Holding together A special report on the euro area l June 13th 2009

EEuroCovNEW.indduroCovNEW.indd 1 22/6/09/6/09 115:27:285:27:28 The Economist June 13th 2009 A special report on the euro area 1

Holding together Also in this section A tortuous path From Bretton Woods to euro. Page 2

One size †ts none The euro did not cause all the euro area’s troubles, but it will make them harder to put right. Page 3

No exit Staying in the euro will be tough for some members, but leaving would be too awful to contemplate. Page 5

The non•nuclear options In place of devaluation, troubled members could try reform. Page 6

Fear of ‡oating The †nancial crisis has made the euro look more alluring. Page 8

Soft centre The euro area, sorely tested by the †nancial crisis, has survived intact Can a currency survive without a state? and is likely to expand further, says John O’Sullivan Page 11 N THE mid•1980s Rolling Stone magazine 1992. A rider to the act sketched out an am• Ipublished an essay by P.J. O’Rourke, a bition to complement the single market Warmer inside conservative American humorist, with the with a single currency. Few took that seri• The gains outweigh the losses. Page 13 splendid title ŒAmong the Euro•Weenies. ously, least of all British politicians, who In it the author poured scorn on Europe, an had signed up to the act with enthusiasm annoyingly fractured continent with its because they were keen free•traders, but Œdopey little countries, Œpokey borders, dismissed the grander kind of Community Œitty•bitty languages and ŒLilliputian rhetoric as Œeuro•gu . drinks measures. The mosaic of countries made the visitor feel claustrophobic: ŒYou An idea whose time had come can’t swing a cat without sending it Yet by the time a 1991 European summit through customs, he complained. was held in the Dutch city of Maastricht, a He will not have been aware, or cared plan for economic and monetary union much, that plans were already in train to (EMU) was written into a new EU treaty, to give ŒEurope the continental scale it so be rati†ed by member states later. That the painfully lacked, as well as a currency that proposal had gained ground so swiftly was would rival the dollar. In 1986, the year of a surprise to many. The British government Acknowledgments Mr O’Rourke’s visit, the European Eco• had thought that a committee of EU cen• In addition to those mentioned in the report, the author would like to thank: Marco Annunziata, Elsa Artadi, nomic Community (as the European Un• tral•bank governors, charged in 1988 with Katinka Barysch, Julian Callow, Andreas Galanakis, Luis ion was then known) expanded from 10 to studying if monetary union was feasible, Garicano, Stephen Jen, Philip Lane, Helen Louri, Spyros 12 countries, with the addition of Portugal would quash the idea. Instead the group, Papanicolaou, George Sfakianakis, Yannis Stournaras, Alan M. Taylor, Simon Tilford, Xavier Vives and Beatrice and Spain. Its members had spent most of chaired by Jacques Delors, then president Weder di Mauro. the 1970s erecting non•tari barriers to in• of the European Commission, the EU’s ex• ternal trade, and the early 1980s battling ecutive branch, gave it quali†ed approval. A list of sources is at over who should pay for its joint budget (a The Delors Report concluded that EMU Economist.com/specialreports †ght which, to be fair to the others, Britain could work if control of the single currency started). With that settled, there was a fresh was kept from meddling politicians and An audio interview with the author is at desire to make progress towards a genuine• left to independent technocrats at a Euro• Economist.com/audiovideo ly open free•trade block. pean central bank, to be modelled on Ger• The †rst fruit of that e ort was the Sin• many’s Bundesbank. The report gave More articles about the euro are at gle European Act, an agreement to disman• warning, however, that to prevent large Economist.com/euro tle barriers to internal trade by the end of trade imbalances, reforms would be need• 1 2 A special report on the euro area The Economist June 13th 2009

2 ed to make prices and wages more ‡exible 1985 and 1994 marked the zenith of this sort population of 329m have handed over and workers and capital more mobile. of integrationist zeal. monetary sovereignty to an entity at arm’s EMU’s route from rhetoric to economic After many a ‡ap (see box), EMU even• length from national politics: the European blueprint was a familiar one, if unusually tually metamorphosed into a bird of much Central Bank (ECB). swift. The push behind trade integration in grander plumage. On January 1st 1999 the So far the experiment has worked fairly Europe has been primarily political rather currencies of 11 countries were †xed well. The ECB has ful†lled its remit to than economic. The EU itself was born of against a new currency, the euro, which be• maintain the purchasing power of the the catastrophe of two world wars, colli• came the unit of reckoning in wholesale †• euro. Since the currency’s creation the av• sions of competing nation•states. It was de• nancial markets. In 2002 euro notes and erage in‡ation rate in the euro area has signed to avoid a repeat of such con‡icts by coins came in and the old paper currencies been just over 2%. Fears that the euro forging Œever closer union in Europe. Eco• were phased out. Since the single curren• would be a Œsoft currency have proved nomic ties were viewed as much as a cy’s launch †ve more countries have unfounded. It is unquestioningly accepted means to co•operation as an end in them• joined the euro area. In a unique economic at home and widely used beyond the euro selves. The Delors Commission between experiment, 16 countries with a combined area’s borders. (Several countries, includ•1

A tortuous path From Bretton Woods to euro

HE idea of a single money as a path to cooling on monetary union. vent speculative attacks on currencies TEuropean political union goes back a Currency markets were also stirring. At and to ensure that Europe’s monetary long way. In the 1950s a French economist, the time all 12 EU countries, bar Greece, policy was not made exclusively in Ger• Jacques Rue , wrote that ŒEurope shall be were in the exchange•rate mechanism many. Some German policymakers, pre• made through the currency, or it shall not (ERM), a system that tied currencies to viously sceptical of EMU, fretted that any be made. But the euro had pragmatic each other within narrow trading repeat of the crisis would be a threat to the roots too. After the breakdown of the Bret• bounds. Germany was at the scheme’s single market. ton Woods system of †xed exchange rates heart: currencies were oˆcially pegged to It was residual German scepticism that in 1973 the Deutschmark emerged as the each other in a complex grid of bilateral caused sti tests to be set up for countries benchmark currency in continental Eu• rates but all were, in e ect, tied to the D• that wish to join the euro. The Œconver• rope. The instability of ‡oating currencies mark. That became a problem when eco• gence criteria set out in the treaty called was a barrier to harmonious trade, but nomic conditions in Germany and the for would•be joiners to meet targets for in• schemes to peg exchange rates frequently rest of Europe diverged. To head o in‡a• ‡ation, bond yields, exchange•rate stabil• had to be redrawn because few countries tionary pressures caused by Germany’s ity, budget de†cits and public debt. The could consistently match the Bundes• post•uni†cation boom, the Bundesbank criteria were criticised as having little to bank’s anti•in‡ation zeal. The might of in July 1992 raised interest rates to 8.75%, a do with a country’s ability to cope once German manufacturing forced frequent 60•year high. monetary policy was no longer tailored to devaluations on others to keep their in• Those German rates caused strains in national needs. Instead, they seemed de• dustries competitive. currency markets that worsened over the signed to favour a core group of like•mind• Changes to exchange•rate pegs often summer. In September †rst Italy and then ed countries, centred around Germany, caused tensions. François Mitterrand, Britain were forced to devalue, in Britain’s and to exclude others, particularly Italy, who as French president was one of the case after spending billions of dollars try• which it was feared would use EMU’s low signatories of the Maastricht treaty, is said ing to defend its ERM parity against specu• interest rates to relax †scal discipline. to have remarked that Œdevaluations are lators. In the following months Spain, Por• Things turned out di erently. By 1997, never small enough to avoid losing face tugal and Ireland too had to let their the year in which the tests would be ap• and never large enough to make a real dif• currencies slide. France battled to hold to plied to a †rst wave of would•be entrants, ference to exports. As soon as Maastricht its parity and only just succeeded. Its refer• Germany and others in the core group had been signed (with a British opt•out endum produced a narrow vote in favour had trouble †tting into the Maastricht from EMU), those tensions resurfaced. In of the Maastricht treaty. straitjacket themselves. The time scale for June 1992 the Danes voted narrowly the †scal targets had to be fudged, which against rati†cation, raising a question Look at it this way let Italy and others slip through. France in• mark over the assumption that the path to Di erent countries learnt di erent lessons sisted that the Œstability pact proposed in EMU would be smooth. The Irish, in the from the crisis. Britain saw dangers in the treaty be renamed Œstability and only other scheduled referendum, voted †xed exchange•rate schemes. Its economy growth pact. Germany demanded a cap in favour shortly afterwards, but Mitter• started to pick up almost immediately on budget de†cits of 3% of GDP. When rand announced a referendum in France after its ejection from the ERM. The French both countries themselves later breached for the following September, a risky gam• were con†rmed in their belief that a mon• that limit, the rules had to be made some• bit because French public opinion was etary union was necessary both to pre• what more elastic. The Economist June 13th 2009 A special report on the euro area 3

