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

EuroCovNEW.indd 1EuroCovNEW.indd 1 2/6/09 15:27:282/6/09 15:27:28

The Economist June 13th 2009 A special report on the euro area 1

The euro area, sorely tested by the �nancial crisis, has survived intactand is likely to expand further, says John O’Sullivan

1992. A rider to the act sketched out an am­bition to complement the single marketwith a single currency. Few took that seri­ously, least of all British politicians, whohad signed up to the act with enthusiasmbecause they were keen free­traders, butdismissed the grander kind of Communityrhetoric as �euro­gu��.

An idea whose time had comeYet by the time a 1991 European summitwas held in the Dutch city of Maastricht, aplan for economic and monetary union(EMU) was written into a new EU treaty, tobe rati�ed by member states later. That theproposal had gained ground so swiftly wasa surprise to many. The British governmenthad thought that a committee of EU cen­tral­bank governors, charged in 1988 withstudying if monetary union was feasible,would quash the idea. Instead the group,chaired by Jacques Delors, then presidentof the European Commission, the EU’s ex­ecutive branch, gave it quali�ed approval.

The Delors Report concluded that EMU

could work if control of the single currencywas kept from meddling politicians andleft to independent technocrats at a Euro­pean central bank, to be modelled on Ger­many’s Bundesbank. The report gavewarning, however, that to prevent largetrade imbalances, reforms would be need­

Holding together

IN THE mid­1980s Rolling Stone magazinepublished an essay by P.J. O’Rourke, a

conservative American humorist, with thesplendid title �Among the Euro­Weenies�.In it the author poured scorn on Europe, anannoyingly fractured continent with its�dopey little countries�, �pokey borders�,�itty­bitty� languages and �Lilliputian�drinks measures. The mosaic of countriesmade the visitor feel claustrophobic: �Youcan’t swing a cat without sending itthrough customs,� he complained.

He will not have been aware, or caredmuch, that plans were already in train togive �Europe� the continental scale it sopainfully lacked, as well as a currency thatwould rival the dollar. In 1986, the year ofMr O’Rourke’s visit, the European Eco­nomic Community (as the European Un­ion was then known) expanded from 10 to12 countries, with the addition of Portugaland Spain. Its members had spent most ofthe 1970s erecting non­tari� barriers to in­ternal trade, and the early 1980s battlingover who should pay for its joint budget (a�ght which, to be fair to the others, Britainstarted). With that settled, there was a freshdesire to make progress towards a genuine­ly open free­trade block.

The �rst fruit of that e�ort was the Sin­gle European Act, an agreement to disman­tle barriers to internal trade by the end of

An audio interview with the author is at

Economist.com/audiovideo

A list of sources is at

Economist.com/specialreports

A tortuous pathFrom Bretton Woods to euro. Page 2

One size �ts noneThe euro did not cause all the euro area’stroubles, but it will make them harder to putright. Page 3

No exitStaying in the euro will be tough for somemembers, but leaving would be too awful tocontemplate. Page 5

The non­nuclear optionsIn place of devaluation, troubled memberscould try reform. Page 6

Fear of �oatingThe �nancial crisis has made the euro lookmore alluring. Page 8

Soft centreCan a currency survive without a state?Page 11

Warmer insideThe gains outweigh the losses. Page 13

Also in this section

AcknowledgmentsIn addition to those mentioned in the report, the authorwould like to thank: Marco Annunziata, Elsa Artadi,Katinka Barysch, Julian Callow, Andreas Galanakis, LuisGaricano, Stephen Jen, Philip Lane, Helen Louri, SpyrosPapanicolaou, George Sfakianakis, Yannis Stournaras,Alan M. Taylor, Simon Tilford, Xavier Vives and BeatriceWeder di Mauro.

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More articles about the euro are at

Economist.com/euro

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ed to make prices and wages more �exibleand workers and capital more mobile.

EMU’s route from rhetoric to economicblueprint was a familiar one, if unusuallyswift. The push behind trade integration inEurope has been primarily political ratherthan economic. The EU itself was born ofthe catastrophe of two world wars, colli­sions of competing nation­states. It was de­signed to avoid a repeat of such con�icts byforging �ever closer union� in Europe. Eco­nomic ties were viewed as much as ameans to co­operation as an end in them­selves. The Delors Commission between

1985 and 1994 marked the zenith of this sortof integrationist zeal.

After many a �ap (see box), EMU even­tually metamorphosed into a bird of muchgrander plumage. On January 1st 1999 thecurrencies of 11 countries were �xedagainst a new currency, the euro, which be­came the unit of reckoning in wholesale �­nancial markets. In 2002 euro notes andcoins came in and the old paper currencieswere phased out. Since the single curren­cy’s launch �ve more countries havejoined the euro area. In a unique economicexperiment, 16 countries with a combined

population of 329m have handed overmonetary sovereignty to an entity at arm’slength from national politics: the EuropeanCentral Bank (ECB).

So far the experiment has worked fairlywell. The ECB has ful�lled its remit tomaintain the purchasing power of theeuro. Since the currency’s creation the av­erage in�ation rate in the euro area hasbeen just over 2%. Fears that the eurowould be a �soft� currency have provedunfounded. It is unquestioningly acceptedat home and widely used beyond the euroarea’s borders. (Several countries, includ­

THE idea of a single money as a path toEuropean political union goes back a

long way. In the 1950s a French economist,Jacques Rue�, wrote that �Europe shall bemade through the currency, or it shall notbe made.� But the euro had pragmaticroots too. After the breakdown of the Bret­ton Woods system of �xed exchange ratesin 1973 the Deutschmark emerged as thebenchmark currency in continental Eu­rope. The instability of �oating currencieswas a barrier to harmonious trade, butschemes to peg exchange rates frequentlyhad to be redrawn because few countriescould consistently match the Bundes­bank’s anti­in�ation zeal. The might ofGerman manufacturing forced frequentdevaluations on others to keep their in­dustries competitive.

Changes to exchange­rate pegs oftencaused tensions. François Mitterrand,who as French president was one of thesignatories of the Maastricht treaty, is saidto have remarked that �devaluations arenever small enough to avoid losing faceand never large enough to make a real dif­ference to exports.� As soon as Maastrichthad been signed (with a British opt­outfrom EMU), those tensions resurfaced. InJune 1992 the Danes voted narrowlyagainst rati�cation, raising a questionmark over the assumption that the path toEMU would be smooth. The Irish, in theonly other scheduled referendum, votedin favour shortly afterwards, but Mitter­rand announced a referendum in Francefor the following September, a risky gam­bit because French public opinion was

cooling on monetary union.Currency markets were also stirring. At

the time all 12 EU countries, bar Greece,were in the exchange­rate mechanism(ERM), a system that tied currencies toeach other within narrow tradingbounds. Germany was at the scheme’sheart: currencies were o�cially pegged toeach other in a complex grid of bilateralrates but all were, in e�ect, tied to the D­mark. That became a problem when eco­nomic conditions in Germany and therest of Europe diverged. To head o� in�a­tionary pressures caused by Germany’spost­uni�cation boom, the Bundesbankin July 1992 raised interest rates to 8.75%, a60­year high.

Those German rates caused strains incurrency markets that worsened over thesummer. In September �rst Italy and thenBritain were forced to devalue, in Britain’scase after spending billions of dollars try­ing to defend its ERM parity against specu­lators. In the following months Spain, Por­tugal and Ireland too had to let theircurrencies slide. France battled to hold toits parity and only just succeeded. Its refer­endum produced a narrow vote in favourof the Maastricht treaty.

Look at it this wayDi�erent countries learnt di�erent lessonsfrom the crisis. Britain saw dangers in�xed exchange­rate schemes. Its economystarted to pick up almost immediatelyafter its ejection from the ERM. The Frenchwere con�rmed in their belief that a mon­etary union was necessary both to pre­

vent speculative attacks on currenciesand to ensure that Europe’s monetarypolicy was not made exclusively in Ger­many. Some German policymakers, pre­viously sceptical of EMU, fretted that anyrepeat of the crisis would be a threat to thesingle market.

It was residual German scepticism thatcaused sti� tests to be set up for countriesthat wish to join the euro. The �conver­gence criteria� set out in the treaty calledfor would­be joiners to meet targets for in­�ation, bond yields, exchange­rate stabil­ity, budget de�cits and public debt. Thecriteria were criticised as having little todo with a country’s ability to cope oncemonetary policy was no longer tailored tonational needs. Instead, they seemed de­signed to favour a core group of like­mind­ed countries, centred around Germany,and to exclude others, particularly Italy,which it was feared would use EMU’s lowinterest rates to relax �scal discipline.

