Sunday, November 21, 2010
Keeping the euro jigsaw from breaking up
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

jigsaw.jpg

My regular column is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

Ireland’s woes in recent weeks, indeed the panic over the euro’s ability to survive, can be put down to the clumsiness of Angela Merkel, the German chancellor and her insistence that investors in European sovereign debt should bear some of the cost of future eurozone crises. For future the markets read current, and panic ensued.

That was how we got here, though at some stage we would have reached this point, if not for Ireland, then for Greece (again), Portugal, or Spain.

There will be those in Europe who see the eurozone’s woes as an Anglo-Saxon plot - driven by uncontrolled financial markets - to wreck their grand project. European leaders may regret having insisted the eurozone would be a haven of stability as the global crisis raged.

You might think, as one who long argued that Britain should not touch the euro with a very big bargepole - I still get people suggesting entry now would be a good thing - I would be crowing at the eurozone’s woes.

You might think, as the author of a book more than a decade ago (Will Europe Work?) arguing the euro project would hit problems because Europe is not an optimal currency area, I would be dancing on its grave. (An optimal currency area is one is which there is wage flexibility, geographical mobility of labour and a strong element of centralised fiscal policy).

Far from it. A break-up of the euro now, if allowed to happen, would seriously set back an impressive global recovery. When all the talk has been of currency wars, the distintegration of the euro would be like somebody exploding a nuclear device.

The euro, for its current problems, has not been a disaster. The European Central Bank, under Jean-Claude Trichet, has earned credibility in the markets.

Some will say Britain, despite being prepared to help out Ireland, is in no position to lecture. We had our boom and bust, and our spectacular shift into budget deficit. Being out of the eurozone, however, has allowed sterling a substantial fall from what was a seriously overvalued position before the the autumn of 2007. There is a flexibility in UK monetary policy eurozone members can only dream of.

Moreover, the nature of the boom in Britain was different. Ireland and Spain are picking up the pieces after construction booms fed by banks falling over themselves to lend. Here, there was plenty of action on house prices but activity struggled, the building of new homes never getting to levels needed to meet long-term demand.

In Ireland, in contrast, there are some 300,000 unsold and unoccupied homes left over from the crisis. In Spain, there are 1.5m, a backlog that on optimistic assumptions will not be cleared until 2017. Everybody’s problems are different. One problem Britain does not have is being in the euro.

So what does the euro have to do to get through this. Can it do so? I still think that while the euro will survive, it will not do so with all its members. Greece had no business joining, and the authorities no business allowing it to do so. The others had a stronger case, but did not follow through with the correct economic discipline.

The pact euro members signed up to was that they would keep costs down, ensuring they maintained competitiveness against the stronger members, in return for which they would be rewarded with German-style short and long-run borrowing costs. Instead, most of the problem-hit “peripheral” economies - I won’t call them the Pigs - allowed their labour costs to rise, over time, by 20% to 30% vis-a-vis Germany.

Greece, as I say, should not be there, though will not be leaving for some time. For now it needs to be kept in to protect others from contagion fears. The question for Ireland, Portugal and Spain is whether their people can make the sacrifices, which will include wage cuts, to survive in the euro. Ireland has started on this path but there is a long way to go. Countries in the euro waiting room in central and eastern Europe are considering their positions.

It is not just the weaker members where the problems lie, however. The eurozone’s problems are a scaled-down version of those facing the global economy. It has big surplus economies, most notably Germany, whose formidable exporting machine has produced what looks like a permanent current account surplus. Then it has those with chronic current account deficits, such as Greece and Portugal.

On the world stage, these imbalances have led to talk of exchange rate manipulation and currency wars. In Europe, as long as the eurozone holds together, there cannot be a way out of it through currency adjustment. These very considerable tensions have to be resolved by other means.

One of those means will be greater economic discipline among weaker “deficit” countries. But this is a two-way street. If Germany wants the euro to develop in the image of the D-mark, an ultra low inflation currency with permanently weak domestic demand growth, it will only succeed in splitting the euro up.

It will not just be the peripheral economies who will struggle to keep up with this, but those at Europe’s heart, including of course Italy, but also France. Both have lost significant competitiveness versus Germany in the euro’s 11-year existence.

So Germany has to change to make the euro work. She has to loosen her stays, get her current account surplus down and meet the other euro members somewhere in the middle. Otherwise the euro’s break-up will not be the fault of Greece, Ireland, Portugal, or Spain, but Germany.