During the run up to the euro, I used to complain that our leaders reminded me of the World War I generals, trying to win the battle of the euro by frontal assault, regardless of casualties. I was wrong to think that this attempt would fail. My brief as an economist is now to spell out the policies of the different member states needed for it to be a success and to assess the likelihood that these conditions will be fulfilled.
Success in the launching of a new currency has many dimensions. The first is keeping the legacy of the Deutschmark intact. The euro is having such an auspicious start because its birth has coincided with a continental boom and, more fundamentally, because Germany generously donated its monetary goodwill to its euro partners. The question now is whether the European Central Bank will do its duty from the very beginning and over the next two or three decades, until its reputation for issuing an inflation-free money is solidly established.
The ECB seems to have decided that it will use German methods to track and control money creation. This means setting M1 and M3 growth targets, using interest rates to feed or starve the interbank market, and resorting to cash ratios when stronger action is needed. The object of this system is twofold: avoiding monetary inflation, while fine-tuning the European economy.
Here is a pointer to possible difficulties for the euro. The ECB will have to decide on interest rates and money supply for the whole of euroland. In an old nation state, regions and trades will accept central bank interest rates that do not suit their moment in the cycle with more equanimity than will the different parts of an artificially assembled European Union. In difficult times, the temptation may be to let the euro weaken towards the dollar. This has even been the Bundesbank policy for the Deutschmark, which has been allowed to lose value against the dollar over the last two years with the effect of reviving the German and French economies, and perhaps overheating of the Irish, Spanish and Portuguese.
To avoid the danger of euro weakness, a stability pact was hastily stitched together. This implies one of three things a non-bail-out rule for errant exchequers, or deficits fluctuating around zero, or continuous chastising by Ecofin. The let-’em-behave-or-sink rule is not on. The other two courses may give rise to conflict.
The likelihood of increased social tensions when discipline is imposed from the outside is the main argument of those of us who think the euro should have been imposed more slowly. The European ideal is too weak to reconcile people to the pain the a strict pan-continental monetary order will inflict.
One way to impose monetary stability is to fix the exchange rate of the national currency to some stable standard. The euro is the extreme of fixed exchange rates, with no escape clause when rigidities in the economy or macroeconomic mistakes bring about unsustainable increases in domestic costs. Individual countries in the European Union will not be able to rely on the mechanism that has helped France and Germany recover from their latest recession, the depreciation of the Deutschmark.
Yet, given voter resistance to higher taxes, social spending may turn out to be incompatible with monetary soundness. Again, the EU could take the blame.
“L’Europe n’est pas faite,” I heard a French friend exclaim on watching French agriculturists burn lorries full with Spanish agricultural produce. Loyalty to the idea of a united Europe does not go much beyond a political and bureaucratic elite in some state capitals.
In fact, the drive towards European unity is bringing about an unwanted result: the prospect of EU is helping to break up the old nation states. Some Scots and Welsh are dreaming of independence with a remote link to Brussels. Many Basques and some Catalonians are taking Europe as a pretext to break away from Spain. Italy is witnessing unexpected separatist tensions. While Europe is still many decades away from unity, balkanization is spreading now and may multiply with the arrival of new members. The tensions springing from the clash between an orthodox monetary policy and rigid social structures may compound the effects of petty local nationalism. However, the defenders of the euro as a force not only for monetary stability but also for wider markets, structural reform and European sentiment may yet be right. Many good things will flow from a single currency, especially in financial markets and commercial competition. But judgement and tireless explanation are needed. Now the war for the single currency is over, I would like the peace signed by the contestants not to lay euroland to waste.
Pedro Schwartz is executive president of Fundesco, a think tank based in Madrid