Things turned out di�erently. By 1997,the year in which the tests would be ap­plied to a �rst wave of would­be entrants,Germany and others in the core grouphad trouble �tting into the Maastrichtstraitjacket themselves. The time scale forthe �scal targets had to be fudged, whichlet Italy and others slip through. France in­sisted that the �stability pact� proposed inthe treaty be renamed �stability andgrowth pact�. Germany demanded a capon budget de�cits of 3% of GDP. Whenboth countries themselves later breachedthat limit, the rules had to be made some­what more elastic.

From Bretton Woods to euroA tortuous path

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ing Montenegro and Kosovo, use the euroas their currency without formally belong­ing to the euro zone.) The switch from oldcurrency to new went remarkablysmoothly, though consumers in manycountries complained, perhaps predict­ably, that they were charged higher pricesas merchants rounded up to new price­points in euros. But this caused barely ablip in the o�cial in�ation �gures.

So far the euro has brought neithergreater prosperity nor political union. Job­creation improved but productivity in­creases slowed, leaving the region’s trendgrowth rate much the same as before EMU.In its early years the euro fell against thedollar, but it has since more than made upfor its early losses. It has quickly estab­lished itself as a global currency withoutbecoming a true rival to the greenback’sstatus. For much of the euro zone’s �rst de­cade Germany, its largest economy, was inthe doldrums, but after a long period ofwage restraint its export industries startedto lift the economy. Spain, Greece and Ire­land proved more dynamic, each enjoyinga consumer boom.

All seemed well until the present �nan­cial crisis struck. This reawakened worriesabout the imbalances that have built up in­side the euro zone. Germany’s huge cur­

rent­account surplus is matched by big def­icits elsewhere, particularly in theMediterranean countries that Germanpolicymakers had been so keen to excludefrom joining. It remains an open questionhow these will be resolved.

The �nancial crisis is proving by far thebiggest test to date for the euro zone. Thisspecial report will look at its e�ects on theeuro area and consider whether such a dis­

parate group of countries can continue toshare the same monetary policy. It will askwhether the crisis will spur economic re­form and whether it will attract moremembers to the club or, conversely, wheth­er some of them might be thinking aboutleaving. Lastly, it will examine the idea thatin the longer term a multinational curren­cy area will require greater political unionto function properly. 7

TALK of economic hardship seems outof place on a sunny April day in Barce­

lona, one of Spain’s most prosperous cit­ies. Yet for all the bustle along the Ramblade Catalunya, the city’s main drag, the res­taurants and cafés are not as full as youmight expect at the start of the Easterbreak. Jordi Galí, an economist at the near­by Universitat Pompeu Fabra (UPF), gives adecidedly unsunny assessment of the taskfacing Spain.

The country is enduring a painful hous­ing bust that has led to a collapse in theconstruction industry, doubling the unem­ployment rate to 18.1% in little more than ayear. Recovery seems a distant prospect,not least because during Spain’s longboom production costs rose far faster thanthey did across the euro area as a whole. Ifleft unchecked, higher costs will make ithard for exporters to compete with �rmsfrom other euro­zone countries, which ac­

count for most of Spain’s foreign trade. Locked into the single currency, Spain

can no longer regain its lost competitive­ness by cutting its exchange rate. Mr Galífrets that this may condemn the country toa protracted slump. �The discipline of liv­ing without devaluation is tough,� he says.�It’s like enrolling your child in a demand­ing school. Results may improve, butthere’s also a risk the child will rebel andfail if you push too hard.�

De�ance will be all the greater after along period of relative ease. For most of theeuro’s �rst decade Spain was a star pupil.Its economy grew at an average annualrate of 3.9% between 1999 and 2007, almosttwice the euro­zone average and muchfaster than in any of the currency area’sother big countries, France, Germany andItaly. Unemployment fell from close to 20%in the mid­1990s to just 7.9% in 2007. Eventhat startling drop does not do justice to the

pace of job creation. Employment rose atan average annual rate of 2.8% between1997 and 2007. The boom in housebuildinglured in migrant workers, many from Afri­ca. The proportion of women at work in­creased from 38.5% in 1999 to 54.7% in 2007.

Now the legacy of that long boomthreatens to deliver a long slump. Of the 11countries that adopted the euro in 1999,Spain has seen the fastest rise in outputprices. Its real e�ective exchange rate,which measures the rise in domestic pricescompared with those in 36 countriesweighted by their trade with Spain, rose byaround a �fth in the decade after the euro’slaunch (see chart 1 on the next page, leftside). Competitiveness gauges such asthese are notoriously sensitive to the pricemeasure used, but on another indicator,based on relative unit wage costs, the ero­sion of Spain’s cost edge is almost asmarked (see chart 1, right side).

One size �ts none

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

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Both gauges point up problems in thesame handful of countries: Portugal, Ire­land, Italy, Greece and Spain�a group giv­en the ugly acronym PIIGS. All �ve haveseen a sharp deterioration in their current­account balances since the start of EMU

(see chart 2). Those shifts testify to unsus­tainable booms in domestic demand, butalso signal that local �rms have found ithard to compete with imports at home andto sell their wares abroad. Pay rises ranwell ahead of e�ciency gains in all thesecountries. In Ireland and Greece gains inoutput per worker were healthy but wagein�ation was high. In Portugal and Spainin�ation was a little lower but still wellabove the euro­area norm. The bigger issuewas dismal productivity growth, whichwas Italy’s main problem too.

Swines with �uAll these countries su�er not only from alack of competitiveness but from other,perhaps more damaging, disorders too.Heavy public­debt burdens and chronicde�cits were a feature in Greece and Italylong before the current crisis. Ireland andSpain enjoyed house­price and construc­tion booms that have now turned to busts.In Ireland propping up ailing banks thathad lent too freely to property developersand homebuyers, at home and abroad, hasbumped up the �scal cost of recession.(Luckily for Spain, its regulators forcedcommercial banks to behave more pru­dently in the boom.) A steady accumula­tion of current­account de�cits has leftGreece, Portugal and Spain with net for­eign debts of 80­100% of their GDP. Thesefrailties are a threat to the stability of theeuro area as a whole.

How much of these imbalances are dueto the euro itself? The ECB, a �edgling insti­tution, has managed to keep a lid on in�a­

tion: in the euro’s �rst decade consumerprices across the currency zone rose at anaverage of only 2.1% a year. But in such alarge and diverse economy price pressuresnaturally vary. Capping in�ation in fast­growing hotspots, such as Greece andSpain, would have needed a far tightermonetary policy than in the cooler north­ern climes. Interest rates that seemed rightfor the whole euro area were too high forsluggish Germany and too low for friskierGreece, Ireland and Spain.

The ECB’s one­size­�ts­all monetarypolicy can never be perfectly tailored forany individual member country. In princi­ple, higher in�ation should act as a coolantto overheating economies by reducing realhousehold incomes and by making �rmsless competitive, reducing the incentive toinvest. In practice, strong real growth andhigh in�ation are a draw to foreign capital,adding more fuel to the �re. For the sameexchange­rate risk, a euro put to work inSpain might earn a better return than inslower­growing parts of the euro zone.

The main hazard for investors in high­in�ation countries�that a steady loss ofdomestic purchasing power will drag thecurrency down�is eliminated in a �xed­exchange­rate zone. The removal of cur­rency risk from within the euro area helpsexplain why some countries were able torun eye­watering current­account de�cits.In 2007 both Spain and Portugal had de�­cits close to 10% of GDP. Greece’s was 13%.In its absolute size, Spain’s de�cit was sec­ond only to America’s.

Foreign capital kept booms going forlonger, but that was true in many richcountries outside the euro zone as well.There were other factors at play. The eurowas created at a point when the GreatModeration, a long period of stablegrowth and low in�ation in rich countries,

was in full train. Investors had come to be­lieve that wild swings in the business cyclewere a thing of the past, making them alltoo willing to take on risk, including loansto countries that already had large foreigndebts. Exchange rates often provide usefulwarnings about emerging imbalances, butovercon�dence and herd behaviour weak­ened the signal.

Even if the �rst wave of currency unionhad excluded Spain and Greece, as someGerman policymakers had wanted, theireconomies might still have sucked in for­eign capital. The eight eastern Europeancountries that joined the EU from 2004 at­tracted huge sums of foreign capital eventhough for many of them euro member­ship was a distant prospect. This suggeststhat, even outside the euro, Spain andGreece would have had access to plenty offoreign credit with which to feed a domes­tic spending boom.

Ireland and Spain were ripe for housingbooms too. Both countries have a high rateof owner­occupancy and space for freshconstruction. The obsession with housingspilled over from Britain, a serial miscreantwhen it comes to house­price booms.When Spain and Ireland adopted the euro,they imported low interest rates from Ger­many: the ECB was the Bundesbank writlarge. By then Britain had already adoptedthe German model of a central bank freefrom political in�uence and determined to�ght in�ation. The results, inside and out­side the euro zone, were much the same:lower interest rates that sent house pricesmad. Britain, at least, was able to tailor itsinterest rates to local conditions, but not byenough to prevent a housing bubble.