2 ing Montenegro and Kosovo, use the euro as their currency without formally belong• ing to the euro zone.) The switch from old currency to new went remarkably smoothly, though consumers in many countries complained, perhaps predict• ably, that they were charged higher prices as merchants rounded up to new price• points in euros. But this caused barely a blip in the oˆcial in‡ation †gures. So far the euro has brought neither greater prosperity nor political union. Job• creation improved but productivity in• creases slowed, leaving the region’s trend growth rate much the same as before EMU. In its early years the euro fell against the dollar, but it has since more than made up for its early losses. It has quickly estab• lished itself as a global currency without becoming a true rival to the greenback’s status. For much of the euro zone’s †rst de• cade Germany, its largest economy, was in rent•account surplus is matched by big def• parate group of countries can continue to the doldrums, but after a long period of icits elsewhere, particularly in the share the same monetary policy. It will ask wage restraint its export industries started Mediterranean countries that German whether the crisis will spur economic re• to lift the economy. Spain, Greece and Ire• policymakers had been so keen to exclude form and whether it will attract more land proved more dynamic, each enjoying from joining. It remains an open question members to the club or, conversely, wheth• a consumer boom. how these will be resolved. er some of them might be thinking about All seemed well until the present †nan• The †nancial crisis is proving by far the leaving. Lastly, it will examine the idea that cial crisis struck. This reawakened worries biggest test to date for the euro zone. This in the longer term a multinational curren• about the imbalances that have built up in• special report will look at its e ects on the cy area will require greater political union side the euro zone. Germany’s huge cur• euro area and consider whether such a dis• to function properly. 7 One size †ts none

The euro did not cause all the euro area’s troubles, but it will make them harder to put right

ALK of economic hardship seems out count for most of Spain’s foreign trade. pace of job creation. Employment rose at Tof place on a sunny April day in Barce• Locked into the single currency, Spain an average annual rate of 2.8% between lona, one of Spain’s most prosperous cit• can no longer regain its lost competitive• 1997 and 2007. The boom in housebuilding ies. Yet for all the bustle along the Rambla ness by cutting its exchange rate. Mr Galí lured in migrant workers, many from Afri• de Catalunya, the city’s main drag, the res• frets that this may condemn the country to ca. The proportion of women at work in• taurants and cafés are not as full as you a protracted slump. ŒThe discipline of liv• creased from 38.5% in 1999 to 54.7% in 2007. might expect at the start of the Easter ing without devaluation is tough, he says. Now the legacy of that long boom break. Jordi Galí, an economist at the near• ŒIt’s like enrolling your child in a demand• threatens to deliver a long slump. Of the 11 by Universitat Pompeu Fabra (UPF), gives a ing school. Results may improve, but countries that adopted the euro in 1999, decidedly unsunny assessment of the task there’s also a risk the child will rebel and Spain has seen the fastest rise in output facing Spain. fail if you push too hard. prices. Its real e ective exchange rate, The country is enduring a painful hous• De†ance will be all the greater after a which measures the rise in domestic prices ing bust that has led to a collapse in the long period of relative ease. For most of the compared with those in 36 countries construction industry, doubling the unem• euro’s †rst decade Spain was a star pupil. weighted by their trade with Spain, rose by ployment rate to 18.1% in little more than a Its economy grew at an average annual around a †fth in the decade after the euro’s year. Recovery seems a distant prospect, rate of 3.9% between 1999 and 2007, almost launch (see chart 1 on the next page, left not least because during Spain’s long twice the euro•zone average and much side). Competitiveness gauges such as boom production costs rose far faster than faster than in any of the currency area’s these are notoriously sensitive to the price they did across the euro area as a whole. If other big countries, France, Germany and measure used, but on another indicator, left unchecked, higher costs will make it Italy. Unemployment fell from close to 20% based on relative unit wage costs, the ero• hard for exporters to compete with †rms in the mid•1990s to just 7.9% in 2007. Even sion of Spain’s cost edge is almost as from other euro•zone countries, which ac• that startling drop does not do justice to the marked (see chart 1, right side). 1 4 A special report on the euro area The Economist June 13th 2009

2 Both gauges point up problems in the tion: in the euro’s †rst decade consumer same handful of countries: Portugal, Ire• prices across the currency zone rose at an Taking the strain 2 land, Italy, Greece and Spain‹a group giv• average of only 2.1% a year. But in such a Current-account balance, % of GDP PIIGS en the ugly acronym . All †ve have large and diverse economy price pressures 1999 2008 seen a sharp deterioration in their current• naturally vary. Capping in‡ation in fast• account balances since the start of EMU growing hotspots, such as Greece and 15 10 5– 0+ 5 (see chart 2). Those shifts testify to unsus• Spain, would have needed a far tighter Greece tainable booms in domestic demand, but monetary policy than in the cooler north• also signal that local †rms have found it ern climes. Interest rates that seemed right Portugal hard to compete with imports at home and for the whole euro area were too high for to sell their wares abroad. Pay rises ran sluggish Germany and too low for friskier Spain well ahead of eˆciency gains in all these Greece, Ireland and Spain. Ireland countries. In Ireland and Greece gains in The ECB’s one•size•†ts•all monetary output per worker were healthy but wage policy can never be perfectly tailored for Italy in‡ation was high. In Portugal and Spain any individual member country. In princi• Source: European Commission in‡ation was a little lower but still well ple, higher in‡ation should act as a coolant above the euro•area norm. The bigger issue to overheating economies by reducing real was dismal productivity growth, which household incomes and by making †rms was in full train. Investors had come to be• was Italy’s main problem too. less competitive, reducing the incentive to lieve that wild swings in the business cycle invest. In practice, strong real growth and were a thing of the past, making them all Swines with ‡u high in‡ation are a draw to foreign capital, too willing to take on risk, including loans All these countries su er not only from a adding more fuel to the †re. For the same to countries that already had large foreign lack of competitiveness but from other, exchange•rate risk, a euro put to work in debts. Exchange rates often provide useful perhaps more damaging, disorders too. Spain might earn a better return than in warnings about emerging imbalances, but Heavy public•debt burdens and chronic slower•growing parts of the euro zone. overcon†dence and herd behaviour weak• de†cits were a feature in Greece and Italy The main hazard for investors in high• ened the signal. long before the current crisis. Ireland and in‡ation countries‹that a steady loss of Even if the †rst wave of currency union Spain enjoyed house•price and construc• domestic purchasing power will drag the had excluded Spain and Greece, as some tion booms that have now turned to busts. currency down‹is eliminated in a †xed• German policymakers had wanted, their In Ireland propping up ailing banks that exchange•rate zone. The removal of cur• economies might still have sucked in for• had lent too freely to property developers rency risk from within the euro area helps eign capital. The eight eastern European and homebuyers, at home and abroad, has explain why some countries were able to countries that joined the EU from 2004 at• bumped up the †scal cost of recession. run eye•watering current•account de†cits. tracted huge sums of foreign capital even (Luckily for Spain, its regulators forced In 2007 both Spain and Portugal had de†• though for many of them euro member• commercial banks to behave more pru• cits close to 10% of GDP. Greece’s was 13%. ship was a distant prospect. This suggests dently in the boom.) A steady accumula• In its absolute size, Spain’s de†cit was sec• that, even outside the euro, Spain and tion of current•account de†cits has left ond only to America’s. Greece would have had access to plenty of Greece, Portugal and Spain with net for• Foreign capital kept booms going for foreign credit with which to feed a domes• eign debts of 80•100% of their GDP. These longer, but that was true in many rich tic spending boom. frailties are a threat to the stability of the countries outside the euro zone as well. Ireland and Spain were ripe for housing euro area as a whole. There were other factors at play. The euro booms too. Both countries have a high rate How much of these imbalances are due was created at a point when the Great of owner•occupancy and space for fresh to the euro itself? The ECB, a ‡edgling insti• Moderation, a long period of stable construction. The obsession with housing tution, has managed to keep a lid on in‡a• growth and low in‡ation in rich countries, spilled over from Britain, a serial miscreant when it comes to house•price booms. When Spain and Ireland adopted the euro, Losing effectiveness 1 they imported low interest rates from Ger• Real effective exchange rates measured by: Spain Ireland Greece Portugal Italy many: the ECB was the Bundesbank writ GDP deflator, Jan 1999=100 unit-wage-cost deflator, Jan 1999=100* large. By then Britain had already adopted the German model of a central bank free 130 140 from political in‡uence and determined to †ght in‡ation. The results, inside and out• 130 120 side the euro zone, were much the same: 120 lower interest rates that sent house prices mad. Britain, at least, was able to tailor its 110 110 interest rates to local conditions, but not by 100 enough to prevent a housing bubble. 100 90 If euro membership is only partly re• sponsible for the overheating in Ireland, 90 80 Greece, Portugal and Spain (sluggish Italy 19992000 2001 02 03 04 05 06 07 08 19992000 2001 02 03 04 05 06 07 08 can only dream of such excesses), it will Source: European Central Bank *Data not available for Portugal make it harder for these countries to deal 1 The Economist June 13th 2009 A special report on the euro area 5

