Euro Crisis

Europe's experiment in monetary union is showing dangerous signs of drift. But there is a way out

The euro is in crisis, and as it goes, so may go the future of the New Europe. After a flawless and much-acclaimed debut just 20 months ago, Europe's new single currency has lost more than 25% of its value against the dollar--and there is still no bottom in sight. In the next two weeks, the twin threats of $40-a-barrel oil and a vote of no confidence from the tiny nation of Denmark threaten to do it serious new damage. On this fissured terrain, it's entirely conceivable that the grand euro experiment--which has done so much to start real economic reform in Europe--will lose momentum. The sickly euro may end up as the currency that no country wants to really embrace as its own.

Nothing like this was foreseen when the euro entered the monetary world on Jan. 1, 1999. The military precision with which governments, banks, trading rooms, stock exchanges, and corporations adopted the new currency on a clear New Year's Day suggested a Europe finally committed to creating a unified economy of 350 million people. At that point, the worst-case scenario was that the markets might test the currency's real strength sometime ahead--by most reckonings, after the euro had become the currency of daily life, with euro notes replacing francs and Deutschemarks in consumers' pockets and ordinary Europeans opening up euro-denominated savings accounts.

But the problems have come a lot sooner, accelerated by a vast tidal wave of investment leaving Europe. That's not because Europe is so bad, but because America's high-tech economy and markets look so much more attractive. Europe itself is turning in its best performance in a decade--and that anomaly has given euro backers great comfort. In their world, it's only a matter of time before markets come to their senses and send the euro's value back up again. But the euro is a fragile money with no convincing government backing--unlike the dollar, the yen, or the Swiss franc.

If Europe's leaders really want to save their baby, it's time to take a stand. There are short-term and medium-terms steps that can do a lot of good. But they have to be convincing, and they have to show that the big European governments will take some risk to make the euro a true European currency. Like any money, the euro is both a currency with which to do business and save, and an important symbol of Europe's commitment to real economic and political change. The mass of corporate deals and restructurings, large-scale euro-bond financings, accelerated deregulation, and new high-tech investments that Europeans have implemented since the debut show there's widespread boardroom support for the new currency. What's lacking is an assurance from Europe's political leaders that they'll see the new money through. Until this crisis of confidence is resolved, the euro will remain a deeply flawed experiment.

Here's what's needed now:

Short-term, the leaders of the core European countries--France, Germany, Italy, the Netherlands, and Spain--need to show they will back the euro with reserves from their national treasuries and central banks. In part, this means intervening when the timing is right to support the euro directly. But it also means building up a greater stock of euros in their national reserves as a matter of policy. If the big governments don't want to hold euros, why would anyone else?

In the medium-term, Europe's politicians must make it crystal clear that they are serious about giving their shared economy a big push by forcing through a package of structural reforms that will make Europe as productive and flexible as the U.S. Taxes must come down further, labor markets must be deregulated and the process for setting up new businesses must be made easier.

The European Central Bank and its president, Wim Duisenberg, lack the prestige and the power to salvage the situation on their own. While they can set monetary policy in the euro zone--for good or ill--fiscal and economic policy is still firmly in the hands of national governments, whose leaders have made conflicting statements about the euro and followed contradictory economic policies. Until they work together, the markets aren't going to take the euro seriously. "The root of the problem is that the markets do not think [11] countries can act as if they were a single country," says Italian Treasury Minister Vincenzo Visco.

He's clearly right. The single currency is exposing the nationalist maneuvering that has hardly let up for a moment in the past two years. Time and again members of the Eurocracy in Brussels have squabbled publicly with policymakers at the national level, while politicians from different euro zone countries have made conflicting statements about the euro.

Their response to the recent unprecedented wave of protests against high fuel duties opened bigger gaps. Some national governments have held their ground, while others have given way to tax cuts. It's the same when it comes to much-needed structural reforms. Some are more willing to tackle the issues, others less so. That lack of policy coordination unsettles markets.

Little wonder, then, that the euro crisis will dominate discussion at the Sept. 23 meeting of the Group of Seven finance ministers and central bankers in Prague, and preoccupy the powerful bureaucrats meeting at the joint annual confab of the International Monetary Fund and World Bank. World leaders worry that the triple whammy of a weak euro, high oil prices, and rising rates could eventually cause growth to stall. "The euro zone economy has already peaked and these problems will slow growth more," says Janet Henry, an economist at HSBC Investment Bank in London, who sees growth slowing to 2.3% next year.

Corporate Europe is already hurting. Exports may be surging but earnings at many companies are plunging because imports--especially oil--are much more expensive than they used to be. The weak euro "is causing real disruption," says Edouard Michelin, CEO of Michelin, the French tire manufacturer. "It has an effect on the economy, on the confidence of consumers." Michelin cites an anemic euro as one of the culprits in the 29.1% slump in his company's first-half earnings.