If euro membership is only partly re­sponsible for the overheating in Ireland,Greece, Portugal and Spain (sluggish Italycan only dream of such excesses), it willmake it harder for these countries to deal

2000 02 04 06 072000 02 04 06 07

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*Data not available for Portugal

Losing effectiveness

Source: European Central Bank

GDP deflator, Jan 1999=100

Real effective exchange rates measured by:

unit-wage-cost deflator, Jan 1999=100*

1999 2001 03 05 0890

100

110

120

130

Ireland GreeceSpain ItalyPortugal

1999 2001 03 05 0880

90

100

110

120

130

140

2Taking the strain

Source: European Commission

Current-account balance, % of GDP

15 10 5 0 5+–

Greece

Portugal

Spain

Ireland

Italy

1999 2008

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with the resulting loss of competitiveness.Spain’s unemployment rate is already thehighest in the euro area and likely to risefurther. If Spain’s jobless rate sticks at 20%,will voters blame the euro?

A handy scapegoat�No one sold the euro as a solution to highunemployment,� says Mr Galí. But, headds, the economy used to bene�t whenmarket pressures forced down the localcurrency: �In 1992 and 1993 a series of de­valuations got us out of trouble.� NowSpain needs other adjustment mecha­nisms: lower wages to restore cost compet­

itiveness to its �rms and a �exible job mar­ket to speed the �ow of workers fromindustries such as construction, which ca­tered to a boom �red by domestic demand,to export �rms that can generate the rev­enues to service Spain’s debts.

That transition would be hard enoughin the best of circumstances. Spain has oneof the most rigid job markets in the devel­oped world. Many jobs are heavily protect­ed and wages are set centrally. That willmake adjustment all the more di�cult. Thefear is that Spain will stagnate even as oth­er economies start to revive. �My night­mare is that the world economy, including

Europe, recovers and Spain does not man­age to hook up to that,� says Andreu Mas­Colell, another economist at UPF. �Thatwould be a disaster. It would strain the linkbetween Spain and the rest of the EU. Wewill also have to deal with tighter mone­tary policy if the rest of the euro area picksup, creating more pressure.�

That fear of being left behind is widelyshared in other countries too. Some econo­mists believe that countries now stuck in aslump and unable to adjust their produc­tion costs may well start questioning thebene�ts of euro membership. But where isthe exit sign? 7

IN THE weeks following the collapse ofLehman Brothers last September the

number of euro banknotes in circulationsuddenly increased. Fears about the rick­ety state of banks had made many peoplemistrustful of keeping money on deposit.Far safer to keep cash stu�ed under a mat­tress. The more discriminating hoarders, itwas said, were careful to squirrel awaybanknotes with serial numbers pre�xedby the letter �X�, indicating currency is­sued in Germany. Notes with �U� (French)or �P� (Dutch) pre�x were also �ne, butthose with a �Y� or an �S�, issued by Greeceand Italy, were shunned.

The logic was that if you were prepar­ing for �nancial apocalypse, you had bet­ter not rely on the euro area surviving in­tact. In fact, banknotes are a sharedobligation of all euro­zone members, nomatter where they are printed. If the issu­ing country were to leave the single curren­cy, a �ve­euro note would still be worth�ve euros, whatever the serial number.However, interest­bearing debt denomi­nated in euros is a di�erent matter, andbond markets quickly started to sort the Xsfrom the Ys.

By early 2009 the yield on a ten­yearGreek government bond was almost twicethat on a comparable German Bund. Thespread over Bunds for Italian, Spanish andIrish bonds also widened dramatically be­fore narrowing again more recently. Oneexplanation was that in skittish marketsBunds were prized for their extra liquidity.Another was that the bond­trading armsof bombed­out banks were less willing to

make markets in the issues of small coun­tries, such as Greece and Ireland, which lefttheir prices unmoored.

But at least part of the rise in spreads re­�ected concern that countries might �nd ithard to pay back their borrowings. Thegovernment bonds of Greece, Ireland, Por­tugal and Spain were all downgraded anotch by credit­rating agencies. For some,bond spreads are a crude gauge of the riskthat the euro will break up. If a euro­zonemember were shut out of capital marketsand had to default on its debt, it might betempted to use the opportunity to recreateits own currency and devalue. In thatevent, creditors could be forced to converttheir bonds into claims in a new currencyat a discount linked to a new exchange rateagainst the euro. Default would be oneway for countries to free themselves fromthe euro’s shackles�or, to look at it fromthe opposite point of view, for the eurozone to rid itself of troublesome members.

A game of consequencesThat kind of thinking, however, is foundmostly among those who were doubtfulthat the euro would ever get o� the groundin the �rst place. It is rare in countries seenas candidates for exit. As Eurocrats in Brus­sels are keen to stress, far from breaking up,the euro zone is growing. Since its launch ithas taken on �ve new members, and moreare queuing to join.

The costs of backing out of the euro arehard to calculate but would certainly beheavy. The mere whi� of devaluationwould cause a bank run: people would

scramble to deposit their euros with for­eign banks to avoid forced conversion tothe new, weaker currency. Bondholderswould shun the debt of the departingcountry, and funding of budget de�citsand maturing debt would be suspended.

Changing all contracts in euros�bonds,mortgages, bank deposits, wage deals andso on�to the new currency would be a lo­gistical nightmare. The changeover to theeuro was planned in detail and the ex­change rate was �xed in advance, in co­op­eration with all the euro members. The re­verse operation would be nothing like asorderly, not least because the exchange ratewould be a moving target.

If businesses converted their debts to aweaker currency, that might constitute de­fault and trigger legal challenges. If theystuck to their covenants, they would haveto service their euro debts from earnings ina weaker currency. That would hurt �rmswhich rely mostly on pro�ts from their do­mestic market. The convulsions would befelt by other euro­area members too. Thewritedown of the departing country’s gov­ernment bonds might threaten the solven­cy of banks in the rest of the euro zone.Around half of Italian government bonds,for instance, are held outside Italy. Othereuro­area members could su�er contagionas markets bet on further defaults.

If the act of leaving would be hard, theaftermath might be even harder. A countrythat forced bondholders to take a losswould be punished. Continued access tobond markets would come at a high price.Investors would ask for a huge premium to

No exit

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

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cover the risk of further default. On thatcount alone, borrowing costs would be farhigher than they were within the safercon�nes of the euro area.

Investors would have to protect them­selves from two further risks: exchange­rate volatility and in�ation. A former euromember would have to reinvent its ownmonetary policy and would struggle toconvince investors that it could keep a lidon in�ation. One of the euro’s big attrac­tions was that it o�ered many countries ashortcut to a credible monetary set­up. De­

valuation could itself trigger a wage­pricespiral. For high­debt countries, such asGreece and Italy, the interest rates demand­ed by markets to insure themselves againstsuch risks would be ruinous.

And even though the costs are likely tobe heavy, the immediate bene�ts mightprove only transitory. A devaluation is aproxy for a national pay cut: it helps ex­porters but makes consumers of importspoorer. Workforces would put up strong re­sistance to being paid in a weaker currency.In countries such as Greece and Ireland,

whose exports contain a lot of imports, adevaluation would push up in�ation. Andwhere a large proportion of wage contractsis indexed to prices, as in Spain, higher in­�ation would rapidly work its waythrough to wages.

The wrong cureAn exit from the euro would not tackleweak productivity growth and in�exiblewages, which are the root causes of lowcompetitiveness. In time, further devalua­tions might be needed. Countries withhigh debts and a history of poor macroeco­nomic management would be most tempt­ed to leave. But these are also the countriesmost likely to be hurt.

A more plausible, though still unlikely,scenario would involve a breakaway by agroup of low­debt and cost­competitivecountries, centred around Germany. Mem­bers of a new, �hard� European currencywould leave behind a stock of depreciat­ing euro debt and might be rewarded bylower borrowing costs on debt issues inthe new currency. Yet a large part of the ap­peal to Germany of the single currency hasbeen that it rules out revaluations and re­wards its �rms for being competitive. Ger­many, France and the rest have too muchinvested in the success of the EU and theeuro to put it at risk. As Daniel Gros of theCentre for European Policy Studies, a Brus­sels think­tank, puts it: �The weak can’tleave and the strong won’t leave.� 7

SPAIN may soon be faced with two op­tions, says UPF’s Mr Mas­Colell: a per­

manent slump or economic reform. �Athird option, exit from the euro, is not apossibility. Spain won’t leave because it isvery pro­Europe. To leave would be seenas a national failure rather than a libera­tion.� Euro membership is a symbol ofSpain’s progress as a democracy as well asits economic development. For some, it isan insurance against a return to dictator­ship and autarky. �Our experience is thatwhen we went for being more European,the results were positive,� says Elena Pi­sonero, a former vice­minister for com­merce, now at the Madrid o�ce of KPMG,a consultancy. �In the past [during the dic­tatorship of Francisco Franco, which end­

ed in 1975] we were closed o�. Opening upour borders brought huge bene�ts.�

Ireland, like Spain, has been helped byEU funds for roads, farming and universi­ties. According to the most recent Euroba­rometer, a twice­yearly opinion poll, 79%of respondents in Ireland believe thatoverall their country has bene�ted fromEU membership, and only 11% think it hasnot. The positive response in Greece, Spainand Portugal was above the average for allEU countries (see chart 3, next page).