2 with the resulting loss of competitiveness. itiveness to its †rms and a ‡exible job mar• Europe, recovers and Spain does not man• Spain’s unemployment rate is already the ket to speed the ‡ow of workers from age to hook up to that, says Andreu Mas• highest in the euro area and likely to rise industries such as construction, which ca• Colell, another economist at UPF. ŒThat further. If Spain’s jobless rate sticks at 20%, tered to a boom †red by domestic demand, would be a disaster. It would strain the link will voters blame the euro? to export †rms that can generate the rev• between Spain and the rest of the EU. We enues to service Spain’s debts. will also have to deal with tighter mone• A handy scapegoat That transition would be hard enough tary policy if the rest of the euro area picks ŒNo one sold the euro as a solution to high in the best of circumstances. Spain has one up, creating more pressure. unemployment, says Mr Galí. But, he of the most rigid job markets in the devel• That fear of being left behind is widely adds, the economy used to bene†t when oped world. Many jobs are heavily protect• shared in other countries too. Some econo• market pressures forced down the local ed and wages are set centrally. That will mists believe that countries now stuck in a currency: ŒIn 1992 and 1993 a series of de• make adjustment all the more diˆcult. The slump and unable to adjust their produc• valuations got us out of trouble. Now fear is that Spain will stagnate even as oth• tion costs may well start questioning the Spain needs other adjustment mecha• er economies start to revive. ŒMy night• bene†ts of euro membership. But where is nisms: lower wages to restore cost compet• mare is that the world economy, including the exit sign? 7 No exit

Staying in the euro will be tough for some members, but leaving would be too awful to contemplate

N THE weeks following the collapse of make markets in the issues of small coun• scramble to deposit their euros with for• ILehman Brothers last September the tries, such as Greece and Ireland, which left eign banks to avoid forced conversion to number of euro banknotes in circulation their prices unmoored. the new, weaker currency. Bondholders suddenly increased. Fears about the rick• But at least part of the rise in spreads re• would shun the debt of the departing ety state of banks had made many people ‡ected concern that countries might †nd it country, and funding of budget de†cits mistrustful of keeping money on deposit. hard to pay back their borrowings. The and maturing debt would be suspended. Far safer to keep cash stu ed under a mat• government bonds of Greece, Ireland, Por• Changing all contracts in euros‹bonds, tress. The more discriminating hoarders, it tugal and Spain were all downgraded a mortgages, bank deposits, wage deals and was said, were careful to squirrel away notch by credit•rating agencies. For some, so on‹to the new currency would be a lo• banknotes with serial numbers pre†xed bond spreads are a crude gauge of the risk gistical nightmare. The changeover to the by the letter ŒX, indicating currency is• that the euro will break up. If a euro•zone euro was planned in detail and the ex• sued in Germany. Notes with ŒU (French) member were shut out of capital markets change rate was †xed in advance, in co•op• or ŒP (Dutch) pre†x were also †ne, but and had to default on its debt, it might be eration with all the euro members. The re• those with a ŒY or an ŒS, issued by Greece tempted to use the opportunity to recreate verse operation would be nothing like as and Italy, were shunned. its own currency and devalue. In that orderly, not least because the exchange rate The logic was that if you were prepar• event, creditors could be forced to convert would be a moving target. ing for †nancial apocalypse, you had bet• their bonds into claims in a new currency If businesses converted their debts to a ter not rely on the euro area surviving in• at a discount linked to a new exchange rate weaker currency, that might constitute de• tact. In fact, banknotes are a shared against the euro. Default would be one fault and trigger legal challenges. If they obligation of all euro•zone members, no way for countries to free themselves from stuck to their covenants, they would have matter where they are printed. If the issu• the euro’s shackles‹or, to look at it from to service their euro debts from earnings in ing country were to leave the single curren• the opposite point of view, for the euro a weaker currency. That would hurt †rms cy, a †ve•euro note would still be worth zone to rid itself of troublesome members. which rely mostly on pro†ts from their do• †ve euros, whatever the serial number. mestic market. The convulsions would be However, interest•bearing debt denomi• A game of consequences felt by other euro•area members too. The nated in euros is a di erent matter, and That kind of thinking, however, is found writedown of the departing country’s gov• bond markets quickly started to sort the Xs mostly among those who were doubtful ernment bonds might threaten the solven• from the Ys. that the euro would ever get o the ground cy of banks in the rest of the euro zone. By early 2009 the yield on a ten•year in the †rst place. It is rare in countries seen Around half of Italian government bonds, Greek government bond was almost twice as candidates for exit. As Eurocrats in Brus• for instance, are held outside Italy. Other that on a comparable German Bund. The sels are keen to stress, far from breaking up, euro•area members could su er contagion spread over Bunds for Italian, Spanish and the euro zone is growing. Since its launch it as markets bet on further defaults. Irish bonds also widened dramatically be• has taken on †ve new members, and more If the act of leaving would be hard, the fore narrowing again more recently. One are queuing to join. aftermath might be even harder. A country explanation was that in skittish markets The costs of backing out of the euro are that forced bondholders to take a loss Bunds were prized for their extra liquidity. hard to calculate but would certainly be would be punished. Continued access to Another was that the bond•trading arms heavy. The mere whi of devaluation bond markets would come at a high price. of bombed•out banks were less willing to would cause a bank run: people would Investors would ask for a huge premium to1 6 A special report on the euro area The Economist June 13th 2009

whose exports contain a lot of imports, a devaluation would push up in‡ation. And where a large proportion of wage contracts is indexed to prices, as in Spain, higher in• ‡ation would rapidly work its way through to wages.

The wrong cure An exit from the euro would not tackle weak productivity growth and in‡exible wages, which are the root causes of low competitiveness. In time, further devalua• tions might be needed. Countries with high debts and a history of poor macroeco• nomic management would be most tempt• ed to leave. But these are also the countries most likely to be hurt. A more plausible, though still unlikely, scenario would involve a breakaway by a group of low•debt and cost•competitive countries, centred around Germany. Mem• bers of a new, Œhard European currency 2 cover the risk of further default. On that valuation could itself trigger a wage•price would leave behind a stock of depreciat• count alone, borrowing costs would be far spiral. For high•debt countries, such as ing euro debt and might be rewarded by higher than they were within the safer Greece and Italy, the interest rates demand• lower borrowing costs on debt issues in con†nes of the euro area. ed by markets to insure themselves against the new currency. Yet a large part of the ap• Investors would have to protect them• such risks would be ruinous. peal to Germany of the single currency has selves from two further risks: exchange• And even though the costs are likely to been that it rules out revaluations and re• rate volatility and in‡ation. A former euro be heavy, the immediate bene†ts might wards its †rms for being competitive. Ger• member would have to reinvent its own prove only transitory. A devaluation is a many, France and the rest have too much monetary policy and would struggle to proxy for a national pay cut: it helps ex• invested in the success of the EU and the convince investors that it could keep a lid porters but makes consumers of imports euro to put it at risk. As Daniel Gros of the on in‡ation. One of the euro’s big attrac• poorer. Workforces would put up strong re• Centre for European Policy Studies, a Brus• tions was that it o ered many countries a sistance to being paid in a weaker currency. sels think•tank, puts it: ŒThe weak can’t shortcut to a credible monetary set•up. De• In countries such as Greece and Ireland, leave and the strong won’t leave. 7 The non•nuclear options

