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 user 2005-05-30 at 10:16:00 am Views: 45
  • #9438

    Squeezed By The Euro
    Europe’s single currency has not promoted
    growth. It has also failed to spark needed reforms and fiscal discipline

    Were the skeptics right? In early 1998, University
    of Bonn Professor Manfred J.M. Neumann mobilized 155 fellow economists to
    protest the coming introduction of the European common currency. The euro was
    dangerously premature, they argued in open letters published in major
    newspapers. Big countries such as Germany and France lacked the flexible labor
    markets they needed to compensate for losing control over monetary policy as a
    tool to promote growth. Needless to say, the protests had little effect. The
    euro blasted off on Jan. 1, 1999, as planned.

    Six years later, Neumann’s
    warning seems ominously prescient. Far from becoming a powerhouse to compete
    with the U.S. and Asia, Europe in the past four years has been nearly stagnant,
    with average annual growth in the euro zone of of 1.2% since 2002. Meanwhile,
    it’s hard to overlook the superior economic performance of European Union
    members that stayed clear of the common currency. Britain and Sweden have
    enjoyed healthy expansions and lower unemployment. Britain’s jobless rate is
    4.7%, compared with 8.9% for the euro zone.

    Even common currency
    champions such as European Central Bank President Jean-Claude Trichet see little
    chance of a euroland boom anytime soon. Just as Neumann predicted, overregulated
    labor markets in much of the euro zone prevent pay scales from reacting fast
    enough to competitive pressure from abroad. And individual countries can no
    longer compensate for these rigidities by devaluing their currencies to boost
    exports, usually through the swift downward movement of interest rates.
    “Unfortunately,” says Professor Neumann ruefully, “we were right.”

    raises a larger question: Was the euro a mistake? Not even euro-skeptics such as
    Neumann argue that the currency should be scrapped now that euro coins and notes
    have become a fact of life from Finland to Greece. “It would be insane to give
    up the euro. We have to make the most of it,” Neumann says.

    Still, the question hangs in the
    air, especially amid evidence of growing popular discontent over core Europe’s
    dreadful economic performance. A dramatic expression of that discontent came on
    May 22 when German Chancellor Gerhard Schröder’s Social Democratic Party (SPD)
    was booted from power in North Rhine-Westphalia, an economically battered
    industrial state that had been ruled by the party for four decades. Schröder, in
    what amounts to an admission that his tepid economic reforms have failed, has
    called for national elections in September, a year early. In addition, French
    and Dutch voters may reject the proposed European constitution in referendums
    May 29 and June 1. If so, the votes will surely be interpreted as protests
    against a European system that seems ever more powerful yet ever more unable to
    deliver jobs and prosperity. The euro is integral to that

    Stagnation and political upheaval were obviously not part of the
    plan when the currency was launched six years ago. At the time, euro-optimism
    was running high. The idea was this: Before they could adopt the currency,
    countries like France, Germany, Italy, and others would rein in their budget
    deficits, and afterwards keep public spending in check to support monetary
    union. The existence of one currency, backed by fiscal discipline across the
    board, would then turn the half-fiction of a common market into reality. As
    Europe’s various economies melded together into one, internal barriers to
    competition would tumble and the best-managed countries and companies would pull
    ahead. Countries that lagged would respond by loosening labor rules and cutting
    taxes to boost competitiveness. Like the Bundesbank, which had made Germany a
    beacon of monetary stability, the ECB would squash any hint of inflation with a
    rate hike. If countries wanted to grow, they would have to deregulate their
    economies and keep wage hikes in line with productivity.

    Now check out
    what happened. First, the benefits. Currency risk within the euro zone is gone:
    no need to hedge the lira against the franc, for example. Finnish mobile-phone
    company Nokia Corp. (NOK ) estimates that it saves at
    least $6 million a year in transaction costs within the euro zone, and that
    doesn’t count savings by suppliers that ultimately benefit Nokia. “It makes the
    whole supply chain more efficient,” says Nokia Chief Financial Officer Rick

    Financial markets in Europe, meanwhile, have gotten a huge
    boost. Companies in countries whose national currency had been weak, such as
    Italy and Portugal, almost overnight saw their credit ratings improve. Italian
    companies were able to raise $82 billion on capital markets in 2003, more than
    double the amount they raised in 1999, says the ECB. Governments have saved
    billions by refinancing the national debt at lower interest rates. The euro,
    bolstered by initially high rates, has also ushered in an era of unprecedented
    low inflation in Europe.

