Can Europe Avoid Currency Meltdown?

The Mexican-peso crash is turning out to be a rude wake-up call for Europe. What initially shook up markets in Latin America and Asia is now seen to have dealt a fierce blow to Europe as well. From Spain to Sweden, shock waves from the peso devaluation have hit hard, sending currencies plummeting and interest rates soaring. Financial vigilantes are cleaving the world economy into high-risk and low-risk zones of investment--and a good portion of Europe is winding up with emerging-market levels of creditworthiness. Unless this is changed quickly, it is unlikely that Europe's dreams of monetary union will come true this decade. Economic divergence, not convergence, is driving Europe apart.

It's clear that investors are declaring war on the welfare state and its high public-debt levels, which result from heavy spending on social-welfare programs. Germany has done the most to get its house in order, and that shows in the credit markets. Italy is being forced to price its 10-year government bonds to yield 12.20%, compared with 7.55% for equivalent German paper. Belgium has to sell its 10-year bonds to yield 8.41%, 237 basis points higher than Chile's. With integrated markets and fast-moving capital, policy rather than geography determines risk and creditworthiness.

The message isn't lost on European policymakers. Italian acting Prime Minister Lamberto Dini is racing to overhaul his nation's costly pension plan and rein in the budget deficit. Sweden has just announced a four-year program that would cut $15 billion a year from state spending. Spain is also trying to tighten, and French Prime Minister Edouard Balladur, the likely winner in the May 7 final round of presidential elections, is promising to reduce health and welfare charges.

Investors have heard such promises before, however. And they are turning to Germany and Japan--as these countries emerge from recession--for greater, and safer, returns on capital. Another currency meltdown is facing Europe unless politicians find the courage to attack deep-rooted economic problems. The time is short.

    Before it's here, it's on the Bloomberg Terminal.