In place of devaluation, troubled members could try reform

PAIN may soon be faced with two op• ed in 1975] we were closed o . Opening up Greece’s borrowing costs was driven by Stions, says UPF’s Mr Mas•Colell: a per• our borders brought huge bene†ts. the mistaken belief that last December’s manent slump or economic reform. ŒA Ireland, like Spain, has been helped by violent street protests were due to a falter• third option, exit from the euro, is not a EU funds for roads, farming and universi• ing economy. In fact the demonstrations possibility. Spain won’t leave because it is ties. According to the most recent Euroba• were sparked by the killing of a 15•year•old very pro•Europe. To leave would be seen rometer, a twice•yearly opinion poll, 79% boy in Athens by a policeman. Some peo• as a national failure rather than a libera• of respondents in Ireland believe that ple had taken rising bond spreads as an tion. Euro membership is a symbol of overall their country has bene†ted from omen of default and euro break•up. That Spain’s progress as a democracy as well as EU membership, and only 11% think it has prospect, always distant, has now receded its economic development. For some, it is not. The positive response in Greece, Spain further. ŒDespite the high spreads, we have an insurance against a return to dictator• and Portugal was above the average for all shown that we can re†nance our debt, ship and autarky. ŒOur experience is that EU countries (see chart 3, next page). says Mr Papathanassiou. when we went for being more European, Most Greeks are in favour of the euro, Italy’s economic travails have attracted the results were positive, says Elena Pi• and only 12% think EU membership is bad less attention recently. Unlike Greece, Ire• sonero, a former vice•minister for com• for their country. That is poor ground on land and Spain, whose economies grew merce, now at the Madrid oˆce of KPMG, which to build a case for quitting the euro. rapidly before crisis struck, Italy has seen a consultancy. ŒIn the past [during the dic• Greece’s †nance minister, Yannis Papatha• its GDP growth drift consistently below tatorship of Francisco Franco, which end• nassiou, thinks that the recent spike in the euro•zone average (see chart 4). Its cost•1 The Economist June 13th 2009 A special report on the euro area 7

ducing things that can be traded across cause of that sensitivity to the world busi• Appreciated 3 borders. A weaker currency also shifts the ness cycle and its reliance on big multina• Balance* of people polled who believe membership of balance of demand by making imported tional †rms for investment, wages are the European Union has benefited their country, % consumer goods dearer and exports unlikely to stay out of whack for too long. cheaper. That cools spending at home and In the Mediterranean economies the 20– 0+ 20 40 60 80 tilts the scales towards †rms that sell pressure on wages is mostly in the wrong Ireland abroad, nudging workers and capital in direction. In Spain most private•sector pay Greece their direction. deals contain clauses that compensate em• Spain In a currency union, pay needs to adjust ployees if in‡ation is stronger than expect• Portugal that much more quickly to changing mar• ed. The country also has a managed sys• ket conditions to shift workers out of high• tem of wage•setting that fails to make EU-27 cost industries. But until quite recently pay enough allowance for di erent productivi• Italy has tended to be Œsticky on the way ty levels across the economy. Britain down: workers have generally been reluc• Wages in Italy are set centrally too (as Source: European *Difference between those who said “benefited” tant to take wage cuts, at least in nominal they are in Greece), although compensa• Commission against “not benefited”, autumn 2008 terms, which has made real•wage adjust• tion for in‡ation is no longer automatic. ment slow. On many reckonings, the rate at The infamous scala mobile, which main• 2 competitiveness has declined and its pub• which Germany went into the euro in 1999 tained a rigid link between Italian wages lic debt was already 106% of GDP last year was too high. The traded value of the and prices, was scrapped in 1992 after a and will now rise still further. Yet in March, Deutschmark had not fallen to re‡ect the long struggle. when the strains in the euro area’s public• higher unit wage costs that were a legacy debt markets were at their greatest, Italy’s of the uni†cation boom. It took many Here today, gone tomorrow ten•year bond yields were around 1.5 per• years of very low wage growth and rising The spread of †xed•term employment con• centage points above Germany’s, com• productivity before Germany regained its tracts in Spain (from the mid•1980s) and Ita• pared with a gap of 2.8 percentage points edge on costs. ly (in the mid•1990s) helped make hiring for Greece. That route to redemption has become and †ring more responsive to the business Nor was Italy’s public debt downgrad• even harder for today’s high•cost countries cycle. The innovation had an immediate ed. ŒPerhaps the credit•rating agencies are because there is little consumer•price in‡a• pay•o : it created jobs. Firms were content being responsible, an Italian economist tion around to erode real wages and re• to take on temporary workers, often immi• suggests by way of explanation. If Italy did build pro†t margins. Unemployment grants, because they knew they could easi• get into funding trouble, that would have seems likely to rise steeply before wages ly lay them o again. Before the crisis hit, repercussions for the rest of the euro zone. start to adjust. temporary jobs accounted for more than a Its public debt dwarfs that of countries the Ireland will make the adjustment more third of Spain’s total, the largest share in size of Ireland or Greece. quickly than the others. Already there are the EU. Tito Boeri of Bocconi University If the rating agencies have been careful signs that private•sector wages are falling reckons that a †fth of Italy’s workforce are not to sound the alarm, the same is true of in response to rapidly rising unemploy• on (short) †xed•term contracts. The rest en• Italy’s politicians. In the past Silvio Berlus• ment. The 7.5% cut in public•sector pay that joy a high level of job protection which coni, the prime minister, and Giulio Tre• came into force in May was mostly a re• politicians dare not dismantle. Both coun• monti, the †nance minister, have been sponse to the †scal crisis, but was also sold tries saw temporary contracts as the only quick to blame the euro and the ECB for Ita• as a remedy for lost competitiveness. Ire• way to free the jobs market. ly’s economic problems. Bashing the euro land is set to endure a deeper recession Jobs that were created in good times are was a useful way of attacking Romano than other rich countries because of its now being shed quickly. The downturn Prodi, a centre•left opponent, who in his Œglobalised economic model. But be• has highlighted the gross unfairness of the †rst stint as prime minister, in the late dual labour market. It puts the burden of 1990s, took Italy into the euro before be• adjustment on groups with no tenure coming president of the European Com• Where it hurts 4 (women, immigrants and the young). Pro• mission. The rhetoric has noticeably soft• GDP, % change on year earlier tected workers, the bulk of the workforce, ened. Earlier this year Mr Tremonti cling to their jobs. That tends to fossilise 1999-07* 2008 2009† described the euro zone as Œtotally sustain• the structure of the economy. Old indus• able. The currency crises in Hungary and 10 5– 0+ 5 10 tries, where productivity is waning, are Iceland were salutary, says Roberto Perotti slow to die and new †rms slow to start up. Ireland of Milan’s Bocconi University. ŒNo serious The growth of temporary contracts politician now says ‘let’s leave’. hurts productivity in another way. Firms Greece are obliged to lay o (typically young) con• Devaluation by proxy tract workers at the end of a †xed period, Spain Is there a way of achieving the e ects of a so they have little incentive to train tomor• fall in the real exchange rate without going row’s workforce. Instead they are stuck Euro area to the extremes of ditching the euro? As with older, tenured workers heading for re• long as it does not trigger a burst of wage tirement. The result in Italy, says Mr Boeri, Italy in‡ation, a devaluation lowers wage costs is a Œlost generation of workers with limit• relative to those of workers abroad, im• *Average annual rate ed skills. Admittedly the growth in tempo• Source: European Commission †Forecast proving the competitiveness of †rms pro• rary contracts has helped many people 1 8 A special report on the euro area The Economist June 13th 2009