Most Greeks are in favour of the euro,and only 12% think EU membership is badfor their country. That is poor ground onwhich to build a case for quitting the euro.Greece’s �nance minister, Yannis Papatha­nassiou, thinks that the recent spike in

Greece’s borrowing costs was driven bythe mistaken belief that last December’sviolent street protests were due to a falter­ing economy. In fact the demonstrationswere sparked by the killing of a 15­year­oldboy in Athens by a policeman. Some peo­ple had taken rising bond spreads as anomen of default and euro break­up. Thatprospect, always distant, has now recededfurther. �Despite the high spreads, we haveshown that we can re�nance our debt,�says Mr Papathanassiou.

Italy’s economic travails have attractedless attention recently. Unlike Greece, Ire­land and Spain, whose economies grewrapidly before crisis struck, Italy has seenits GDP growth drift consistently belowthe euro­zone average (see chart 4). Its cost­

The non­nuclear options

In place of devaluation, troubled members could try reform

The Economist June 13th 2009 A special report on the euro area 7

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competitiveness has declined and its pub­lic debt was already 106% of GDP last yearand will now rise still further. Yet in March,when the strains in the euro area’s public­debt markets were at their greatest, Italy’sten­year bond yields were around 1.5 per­centage points above Germany’s, com­pared with a gap of 2.8 percentage pointsfor Greece.

Nor was Italy’s public debt downgrad­ed. �Perhaps the credit­rating agencies arebeing responsible,� an Italian economistsuggests by way of explanation. If Italy didget into funding trouble, that would haverepercussions for the rest of the euro zone.Its public debt dwarfs that of countries thesize of Ireland or Greece.

If the rating agencies have been carefulnot to sound the alarm, the same is true ofItaly’s politicians. In the past Silvio Berlus­coni, the prime minister, and Giulio Tre­monti, the �nance minister, have beenquick to blame the euro and the ECB for Ita­ly’s economic problems. Bashing the eurowas a useful way of attacking RomanoProdi, a centre­left opponent, who in his�rst stint as prime minister, in the late1990s, took Italy into the euro before be­coming president of the European Com­mission. The rhetoric has noticeably soft­ened. Earlier this year Mr Tremontidescribed the euro zone as �totally sustain­able�. The currency crises in Hungary andIceland were salutary, says Roberto Perottiof Milan’s Bocconi University. �No seriouspolitician now says ‘let’s leave’.�

Devaluation by proxyIs there a way of achieving the e�ects of afall in the real exchange rate without goingto the extremes of ditching the euro? Aslong as it does not trigger a burst of wagein�ation, a devaluation lowers wage costsrelative to those of workers abroad, im­proving the competitiveness of �rms pro­

ducing things that can be traded acrossborders. A weaker currency also shifts thebalance of demand by making importedconsumer goods dearer and exportscheaper. That cools spending at home andtilts the scales towards �rms that sellabroad, nudging workers and capital intheir direction.

In a currency union, pay needs to adjustthat much more quickly to changing mar­ket conditions to shift workers out of high­cost industries. But until quite recently payhas tended to be �sticky� on the waydown: workers have generally been reluc­tant to take wage cuts, at least in nominalterms, which has made real­wage adjust­ment slow. On many reckonings, the rate atwhich Germany went into the euro in 1999was too high. The traded value of theDeutschmark had not fallen to re�ect thehigher unit wage costs that were a legacyof the uni�cation boom. It took manyyears of very low wage growth and risingproductivity before Germany regained itsedge on costs.

That route to redemption has becomeeven harder for today’s high­cost countriesbecause there is little consumer­price in�a­tion around to erode real wages and re­build pro�t margins. Unemploymentseems likely to rise steeply before wagesstart to adjust.

Ireland will make the adjustment morequickly than the others. Already there aresigns that private­sector wages are fallingin response to rapidly rising unemploy­ment. The 7.5% cut in public­sector pay thatcame into force in May was mostly a re­sponse to the �scal crisis, but was also soldas a remedy for lost competitiveness. Ire­land is set to endure a deeper recessionthan other rich countries because of its�globalised� economic model. But be­

cause of that sensitivity to the world busi­ness cycle and its reliance on big multina­tional �rms for investment, wages areunlikely to stay out of whack for too long.

In the Mediterranean economies thepressure on wages is mostly in the wrongdirection. In Spain most private­sector paydeals contain clauses that compensate em­ployees if in�ation is stronger than expect­ed. The country also has a managed sys­tem of wage­setting that fails to makeenough allowance for di�erent productivi­ty levels across the economy.

Wages in Italy are set centrally too (asthey are in Greece), although compensa­tion for in�ation is no longer automatic.The infamous scala mobile, which main­tained a rigid link between Italian wagesand prices, was scrapped in 1992 after along struggle.

Here today, gone tomorrowThe spread of �xed­term employment con­tracts in Spain (from the mid­1980s) and Ita­ly (in the mid­1990s) helped make hiringand �ring more responsive to the businesscycle. The innovation had an immediatepay­o�: it created jobs. Firms were contentto take on temporary workers, often immi­grants, because they knew they could easi­ly lay them o� again. Before the crisis hit,temporary jobs accounted for more than athird of Spain’s total, the largest share inthe EU. Tito Boeri of Bocconi Universityreckons that a �fth of Italy’s workforce areon (short) �xed­term contracts. The rest en­joy a high level of job protection whichpoliticians dare not dismantle. Both coun­tries saw temporary contracts as the onlyway to free the jobs market.

Jobs that were created in good times arenow being shed quickly. The downturnhas highlighted the gross unfairness of thedual labour market. It puts the burden ofadjustment on groups with no tenure(women, immigrants and the young). Pro­tected workers, the bulk of the workforce,cling to their jobs. That tends to fossilisethe structure of the economy. Old indus­tries, where productivity is waning, areslow to die and new �rms slow to start up.

The growth of temporary contractshurts productivity in another way. Firmsare obliged to lay o� (typically young) con­tract workers at the end of a �xed period,so they have little incentive to train tomor­row’s workforce. Instead they are stuckwith older, tenured workers heading for re­tirement. The result in Italy, says Mr Boeri,is a �lost generation� of workers with limit­ed skills. Admittedly the growth in tempo­rary contracts has helped many people

4Where it hurts

Source: European Commission

*Average annual rate†Forecast

GDP, % change on year earlier

10 5 0 5 10+–

Ireland

Greece

Spain

Euro area

Italy

1999-07* 2008 2009†

3Appreciated

Source: European

Commission

*Difference between those who said “benefited”

against “not benefited”, autumn 2008

Balance* of people polled who believe membership of

the European Union has benefited their country, %

20 0 20 40 60 80+–

Ireland

Greece

Spain

Portugal

EU-27

Italy

Britain

8 A special report on the euro area The Economist June 13th 2009

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1

back into work and has lowered long­termunemployment. But the evidence fromSpain suggests that such contracts are rare­ly a bridge to better things: less than 5% areconverted into permanent jobs.

A group of economists led by SamuelBentolila of CEMFI, a graduate school inMadrid, have set out a reform manifestofor Spain’s jobs market. They suggest thatwage­setting could be made more �exibleif deals struck at the level of individual�rms were allowed to prevail over regionalor industry agreements. They also proposereplacing �xed­term contracts for newhires with a permanent contract in which�ring costs rise with seniority but not ashigh as at present.

Mr Boeri and his colleagues have calledfor a similar scheme in Italy, where work­ers build up employment rights over time.Abolishing job protection makes mostworkers worse o�, so it tends to run intopolitical obstacles. The next best thing isgradually to reduce average �ring costs andgiving �rms better incentives to train theirworkers. If Italy wants to encourage work­ers to risk moving jobs, it also needs to beefup its skimpy unemployment bene�ts. �It­aly should say to its partners: ‘our �scalstimulus is to introduce a welfare safetynet to speed up the reallocation of jobs’,�says Mr Boeri.

