Charlemagne: Euro blues

A solid currency, maybe, but a shame about the economic performance

NEXT month, the European Union's innermost circle may embark on a new expansion, if tiny Slovenia gets the go-ahead to join the euro, in January 2007. At the same time, an even smaller place, Lithuania, is likely to be rebuffed, and told firmly that it is not ready for the single currency.

Elsewhere the euro is making its mark in a rather different way. Were Italy not a member, there would surely have been a run on the lira by now, given the troubles facing Romano Prodi's would-be centre-left coalition. And there actually has been a run on Iceland's currency--to the extent that some Icelanders have wondered whether they might perhaps be allowed to adopt the euro, please, to prevent further speculative attacks, even though Iceland is not a member of the EU.

In short, as it prepares to expand again, the euro seems to be working more or less as its founders intended. It has brought stability (oil prices of $75 a barrel have had little impact, even though Europe depends more on imported oil than does America). Countries are queuing up to join (all EU countries bar Britain and Denmark, which have specially negotiated opt-outs, are supposed to become members one day). And the tests of readiness to enter the euro remain as they were agreed at Maastricht in 1991: low inflation, budgetary austerity and exchange-rate stability (the so-called "convergence criteria").

The reality is rather different. The euro is working, in that it is stable, has established itself as a currency and provides a monetary anchor. But it is not working as it was meant to. When it was dreamt up, the euro was supposed to bring about faster economic convergence. A single currency was the logical completion of the single market, it was said, and would encourage more integration. The end of exchange-rate risk would boost investment and bring economic cycles into line. The reduction in transaction costs would make economies more efficient, boosting growth.

Moreover, a single currency would, it was claimed, foster policy convergence. Because countries could no longer devalue, they would be forced to undergo the hard grind of reform. Since reform would push all countries in a similar direction, the euro would produce convergence. True believers went further, arguing that currency union would, ultimately, bring about political union. Indeed, for them, that was the point. But even short of this, a single currency would still pull economies together. As a result, the perils of a one-size-fits-all monetary policy would not be so worrisome: eventually, one size would, indeed, fit all.

Seven years on, there has been convergence of a kind. The euro area's long-term interest rates are broadly the same: they have converged on Germany's. Some countries, such as Ireland and Spain, have played economic catch-up (convergence in income and wealth), though this may have little to do with the euro as such. Arguably, fiscal policy has converged too. That may sound odd when 13 of the 25 EU countries are being hauled over the coals for running "excessive" budget deficits. Yet euro governments have shown greater fiscal restraint than their peers in America or Britain in the past few years.

There has, however, been less convergence of economic performance. Ireland has grown by an average of 6% a year since 1999, Germany by barely 1%. Spain's growth has been twice Portugal's. As a recent paper* from Bruegel, a think-tank in Brussels, points out, such divergences are no greater than among American states, but in America they usually result from states being at different points in the economic cycle; in Europe, growth differentials seem to be more persistent. There are few signs that economic cycles have become more closely aligned.

Even when countries have experienced similar pressures (loss of competitiveness, say), they have reacted differently. Ireland and Italy have both lost competitiveness (by running above-average inflation). But Irish exports have boomed, whereas Italy's have stagnated. Germany and France have both gained competitiveness (having below-average inflation), but French exports have been weak while Germany has regained its position as the world's biggest exporter of goods.

As a result, the risk of the euro's one-size-fits-all policy (that interest rates will be too loose for the hares, too tight for the tortoises) has been unpleasantly realised. And as for the broader ambitions for the euro, European countries have not noticeably converged upon economic reform, still less political union: witness the rejection of the draft EU constitution last year by French and Dutch voters.

In search of reality

The euro, in short, has provided currency stability but has done little to promote growth, jobs or reform. That is a long way from branding the currency a complete failure. But it is clear that what matters most is the "real" side of the economy (growth, jobs, markets), not the nominal indicators of stability (inflation, budget deficits) that are used to decide both whether countries are ready to join, and how they are doing once they are in.

A key lesson is that flexible economies, such as Ireland's and Britain's, thrive, whether in or out of the euro. Inflexible ones can claw back lost competitiveness even inside the euro--but this takes a long time, and can come at a high price because they must keep growth in unit labour costs below average for years. Germany has done this. Italy and Portugal now face the same challenge, but without the German tradition of belt-tightening.

For countries now anxious to join the single currency, however, economic considerations hardly matter. They wanted to join the EU to show they were normal countries and now want to join the euro to show they are good Europeans. But being a good European can come at a cost--and it is not clear that all of the aspirants either understand this or are ready to pay.

* "The euro: only for the agile". By Alan Ahearne and Jean Pisani-Ferry

Commentary feature says that the EU has a 'solid currency, maybe, shame about the economic performance'. The euro has provided currency stability but done little to promote growth, jobs or economic reform.