2 back into work and has lowered long•term For now, policymakers are too worried unemployment. But the evidence from about fragile demand to risk tackling the Spain suggests that such contracts are rare• supply side of the economy. Today’s eco• ly a bridge to better things: less than 5% are nomic crisis has little to do with di eren• converted into permanent jobs. tial wage costs within the euro. In terms of A group of economists led by Samuel relative unit wage costs, Germany’s com• Bentolila of CEMFI, a graduate school in petitiveness has improved by around 13% Madrid, have set out a reform manifesto since the euro started. Yet this year the Ger• for Spain’s jobs market. They suggest that man economy is set to shrink by more than wage•setting could be made more ‡exible any other in the euro area bar Ireland be• if deals struck at the level of individual cause of its heavy reliance on exports. †rms were allowed to prevail over regional Greece is expected to hold up better be• or industry agreements. They also propose cause it is less exposed to the global econ• replacing †xed•term contracts for new omy (Œa good thing for a bad reason, notes hires with a permanent contract in which one policymaker). Its GDP is likely to fall by †ring costs rise with seniority but not as around 1%, making it one of the most resil• high as at present. ient economies of the OECD’s 30 mem• Mr Boeri and his colleagues have called bers. Italy’s economy will do far worse, but for a similar scheme in Italy, where work• the euro helped provide. Without a crisis it there is less of a sense of crisis because it ers build up employment rights over time. is hard to persuade voters of the need for has long been struggling anyway. Abolishing job protection makes most radical change. Yet recession is the worst Root•and•branch structural reform will workers worse o , so it tends to run into time to make changes that leave some have to wait a while longer. Germany’s tra• political obstacles. The next best thing is groups poorer. vails are not a good advertisement for gradually to reduce average †ring costs and Italy’s previous big recession, in 1992•93, maximising competitiveness. Only in Ire• giving †rms better incentives to train their prompted a wave of reforms: privatisa• land, where the economic model is based workers. If Italy wants to encourage work• tions, changes to pension entitlements, the on openness to trade and foreign invest• ers to risk moving jobs, it also needs to beef creation of a competition authority and ment, is competitiveness a big part of the up its skimpy unemployment bene†ts. ŒIt• the demise of the scala mobile. Greece is policy debate. Elsewhere politicians seem aly should say to its partners: ‘our †scal now inching ahead with some reforms somewhat stuck. ŒAt some point we’ll stimulus is to introduce a welfare safety along similar lines. The government has have to accept that it’s better to have peo• net to speed up the reallocation of jobs’, sold Olympic Airways, a subsidy•thirsty ple in work than to have high wages, says says Mr Boeri. airline, and a competition law is going Mr Mas•Colell. ŒIn Spain we are not ready through parliament that will give antitrust for that. There is an illusion, a hope, that Never a good time for reforms authorities more power to challenge‹and we will wake up tomorrow and things will Such reforms would be desirable even if break up‹big companies that can set be better. nobody had signed up to the euro. When prices. In Spain one relatively painless re• Yet all the current troubles of the hard• the currency was created, the hope was form would be to change the rules for rent• est•hit euro•zone countries do not seem to that the loss of the safety valve of devalua• ing out property, which currently overpro• have put o a raft of applicants, mostly in tion would help to boost productivity and tect tenants. If owners felt more relaxed eastern Europe, from trying to join the club. make markets more ‡exible. For most of its about letting out second homes, workers Indeed, if anything, the †nancial crisis has †rst decade timid politicians were able to might †nd it easier to move in search of made many countries even keener to join. shelter behind the economic stability that jobs. It might even lift house prices. Do they know what they are doing? 7 Fear of ‡oating

The †nancial crisis has made the euro look more alluring

N 1999, the year the euro was launched, ciently inclined to move jobs to even out ble trinity: that a country could not simul• Ithe Nobel prize for economics was regional booms and slumps. In later re• taneously have a †xed exchange rate, be awarded to Robert Mundell, a Canadian search others added strong trade links, open to capital ‡ows and operate an inde• economist. That was good timing because wage ‡exibility and a central †scal author• pendent monetary policy. It could opt for his work was in‡uential in shaping the ity to the list of necessary features. any two of these features but not all three euro zone. In a 1961 paper Mr Mundell had Equally important to the decision to together. With free capital ‡ows, monetary pioneered the theory of an Œoptimal cur• join a monetary union was another of policy could be directed either at stabilis• rency area, a territory suited to adopting a Mundell’s insights, developed with Mar• ing an exchange rate or controlling in‡a• common monetary policy. A main require• cus Fleming at the International Monetary tion, but not both. A country that targets ment, he concluded, was that workers Fund, which entered the economics text• domestic in‡ation and is open to foreign throughout such an area would be suˆ• books. This was the idea of the Œimpossi• capital must have a ‡exible exchange rate. 1 The Economist June 13th 2009 A special report on the euro area 9

2 When Mr Mundell expounded his the• warmed up since last autumn’s †nancial rich as Sweden in terms of income per ory, in the early 1960s, most rich countries turmoil. Most are small and very open head, it has many more people, so its econ• were tied to the Bretton Woods system of economies whose exports account for a omy is bigger. Its exports account for two• †xed exchange rates. Because capital ‡ows large share of GDP and whose trade ties to †fths of GDP. Because its exposure to were tightly controlled, countries could set the euro area are strong. As emerging econ• world trade is smaller than that of many their own interest•rate policies and still omies they are prone to sudden shifts in other EU countries, it has su ered far less keep exchange rates more or less †xed foreign•investor sentiment, which makes from the global recession. The European against the American dollar. for volatile currencies, so exchange•rate Commission reckons its economy will Canada was di erent. Its long border, stability holds considerable appeal for shrink by 1.4% this year, which is not a lot heavy trade and strong industry links with them. None of them has a long record of by the dismal standards of the region. America made capital controls impracti• stable money, so loss of monetary inde• cal. For Canada to have an independent pendence would not be greatly mourned. The case for a quick dash monetary policy, it had to let its currency For four of the eight the euro is already Despite the size and resilience of Poland’s ‡oat. In later writings Mr Mundell ex• their monetary anchor. The three Baltic economy, its government wants to get into pressed regret about Canada’s choice, as countries, Estonia, Latvia and Lithuania, the euro as soon as possible. It hopes to well as enthusiasm for European mone• have long pegged their currencies to the join the ERM•2 (a pledge to keep the ex• tary union. In principle, a currency adjusts euro, and before that to the D•mark. Bulgar• change rate within agreed bounds for two to keep economies in balance, but in prac• ia also has a euro peg. years) early next year in order to qualify for tice, argued Mr Mundell, exchange rates For small, open economies such as euro membership by 2012. As elsewhere in veer wildly from their ideal levels. Large those of the Baltic states (and Iceland, the region, part of the rush to qualify is to and volatile capital ‡ows mean that ‡oat• which now plans to join the EU as a step• forestall a further drop in the zloty, which ing currencies can be a source of instabil• ping stone to adopting the euro), it makes would make foreign•currency loans hard• ity. They are also a poor substitute for fully sense to tie currencies to a big and stable er to pay o . Around 30% of private•sector ‡exible wages and prices. neighbour. Even Milton Friedman, a fer• debt is in foreign currency, far less than in vent advocate of ‡oating exchange rates, Hungary but more than enough to hurt the In or out? thought so. In the Baltics, Latvia’s euro am• economy if the zloty sinks. Hopes of entry The merits of monetary ‡exibility versus bitions are on hold. Following a bail•out in 2012 may be optimistic, and some econ• exchange•rate stability have to be weighed led by the IMF in December, its economy omists question the wisdom of forcing the up by the 11 EU countries that are not (yet) and public †nances are in intensive care. pace. As a fast•changing economy Poland in the euro. The choice is straightforward Estonia wants to join quickly and may do might need the ‡exibility of a ‡oating ex• for Britain, which has long been reluctant so as soon as 2011. A realistic target for Lith• change rate for a little longer to keep it com• to give up its independent monetary poli• uania is 2012. petitive and to smooth adjustments. cy and has an opt•out from the euro. Brit• For a larger country, such as Britain, the But can it rely on the right kind of help ain’s policy brass tend to see a ‡exible ex• bene†ts of membership are less obvious. from currency markets? Recent experience change rate as a useful safety valve. A bigger portion of the goods and services suggests that there is no stable link be• Sweden, like Britain, does not seem to have it consumes is produced at home, so there tween the economy’s vital signs and shifts much to gain from hitching itself to the is more scope to manage domestic prices in its currency. For a while the exchange ECB. It has built a credible monetary re• through an independent monetary policy. rate had been a balm. Between 2005 and gime, with an independent central bank, Poland could †t that bill too. It is the 2007 the zloty’s value increased in line along similar lines. Since a referendum in largest and one of the least open of the with productivity (as a country becomes 2003 that came out against membership, CEE8 (see table 5). Though not nearly as richer, its currency tends to rise in real 1 Sweden has shown no interest in getting closer to the euro club. Denmark’s currency is pegged to the The outsiders 5 euro but the country remains outside the euro zone after twice failing to secure a % of GDP 2009 GDP at market Exports, % of Consumer 10-year gov’t popular vote in favour of joining. It has the Budget balance Public debt prices, ¤bn, 2008 GDP, 2007 prices* bond yield, %† worst of all worlds. The currency peg is Euro area -5.3 77.7 9,209 41.6 2.7 3.69 open to speculative attack, so its exchange• Britain -11.5 68.4 1,812 26.4 3.7 4.11 rate stability is precarious; yet to preserve Bulgaria -0.5 16.0 34 63.4 10.1 7.04‡ it, the country has had to sacri†ce an inde• Czech Republic -4.3 33.7 149 80.2 4.7 4.65 pendent monetary policy. The govern• Denmark -1.5 32.5 233 52.3 3.2 4.10 ment has been mulling a third referendum Estonia -3.0 6.8 16 74.4 8.6 na but the new prime minister, Lars Lokke Hungary -3.4 80.8 105 80.3 5.0 9.40 Rasmussen, said in April that it would not Latvia -11.1 34.1 23 42.2 13.4 7.90 take place this year. Lithuania -5.4 22.6 32 54.4 10.5 7.89§ The other eight potential members are former planned economies in central and Poland -6.6 53.6 362 40.8 4.0 6.02 eastern Europe (CEE) that joined the EU on Romania -5.1 18.2 137 29.5 7.6 8.95 or after May 2004. All are keen to adopt the Sweden -2.6 44.0 328 52.6 3.1 3.49 euro. Those that had been cool on mem• Sources: European Commission; *% increase on a year earlier, latest 12-month average Thomson Datastream; Bloomberg †Latest 12-month average ‡Latest 5-month average §8-year gov’t bond bership, such as the Czech Republic, have 10 A special report on the euro area The Economist June 13th 2009