    That’s the bright side. But the costs have been
    enormous. Europeans remain skeptical about the euro, which they see as a project
    driven by politicians with little regard for ordinary people. Huge majorities
    are convinced that shops and restaurants used the introduction of euro notes and
    coins in 2002 to raise prices, which in fact was often the case, even if overall
    inflation remained steady. These resentments have increased doubts about the
    whole European project. “Prices rocketed. Now we can’t buy as much,” says
    Catherine Dumont, 47, a secretary who spoke as she shopped at a Monoprix
    supermarket in Paris. “It will have an impact on my opinion on referendum day,”
    she adds, leaving little doubt she will vote “no” on the

    More important, the virtuous circle of competition and
    reform that the euro was supposed to kick off never materialized. The ECB, sworn
    to fight inflation, cut rates gradually from a high of 4.75% in 2000 to the
    current benchmark rate of 2% in June, 2003. That kind of monetary discipline was
    tough for Italy, which is having a hard time adjusting to a world where it can’t
    devalue its way out of trouble, says Domenico Siniscalco, Italy’s Finance and
    Economy Minister. “It’s like taking a tiger and trying to make it turn
    vegetarian,” he says. Germany would also benefit from a weaker currency, which
    would make its exports cheaper. “Things would have been better with the
    Deutschemark,” says Joachim Preissl, owner and president of BING Power Systems,
    a Nuremberg-based maker of engine parts for customers including Porsche and BMW.
    Preissl says the strong euro makes it harder to compete with Mexican and Chinese

    To compensate for the loss of currency flexibility, both Italy
    and Germany could opt to reform much faster. But not even the harangues of the
    ECB can get the Italians, French, and Germans to confront politically explosive
    tasks, whether it’s changing rules in France that make it difficult and costly
    to fire workers, or getting Germany to allow Dutch plumbers to compete for
    business in Dusseldorf. “None of the big countries is fighting to create a
    European market,” says Rafael Pampillón, an economics professor at Madrid
    business school Instituto de Empresa.

    Even the fiscal discipline imposed as a precondition to
    monetary union is going by the board. Germany’s budget deficit has exceeded the
    limit of 3% of gross domestic product since 2002. Now Italy and Portugal are
    also overdrawn. Rather than reining in spending, euro-zone countries earlier
    this year agreed to loosen the deficit restrictions.

    While Germany,
    Italy, and France would suffer if rates rose, other countries in the zone could
    use tighter money. Spain has an inflation rate of 3.5%, vs. 2% for the ECB’s
    benchmark interest rate. That means Spain effectively has negative interest

    The divergence makes it almost impossible for the ECB to
    formulate an economic policy that fits all the countries. Derek Scott, former
    economic adviser to British Prime Minister Tony Blair and a leading
    euro-skeptic, says the ECB can’t risk hurting German growth by tightening the
    money supply, even if that means higher inflation in countries such as Spain.
    That in turn could undermine the ECB’s reputation as a stern inflation-fighter.
    “With a single currency, you exchange the apparent stability of nominal exchange
    rates for greater instability of the things that matter: output, jobs, and
    inflation,” Scott says.

    Of course, European central bankers dispute such
    theories. “One size does fit all!” insisted Otmar Issing, a member of the ECB’s
    executive board, in a speech to a Frankfurt audience on May 20. The divergence
    in member-country growth rates is below the historical average, he said, an
    indication that the euro is not pushing countries to move at different speeds.
    Likewise, ECB President Trichet was at pains to point out the euro’s benefits to
    an Italian business audience recently. But in a sign of growing nervousness
    within the bank, he also warned political leaders to step up the pace of reform.
    “Many countries have not adapted their economic, social, and legal frameworks in
    order to face the new challenges,” Trichet said.

    Some governments have
    pulled off those changes, cutting taxes, rolling back job regulations, and
    eliminating barriers to competition. That’s true of countries in the euro, like
    Ireland, and outside it, like Britain, Denmark, and Sweden, which focused on
    deep structural reforms after experiencing wrenching economic crises. Now,
    Germany may get a reformist government in September led by Christian Democrat
    Angela Merkel. A stronger dollar would also do wonders for Europe by making its
    exports cheaper abroad.

    But the euro countries will enter uncharted
    territory if, say, Italy and Portugal continue to deteriorate or Germany proves
    unable to return to health. Some economists speculate that in the worst case, a
    country such as Italy might get into such trouble that it would seek to pull out
    of the currency union. Patrick Minford, an economist at Cardiff Business School
    in Britain, thinks it more likely that one of the weak countries will run into
    budget problems and seek a bailout from its neighbors — provoking a political
    backlash in Germany, where the euro was never popular. That could strain the
    currency union to the point of collapse. “The weakest point is Germany,” says
    Minford, a member of the EMU Monitor, a group of university economists from
    around Europe who issue periodic reports on European monetary policy. Minford
    considers the possibility of a euro meltdown remote but adds: “It could be a
    very uncomfortable decade.”

    Can the euro survive? That’s a question no
    one wants to contemplate. The pressure is on European leaders to make sure they
    never have to