed below- the case for the euro is woefully deficient.  Even the chief economist of the ECB told the Financial Timeson June 3 that, “there was no question whatsoever that these 11 and later 12 countries participating… did not form anything close to an optimal currency union. Studies at the time had shown four or five countries coming close to that.”

The fiscal aspect

Government expenditures and borrowing, seen as the other component requisite to ensure price stability in the EU, can have deleterious effects on the integrity of the EMU when profligate governments fail to heed fiscal prescriptions.  Excessive deficits and mounting debt by any number of member states may drive up borrowing costs to eurozone governments, engender inflationary expectations in the economy, and soften the euro’s exchange rate. 

For those reasons, EMU requires member states to abide by common fiscal rules and supranational monitoring mechanisms. The Stability and Growth Pact remains the chief surveillance and enforcement authority on government expenditures, augmenting and clarifying the Maastricht criteria concerning eurozone deficits and debts. In brief, the document commits member states to run fiscal positions close to balance or in surplus and recommends corrective mechanisms, on penalty of sanctions, to ensure offenders of the critical 3% ceiling for acceptable budget deficits and the scarcely-enforced stricture on government debt stocks exceeding 60% of GDP bring their excesses to heel.

Already deprived of one instrument of economic manipulation –- counterfeiting a national fiat currency -- and confronted with poor economic growth prospects, EU governments have employed covert subversion and outright defiance of the SGP to repatriate control over the level of government spending.  Indeed, the French and German governments were instrumental in suspending the pact in late 2003 and overhauling it earlier this year.  Specifically, EU leaders agreed to lengthen the period that fiscal miscreants are permitted to rectify the breach, broadened the circumstances that a member state can invoke to justify a violation of the deficit reference value and exempted certain expenditures from deficit calculations.

At present, Paris and Berlin have been spared censure under the emasculated pact, despite being far from bringing recurring excessive deficits under control.  Neither government has demonstrated any compelling evidence it will reduce borrowing anytime soon. 

Similarly, the Italian government, an entity notorious for accounting chicanery akin to Enron, was fingered in June for breaching the deficit reference value in past years.  Having evaded formal censure from the EU Commission and Council on several occasions, the Italians are known now to have been in breach of the Maastricht criteria in 2001, 2003 and 2004 and will persist through 2006 without genuine policy changes.  

Portugal, the first member state to be subjected to the excessive deficit procedure more than two years ago, will likely reappear on the offender list as its budget deficit this year may approach as much as 7% of GDP.  Greece continues to grapple with revelations that the previous government had cooked the books2 Athens serially understated its annual deficits since 1997, which means its fiscal position did not warrant obtaining permission to join the common currency.  Although the Greek government appears on course to bring its deficit to heel by 2006, the fact that it was the only euro candidate country barred admission in 1999 and was granted entry only in 2001 via false deficit figures tarnishes the now-worthless pact and questions the legitimacy of EMU itself.

Aggregate trends in the eurozone indicate that member state finances are deteriorating. Whereas the deficit level relative to GDP of the 12 eurozone participants decreased slightly for the first time in three years, the debt ratio continues to worsen.  The present debt level in the eurozone is 71.3% of GDP; Greece, Belgium and Italy post debt levels over 100%.  What is most worrisome about these adverse debt developments is that Italy’s burden will continue to grow, coupled with projected increases from relatively high levels in France and Germany. 

Still standing?

The question remains, how will the euro fare?  As EMU is the creature of the European Commission and member state leaders, economics and politics are inextricably tied.  Based on the economic evaluation of the eurozone’s fitness as an optimal currency union, the conditions are gravely lacking.  Nowhere are the benefits and drawbacks of EMU more apparent than in Italy, a founding member and present sick man on Europe, which is on pace to post zero or even negative growth for the year.

Prior to adopting the euro in 1999, indebted and inflation-prone Italian governments reflexively relied on devaluations of the lira to ease exporters’ competitive disadvantages from an overvalued exchange rate.  EMU denies this avenue of escape to Rome, which has been unable to curtail rising production costs.  The average price of Italian labour has risen by 1.5% each year more than the eurozone's average growth rate, prompting the country’s real exchange rate to appreciate by almost 20%.  By contrast, German commitment to wage moderation has decreased its real exchange rate relative to Italy's by almost the same amount.  Germany leads the world in exports, while Italian exports have barely grown in the past five years and have even declined by more than 4% on an annualised rate in each of the past two quarters.

To recover, Italian firms must squeeze costs and freeze the nominal growth in wages to stymie price rises of goods and services –in effect, painfully incurring a decline in the price level and dearer real interest rates.  Alternatively, Italian politicians could withdraw from the eurozone and prime the fiscal pump.  As mentioned earlier, Rome is already in the doghouse for breaching the deficit limits three of the past five years and is unlikely to mend its spending habits in the foreseeable future. 

However, a loose monetary policy and attendant devaluation by a euro-free Italy would prompt lenders to demand higher interest rates to compensate for currency risk, threatening to push the de facto bankrupt government into formal insolvency, not unlike the collapse of Argentina’s currency peg to the dollar and its attendant sovereign default in late 2001.  The heavily-indebted Italian government had little recourse but to join the euro in the first place, as membership placed its fantastic debt stock into a much larger pool that annually saves Italian borrowers more than $70bn in interest payments.