Never a good time for reformsSuch reforms would be desirable even ifnobody had signed up to the euro. Whenthe currency was created, the hope wasthat the loss of the safety valve of devalua­tion would help to boost productivity andmake markets more �exible. For most of its�rst decade timid politicians were able toshelter behind the economic stability that

the euro helped provide. Without a crisis itis hard to persuade voters of the need forradical change. Yet recession is the worsttime to make changes that leave somegroups poorer.

Italy’s previous big recession, in 1992­93,prompted a wave of reforms: privatisa­tions, changes to pension entitlements, thecreation of a competition authority andthe demise of the scala mobile. Greece isnow inching ahead with some reformsalong similar lines. The government hassold Olympic Airways, a subsidy­thirstyairline, and a competition law is goingthrough parliament that will give antitrustauthorities more power to challenge�andbreak up�big companies that can setprices. In Spain one relatively painless re­form would be to change the rules for rent­ing out property, which currently overpro­tect tenants. If owners felt more relaxedabout letting out second homes, workersmight �nd it easier to move in search ofjobs. It might even lift house prices.

For now, policymakers are too worriedabout fragile demand to risk tackling thesupply side of the economy. Today’s eco­nomic crisis has little to do with di�eren­tial wage costs within the euro. In terms ofrelative unit wage costs, Germany’s com­petitiveness has improved by around 13%since the euro started. Yet this year the Ger­man economy is set to shrink by more thanany other in the euro area bar Ireland be­cause of its heavy reliance on exports.Greece is expected to hold up better be­cause it is less exposed to the global econ­omy (�a good thing for a bad reason,� notesone policymaker). Its GDP is likely to fall byaround 1%, making it one of the most resil­ient economies of the OECD’s 30 mem­bers. Italy’s economy will do far worse, butthere is less of a sense of crisis because ithas long been struggling anyway.

Root­and­branch structural reform willhave to wait a while longer. Germany’s tra­vails are not a good advertisement formaximising competitiveness. Only in Ire­land, where the economic model is basedon openness to trade and foreign invest­ment, is competitiveness a big part of thepolicy debate. Elsewhere politicians seemsomewhat stuck. �At some point we’llhave to accept that it’s better to have peo­ple in work than to have high wages,� saysMr Mas­Colell. �In Spain we are not readyfor that. There is an illusion, a hope, thatwe will wake up tomorrow and things willbe better.�

Yet all the current troubles of the hard­est­hit euro­zone countries do not seem tohave put o� a raft of applicants, mostly ineastern Europe, from trying to join the club.Indeed, if anything, the �nancial crisis hasmade many countries even keener to join.Do they know what they are doing? 7

IN 1999, the year the euro was launched,the Nobel prize for economics was

awarded to Robert Mundell, a Canadianeconomist. That was good timing becausehis work was in�uential in shaping theeuro zone. In a 1961 paper Mr Mundell hadpioneered the theory of an �optimal cur­rency area�, a territory suited to adopting acommon monetary policy. A main require­ment, he concluded, was that workersthroughout such an area would be su�­

ciently inclined to move jobs to even outregional booms and slumps. In later re­search others added strong trade links,wage �exibility and a central �scal author­ity to the list of necessary features.

Equally important to the decision tojoin a monetary union was another ofMundell’s insights, developed with Mar­cus Fleming at the International MonetaryFund, which entered the economics text­books. This was the idea of the �impossi­

ble trinity�: that a country could not simul­taneously have a �xed exchange rate, beopen to capital �ows and operate an inde­pendent monetary policy. It could opt forany two of these features but not all threetogether. With free capital �ows, monetarypolicy could be directed either at stabilis­ing an exchange rate or controlling in�a­tion, but not both. A country that targetsdomestic in�ation and is open to foreigncapital must have a �exible exchange rate.

Fear of �oating

The �nancial crisis has made the euro look more alluring

The Economist June 13th 2009 A special report on the euro area 9

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1

When Mr Mundell expounded his the­ory, in the early 1960s, most rich countrieswere tied to the Bretton Woods system of�xed exchange rates. Because capital �owswere tightly controlled, countries could settheir own interest­rate policies and stillkeep exchange rates more or less �xedagainst the American dollar.

Canada was di�erent. Its long border,heavy trade and strong industry links withAmerica made capital controls impracti­cal. For Canada to have an independentmonetary policy, it had to let its currency�oat. In later writings Mr Mundell ex­pressed regret about Canada’s choice, aswell as enthusiasm for European mone­tary union. In principle, a currency adjuststo keep economies in balance, but in prac­tice, argued Mr Mundell, exchange ratesveer wildly from their ideal levels. Largeand volatile capital �ows mean that �oat­ing currencies can be a source of instabil­ity. They are also a poor substitute for fully�exible wages and prices.

In or out?The merits of monetary �exibility versusexchange­rate stability have to be weighedup by the 11 EU countries that are not (yet)in the euro. The choice is straightforwardfor Britain, which has long been reluctantto give up its independent monetary poli­cy and has an opt­out from the euro. Brit­ain’s policy brass tend to see a �exible ex­change rate as a useful safety valve.Sweden, like Britain, does not seem to havemuch to gain from hitching itself to theECB. It has built a credible monetary re­gime, with an independent central bank,along similar lines. Since a referendum in2003 that came out against membership,Sweden has shown no interest in gettingcloser to the euro club.

Denmark’s currency is pegged to theeuro but the country remains outside theeuro zone after twice failing to secure apopular vote in favour of joining. It has theworst of all worlds. The currency peg isopen to speculative attack, so its exchange­rate stability is precarious; yet to preserveit, the country has had to sacri�ce an inde­pendent monetary policy. The govern­ment has been mulling a third referendumbut the new prime minister, Lars LokkeRasmussen, said in April that it would nottake place this year.

The other eight potential members areformer planned economies in central andeastern Europe (CEE) that joined the EU onor after May 2004. All are keen to adopt theeuro. Those that had been cool on mem­bership, such as the Czech Republic, have

warmed up since last autumn’s �nancialturmoil. Most are small and very openeconomies whose exports account for alarge share of GDP and whose trade ties tothe euro area are strong. As emerging econ­omies they are prone to sudden shifts inforeign­investor sentiment, which makesfor volatile currencies, so exchange­ratestability holds considerable appeal forthem. None of them has a long record ofstable money, so loss of monetary inde­pendence would not be greatly mourned.For four of the eight the euro is alreadytheir monetary anchor. The three Balticcountries, Estonia, Latvia and Lithuania,have long pegged their currencies to theeuro, and before that to the D­mark. Bulgar­ia also has a euro peg.

For small, open economies such asthose of the Baltic states (and Iceland,which now plans to join the EU as a step­ping stone to adopting the euro), it makessense to tie currencies to a big and stableneighbour. Even Milton Friedman, a fer­vent advocate of �oating exchange rates,thought so. In the Baltics, Latvia’s euro am­bitions are on hold. Following a bail­outled by the IMF in December, its economyand public �nances are in intensive care.Estonia wants to join quickly and may doso as soon as 2011. A realistic target for Lith­uania is 2012.

For a larger country, such as Britain, thebene�ts of membership are less obvious.A bigger portion of the goods and servicesit consumes is produced at home, so thereis more scope to manage domestic pricesthrough an independent monetary policy.

Poland could �t that bill too. It is thelargest and one of the least open of theCEE8 (see table 5). Though not nearly as

rich as Sweden in terms of income perhead, it has many more people, so its econ­omy is bigger. Its exports account for two­�fths of GDP. Because its exposure toworld trade is smaller than that of manyother EU countries, it has su�ered far lessfrom the global recession. The EuropeanCommission reckons its economy willshrink by 1.4% this year, which is not a lotby the dismal standards of the region.

The case for a quick dashDespite the size and resilience of Poland’seconomy, its government wants to get intothe euro as soon as possible. It hopes tojoin the ERM­2 (a pledge to keep the ex­change rate within agreed bounds for twoyears) early next year in order to qualify foreuro membership by 2012. As elsewhere inthe region, part of the rush to qualify is toforestall a further drop in the zloty, whichwould make foreign­currency loans hard­er to pay o�. Around 30% of private­sectordebt is in foreign currency, far less than inHungary but more than enough to hurt theeconomy if the zloty sinks. Hopes of entryin 2012 may be optimistic, and some econ­omists question the wisdom of forcing thepace. As a fast­changing economy Polandmight need the �exibility of a �oating ex­change rate for a little longer to keep it com­petitive and to smooth adjustments.

