Sunday, June 12, 2005
Italy catches a cold, and the euro looks sickly
Posted by David Smith at 10:59 AM
Category: David Smith's other articles

Two days before Christmas 1865, a ceremony was held in Paris to mark the signing of the foundation treaty for a new and exciting development in Europe, the so-called Latin monetary union.

This new union was proposed and led by France — the biggest economy in the grouping — and included Belgium, Italy and Switzerland. Not long afterwards Greece and Bulgaria signed up. At one time 20 countries were effectively tied to the “gold franc” zone, in which each nation’s gold and silver coins were legal tender in the others.

When it started there were questions over Italy, the weak member of the union, then running a budget deficit of 10% of gross domestic product. Italy, indeed, found it hard to cope, suspending certain aspects of its monetary union membership six months after the Paris treaty was signed.

But the union soldiered on, before finally being brought to its knees by the impact of the first world war and the subsequent problems for the gold standard. It was finally buried in 1926.

The 19th century was a boom time for monetary unions, particularly in Europe. An international monetary conference was held in 1867 to discuss the launch of a new world currency. That did not happen but, meanwhile, countries got on with their own monetary unions.

There was a Scandinavian monetary union between Sweden, Denmark and Norway, which lasted from 1873 to 1920. There was also the Austro-Hungarian monetary union, which many experts see as the closest parallel to the euro. It was a customs union, like the European Union, and it had a common central bank, like the European central bank. But the two countries were not required to co-ordinate their tax and spending policies. The union lasted from 1867 to 1914.

What killed these monetary unions off and does history have any implications for the future of the euro? Gerard Lyons, head of research at Standard Chartered Bank, has studied the history of previous monetary unions and has no doubt.

“Here in the UK people often look at the euro as a short-term political cost for a long-term economic gain,” he says. “On the Continent they tend to think of it as a short-term economic cost for a long-term political gain, that of ever-closer union.

“The problem has been that those short-term economic costs have been much greater than anybody expected. And if monetary union is to survive there has to be political union; no ifs, no buts. There is no example of a monetary union between large countries surviving without political union.”

Pro-euro economists point to the Zollverein, which came into existence in 1834. It started as a common market and customs union, like the EU (zollverein means customs’ union). But it was also effectively a monetary union run by the Prussian central bank.

The Zollverein, however, led to the political union of what became Germany in 1871, followed a few years later by the launch of the Reichsmark, its single currency. Political union was not needed for the launch of monetary union, but it did follow.

Others argue that the monetary union between Britain and Ireland, which lasted from 1921 to 1979, was an example of a long-running currency union without the accompanying political union. But it was also an example of a small country, Ireland, effectively piggybacking on a larger one, in the way that west African countries took part in the franc zone from 1948.

Previous monetary unions were, it should be said, killed off by dramatic events, most notably war. Surely if European integration has brought peace to a once-bloody continent it can also make a single currency work? That, until recently, was the unanimous view within Europe. The euro, which came into being as an electronic currency at the start of 1999 and as a paper currency three years later had, it seemed, done the hard part. The big political heave was getting the single currency established.

Even the currency markets appeared to accept that the euro was as permanent as the European commission insists it is; after a shaky start it rose against the dollar to levels higher than when it came into being six years ago.

All that changed when France and Holland said no to the EU constitution in their referendums. Suddenly the old faultlines in Europe were exposed and the future of the euro was in doubt. The votes, and subsequent attempts by Europe’s political elite to keep the constitution alive, recalled Monty Python’s dead-parrot sketch. Could the European monetary union (Emu), like the constitution, cease to be? When, 10 days ago, Roberto Maroni, Italy’s welfare minister, speculated on the return of the lira, it seemed like a faux pas from a political maverick. But Maroni’s party, the Northern League, which is part of Silvio Berlusconi’s coalition government, means what it says.

Roberto Castelli, the justice minister and from the same party, said: “Does sterling have no economic foundation because it is outside the euro? Is Denmark living in absolute poverty because it is outside the euro? Are the Swedes poor because they are outside the euro?” The Northern League is in the process of getting the 500,000 signatures needed to have a referendum on Italy’s continued membership of the euro. A no vote, which the polls say would be assured, would be a much bigger setback for the EU than the French and Dutch constitution votes.

Not everybody thinks the Northern League has a point. Roberto Benigni, an Italian comic actor, said Italy should go a stage further and bring back not the lira but the sesterces, the silver and bronze coins of ancient Rome.

But as in the 1860s, the weak point in Europe’s monetary union is Italy. A supermarket chain in Tuscany, admittedly as a publicity stunt, has said it will accept the lira and has its store assistants holding up “Welcome back lira” signs.

A report from the Brussels-based Centre for European Policy Studies, Emu At Risk, warns that the strains are growing. The report, by economists Daniel Gros, Thomas Mayer and Angel Ubide, warns that the euro is caught between a rock and a hard place. Either it will suffer “lira-isation” and become a permanently weak currency, or some of its weaker members — Italy, Greece and Portugal — will come under intense internal political pressure to leave.