If an exit from the euro is too dicey, then constraining costs by introducing competitiveness and flexibility into the economy is the only other option.  On that score, the Italian government has a dismal record, as Prime Minster Silvio Berlusconi’s election promises to liberalise the marketplace have gone largely unfulfilled.  Over the past ten years, Italy’s productivity growth has averaged 0.5% a year, trailing the EU average of 1.5%.  Within a five-year period, productivity has actually declined in Italy by 1.5% while France and Germany posted gains of 10% or more.

Italy’s poor productivity performance, anaemic growth, withering export competitiveness and fiscal licentiousness come despite the fact the country devalued the lira by almost 34% in the early 1990s, allowing it to enter the initial stages of EMU at an enviable exchange rate.  Market participants and the government were reluctant to liberalise the Italian economy, as entry to the eurozone made the threat of sovereign default remote.

To a greater or lesser degree, all of the eurozone members are bedevilled by lavish welfare states underwritten by enormous debts and taxes and onerous regulations that impede the free exchange of factors of production, goods and services -characteristics that have not substantially changed since the introduction of the euro.  Empirical studies by both the Bank of England and the Organisation for Co-operation and Development indicate that the existence of a currency union or lack of national monetary policy autonomy relax the impetus for structural reform.  This development is not at all what the architects of the euro imagined.  Rather, many economists believed EMU would be an instrument to foster productivity, liberalisation and competition.

This dearth of activity can be explained in two ways that are not mutually exclusive.  First, national authorities dare not rile the electorate by introducing market reforms that are painful in the short term without cushioning the blow via accommodative monetary policy.  Second, the necessity for economic restructuring is obviated by the pooling of national debts into a currency union. 

Concerning the latter, Guido Hülsmann3  explains the conditions and incentive structure that impels nation states toward political unification, or in the EU’s case, monetary union administered by a quasi-government. Indebted states that cannot possibly repay its obligations eschew tax rises and debt repudiation given the negative political and capital market riposte.  Monetizing debt is an even more risky proposition because it accelerates inflation beyond what the government and its connected business allies can control, dashing their cash cow and imperilling their very existence. 

It makes sense, Hülsmann argues, that bankrupt and relatively sound governments exchange political favours to keep each other afloat, as contagion may ensue if even one insolvent government goes belly-up. The purpose of the EU and EMU becomes clear when one understands that the European institutions co-ordinate the financial and political ties between member states and shield them from looming bankruptcies.  Indeed, EMU amalgamates all eurozone member states’ debts and the ECB considers each country’s bonds -– whatever the member state’s debt burden -- as near-perfect substitutes.

Of course, the fate of the debtors’ collective security pact hinges on whether eurozone member states opt to introduce flexibility into their economies or succumb to the unremitting pressure to spare their welfare states and repatriate domestic control over monetary policy, irrespective of the capital market backlash. 

Thus, the enthusiasm for European integration demonstrated by national leaders, the media, and commercial classes and at least sanctioned by acquiescent voters is paramount, as these groups were instrumental in ensuring aspiring eurozone candidate states were able to adhere to the Maastricht Criteria.  Now, such cohesion between member states and affinity for European integration is ebbing. 

France and Germany have become increasingly assertive in insulating domestic jobs from outside competition.  Berlin plans to introduce a minimum wage to protect its workers from being undercut by cheaper labour from Eastern Europe.  In recent months segments of the country’s centre-left coalition government have tilted decidedly leftwards, denouncing private equity investors as “locusts” -in the words of Social Democrat leader Franz Müntefering.

French opposition to noxious Anglo-Saxon market reforms prompted President Jacques Chirac in March to lambaste ultra-liberalism as the new communism.  The country’s overblown fear of an influx of Polish plumbers scuppered the EU Commission’s proposed services directive, an imperfect but nonetheless liberal measure that aims to extend the single market by permitting European service firms to operate across national borders. 

French opposition to the directive was foolhardy in that liberalisation of service provision would provide a significant boost to an EU that is predominantly geared toward services.  French enterprises would also benefit greatly from the measure.  However, when unemployment exceeds 10% -never below 8% in the past two decades4 - and the country’s oldest and youngest workers are already priced out of the labour market by government interventionism, protecting those people whom are still employed is of greater electoral importance.

While European leaders debate the EU’s economic orientation and the onerous constraints of EMU, the contingent liabilities from income security promises European leaders made years ago to today’s burgeoning ranks of pensioners are growing.  Most EU member states face acute long-term fiscal headaches and many already suffer seriously constrained revenue and expenditure flexibility5 .

At the moment, bond markets allow EU leaders to remain sanguine. 

Extra liquidity in sovereign bonds has allowed European governments to borrow at cheap rates that imply little chance of default.  Should demand fade, however, and lenders become more circumspect about the low growth, deteriorating competitiveness and looming insolvency of EU member states, capital markets may no longer purchase eurozone sovereigns as eagerly. Rather they will likely ask for higher interest rates to compensate for risk from the most profligate debtors.

Even EMU cannot permanently shield member states from ominous fiscal crises.

  • 1Karlsson, Stefan.  “The Future of the World Economy.”  Mises.org.  29 April 2005. 
  • 2Nülle, Grant. “Some Pact!” Mises.org. 19 Jan. 2005.
  • 3Hülsmann, J. Guido. “Political Unification: A Generalised Progression Theorem.”  Journal of Libertarian Studies. Vol. 13 Num. 1. 
  • 4Organisation for Economic Co-operation and Development. “Economic Survey of France 2005: Improving labour market performance.” 16 June 2005.
  • 5Standard & Poors. “2005 Flexibility Index: Little Budgetary Leeway for Continental Sovereigns.” 19 May 2005.
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