2 terms). That helped to keep in‡ation low risk of credit and housing booms because without harming exports. Oh for an anchor 6 the climate now favours tighter bank regu• The benign period ended in the au• Exchange rates against the euro, January 2007 =100 lation. ŒBanking supervisors must have tumn of 2007. The zloty, and some other Czech koruna Hungarian forint the authority to react to the business cycle eastern European currencies, were driven Polish zloty New Romanian leu in a dynamic way, says Mr Slawinski. up (see chart 6) as investors piled into 120 Governments must also be careful not to emerging markets in the belief that they fuel housing booms with tax breaks. In• would soon Œdecouple from troubled 110 stead property taxes could be used to cool rich•world economies. A year later, follow• 100 overheated housing markets. ing the collapse of Lehman Brothers, the Once Poland and the smaller CEE coun• markets made a U•turn. Capital ‡ooded 90 tries adopt the euro, might Britain’s atti• out of eastern Europe, starving the region 80 tude change? If Denmark were to join too, of foreign currency and plunging it into a the euro area would cover almost all of the severe crisis. 70 EU’s member states, so Britain might once When a ‡oating exchange rate proves to 2007 08 09 again look like the odd one out. Even so, it Source: Thomson Datastream be an irritant rather than an emollient, †x• is likely to draw the same lesson from this ing it once and for all has greater appeal. crisis as it did from the ERM expulsion in Most of Poland’s trade is with the euro area ing up on potential entrants would under• 1992: that devaluation is a good thing. and much of that is intra•†rm trade: be• mine the single currency. There may be a There is chagrin in some European capitals tween, say, a German †rm and its Polish feeling that Œwe had to su er to get in; so (especially in Dublin) that sterling has subsidiary. Adopting the euro should open should you. Some outside the ark are also dropped so far and fast against the euro. A Poland up to more of that sort of trade and against a free•for•all. The stronger aspi• weaker pound, even with world trade in the stable, long•term capital investment rants, Poland and the Czech Republic, have retreat, still cushions the pro†t margins of that goes with it. And once currency risk distanced themselves from calls by trou• struggling exporters. It will only harden vanishes, government, †rms and house• bled Hungary (like Latvia, an IMF suppli• the belief in Britain that currency ‡exibili• holds will all be able to borrow more cant) to shorten the qualifying period in ty should not be lightly given up. cheaply‹and, as important, given the re• ERM•2 from two years. In any case, no British government cent freeze•outs‹more easily. Would fast•track entry really harm the could now consider signing up to the euro euro? The worry that euro•zone countries without †rst winning a referendum, and In purgatory such as Spain may su er prolonged opinion polls have shown a fairly consis• The †nancial crisis may have increased the slumps because they lost control of unit tent two•to•one majority against joining allure of the euro zone, but it has also made wage costs lends the in‡ation test some the single currency. Even if Britons could it trickier to get in. To join, countries must weight, though not much. Willem Buiter at be sold on the narrower issue of economic †rst meet the Œconvergence criteria: tar• the London School of Economics is not bene†t, they are more likely than most gets for in‡ation and public †nances, as convinced. He thinks that in‡ation conver• Europeans to see national control over well as market•based tests for low long• gence is something to be expected after monetary policy as indivisible from other term interest rates and a stable exchange adopting the euro, not before. Getting rid kinds of sovereignty. The euro’s success so rate (ie, two years in ERM•2). Slovakia of anything that may give rise to in‡ation far has suggested that a currency can be made the cut when the criteria were last as• is in the self•interest of new joiners. So is stable without the backing of a unitary sessed, in May 2008, and joined in January. †scal discipline. But insisting on them pri• state. But the †nancial crisis has raised a Of the eight CEE countries still outside, all or to entry amounts to Œmisplaced pater• fresh question mark over that idea. 7 bar Poland and the Czech Republic missed nalism, according to Mr Buiter. ŒIf you the mark on in‡ation, which was sup• have time to get in‡ation down, †ne. But posed to be no more than 1.5 percentage ‡oating exchange rates are dangerous. The points above the average of the three EU main thing is to get in. countries with the lowest rate. Poland, for On one count, the would•be entrants its part, failed to qualify because of doubts are more ‡exible than the incumbents. Mi• that it could control its budget de†cit and grants from Poland and other eastern Euro• worries that it owed its low in‡ation to the pean countries have shown themselves rise in the zloty (which was not in ERM•2). willing to move in search of work. Lessons With economies facing a deep reces• can also be learnt from the mistakes of oth• sion, in‡ation is set to drop sharply ers. Andrzej Slawinski, a member of the (though the benchmark for the test is fall• Polish central bank’s monetary•policy ing too). The public•†nance criteria will be council, believes there is less of a risk that far harder to meet. Euro aspirants must the new member states will follow in the show that they can keep their budget de†• footsteps of Greece, Ireland, Portugal and cits below 3% of GDP and cap their debt ra• Spain. They are still poor by EU standards, tio at 60%. That is tough in a downturn: so can look forward to a period of fast pro• most countries inside the euro area are al• ductivity growth. Were unit wage costs to ready in breach of these rules. But hopes rise too far, they could recover competitive• that the rules might be relaxed have been ness more quickly. dashed. Those inside the euro fear that eas• Poland may be able to guard against the The Economist June 13th 2009 A special report on the euro area 11

Soft centre

Can a currency survive without a state?

AST November the European Commis• man parliament that it was a Œfallacy that lurch in its economy by running a bal• Lsion set out its proposals for a Europe• monetary union could last without politi• anced budget or, in good times, a surplus. wide †scal stimulus, worth a combined cal union. By the time the euro was These †scal rules had another purpose, ¤200 billion, roughly 1.5% of the 27•nation launched in 1999, many people thought which was often given greater emphasis: block’s combined GDP. The commission that some form of †scal counterweight to to prevent imprudent countries from im• has a relatively small budget and no au• monetary union would soon follow. ŒYou posing costs on others. Big de†cits in one thority to compel member states to shell didn’t have to be a federalist to believe country might make it harder for others to out extra cash or cut taxes (and, to its regret, then that the euro would prompt more po• compete for funds from savers, driving up little clout to stop them from running up litical integration, says Jean Pisani•Ferry interest rates for all. If such de†cits were to budget de†cits). So it had to content itself of Bruegel, a Brussels think•tank. add materially to the average debt burden, mainly with a co•ordinating role. The belief seemed well founded on investors might fret that governments will The commission, along with the Euro• several counts. Money is a form of govern• attempt either to in‡ate away their debts pean Investment Bank, found ¤30 billion ment debt, so a paper currency, it was or to pass them on to other countries, so of EU money to contribute towards the thought, must need a state behind it. His• will demand higher rates from all borrow• ¤200 billion target, mostly by speeding up torical examples of a currency block not ers as protection. The EU treaty contains spending programmes. Of this, ¤5 billion backed by a unitary state are rare, and such two clauses to try to limit this transfer of was unspent infrastructure money from few as there have been did not last long. costs. The †rst bars the ECB from creating the EU budget which would normally be According to the theory of optimal curren• money to †nance de†cits. The second for• returned to the rich member states that cy areas, a central †scal policy is necessary bids countries from assuming the debts of had provided it. Three months later gov• because a single interest rate will not suit others (the Œno bail•out clause). ernments were still arguing about where conditions in all parts of a currency zone. The pact did not work well. The empha• or indeed whether this money, a tri‡ing Just as welfare spending and revenue rais• sis on the costs to others of †scal indisci• sum in the scheme of things, should be ing help to smooth out regional kinks in pline meant that countries were careful to spent. Brussels insiders see this episode as national business cycles, a Œ†scal euro behave no worse than their peers, rather typical of the painfully slow process of zone would act as a stabilising force for a than trying to be prudent on their own be• putting plans into action. It also illustrated shared currency area. half. In good times public †nances tended how reluctant governments are to cede to add to, not subtract from, demand pres• control over their own revenues. Rules of the game sures: †scal policy often worked against There had been hopes that they might What institutional structures would be the monetary sort rather than comple• become more co•operative. Helmut Kohl, needed for political union was rarely menting it, as the pact intended. The costs who as German chancellor was one of the made clear, only that there would soon be of †scal laxity were low. Before crisis midwives of the Maastricht treaty, thought more of it. In the meantime a set of †scal struck, the slack attitude towards credit risk a single currency could not survive with• rules‹the stability and growth pact, which in bond markets meant that borrowing out political union; indeed its main appeal put a cap on budget de†cits and public costs for high• and low•debt countries was that it would make such union more debt‹would take the place of a central sys• were similar. When in 2003 the European likely. In November 1991, a month before tem of revenue sharing. Each country Commission threatened to impose penal• the Maastricht summit, he told the Ger• would insure itself against a downward ties on France and Germany for excessive 1 12 A special report on the euro area The Economist June 13th 2009

