The eurozone's next decade will be tough
Comment of the Day

January 06 2010

Commentary by David Fuller

The eurozone's next decade will be tough

My thanks to a subscriber for this informative column by Martin Wolf of the Financial Times. Here is the opening
What would have happened during the financial crisis if the euro had not existed? The short answer is that there would have been currency crises among its members. The currencies of Greece, Ireland, Italy, Portugal and Spain would surely have fallen sharply against the old D-Mark. That is the outcome the creators of the eurozone wished to avoid. They have been successful. But, if the exchange rate cannot adjust, something else must instead. That "something else" is the economies of peripheral eurozone member countries. They are locked into competitive disinflation against Germany, the world's foremost exporter of very high-quality manufactures. I wish them luck.

The eurozone matters. Its economy is almost as big as that of the US. It is three times bigger than those of Japan or China. So far, it has passed its initial test. Nevertheless, the peak to trough decline of the US economy was only 3.8 per cent (second quarter 2008 to second quarter 2009), while the eurozone's was 5.1 per cent (first quarter 2008 to second quarter 2009).

More important than the eurozone's overall performance is what is going on inside the zone. The starting point must be with the pattern of current account deficits and surpluses. In 2006, the zone was in rough balance. Inside it, however, were Germany, with a huge surplus of $190bn (6.5 per cent of gross domestic product) and the Netherlands, with a surplus of $64bn (9.4 per cent of GDP). At the opposite end of the spectrum were the capital importers, of which Spain was the most important, with a huge deficit of $111bn (9 per cent of GDP).

Many have argued that, within a currency union, current account deficits do not matter any more than between Yorkshire and Lancashire. They are wrong. Deficit countries are net sellers of claims to the rest of the world. What happens if people in the rest of the world sell these claims or withdraw their loans? The answer is a recession. But within a country, people can move relatively easily to another region. That is usually far harder across borders. There is another, bigger, difference: the Spanish government cannot respond to the complaints of the Spanish unemployed by arguing that things are not so bad elsewhere in the eurozone. It must offer a national solution. The question is what.

David Fuller's view In joining the euro, Europe's more fiscally challenged countries gained lower interest rates but lost the option of unilateral devaluation, which had been used repeatedly to maintain competitiveness within the region. Without devaluation, many companies have had to resort to cost cutting, mainly in the form of wage compression. This has also happened with public sector pay in Euroland, politicans aside.

When the euro was introduced in 1999, many commentators were sceptical about its long-term survival. I was among them but we have been proved wrong, at least so far. A severe regional recession, let alone one of near global scale, was always going to present the ultimate challenge for any currency union.

To date, there has been little political backlash against the euro from within its constituent states, beyond some grumbling acknowledgement of the obvious, that it is not an economic panacea. This could change if Euroland's economic recovery is too weak to feel like more than an extended recession in the next few years. Conversely, if the euro rides out the next decade without losing any of its member nations, we can justifiably call it the world's most significant example of an enduring currency union.

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