But can it rely on the right kind of helpfrom currency markets? Recent experiencesuggests that there is no stable link be­tween the economy’s vital signs and shiftsin its currency. For a while the exchangerate had been a balm. Between 2005 and2007 the zloty’s value increased in linewith productivity (as a country becomesricher, its currency tends to rise in real

The outsiders

Sources: European Commission;

Thomson Datastream; Bloomberg

*% increase on a year earlier, latest 12-month average†Latest 12-month average ‡Latest 5-month average §8-year gov’t bond

GDP at market Exports, % of Consumer 10-year gov’t Budget balance Public debt prices, ¤bn, 2008 GDP, 2007 prices* bond yield, %†

Euro area -5.3 77.7 9,209 41.6 2.7 3.69

Britain -11.5 68.4 1,812 26.4 3.7 4.11

Bulgaria -0.5 16.0 34 63.4 10.1 7.04‡

Czech Republic -4.3 33.7 149 80.2 4.7 4.65

Denmark -1.5 32.5 233 52.3 3.2 4.10

Estonia -3.0 6.8 16 74.4 8.6 na

Hungary -3.4 80.8 105 80.3 5.0 9.40

Latvia -11.1 34.1 23 42.2 13.4 7.90

Lithuania -5.4 22.6 32 54.4 10.5 7.89§

Poland -6.6 53.6 362 40.8 4.0 6.02

Romania -5.1 18.2 137 29.5 7.6 8.95

Sweden -2.6 44.0 328 52.6 3.1 3.49

% of GDP 2009

5

10 A special report on the euro area The Economist June 13th 2009

2 terms). That helped to keep in�ation lowwithout harming exports.

The benign period ended in the au­tumn of 2007. The zloty, and some othereastern European currencies, were drivenup (see chart 6) as investors piled intoemerging markets in the belief that theywould soon �decouple� from troubledrich­world economies. A year later, follow­ing the collapse of Lehman Brothers, themarkets made a U­turn. Capital �oodedout of eastern Europe, starving the regionof foreign currency and plunging it into asevere crisis.

When a �oating exchange rate proves tobe an irritant rather than an emollient, �x­ing it once and for all has greater appeal.Most of Poland’s trade is with the euro areaand much of that is intra­�rm trade: be­tween, say, a German �rm and its Polishsubsidiary. Adopting the euro should openPoland up to more of that sort of trade andthe stable, long­term capital investmentthat goes with it. And once currency riskvanishes, government, �rms and house­holds will all be able to borrow morecheaply�and, as important, given the re­cent freeze­outs�more easily.

In purgatoryThe �nancial crisis may have increased theallure of the euro zone, but it has also madeit trickier to get in. To join, countries must�rst meet the �convergence criteria�: tar­gets for in�ation and public �nances, aswell as market­based tests for low long­term interest rates and a stable exchangerate (ie, two years in ERM­2). Slovakiamade the cut when the criteria were last as­sessed, in May 2008, and joined in January.Of the eight CEE countries still outside, allbar Poland and the Czech Republic missedthe mark on in�ation, which was sup­posed to be no more than 1.5 percentagepoints above the average of the three EU

countries with the lowest rate. Poland, forits part, failed to qualify because of doubtsthat it could control its budget de�cit andworries that it owed its low in�ation to therise in the zloty (which was not in ERM­2).

With economies facing a deep reces­sion, in�ation is set to drop sharply(though the benchmark for the test is fall­ing too). The public­�nance criteria will befar harder to meet. Euro aspirants mustshow that they can keep their budget de�­cits below 3% of GDP and cap their debt ra­tio at 60%. That is tough in a downturn:most countries inside the euro area are al­ready in breach of these rules. But hopesthat the rules might be relaxed have beendashed. Those inside the euro fear that eas­

ing up on potential entrants would under­mine the single currency. There may be afeeling that �we had to su�er to get in; soshould you.� Some outside the ark are alsoagainst a free­for­all. The stronger aspi­rants, Poland and the Czech Republic, havedistanced themselves from calls by trou­bled Hungary (like Latvia, an IMF suppli­cant) to shorten the qualifying period inERM­2 from two years.

Would fast­track entry really harm theeuro? The worry that euro­zone countriessuch as Spain may su�er prolongedslumps because they lost control of unitwage costs lends the in�ation test someweight, though not much. Willem Buiter atthe London School of Economics is notconvinced. He thinks that in�ation conver­gence is something to be expected afteradopting the euro, not before. Getting ridof anything that may give rise to in�ationis in the self­interest of new joiners. So is�scal discipline. But insisting on them pri­or to entry amounts to �misplaced pater­nalism�, according to Mr Buiter. �If youhave time to get in�ation down, �ne. But�oating exchange rates are dangerous. Themain thing is to get in.�

On one count, the would­be entrantsare more �exible than the incumbents. Mi­grants from Poland and other eastern Euro­pean countries have shown themselveswilling to move in search of work. Lessonscan also be learnt from the mistakes of oth­ers. Andrzej Slawinski, a member of thePolish central bank’s monetary­policycouncil, believes there is less of a risk thatthe new member states will follow in thefootsteps of Greece, Ireland, Portugal andSpain. They are still poor by EU standards,so can look forward to a period of fast pro­ductivity growth. Were unit wage costs torise too far, they could recover competitive­ness more quickly.

Poland may be able to guard against the

risk of credit and housing booms becausethe climate now favours tighter bank regu­lation. �Banking supervisors must havethe authority to react to the business cyclein a dynamic way,� says Mr Slawinski.Governments must also be careful not tofuel housing booms with tax breaks. In­stead property taxes could be used to cooloverheated housing markets.

Once Poland and the smaller CEE coun­tries adopt the euro, might Britain’s atti­tude change? If Denmark were to join too,the euro area would cover almost all of theEU’s member states, so Britain might onceagain look like the odd one out. Even so, itis likely to draw the same lesson from thiscrisis as it did from the ERM expulsion in1992: that devaluation is a good thing.There is chagrin in some European capitals(especially in Dublin) that sterling hasdropped so far and fast against the euro. Aweaker pound, even with world trade inretreat, still cushions the pro�t margins ofstruggling exporters. It will only hardenthe belief in Britain that currency �exibili­ty should not be lightly given up.

In any case, no British governmentcould now consider signing up to the eurowithout �rst winning a referendum, andopinion polls have shown a fairly consis­tent two­to­one majority against joiningthe single currency. Even if Britons couldbe sold on the narrower issue of economicbene�t, they are more likely than mostEuropeans to see national control overmonetary policy as indivisible from otherkinds of sovereignty. The euro’s success sofar has suggested that a currency can bestable without the backing of a unitarystate. But the �nancial crisis has raised afresh question mark over that idea. 7

6Oh for an anchor

Source: Thomson Datastream

Exchange rates against the euro, January 2007 =100

2007 08 0970

80

90

100

110

120

Hungarian forint

Polish zloty

Czech koruna

New Romanian leu

The Economist June 13th 2009 A special report on the euro area 11

1

LAST November the European Commis­sion set out its proposals for a Europe­

wide �scal stimulus, worth a combined¤200 billion, roughly 1.5% of the 27­nationblock’s combined GDP. The commissionhas a relatively small budget and no au­thority to compel member states to shellout extra cash or cut taxes (and, to its regret,little clout to stop them from running upbudget de�cits). So it had to content itselfmainly with a co­ordinating role.

The commission, along with the Euro­pean Investment Bank, found ¤30 billionof EU money to contribute towards the¤200 billion target, mostly by speeding upspending programmes. Of this, ¤5 billionwas unspent infrastructure money fromthe EU budget which would normally bereturned to the rich member states thathad provided it. Three months later gov­ernments were still arguing about whereor indeed whether this money, a tri�ingsum in the scheme of things, should bespent. Brussels insiders see this episode astypical of the painfully slow process ofputting plans into action. It also illustratedhow reluctant governments are to cedecontrol over their own revenues.

There had been hopes that they mightbecome more co­operative. Helmut Kohl,who as German chancellor was one of themidwives of the Maastricht treaty, thoughta single currency could not survive with­out political union; indeed its main appealwas that it would make such union morelikely. In November 1991, a month beforethe Maastricht summit, he told the Ger­

man parliament that it was a �fallacy� thatmonetary union could last without politi­cal union. By the time the euro waslaunched in 1999, many people thoughtthat some form of �scal counterweight tomonetary union would soon follow. �Youdidn’t have to be a federalist to believethen that the euro would prompt more po­litical integration,� says Jean Pisani­Ferryof Bruegel, a Brussels think­tank.

The belief seemed well founded onseveral counts. Money is a form of govern­ment debt, so a paper currency, it wasthought, must need a state behind it. His­torical examples of a currency block notbacked by a unitary state are rare, and suchfew as there have been did not last long.According to the theory of optimal curren­cy areas, a central �scal policy is necessarybecause a single interest rate will not suitconditions in all parts of a currency zone.Just as welfare spending and revenue rais­ing help to smooth out regional kinks innational business cycles, a ��scal eurozone� would act as a stabilising force for ashared currency area.