2 de†cits, the pact was †rst suspended and tal losses on asset purchases. countries co•operate. The idea that a †nan• then amended, with get•out clauses for Despite the crisis, there are few signs of cial policeman has to be strict to be e ec• Œexceptional events. progress towards better †scal co•ordina• tive is dated. He sees a European fund as Ireland and Spain had complied with tion. Earlier this year, as bond spreads con• more than an emergency kitty for cash• the pact in good times, but had relied too tinued to rise, policymakers dropped starved euro members. It could act as a per• heavily on windfall revenues that evapo• heavy hints that struggling sovereign bor• manent monitor of economic policies, in• rated along with their housing booms. rowers would not go unaided. Peer Stein• cluding government budgets, and issue a Ministers had been able to insist that their brück, the German †nance minister, said seal of approval for countries wishing to †scal policies were sound because they †t• in February that if a euro•area country take part in a joint bond issue. Over time, ted in with the pact’s narrow guidelines, found itself in trouble, Œwe will show our• the emergency fund could evolve into an says Mr Pisani•Ferry. Since †scal sound• selves to be capable of acting. The follow• institution that improves the euro area’s ness was central to Œstability, they could ing month Joaquín Almunia, head of the †scal co•ordination. claim that their overall economic policy commission’s economics directorate, said was †ne too. that a European Œsolution was in place so The beauty of a euro bond Once the crisis had blown up last au• that any cash•starved country would not The hurdle for membership of such a pro• tumn, the lack of a †scal centre to the euro have to go to the IMF for an emergency gramme would need to be high to per• zone became a live issue. Initially the euro loan. Mr Almunia did not give any details. suade countries with good credit, such as rallied, but haphazard e orts to shore up The German †nance ministry later denied Germany, to sign up to it, and to convince banks, and later the economy, undid that that it was working on bail•out scenarios. credit•rating agencies and investors to rank early vote of con†dence. Scared investors The panic revealed another gap in the its bonds highly. But a large collective bond rushed into the safest dollar assets, lured euro area’s †scal set•up: a process for deal• issue could have bene†ts even for coun• by the liquidity of the vast market for US ing with a sovereign default, or the threat tries with low credit risk, as it would rival Treasuries, as the euro area was revealed as of one. The larger the number of countries America’s Treasuries market for liquidity. a mess of fragmented bond markets. Small that have adopted the single currency, the A single issuer would make euro•area euro•area countries with oversized bank• more likely it is that one will get into trou• bonds more attractive to managers of for• ing industries, such as Ireland and Bel• ble. It would be sensible to have a contin• eign•exchange reserves, who want safe gium, found that their bonds were gency plan. stores of value that can be converted into shunned, driving up their borrowing costs One idea is a dedicated bail•out fund cash quickly and cheaply in an emergency. relative to Germany’s. Markets were be• for euro•zone members, along the lines of A joint bond issue could thus enhance the coming increasingly anxious that a euro• the IMF. This is proposed by Thomas euro’s standing as a reserve currency, as zone issuer might run into funding diˆcul• Mayer, an economist at Deutsche Bank, well as lowering borrowing costs for all ties, since there was no system for coun• who started his career at the fund in the countries that took part in it. tries to help each other out. 1980s. Like the IMF, a European Monetary The idea of a shared euro bond has The clunky governance of the EU and Fund (EMF) would o er emergency loans been pushed by Italy’s Mr Prodi, George euro area worked against a rapid response for governments unable to †nance their Soros, a veteran investor, and others. That to the crisis. Political power within the EU budget de†cits or roll over maturing debts. Italy is keen on the idea is hardly surpris• is dispersed, residing in state capitals ra• In return for this insurance, each member ing: pooling its poor credit ratings with oth• ther than in Brussels. There is no powerful would contribute capital to the fund in pro• ers of higher standing would lower its bor• executive to take and enforce quick deci• portion to the size of its population or GDP. rowing costs and reduce the risk, albeit sions. National interests got in the way of Loans would come with conditions. A sup• small, that it might have its †nancing cut †scal•stimulus packages and e orts to co• plicant would have to pledge to put its pub• o . Germany is understandably cool on ordinate bank guarantees and rescues. lic †nances in order and undertake other the idea. Mr Steinbrück has said that the Germany has the deepest pockets, but its economic reforms to persuade bond mar• extra cost to his taxpayers would make it instinctive thrift (and the suspicion that the kets to renew lending. hard to sell politically. Many in Germany bene†ts would be felt mostly outside Ger• This sort of proposal attracts two main feel that even temporary help for cash• many) militated against swift and co•ordi• criticisms. First, it is wasteful to duplicate strapped partners should be provided by nated action. That made it harder for less the e orts of the IMF. Until very recently the IMF only, and on strict terms. They re• a‰uent countries to loosen their purse the fund was struggling to de†ne its role sent the fact that Greece and Ireland en• strings, as they could not risk looking in (and raise money) because it had so few joyed years of prosperity and still found worse †scal shape than their peers. lending opportunities. Now it is busy †ght• themselves in †scal trouble. Bail•outs, they ing †res again, many of them in eastern Eu• feel, only encourage pro‡igacy. Good old ECB rope, so there is far less talk of sta cuts. But A rescue of one country by its partners The one euro•zone institution that could‹ an EMF could stand idle for even longer be• could undermine popular support for the and did‹act decisively was the ECB. But fore it saw action. A second quibble is that euro, says Otmar Issing, the ECB’s chief even its ability to tackle slumps is con• a euro fund may †nd it diˆcult to impose economist for its †rst eight years, because it strained. Were there just one sovereign is• tough conditions on rescue loans. Better to would imply a transfer of taxpayers’ mon• suer of euro•zone debt, rather than 16, the let the IMF play the role of bad cop, say ey without endorsement from the voters ECB could more easily engage in unortho• some, than have protesters burning the EU in countries that have to pay. dox policy measures, such as buying up ‡ag in countries forced to slash public Mr Issing, who had previously sat on government bonds to drive down long• spending or hike taxes. the Bundesbank’s rate•setting council, term interest rates. It would also †nd it easi• Mr Mayer retorts that even the IMF has once believed that the euro needed more er to negotiate an indemnity against capi• learnt that its interventions work only if political union to thrive, but has modi†ed 1 The Economist June 13th 2009 A special report on the euro area 13

