The euro boy, just 10 years old, enters the global recession looking manly. It is, at a value of about $1.32, worth more than the $1.17 at which it was launched, and much more than the sub-90 cent lows of 2000-02 to which the then-rampant US dollar bullied it in its infancy.
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But a currency’s value and prestige are not always the best guide to underlying economic strength and durability. The Argentine peso had been worth $1 for a decade when Argentina defaulted and devalued, abandoning the experiment.
Argentina’s currency board system, with its fixed exchange rate and foreign reserve backing for the monetary base, was in theory robust. But it proved brittle. Forming a rigid link between a small, indebted, historically ill-managed and frail economy and the world’s reserve currency did not, in the end, make Argentina strong.
The question with the euro system is whether the same may be true: that the strength of the euro, as an important currency seen by some to rival the dollar as the world’s reserve currency, masks the frailty of some of member economies—until a crisis makes that frailty all too apparent.
By adopting the euro, the member countries surrendered exchange-rate flexibility and their ability to set interest rates independently of one another. What they gained was undoubtedly immense, especially for the smaller economies. The capital market in Irish pounds or Spanish pesetas had been relatively small and the cost of issuing debt high because the currency, inflation and fiscal risks for investors were also high. The euro seemed to eliminate all those risks as if by magic.
There would be no devaluation-provoked surge in inflation. The European Central Bank, sitting in Frankfurt, would be hawkish. The stability and growth pact would ensure fiscal discipline. Governments’ finances would be sound and there would be nothing to cause excessive inflation. Investors in euro-zone members’ debt would face little risk.
Until recently, the market seemed to believe all this, even though many countries breached the 3% of gross domestic product (GDP) limit for budget deficit and the 60% of GDP limit on public debt. The difference in the spread between Irish, Greek, Italian or Spanish debt and German debt was small. But since the credit crunch struck, the spread differentials have begun to widen fast. The markets’ euro assumptions are beginning to be challenged.
Part of the problem is what euro-zone membership obliges and takes away. It obliges governments not to abuse their new-found freedom to issue debt cheaply by issuing too much of it. It obliges countries to achieve long-term competitiveness without resorting to devaluation. It forces adjustment to changing economic circumstances without independent, national monetary policy and exchange rate flexibility. And even the fiscal lever cannot be moved too far if the guideline of a maximum 3% of GDP fiscal deficit is to be observed.
But in recent years, some euro-zone countries appear to have given little thought to the constraints imposed by euro-zone membership. In Spain, for example, labour costs have soared. A construction boom kept the economy growing fast. But with the boom over, Spain is left with an expensive labour force and no means of regaining competitiveness easily.
Spain, unlike the UK , cannot help its industries compete at home and overseas through devaluation against its main trade partners. On the contrary, the euro is strong. That implies economic adjustment must come arduously—through recession, redundancies and renegotiated wage agreements that force wages down. Politically and socially as well as economically, the process will be difficult.
In Ireland, other vulnerabilities created by the euro’s initial free lunch are now exposed. The euro slashed the interest rate on credit and mortgages, provoking a boom in house prices, growth and government revenues. Now Ireland’s deficit is heading towards 10% of GDP. Its previously low debt of a quarter of GDP could double in a few years.
Italy’s debt exceeds its GDP. Fractious politics have put fiscal or labour reform on hold. Labour costs have risen fast. Italy has not even dared think of putting funds into fiscal stimulus. Now in recession, and having grown by barely 1% annually in the recent good years for the global economy, the country risks chronic weak growth.
It was precisely this combination of unremitting high debt, lack of competitiveness and recession that brought Argentina’s currency experiment to an end. When Argentina faced trouble, it could not devalue. Nor could the government print money, as it had done so often in the past with disastrous inflationary consequences. Adopting a strong currency meant Argentina had no way out—other than via a default on debt and abandonment of its currency experiment.
As euro-zone governments face recession, soaring demands on the fiscal purse and rising debts, there is a risk that some countries will find the shared, strong currency more a crushing constraint than a strength.
The euro-zone experiment is entering a new, potentially explosive phase. The admired euro boy may be about to suffer a painful adolescence.0