Rules of the gameWhat institutional structures would beneeded for political union was rarelymade clear, only that there would soon bemore of it. In the meantime a set of �scalrules�the stability and growth pact, whichput a cap on budget de�cits and publicdebt�would take the place of a central sys­tem of revenue sharing. Each countrywould insure itself against a downward

lurch in its economy by running a bal­anced budget or, in good times, a surplus.

These �scal rules had another purpose,which was often given greater emphasis:to prevent imprudent countries from im­posing costs on others. Big de�cits in onecountry might make it harder for others tocompete for funds from savers, driving upinterest rates for all. If such de�cits were toadd materially to the average debt burden,investors might fret that governments willattempt either to in�ate away their debtsor to pass them on to other countries, sowill demand higher rates from all borrow­ers as protection. The EU treaty containstwo clauses to try to limit this transfer ofcosts. The �rst bars the ECB from creatingmoney to �nance de�cits. The second for­bids countries from assuming the debts ofothers (the �no bail­out� clause).

The pact did not work well. The empha­sis on the costs to others of �scal indisci­pline meant that countries were careful tobehave no worse than their peers, ratherthan trying to be prudent on their own be­half. In good times public �nances tendedto add to, not subtract from, demand pres­sures: �scal policy often worked againstthe monetary sort rather than comple­menting it, as the pact intended. The costsof �scal laxity were low. Before crisisstruck, the slack attitude towards credit riskin bond markets meant that borrowingcosts for high­ and low­debt countrieswere similar. When in 2003 the EuropeanCommission threatened to impose penal­ties on France and Germany for excessive

Soft centreCan a currency survive without a state?

12 A special report on the euro area The Economist June 13th 2009

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de�cits, the pact was �rst suspended andthen amended, with get­out clauses for�exceptional� events.

Ireland and Spain had complied withthe pact in good times, but had relied tooheavily on windfall revenues that evapo­rated along with their housing booms.Ministers had been able to insist that their�scal policies were sound because they �t­ted in with the pact’s narrow guidelines,says Mr Pisani­Ferry. Since �scal sound­ness was central to �stability�, they couldclaim that their overall economic policywas �ne too.

Once the crisis had blown up last au­tumn, the lack of a �scal centre to the eurozone became a live issue. Initially the eurorallied, but haphazard e�orts to shore upbanks, and later the economy, undid thatearly vote of con�dence. Scared investorsrushed into the safest dollar assets, luredby the liquidity of the vast market for US

Treasuries, as the euro area was revealed asa mess of fragmented bond markets. Smalleuro­area countries with oversized bank­ing industries, such as Ireland and Bel­gium, found that their bonds wereshunned, driving up their borrowing costsrelative to Germany’s. Markets were be­coming increasingly anxious that a euro­zone issuer might run into funding di�cul­ties, since there was no system for coun­tries to help each other out.

The clunky governance of the EU andeuro area worked against a rapid responseto the crisis. Political power within the EU

is dispersed, residing in state capitals ra­ther than in Brussels. There is no powerfulexecutive to take and enforce quick deci­sions. National interests got in the way of�scal­stimulus packages and e�orts to co­ordinate bank guarantees and rescues.Germany has the deepest pockets, but itsinstinctive thrift (and the suspicion that thebene�ts would be felt mostly outside Ger­many) militated against swift and co­ordi­nated action. That made it harder for lessa�uent countries to loosen their pursestrings, as they could not risk looking inworse �scal shape than their peers.

Good old ECBThe one euro­zone institution that could�and did�act decisively was the ECB. Buteven its ability to tackle slumps is con­strained. Were there just one sovereign is­suer of euro­zone debt, rather than 16, theECB could more easily engage in unortho­dox policy measures, such as buying upgovernment bonds to drive down long­term interest rates. It would also �nd it easi­er to negotiate an indemnity against capi­

tal losses on asset purchases. Despite the crisis, there are few signs of

progress towards better �scal co­ordina­tion. Earlier this year, as bond spreads con­tinued to rise, policymakers droppedheavy hints that struggling sovereign bor­rowers would not go unaided. Peer Stein­brück, the German �nance minister, saidin February that if a euro­area countryfound itself in trouble, �we will show our­selves to be capable of acting.� The follow­ing month Joaquín Almunia, head of thecommission’s economics directorate, saidthat a European �solution� was in place sothat any cash­starved country would nothave to go to the IMF for an emergencyloan. Mr Almunia did not give any details.The German �nance ministry later deniedthat it was working on bail­out scenarios.

The panic revealed another gap in theeuro area’s �scal set­up: a process for deal­ing with a sovereign default, or the threatof one. The larger the number of countriesthat have adopted the single currency, themore likely it is that one will get into trou­ble. It would be sensible to have a contin­gency plan.

One idea is a dedicated bail­out fundfor euro­zone members, along the lines ofthe IMF. This is proposed by ThomasMayer, an economist at Deutsche Bank,who started his career at the fund in the1980s. Like the IMF, a European MonetaryFund (EMF) would o�er emergency loansfor governments unable to �nance theirbudget de�cits or roll over maturing debts.In return for this insurance, each memberwould contribute capital to the fund in pro­portion to the size of its population or GDP.Loans would come with conditions. A sup­plicant would have to pledge to put its pub­lic �nances in order and undertake othereconomic reforms to persuade bond mar­kets to renew lending.

This sort of proposal attracts two maincriticisms. First, it is wasteful to duplicatethe e�orts of the IMF. Until very recentlythe fund was struggling to de�ne its role(and raise money) because it had so fewlending opportunities. Now it is busy �ght­ing �res again, many of them in eastern Eu­rope, so there is far less talk of sta� cuts. Butan EMF could stand idle for even longer be­fore it saw action. A second quibble is thata euro fund may �nd it di�cult to imposetough conditions on rescue loans. Better tolet the IMF play the role of bad cop, saysome, than have protesters burning the EU

�ag in countries forced to slash publicspending or hike taxes.

Mr Mayer retorts that even the IMF haslearnt that its interventions work only if

countries co­operate. The idea that a �nan­cial policeman has to be strict to be e�ec­tive is dated. He sees a European fund asmore than an emergency kitty for cash­starved euro members. It could act as a per­manent monitor of economic policies, in­cluding government budgets, and issue aseal of approval for countries wishing totake part in a joint bond issue. Over time,the emergency fund could evolve into aninstitution that improves the euro area’s�scal co­ordination.

The beauty of a euro bondThe hurdle for membership of such a pro­gramme would need to be high to per­suade countries with good credit, such asGermany, to sign up to it, and to convincecredit­rating agencies and investors to rankits bonds highly. But a large collective bondissue could have bene�ts even for coun­tries with low credit risk, as it would rivalAmerica’s Treasuries market for liquidity.A single issuer would make euro­areabonds more attractive to managers of for­eign­exchange reserves, who want safestores of value that can be converted intocash quickly and cheaply in an emergency.A joint bond issue could thus enhance theeuro’s standing as a reserve currency, aswell as lowering borrowing costs for allcountries that took part in it.

The idea of a shared euro bond hasbeen pushed by Italy’s Mr Prodi, GeorgeSoros, a veteran investor, and others. ThatItaly is keen on the idea is hardly surpris­ing: pooling its poor credit ratings with oth­ers of higher standing would lower its bor­rowing costs and reduce the risk, albeitsmall, that it might have its �nancing cuto�. Germany is understandably cool onthe idea. Mr Steinbrück has said that theextra cost to his taxpayers would make ithard to sell politically. Many in Germanyfeel that even temporary help for cash­strapped partners should be provided bythe IMF only, and on strict terms. They re­sent the fact that Greece and Ireland en­joyed years of prosperity and still foundthemselves in �scal trouble. Bail­outs, theyfeel, only encourage pro�igacy.

A rescue of one country by its partnerscould undermine popular support for theeuro, says Otmar Issing, the ECB’s chiefeconomist for its �rst eight years, because itwould imply a transfer of taxpayers’ mon­ey without endorsement from the votersin countries that have to pay.

Mr Issing, who had previously sat onthe Bundesbank’s rate­setting council,once believed that the euro needed morepolitical union to thrive, but has modi�ed

The Economist June 13th 2009 A special report on the euro area 13

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1

THIS crisis has tested many schemesand wheezes (some to destruction),

from securitised mortgages to collateral­ised­debt obligations, from light­touch reg­ulation to in�ation targeting. How does theeuro fare in this reckoning? According toone school of thought it is a fair­weatherset­up, seemingly e�ective when econo­mies are expanding but poorly equippedto deal with crises and manage the pres­sures and con�icts of a sinking economy.Conversely, many in Brussels and Frank­furt argue that being in the euro zonehelped member countries emerge relative­ly unscathed from the worst �nancial crisissince the 1930s. Which view is right?

