Europe’s monetary union. The euro and its troubles

Testing times for the single currency and its guardian, the European Central Bank

NOT many weeks ago, the question would have been almost risible: is the euro here to stay? Now the French and Dutch have rejected the European Union's constitution, and bad economic news about the euro area, especially its biggest economies, keeps trickling in. Jean-Claude Trichet, president of the European Central Bank (ECB), may dismiss the thought that Europe's monetary union might break up as “absurd”. For now, he is surely right: the euro zone is not about to fall apart, and with central and eastern European countries still keen to join, is more likely to grow than shrink in the next few years. Yet Europe's elite can no longer wave the idea away as mere impertinence.

Says who? For a start, 56% of the Germans polled for Stern, a weekly magazine, who want the D-mark back; the German officials and economists who discussed recently how, if push came to shove, a country might quit the euro; and Roberto Maroni, an Italian welfare minister, who said on June 3rd that his country would be better off with the old lira.

The idea also seems less silly than it did to financial markets. Currency traders, having pushed America's current-account deficit to the backs of their minds, have sold the euro down to about $1.22, from $1.35 at the start of the year. The idea that the euro area is becoming less cohesive is also reflected in bond markets: the spread between the yields on Italian and German ten-year government bonds is now around 17 basis points (hundredths of a percentage point), up from less than six at the end of January. Greek spreads have also widened.

A break-up of the euro area is still in the realm of small probability rather than likelihood. Take the big economy most under strain: Italy's. Relative to Germany's, Italy's unit labour costs have risen by around 20% since the euro was born, making its exports less competitive. Its GDP has shrunk in each of the past two quarters. It might be tempting, therefore, to imagine that, if the lira were revived, Italy could return to its old habit of trying to devalue its way out of trouble. Should the thought ever be seriously entertained, buyers of Italian government bonds would surely demand insurance against the risk of devaluation, in the form of higher bond yields. Spreads might be closer to the 650 basis points that they reached a decade ago than to today's 17. With Italian public debt over 100% of GDP, it is no wonder that politicians senior to Mr Maroni were quick to insist that they did not share his view.

Very likely, the Dutch and French noes would not have triggered such fuss - and might not even have happened - had the euro area been in decent economic shape. Italy is struggling most. But Germany, despite its buoyant exports, is suffering from feeble domestic demand. The panel of forecasters polled monthly by The Economist expects its GDP to grow by only 1.1% this year article. In France, more than one worker in ten is unemployed.

This economic weakness brings Europe's political malaise to the door of the ECB. Couldn't it jolly demand along by cutting interest rates, as lots of politicians and quite a few economists think it should? There is little chance of that just yet. Last week, even as its own staff cut its growth forecast for the zone to just 1.1-1.7% this year, the ECB held rates at 2%, as it has for the past two years.

For much of this year, indeed, Mr Trichet has sounded much more likely to raise rates than to cut them. On June 7th, he told Reuters: “I am not preparing for a rate cut.” Inflation in the euro area is 2% - adjacent to the ECB's target of “close to, but below 2% ” - -and inflationary expectations, says the central bank, are 1.9%. Cutting rates, he fears, could fuel inflationary expectations and thus push up long-term interest rates. Bond yields, he pointed out this week, are at their lowest since the first world war.

A lot of the trouble lies in the half-hearted nature of structural reform in much of Europe. This has left the euro zone with less room to grow, and the ECB with less room for manoeuvre, than America's Federal Reserve. A new report* by the Centre for European Policy Studies, a Brussels think-tank, argues that on average European monetary policy has been roughly as accommodating as, but much less variable than, America's in the past six years. The Fed has had more scope to move rates up or down as circumstances change.

Constrained though the ECB might be, markets are pricing in a rate cut in the next few months. And some economists think that on past form the ECB might now be cutting rates. Last week David Walton, of Goldman Sachs, told a conference on the ECB, organised by the Centre for Financial Studies, a Frankfurt research institute, that the ECB's interest-rate decisions have, by and large, tracked economic activity. Only when the euro area's purchasing managers' index (PMI) has been above 55 has the bank raised rates; readings below 50 have been the cue for a cut. The PMI is now in the cut zone.

Similarly, Mr Walton - who is about to become a central banker himself, by joining the Bank of England's Monetary Policy Committee - has constructed a “forward-looking Taylor rule” for the ECB. This explains interest-rate changes in terms of revisions to forecasts of inflation rates and the gap between actual and potential output. The rule tracked the ECB's behaviour pretty well until recently. With activity faltering, it now predicts a cut of half a percentage point, but there has been none.

The reason for the apparent increase in hawkishness? In a word, money. The ECB, uniquely among leading central banks, has a “two-pillar” monetary strategy: under the first pillar, it looks at how economic activity might influence inflation; under the second, it focuses on monetary growth, to reflect the notion that inflation is a monetary phenomenon. For the past four years, money growth has been well above the bank's “reference value” of 4.5%.

At the same conference, Otmar Issing, the ECB's chief economist, explained how recent experience differs from the last time the ECB was cutting rates, in 2001-03. Then, rapid monetary growth could be explained away by investors shifting out of uncertain stockmarkets into cash. There seemed to be no risk that credit growth was getting out of hand. Since mid-2004, however, monetary growth has been fast, and so has lending. Although the real economy may look weak, the monetary warning lights have been flashing.

Such worries about monetary growth are not lightly dismissed, and are shared by some outside economists. Even if inflation remains low, excess liquidity could spill into asset markets. In some countries, this may have already happened: France, Ireland, Italy and Spain have all seen double-digit growth in housing prices. Cheaper money would risk a property-price boom and eventual bust. Germany's economy is arguably still labouring under the effects of just such an episode in the east of the country after reunification. German property prices are still flat.

Nevertheless, the euro area is wheezing. Domestic demand remains weak. The biggest economy, Germany, is on its back. The third-biggest, Italy, is shrinking. The ECB did not create the euro zone's troubles. But despite the monetary caveats, it could still ease them with a rate cut. Soon.

* “EMU at Risk”, by Daniel Gros, Thomas Mayer and Angel Ubide, June 2005.

Testing times for the single currency and its guardian, the European Central Bank