Squeezed By The Euro

Europe's single currency has not promoted growth. It has also failed to spark needed reforms and fiscal discipline

Were the skeptics right? In early 1998, University of Bonn Professor Manfred J.M. Neumann mobilized 155 fellow economists to protest the coming introduction of the European common currency. The euro was dangerously premature, they argued in open letters published in major newspapers. Big countries such as Germany and France lacked the flexible labor markets they needed to compensate for losing control over monetary policy as a tool to promote growth. Needless to say, the protests had little effect. The euro blasted off on Jan. 1, 1999, as planned.

Six years later, Neumann's warning seems ominously prescient. Far from becoming a powerhouse to compete with the U.S. and Asia, Europe in the past four years has been nearly stagnant, with average annual growth in the euro zone of of 1.2% since 2002. Meanwhile, it's hard to overlook the superior economic performance of European Union members that stayed clear of the common currency. Britain and Sweden have enjoyed healthy expansions and lower unemployment. Britain's jobless rate is 4.7%, compared with 8.9% for the euro zone.

Even common currency champions such as European Central Bank President Jean-Claude Trichet see little chance of a euroland boom anytime soon. Just as Neumann predicted, overregulated labor markets in much of the euro zone prevent pay scales from reacting fast enough to competitive pressure from abroad. And individual countries can no longer compensate for these rigidities by devaluing their currencies to boost exports, usually through the swift downward movement of interest rates. "Unfortunately," says Professor Neumann ruefully, "we were right."

That raises a larger question: Was the euro a mistake? Not even euro-skeptics such as Neumann argue that the currency should be scrapped now that euro coins and notes have become a fact of life from Finland to Greece. "It would be insane to give up the euro. We have to make the most of it," Neumann says.


Still, the question hangs in the air, especially amid evidence of growing popular discontent over core Europe's dreadful economic performance. A dramatic expression of that discontent came on May 22 when German Chancellor Gerhard Schröder's Social Democratic Party (SPD) was booted from power in North Rhine-Westphalia, an economically battered industrial state that had been ruled by the party for four decades. Schröder, in what amounts to an admission that his tepid economic reforms have failed, has called for national elections in September, a year early. In addition, French and Dutch voters may reject the proposed European constitution in referendums May 29 and June 1. If so, the votes will surely be interpreted as protests against a European system that seems ever more powerful yet ever more unable to deliver jobs and prosperity. The euro is integral to that system.

Stagnation and political upheaval were obviously not part of the plan when the currency was launched six years ago. At the time, euro-optimism was running high. The idea was this: Before they could adopt the currency, countries like France, Germany, Italy, and others would rein in their budget deficits, and afterwards keep public spending in check to support monetary union. The existence of one currency, backed by fiscal discipline across the board, would then turn the half-fiction of a common market into reality. As Europe's various economies melded together into one, internal barriers to competition would tumble and the best-managed countries and companies would pull ahead. Countries that lagged would respond by loosening labor rules and cutting taxes to boost competitiveness. Like the Bundesbank, which had made Germany a beacon of monetary stability, the ECB would squash any hint of inflation with a rate hike. If countries wanted to grow, they would have to deregulate their economies and keep wage hikes in line with productivity.

Now check out what happened. First, the benefits. Currency risk within the euro zone is gone: no need to hedge the lira against the franc, for example. Finnish mobile-phone company Nokia Corp. (NOK ) estimates that it saves at least $6 million a year in transaction costs within the euro zone, and that doesn't count savings by suppliers that ultimately benefit Nokia. "It makes the whole supply chain more efficient," says Nokia Chief Financial Officer Rick Simonson.

Financial markets in Europe, meanwhile, have gotten a huge boost. Companies in countries whose national currency had been weak, such as Italy and Portugal, almost overnight saw their credit ratings improve. Italian companies were able to raise $82 billion on capital markets in 2003, more than double the amount they raised in 1999, says the ECB. Governments have saved billions by refinancing the national debt at lower interest rates. The euro, bolstered by initially high rates, has also ushered in an era of unprecedented low inflation in Europe.

That's the bright side. But the costs have been enormous. Europeans remain skeptical about the euro, which they see as a project driven by politicians with little regard for ordinary people. Huge majorities are convinced that shops and restaurants used the introduction of euro notes and coins in 2002 to raise prices, which in fact was often the case, even if overall inflation remained steady. These resentments have increased doubts about the whole European project. "Prices rocketed. Now we can't buy as much," says Catherine Dumont, 47, a secretary who spoke as she shopped at a Monoprix supermarket in Paris. "It will have an impact on my opinion on referendum day," she adds, leaving little doubt she will vote "no" on the constitution.

