Trumpeter 4 Europe

The euro: Can the strain rip it apart? Larry Elliott, Observer Business. 08.03.09

From the moment of its birth, just over a decade ago, sceptics have been writing epitaphs for European monetary union. Yet the euro has survived and in recent years has begun to challenge the dollar for the title of the world’s premier reserve currency. But the recession has exposed the structural weaknesses in monetary union and represents the single currency with its first real test.
  The problem is easy to identify. Under the system of adjustable exchange rates pre-euro, the less competitive countries – Italy in particular – compensated by devaluation. That made their exports cheaper, their imports dearer and allowed them to keep in some sort of balance with Germany, Europe’s most efficient economy.
  Monetary union means devaluation is no longer an option and the failure of Italy, Spain and Greece to match Germany’s productivity record has put increasing strains on their economies. Charles Dumas of Lombard Street Research said last week that Italy’s real exchange rate – which takes inflation into account – was a third too high. Spain, he added, faced “10 years of stagnation” if it stayed in the euro.
  Derek Scott, once economic advisor to Tony Blair, also doubts whether the single currency can survive in its current form and believes that monetary union will be slimmed down to a smaller group of countries in the coming decade.
  At the moment, however, the talk in Europe is of expanding monetary union to the east, rather than a consolidation around a hard core of countries led by Germany. Many former Soviet bloc nations feel the need of the euro’s security blanket during the current crisis.
  Whether these countries are in a fit state to join the euro is a moot point. Despite rapid growth in recent years, they tend to be poorer and less productive than the countries of western and northern Europe, with big current account deficits and weak financial systems.
  All this is happening at a time when the core of monetary union is hurting badly. German growth has collapsed as demand for its high-tech investment goods has dried up and it is contracting even more rapidly than Britain. There is no great appetite in Germany to foot the bill for the pan-European banking bailout that is needed.
  So could these tensions rip Europe apart? In theory, yes, and that would have profound economic and political consequences. Should Italy announce that it was leaving the euro it would send shock waves across the continent and beyond. Consumer and business confidence would be shattered; protectionist pressures would rise.
  In practice, the disintegration of the single currency looks unlikely, at least for now. The euro is not just an economic project, and after all the political capital invested in it over the past two decades there is a determination to ride out the crisis. That determination may, however, be severely tested.