“Without European political union, the European central bank (ECB) lacks a public constituency supporting its monetary policy stance in the face of political pressure,” they write.

“Public support was a cornerstone for the German Bundesbank’s ability to pursue a low-inflation, hard-currency policy.

“It remains to be seen whether the ECB can do the same without strong backing from the general public. Should it yield to the inevitable political pressures, the switches would be set for a higher-inflation, softer-currency Emu.”

As for Italy, a founder member of the EU, leaving the euro would until recently have been unthinkable. To mainstream politicians and Italian economists it still is; Italy gained instant monetary credibility and a huge bonus from cutting the servicing costs on its national debt (more than 100% of GDP) from joining the euro.

But the report also warns that Italy is “on the brink” because of its economic failings. Since joining, Italy has lost competitiveness against other euro members. “The economic situation in Italy has the potential to develop into a full-blown crisis,” it says. “It is likely that the Italian economy will experience a long period of economic stagnation or even contraction.”

The euro is not going to come to an end tomorrow, but its long-term future is in doubt. Far from bringing Europe economic salvation, it has come to be seen as part of the problem.

“There will still be a currency called the euro for a long time, the question is which countries will use it,” said Stephen Lewis, chief economist at Monument Research and a veteran of past currency crises. “Countries like Italy, Greece and Portugal are going to face big pressure to cut their budget deficits and that will start to propel them towards the exit.”

Before the euro came into being and Labour was contemplating membership (now virtually impossible), both sides of the debate in Britain, paraphrasing the famous advertisement, insisted that the euro “wasn’t just for Christmas” but was for ever. The euro has survived six Christmases. In its present form, however, it is unlikely to survive for ever.

From The Sunday Times, June 12 2005


SECTION 2A—Monetary Policy Objectives

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

Wouldn't the European situation be improved enormously if the ECB was simply given the same objectives as the Federal Reserve - ie. additional objectives to increase production and maximise employment?

Posted by: David Sandiford at June 12, 2005 12:11 PM

Yes, but who's economy's maximum employment - France, Greece or the area as a whole?

Posted by: Giles at June 12, 2005 07:31 PM

There’s a handy list of EU unemployment figures here:

(Note the bloated URL – typical.)

I’m assuming most people would say that average unemployment rates of 8.9% for the EU/Eurozone and 10% for France, Germany, Spain and Greece are all too high.

Therefore if the ECB had to balance unemployment against inflation then clearly the balance has to shift towards reducing unemployment. That means a rate cut – not ending the euro. (Anatole Kaletsky makes the case in The Times today).

However, there’s a danger in questioning the euro’s future at all of falling for the same sort of unsubstantiated assertions and rhetorical questions that were used to justify the Iraq invasion.

Just because the French and Dutch voted against the constitution doesn’t actually say anything about the euro. The vote has been interpreted by lots of people with predefined ideas to justify their own thinking. Equally, an opportunistic Italian speculating and another asking rhetorical questions about other currencies don’t justify ending the euro either.

What annoys me is that there are too many politicians that are happy to discuss all issues in terms of some abstract model of how things ought to be rather than take practical steps to make things better. European politics has been taken over by advocates (e.g. Tony Blair), rather than managers.

However if Alan Greenspan keeps on raising US interest rates, as seems likely, the euro issue may fade and the focus can go back to practicalities – or ‘structural reform’ as they call it.

Posted by: David Sandiford at June 13, 2005 07:52 AM

Glad to see you both back. I don't doubt that the ECB could have done more; I do doubt that it could ever have done enough. Real interest rates in euroland have been zero to mildly negative. The ECB could have gone for the Japanese option of zero nominal rates but even then we would still be debating Europe's deeper structural problems.

Posted by: David Smith at June 13, 2005 09:10 AM

"no vote, which the polls say would be assured, would be a much bigger setback for the EU than the French and Dutch constitution votes."

What poll? I have heard that 60% in Italy in latest polls are opposed to ditching the Euro, with 27% in favour of withdrawl.

Methinks that the writer of this article is mixing up "No to withdrawal" to "No to the Euro" in opinion polls.

Anyway, 500,000 signatures doesnt automatically mean a referendum. The Italian Constitutional Court vets all petitions for a referendum, and in the past has ruled that existing EU rules cannot be the subject of this kind of referendum. Also, a referendum cannot be held in the year leading up to a general election, or in the 6 months afterwards. Also, it must be held between April and June. This would push a referendum to 2007 at the earliest, and who knows what state the Italian economy will be in by then.

The Irish economy is doing fine in the Euro.

Posted by: Brian Boru at July 19, 2005 01:48 PM

Also, a turnout less than 51% makes the result invalid under Italian law.

Posted by: Brian Boru at July 19, 2005 01:51 PM