The psychological effect is huge. Though the weak euro has handed Jean Luc Lagardere, co-chairman of mighty European Aeronautics Defense and Space Co., whose units include Airbus, a quick short-term competitive advantage over arch-rivals Boeing and Lockheed, he's a lot more worried about the lasting damage. "Europeans aren't used to a low currency," he says. "If the euro stays between 80 cents and 90 cents it will affect the morale of people right across Europe, including me."

The pain is prompting some policymakers to go public with their alarm. ECB Vice-President Christian Noyer declared on Sept. 18 that the currency has become "dangerously undervalued." The danger, he said, is that there might be a sudden "violent reversal" of the euro's slide that would throw currency markets into chaos. A dramatic strengthening of the euro would slam the dollar and dramatically widen the U.S. trade deficit. That's one scenario. But probably the bigger threat now is that the slide of the euro to 75 cents or so could erode confidence in European Monetary Union for years to come.

As investors and companies shift their money from Europe into the U.S. at the rate of about $3 billion a week, the pressure will build on Europe's leaders. European companies made more than $170 billion worth of acquisitions in the U.S. in the first half of this year. "The U.S. is such a large and vibrant market that you have to be strong there if you're going to be a serious global player," says Niall W. FitzGerald, co-chairman of the Dutch-Anglo conglomerate Unilever Group, which recently bought Bestfoods, based in Englewood Cliffs, N.J.

SHOW OF SOLIDARITY. The only way to reverse these investment flows is for Europe's political leaders to finish their long-promised reforms. There are several things they can do, both in the short and long term. If the leaders of Germany, Italy, and France declared in unison that they support the strong euro, and are ready to back that pledge with reforms, the show of big country solidarity could have a bracing effect. Likewise, the ECB could make it clear that it wants to help Europe overtake the U.S. by resisting the temptation to raise interest rates--currently 4.5%--further and instead play a hand in an expanding economy.

A more concrete, immediate move would be intervention--a coordinated buying of euros on a scale large enough to bolster the market and knock the dollar down. Dealing rooms in London, Frankfurt, and Paris have been abuzz with rumors that French Finance Minister Laurent Fabius proposed such a move to U.S. Treasury Secretary Lawrence H. Summers. European Commission President Romano Prodi has also called on the central banks to intervene.

WAITING FOR THE AMERICANS. If the Federal Reserve and Bank of Japan teamed up with the European euro-states to come to the euro's support, the currency could rocket to 95 cents within days, say traders. "Real intervention by the ECB, with the threat of further intervention, would make the market wary of going short in euros," says Mike Burton, head of foreign exchange sales at Goldman Sachs in London. The Europeans answer for not acting is that the Americans will hold back to guard the strong dollar. Says Klaus-Dieter Kuehbacher, a council member of Bundesbank, Germany's central bank: "It can only be done together with the Americans."

Maybe, though, it's time for the Europeans to contemplate an intervention without the help of the U.S. Treasury. The ECB holds the equivalent of $39.6 billion in foreign currency reserves; its 11 member central banks hold $222 billion more. Trading in a chunk of this cash for euros could have a lasting impact, especially if the timing, as now, is right. Stephen Jen, co-head of currency research at Morgan Stanley Dean Witter in London, thinks the euro-11 central bankers, with or without the U.S., might wait until "the euro has reached an obvious bottom and is on its way up." He figures that level is between 80 cents and 85 cents. Such intervention is risky, but done right it could work.

STRUCTURAL IMPROVEMENTS. What other solutions are there? Reform, of course: more tax cuts, more deregulation of labor markets, more efforts to introduce private pensions to reduce huge social security deficits. To begin with, the Europeans should redouble their search for a New Economy boost. For now, there are precious few signs that Europe is creating a U.S.-style New Economy. Companies, on average, are investing half as much in high tech as their U.S. counterparts. As a result, labor productivity is growing at just half of the U.S. rate.

Granted, European governments have made significant progress in loosening the rules that have held their economies back. Richard Reid, chief European economist at Donaldson, Lufkin & Jenrette Inc., counts no fewer than 350 structural improvements over the past decade. These range from the tax changes that will take effect in Germany in 2002 to the recent laws making it easier to hire part-time and contract workers in the Netherlands and Spain. But there is much left to be done. Only 60% of euro zone citizens of working age actually have jobs, compared with 75% in the U.S. Greater workforce flexibility means that proportion could be increased, spurring growth. European politicians recognize the need for speedier change. They should now agree to coordinate these changes across national borders.

Pushing through radical reform in the Continent's comfortable, consensus societies isn't easy. But everyone knew that at one point, fundamental changes would be needed if the euro was to survive. The euro has brought big benefits for companies by creating a deeper, more liquid capital market where they can raise money more cheaply than they could in their old national currencies. It makes it easier to invest and trade across borders, and it is helping knit together the economies of the euro zone into a more competitive whole. But if the politicians who speak so eloquently of the euro's impact and importance really believe in it, their time has arrived. The short-term fix is to declare their support of the euro and then intervene in the markets. The long-term goal must be to make Europe the kind of dynamic economy in which the single currency can thrive. After all, Europeans deserve a better currency than this.