2 his views. Political union, he now thinks, in America, automatic †scal stabilisers are come more important as more countries may even work against monetary union if more powerful in the old continent. A join. Second is an agreement on how the it is founded on a model that would make measure of co•ordination is already built ECB would be recapitalised in the unlikely economies more rigid. EU policies, once in into the euro area’s †scal policy. event that bank failures were to leave it place, are hard to reverse even if they are The stability and growth pact is now with big losses on its loan book, or that it clearly harmful, as decades of farm subsi• too full of holes to be a binding constraint were to make large outright purchases of dies have shown. The euro has little bear• on †scal policy. In an important sense it securities that subsequently went bad. A ing on ambitions for a common foreign or was always redundant. If monetary †• third element of †scal union is needed to defence policy. nancing is banned and the Œno bail•out bind not just the euro area but the EU’s en• The euro’s short history suggests that a commitment is real, then †scal discipline is tire single market: a shared fund for cross• successful monetary union does not nec• largely an issue for individual countries. If border bank bail•outs. Without an agree• essarily need deeper political integration. they let †nances slip, bond markets will ex• ment on support for troubled multina• True, by American standards the euro act a penalty in higher borrowing costs, as tional banks, an open EU market in area’s response to the crisis was slow and they have done in recent months. †nancial services may be impossible to lacked co•ordination. But that is part of the There are nevertheless a few minimum maintain. Ironically, such a scheme would price countries pay (and consider worth requirements for a †scal euro zone. The have to include Britain and Sweden, two paying) for retaining full †scal sovereignty. †rst is a set of clear rules for what would countries that are outside the euro zone In any case, since welfare bene†ts are more happen if a euro•zone member were fro• but have lots of banking interests in other generous and taxes heavier in Europe than zen out of market funding. This will be be• EU countries. 7 Warmer inside

The gains outweigh the losses

HIS crisis has tested many schemes line with productivity. Yet de‡ation seems Tand wheezes (some to destruction), such a threat precisely because prices and Great exportations 7 from securitised mortgages to collateral• wages are proving less Œsticky on the way Export-market share* and growth ised•debt obligations, from light•touch reg• down than macroeconomic textbooks had Average annual change %, 1999-08 ulation to in‡ation targeting. How does the reckoned with. Slovakia 4 euro fare in this reckoning? According to On standard gauges of competitive• Ireland one school of thought it is a fair•weather ness, such as real e ective exchange rates, a Finland Slovenia 2 Germany set•up, seemingly e ective when econo• number of euro•zone countries appear to + Netherlands ket share Spain Austria mies are expanding but poorly equipped have big problems. Yet things may look 0

-mar Cyprus Greece to deal with crises and manage the pres• worse than they are. Measures based on – France Portugal sures and con‡icts of a sinking economy. relative unit wage costs across the whole Export 2 Belgium Conversely, many in Brussels and Frank• economy are crude. In booming Spain and Malta Italy furt argue that being in the euro zone Greece, much of the heat in wages was in 4 helped member countries emerge relative• parts of the economy, such as construction, 0 2 4 6 8 10 12 Export growth ly unscathed from the worst †nancial crisis that serve domestic spending and are shel• Source: European Commission *35 industrial countries since the 1930s. Which view is right? tered from foreign competition. Export in• The extreme lurches in markets during dustries may have a better chance of bene• the worst of the crunch last autumn made †ting from a global recovery than the Greece fell only slightly between 1999 and the certainties of †xed exchange rates look †gures suggest at †rst glance. 2008 (see chart 7). Export growth was enticing. One lesson from the crisis is that Spain, in particular, may not be quite as stronger than in Belgium, France and Por• asset prices can be unduly volatile and of• uncompetitive as it seems. José Luis tugal, if not as vibrant as in Austria, Fin• ten veer wildly from their true values, in Escrivá, an economist at BBVA, a Madrid• land, Germany and the Netherlands. Ire• ways that undermine economic stability. based bank, reckons that Spanish export• land’s export•market share increased over That goes especially for housing but is also ers have performed fairly well in retaining the period, even if the greatest strides were true of other asset prices, such as exchange export market share against other coun• made in the euro’s early years. Perhaps its rates. Another message is that interest•rate tries, bar super•competitive Germany. exporters, many of them big American• policy is not as powerful a stabilising force ŒWhat Spain had mostly was an import owned †rms, were wise enough to hold as had been thought. Other means of boom, he says. Now imports are declin• back on big wage and price increases in a shaping demand are needed to comple• ing at a much faster rate than GDP, which country that could not devalue. ment it. Swapping an independent mone• will trim Spain’s current•account de†cit to Italian exports, however, were dismal. tary policy for the stability of a †xed ex• a more manageable size. Firms in Italy lost market share faster than change rate now seems less of a sacri†ce. A recent study by the European Com• in any other big euro•zone country. Italy’s That also closes o the escape route of let• mission lends some support to that view. undoing is to specialise in industries such ting the currency slip if wages move out of The export•market shares of Spain and as textiles and furniture where competi•1 14 A special report on the euro area The Economist June 13th 2009

2 tion from China and other emerging mar• world, or indeed of the single currency. A kets is particularly keen. bail•out by fellow members might do A devaluation might o er temporary greater harm by damaging popular sup• respite for Italian exporters, but it would port for the single currency. not be a lasting solution to being in the There is a central irony about the euro. wrong businesses. Neither could it dis• Many of its architects saw it as a means of guise the economy’s real problems: legal advancing political union in Europe and protection for jobs that stops workers mov• were barely interested in a monetary un• ing from dying industries to growing ones; ion as an economic venture. Their hopes a wage•bargaining system that has made have been dashed, but as a technical exer• for poor matches between pay and pro• cise the euro has been a huge success. The ductivity; and an unimpressive record on currency is accepted in vast swathes of the innovation that has inhibited the emer• rich world and quite a bit of the poor gence of new †rms in high•value•added in• world too. The value of euro banknotes in dustries. This familiar Italian litany is the circulation and the market for euro•de• Œnever•ending story of things that need re• nominated securities already rival the dol• form, sighs one economist. lar, a long•established currency backed by However, there are signs of progress. a single nation•state. Con†ndustria, Italy’s biggest employers’ bond issues. But no one was frozen out of For economists such as Robert Mundell body, recently signed an accord with two markets. Even when spreads were at their and others, who saw huge bene†ts in of the three largest trade•union confedera• widest, Greece and Ireland, the euro• shared currencies but had despaired of tions to overhaul the national wage sys• zone’s high•yielders, were able to †nance politicians giving up monetary control, the tem. CGIL, the largest union group, did not their borrowing needs at a reasonable cost. euro is an exciting experiment. By contrast, sign up to the deal, but the Italian govern• The security of access to †nancing has the politicians that made the leap have ment said it would go ahead anyway. made the euro area even more attractive to been disappointed by the euro’s failure, so the EU’s eastern states, some of which far, to spur deeper political integration. Deconstructed have had to fall back on rescue loans or For all its shortcomings, the euro zone is Spain and Ireland have more to worry precautionary credit lines from the IMF. far more likely to expand than shrink over about than wage costs in export industries. The prospect that a euro•zone country the next decade. Most EU countries that re• Big construction busts are, as a rule, hard to might default on its loans, never mind main outside, bar Britain and Sweden, are recover from. At the peak of their housing leave the euro, is fairly remote. But the ta• eager to join. The harm done by housing booms, up to a †fth of their workers had boo around the subject leaves bond inves• and construction booms in Ireland and jobs related to construction or property tors uncertain about how such a problem Spain should be a caution to would•be sales. Many of those jobs will not come might be resolved if it did occur. That un• members who, once inside, may get car• back, and †nding other things to do for certainty should be dealt with. Policymak• ried away by low borrowing costs. Against such an army of redundant workers will ers have dropped hints that should one that, a big lesson from the crisis is not to take time. Ireland has a more ‡exible jobs country’s †nancing troubles spread to an• rely too much on short•term interest rates market, so its recovery is likely to be swift• other, a bail•out plan is in place. Yet the risk to rein in credit and home•loan booms. er, if still far from painless. Its GDP is set to of contagion is overblown. An orderly The rush to join the euro zone is surely a shrink by as much as 9% this year. Spain’s debt restructuring for a country within the vote of con†dence. It must be doing some• economy is more hidebound, so it will take euro zone would not be the end of the thing right. 7 longer to revive. It is hard to see how a devaluation O er to readers would help much even if that option were Future special reports Reprints of this special report are available at a Countries and regions available. ŒIf Spain’s main problem were price of £3.50 plus postage and packing. Texas July 11th competitiveness, I wouldn’t worry, says A minimum order of †ve copies is required. The Arab world July 25th Mr Gros of the CEPS: ŒThe Phillips curve September 12th Corporate o er Indonesia [which suggests an inverse relationship be• Customisation options on corporate orders of 100 tween wage in‡ation and unemployment] or more are available. Please contact us to discuss Business, †nance, economics and ideas would take care of it. your requirements. 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