The euro

High tensions
Feb 5th 2009
From The Economist print edition

The danger of a euro crisis is increasing; it may

prompt more political integration, not less

FOR all the faults they have displayed in recent years, financial markets still
provide useful signals. Right now, they are indicating danger for Europe’s
single currency, the euro.

The signalling is coming not from the foreign-exchange market (the euro has
climbed back from its October low against the dollar) but from the bond
markets. Spreads on the ten-year government debt of Greece, Ireland, Italy,
Portugal and Spain over that of Germany have widened sharply. Rating
agencies are paying particularly close attention to the fiscal positions of the
profligate five: Standard & Poor’s has downgraded three of them and put
another on credit watch.

The recession in the early 1990s saw a near-continual series of currency crises
within Europe’s exchange-rate mechanism. One motive for creating the euro
was precisely to avert such evils in future. Indeed, some of those fretting
about the troubles of the euro area’s weaker economies are publicly drawing
comfort because they have at least been spared pressure from the foreign-
exchange market.

Yet pressure has to go somewhere. And in these countries it is emerging in the

form of lost competitiveness, gaping current-account and budget deficits, and
the markets’ fears for national creditworthiness—with the effects being felt in
falling GDP and rising unemployment.

To a large extent these five countries could be chided for reaping what they
have sown. In the 1990s many made strenuous efforts, through fiscal
tightening, wage restraint and product- and labour-market reforms, to qualify
under the Maastricht treaty’s criteria for euro membership. But once they
passed the test they relaxed, beguiled by the notion that membership of the
single currency would of itself solve their problems. At the same time they
enjoyed the benefits of a boom brought on in part by the euro’s lower interest
rates. Yet the logic of their situation argued for exactly the opposite course.
Once in the euro, and deprived of the chance to devalue again, they should
have pursued more vigorous reforms at home to make their economies better
able to compete with Germany’s; and they should have pulled the fiscal reins
even tighter to offset the euro’s easier monetary policy.

Now that Europe (including Germany) is again in deep recession, this logic is
hitting home. In Spain and Ireland property bubbles that were inflated in part
by the switch to low euro interest rates have burst spectacularly. In Greece,
Italy and Portugal a steady loss of wage and price competitiveness is eroding
growth. In all five countries, as budget deficits grow, worries that public
finances may get onto an unsustainable path are rising (see article). The bond
markets are especially concerned about Greece and Ireland; but fears are
growing even over such big countries as Italy (where public debt stands at
over 100% of GDP) and Spain.

No exit strategy
Anglo-Saxon sceptics about Europe’s single currency gleefully predict that
these strains will blow the euro apart, just as they did the exchange-rate
mechanism in the early 1990s. Yet even if some countries now have a twinge
of regret over joining the euro, they know that the pain would get worse still if
they left. Quite apart from the huge technical problems of reintroducing a
national currency, quitting the euro would surely entail default on euro-
denominated debts, and could also put a country’s membership of the
European Union at risk.

Yet if leaving the euro is unthinkable, the risk of default by a country that stays
in has clearly gone up. As more countries from central and eastern Europe
join, that danger is likely to rise further. This suggests that it would be sensible
to draw up contingency plans for how the rest of the euro area should best
respond to a threatened or actual default.

The rules of the single currency expressly forbid any bail-out of one country by
the centre or by other countries. The Germans, ever fearful that they may be
asked to pick up the bill for the profligacy of others, are already squashing any
talk of issuing joint euro-area bonds to relieve some of the pressure on
national governments. Yet as the euro area’s biggest economy and biggest
exporter, Germany would suffer more than most from any member’s default.
So it has a huge stake in making sure it does not reach that point.

That need not imply a straightforward bail-out. But it does suggest the euro
area might need an equivalent of the International Monetary Fund’s rescue
packages. It would imply both a bigger role for the centre and more intrusive
monitoring of euro members’ budgets. Far from fulfilling the eurosceptics’
dream of kiboshing the entire European project, a crisis could thus lead to
even deeper political integration. That is a guess. But some form of euro
drama looks ever more likely—and it would be better if governments started
preparing for it now.