The extreme lurches in markets duringthe worst of the crunch last autumn madethe certainties of �xed exchange rates lookenticing. One lesson from the crisis is thatasset prices can be unduly volatile and of­ten veer wildly from their true values, inways that undermine economic stability.That goes especially for housing but is alsotrue of other asset prices, such as exchangerates. Another message is that interest­ratepolicy is not as powerful a stabilising forceas had been thought. Other means ofshaping demand are needed to comple­ment it. Swapping an independent mone­tary policy for the stability of a �xed ex­change rate now seems less of a sacri�ce.That also closes o� the escape route of let­ting the currency slip if wages move out of

line with productivity. Yet de�ation seemssuch a threat precisely because prices andwages are proving less �sticky� on the waydown than macroeconomic textbooks hadreckoned with.

On standard gauges of competitive­ness, such as real e�ective exchange rates, anumber of euro­zone countries appear tohave big problems. Yet things may lookworse than they are. Measures based onrelative unit wage costs across the wholeeconomy are crude. In booming Spain andGreece, much of the heat in wages was inparts of the economy, such as construction,that serve domestic spending and are shel­tered from foreign competition. Export in­dustries may have a better chance of bene­�ting from a global recovery than the�gures suggest at �rst glance.

Spain, in particular, may not be quite asuncompetitive as it seems. José LuisEscrivá, an economist at BBVA, a Madrid­based bank, reckons that Spanish export­ers have performed fairly well in retainingexport market share against other coun­tries, bar super­competitive Germany.�What Spain had mostly was an importboom,� he says. Now imports are declin­ing at a much faster rate than GDP, whichwill trim Spain’s current­account de�cit toa more manageable size.

A recent study by the European Com­mission lends some support to that view.The export­market shares of Spain and

Greece fell only slightly between 1999 and2008 (see chart 7). Export growth wasstronger than in Belgium, France and Por­tugal, if not as vibrant as in Austria, Fin­land, Germany and the Netherlands. Ire­land’s export­market share increased overthe period, even if the greatest strides weremade in the euro’s early years. Perhaps itsexporters, many of them big American­owned �rms, were wise enough to holdback on big wage and price increases in acountry that could not devalue.

Italian exports, however, were dismal.Firms in Italy lost market share faster thanin any other big euro­zone country. Italy’sundoing is to specialise in industries suchas textiles and furniture where competi­

Warmer inside

The gains outweigh the losses

7Great exportations

Source: European Commission *35 industrial countries

Export-market share* and growthAverage annual change %, 1999-08

France

Export growth

Exp

ort

-ma

rket

sh

are

4

2

0

+

–

2

4

0 2 4 6 8 10 12

Belgium

Germany

Ireland

Greece

Spain

Italy

Cyprus

Malta

Netherlands

Austria

Portugal

Slovenia

Slovakia

Finland

his views. Political union, he now thinks,may even work against monetary union ifit is founded on a model that would makeeconomies more rigid. EU policies, once inplace, are hard to reverse even if they areclearly harmful, as decades of farm subsi­dies have shown. The euro has little bear­ing on ambitions for a common foreign ordefence policy.

The euro’s short history suggests that asuccessful monetary union does not nec­essarily need deeper political integration.True, by American standards the euroarea’s response to the crisis was slow andlacked co­ordination. But that is part of theprice countries pay (and consider worthpaying) for retaining full �scal sovereignty.In any case, since welfare bene�ts are moregenerous and taxes heavier in Europe than

in America, automatic �scal stabilisers aremore powerful in the old continent. Ameasure of co­ordination is already builtinto the euro area’s �scal policy.

The stability and growth pact is nowtoo full of holes to be a binding constrainton �scal policy. In an important sense itwas always redundant. If monetary �­nancing is banned and the �no bail­out�commitment is real, then �scal discipline islargely an issue for individual countries. Ifthey let �nances slip, bond markets will ex­act a penalty in higher borrowing costs, asthey have done in recent months.

There are nevertheless a few minimumrequirements for a �scal euro zone. The�rst is a set of clear rules for what wouldhappen if a euro­zone member were fro­zen out of market funding. This will be be­

come more important as more countriesjoin. Second is an agreement on how theECB would be recapitalised in the unlikelyevent that bank failures were to leave itwith big losses on its loan book, or that itwere to make large outright purchases ofsecurities that subsequently went bad. Athird element of �scal union is needed tobind not just the euro area but the EU’s en­tire single market: a shared fund for cross­border bank bail­outs. Without an agree­ment on support for troubled multina­tional banks, an open EU market in�nancial services may be impossible tomaintain. Ironically, such a scheme wouldhave to include Britain and Sweden, twocountries that are outside the euro zonebut have lots of banking interests in otherEU countries. 7

14 A special report on the euro area The Economist June 13th 2009

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tion from China and other emerging mar­kets is particularly keen.

A devaluation might o�er temporaryrespite for Italian exporters, but it wouldnot be a lasting solution to being in thewrong businesses. Neither could it dis­guise the economy’s real problems: legalprotection for jobs that stops workers mov­ing from dying industries to growing ones;a wage­bargaining system that has madefor poor matches between pay and pro­ductivity; and an unimpressive record oninnovation that has inhibited the emer­gence of new �rms in high­value­added in­dustries. This familiar Italian litany is the�never­ending story of things that need re­form�, sighs one economist.

However, there are signs of progress.Con�ndustria, Italy’s biggest employers’body, recently signed an accord with twoof the three largest trade­union confedera­tions to overhaul the national wage sys­tem. CGIL, the largest union group, did notsign up to the deal, but the Italian govern­ment said it would go ahead anyway.

DeconstructedSpain and Ireland have more to worryabout than wage costs in export industries.Big construction busts are, as a rule, hard torecover from. At the peak of their housingbooms, up to a �fth of their workers hadjobs related to construction or propertysales. Many of those jobs will not comeback, and �nding other things to do forsuch an army of redundant workers willtake time. Ireland has a more �exible jobsmarket, so its recovery is likely to be swift­er, if still far from painless. Its GDP is set toshrink by as much as 9% this year. Spain’seconomy is more hidebound, so it will takelonger to revive.

It is hard to see how a devaluationwould help much even if that option wereavailable. �If Spain’s main problem werecompetitiveness, I wouldn’t worry,� saysMr Gros of the CEPS: �The Phillips curve[which suggests an inverse relationship be­tween wage in�ation and unemployment]would take care of it.�

The lack of a ��scal euro zone�, a centralspending body �nanced by a shared poolof tax revenues, has hampered an e�ectiveresponse to the economic downturn. Yetwithout the euro things might have been alot worse. Co­ordinating a European re­sponse amid a series of currency crises orexchange­rate rows would have been fartrickier. Bond investors have becomechoosier about sovereign credit risk, sosome euro­area borrowers have had tostump up higher coupons for their recent

bond issues. But no one was frozen out ofmarkets. Even when spreads were at theirwidest, Greece and Ireland, the euro­zone’s high­yielders, were able to �nancetheir borrowing needs at a reasonable cost.The security of access to �nancing hasmade the euro area even more attractive tothe EU’s eastern states, some of whichhave had to fall back on rescue loans orprecautionary credit lines from the IMF.

The prospect that a euro­zone countrymight default on its loans, never mindleave the euro, is fairly remote. But the ta­boo around the subject leaves bond inves­tors uncertain about how such a problemmight be resolved if it did occur. That un­certainty should be dealt with. Policymak­ers have dropped hints that should onecountry’s �nancing troubles spread to an­other, a bail­out plan is in place. Yet the riskof contagion is overblown. An orderlydebt restructuring for a country within theeuro zone would not be the end of the

world, or indeed of the single currency. Abail­out by fellow members might dogreater harm by damaging popular sup­port for the single currency.

There is a central irony about the euro.Many of its architects saw it as a means ofadvancing political union in Europe andwere barely interested in a monetary un­ion as an economic venture. Their hopeshave been dashed, but as a technical exer­cise the euro has been a huge success. Thecurrency is accepted in vast swathes of therich world and quite a bit of the poorworld too. The value of euro banknotes incirculation and the market for euro­de­nominated securities already rival the dol­lar, a long­established currency backed bya single nation­state.

For economists such as Robert Mundelland others, who saw huge bene�ts inshared currencies but had despaired ofpoliticians giving up monetary control, theeuro is an exciting experiment. By contrast,the politicians that made the leap havebeen disappointed by the euro’s failure, sofar, to spur deeper political integration.

For all its shortcomings, the euro zone isfar more likely to expand than shrink overthe next decade. Most EU countries that re­main outside, bar Britain and Sweden, areeager to join. The harm done by housingand construction booms in Ireland andSpain should be a caution to would­bemembers who, once inside, may get car­ried away by low borrowing costs. Againstthat, a big lesson from the crisis is not torely too much on short­term interest ratesto rein in credit and home­loan booms.The rush to join the euro zone is surely avote of con�dence. It must be doing some­thing right. 7