The euro at ten: Challenges ahead

In the months before the Euro was launched in January 1999, economists in the United States—and a fair number in Europe—were busy sharpening their daggers. "It’s not an optimal currency area," they cried. Traders derided it as a "toilet currency." Now, as the euro marks its tenth birthday, it is a strong and well-established currency seen by many analysts as a safe haven from the financial storm currently engulfing the planet.

The story of the euro is one of a mixture of successes and failures. Chief amongst its accomplishments is its very survival – no mean feat if the naysayers of the late 1990s were to be believed. Its record of low inflation and price stability, achieved through the same policies as the old German Bundesbank, is admirable. But such stability did not come without a cost, and the cost was economic growth. The past ten years has seen little improvement in the underlying growth rate and income per person in the Eurozone has remained at around 70 per cent of that in America.

None of this was according to plan. Economics 101 brought comfort to the staunchest proponents of the single currency. By stripping countries of the licence to cheapen their currencies, the euro would force them to compete directly, thus fostering flexible and productive markets. It all seemed so simple. But it was also wrong. Reform fatigue kicked in after 1999 and the single currency helped to mask the long-term damage such fatigue was causing by greatly reducing what investors call country risk. Essentially, all Eurozone members’ bonds were regarded as being almost as good as the old German bunds. Put simply, the euro offered weak governments like Italy protection against one of the most powerful forces shaping global economics – the bond market.

One of the few silver linings of the current crisis might be an overdue market re-evaluation. In recent weeks, spreads on Italian and Greek debt over German bunds have widened sharply. This widening dilutes the protection and will apply pressure to the governments with the worst reform records, the weakest public finances and the least competition to buck up. Where the single currency failed to spur on change, the markets might just succeed.

But that silver may line an incredibly dark cloud. The euro could be heading into the toughest times and tests of its young life. Job losses in the Eurozone will climb and more businesses will be lost through 2009. In the places that suffer worst, the voices calling for exit from the Eurozone may get louder and more numerous. A breakup seems highly improbable though. If, say, Italy or Greece were to make for the door they would find, on the other side, heavier borrowing costs, devaluation, and perhaps even default. Such costs far outweigh the loss of monetary autonomy associated with staying in.

And what of the prospects for British entrance? It seems improbable. Public and political opinion has not shifted significantly on the issue and Britain may well be better placed outside the euro. With its large financial sector, a huge housing boom (now bust), and indebted households, Britain has been hit hard but is suffering from what economists call an "asymmetric shock." Such shocks are notoriously difficult to adjust to within currency unions. Britain has been able to soothe the pain by cutting interest rates and allowing the pound to fall, two options it could not have pursued inside the euro.

These facts make Alex Salmond’s recent statements supporting euro membership for Scotland somewhat baffling. It is hard to see the logic of his position, economically or politically. Economically, a Scotland saddled with the euro right now would face higher interest rates and run the risk of pricing itself out of its biggest export market, the rest of Britain. Politically, as the only separatist party in the EU, the SNP runs the risk of intellectual incoherency by advocating independence from Britain on the one hand and a transfer of monetary sovereignty to Frankfurt on the other. With polls indicating over 70 per cent of Scots are opposed to euro membership the first minister is braving strong political winds – but his recent words stand in contrast to his announcement, prior to last year’s Holyrood elections, that an independent Scotland would keep the pound. Clarification by the SNP of their position would be welcome.

Those pondering the wisdom of an eventual British entry into the single currency will watch the next decade with interest. First the euro must weather the current storm and that means ensuring that its constituent economies become more flexible and competitive. If it succeeds in this, the euro’s next ten years should be as successful as its first ten. If not, then the next decade will be considerably tougher.