More important, the virtuous circle of competition and reform that the euro was supposed to kick off never materialized. The ECB, sworn to fight inflation, cut rates gradually from a high of 4.75% in 2000 to the current benchmark rate of 2% in June, 2003. That kind of monetary discipline was tough for Italy, which is having a hard time adjusting to a world where it can't devalue its way out of trouble, says Domenico Siniscalco, Italy's Finance and Economy Minister. "It's like taking a tiger and trying to make it turn vegetarian," he says. Germany would also benefit from a weaker currency, which would make its exports cheaper. "Things would have been better with the Deutschemark," says Joachim Preissl, owner and president of BING Power Systems, a Nuremberg-based maker of engine parts for customers including Porsche and BMW. Preissl says the strong euro makes it harder to compete with Mexican and Chinese rivals.

To compensate for the loss of currency flexibility, both Italy and Germany could opt to reform much faster. But not even the harangues of the ECB can get the Italians, French, and Germans to confront politically explosive tasks, whether it's changing rules in France that make it difficult and costly to fire workers, or getting Germany to allow Dutch plumbers to compete for business in Dusseldorf. "None of the big countries is fighting to create a European market," says Rafael Pampillón, an economics professor at Madrid business school Instituto de Empresa.


Even the fiscal discipline imposed as a precondition to monetary union is going by the board. Germany's budget deficit has exceeded the limit of 3% of gross domestic product since 2002. Now Italy and Portugal are also overdrawn. Rather than reining in spending, euro-zone countries earlier this year agreed to loosen the deficit restrictions.

While Germany, Italy, and France would suffer if rates rose, other countries in the zone could use tighter money. Spain has an inflation rate of 3.5%, vs. 2% for the ECB's benchmark interest rate. That means Spain effectively has negative interest rates.

The divergence makes it almost impossible for the ECB to formulate an economic policy that fits all the countries. Derek Scott, former economic adviser to British Prime Minister Tony Blair and a leading euro-skeptic, says the ECB can't risk hurting German growth by tightening the money supply, even if that means higher inflation in countries such as Spain. That in turn could undermine the ECB's reputation as a stern inflation-fighter. "With a single currency, you exchange the apparent stability of nominal exchange rates for greater instability of the things that matter: output, jobs, and inflation," Scott says.

Of course, European central bankers dispute such theories. "One size does fit all!" insisted Otmar Issing, a member of the ECB's executive board, in a speech to a Frankfurt audience on May 20. The divergence in member-country growth rates is below the historical average, he said, an indication that the euro is not pushing countries to move at different speeds. Likewise, ECB President Trichet was at pains to point out the euro's benefits to an Italian business audience recently. But in a sign of growing nervousness within the bank, he also warned political leaders to step up the pace of reform. "Many countries have not adapted their economic, social, and legal frameworks in order to face the new challenges," Trichet said.

Some governments have pulled off those changes, cutting taxes, rolling back job regulations, and eliminating barriers to competition. That's true of countries in the euro, like Ireland, and outside it, like Britain, Denmark, and Sweden, which focused on deep structural reforms after experiencing wrenching economic crises. Now, Germany may get a reformist government in September led by Christian Democrat Angela Merkel. A stronger dollar would also do wonders for Europe by making its exports cheaper abroad.

But the euro countries will enter uncharted territory if, say, Italy and Portugal continue to deteriorate or Germany proves unable to return to health. Some economists speculate that in the worst case, a country such as Italy might get into such trouble that it would seek to pull out of the currency union. Patrick Minford, an economist at Cardiff Business School in Britain, thinks it more likely that one of the weak countries will run into budget problems and seek a bailout from its neighbors -- provoking a political backlash in Germany, where the euro was never popular. That could strain the currency union to the point of collapse. "The weakest point is Germany," says Minford, a member of the EMU Monitor, a group of university economists from around Europe who issue periodic reports on European monetary policy. Minford considers the possibility of a euro meltdown remote but adds: "It could be a very uncomfortable decade."

Can the euro survive? That's a question no one wants to contemplate. The pressure is on European leaders to make sure they never have to. zz

By Jack Ewing in Frankfurt, with Carol Matlack in Paris, Stanley Reed in London, Maureen Kline in Milan, Carlta Vitzthum in Madrid, and bureau reports

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