One big EU project—the constitution—has just hit the buffers, or at least been parked for a time in the siding, and another is now under threat. Voters in France and Holland were angry with the established political class and this hostile climate was infected by economic malaise, but putting Europe's economies to right is itself made more difficult by economic and monetary union (Emu). As the economic consequences of Emu bite harder, EU bigwigs had better get ready for further crises: bad economics make for bad politics.
The first thing to recognise is that the poor performance of the "core" economies of the EU is not new: France had three years of strong growth between 1998 and 2000, but that followed a decade in which growth was below 2 per cent every year and even this short and belated spurt of growth came to an abrupt end in 2001 with only anemic recovery since. Germany has enormous strengths and huge potential, but with the exception of a few years around unification, its annual growth rate has averaged less than 2 per cent for over 30 years. Italy is in recession, and although the record of the peripheral economies is mixed, the benefits of "catch-up" have waned and several,including? Portugal and Greece, are in serious trouble.
The second point to note is the growing divergence between economies. Recently, the European Central Bank (ECB) expressed surprise and concern about this. It should be concerned, but not surprised: economic divergence is inherent in Emu. Even the proponents of the single currency recognise that at any one time, interest rates are bound to be less suitable for some countries than others. It is inevitable that during the upswing of the economic cycle, there will be countries for which the nominal interest rates set by the ECB are too low for their own domestic conditions. These will be countries that require a higher equilibrium rate of interest than the eurozone as a whole to keep their economies in overall balance. Inside the eurozone, such countries will experience a pick-up in relative inflation, and the process will be reinforcing since high relative inflation means that real (inflation-adjusted) interest rates are lower at precisely the time they should be higher than elsewhere in euroland.
In the downturn, the position will be reversed. The rate of decline in inflation will be faster in those countries where the rise had been greatest. The result is that even if the ECB is cutting nominal rates, the rate of decline in real interest rates in these countries will be behind the rest of the eurozone at the very time they should be falling more quickly. And countries caught in this position will still be losing competitiveness from their higher inflation, so that the decline in domestic demand will be exacerbated by a reduction in the contribution to overall economic growth from net exports. Thus in both the upswing and the downswing, Emu will increase the volatility of the business cycle for those countries that are landed with an inappropriate level of interest rates.
The experience of the Netherlands is particularly interesting, since the guilder had been linked to the deutschmark since 1972. The Netherlands has particularly close trade links with Germany, and historically has been one of the most determined inflation fighters in Europe: exactly the sort of economy that was supposed to benefit from Emu. Yet during 2000 and 2001, inflation accelerated to 5.5 per cent, and in 2001 and 2002, average inflation was more than twice the rate in Germany. This inevitably made the downturn sharper than it would have otherwise been; growth was a miserable 0.2 per cent in 2002 and actually fell in 2003. There was a brief recovery last year, but this year the Netherlands is back in recession and last month its central bank cut its 2005 growth forecasts from 1.7 per cent to 0.4 per cent.
Today, the only convergence in euroland is towards slower growth and bigger budget deficits. Everyone agrees that budget deficits need to be addressed and public finances put in order, and most people at least pay lip service to the need for "economic reform," but even if the political will existed, implementing the policies to fulfil these objectives is made more difficult or impossible within Emu. This is the third economic point of note.
If budget deficits are to be reduced and debt put on the right track, taxes have to rise or expenditure has to be cut. However, this becomes self-defeating if there is no economic growth or at least the prospects of growth, and this is only possible if monetary policy – the combination of interest rates and exchange rate – is appropriate for the economy of the country taking the measures to put its public finances in order. In Britain, Norman Lamont could only put Britain's public finances on the path to recovery when sterling came out of the exchange rate mechanism (ERM), so that interest rates could be set at the right level for Britain and the pound could depreciate. This can't happen in the eurozone, and it may easily become impossible for individual countries to escape continued deterioration of their public finances.
Likewise, economic reform is impeded within Emu, not only by the lack of political will to implement reforms, but by the economics of the single currency. Economic reform can take many forms, and its implementation is bound to reflect differing cultural and political traditions in Europe. But whatever form it takes, economic reform must result in a rise in rates of return on investment; without that, it has no economic meaning at all, and the more radical the reform the bigger the impact.
Initially, economic reform often appears to make things worse, as unproductive capital is closed down and labour laid off, and this needs to be offset as far as is possible by slacker monetary policy. However, as underused capacity is taken up and the benefits of reform come through, monetary policy needs to adjust if the rise in anticipated rates of return generated by economic reform are not to spill over into a boom. In the eurozone it is not possible for an individual country to adjust its monetary policy in this way, and Britain's own experience shows what can happen. In the late 1980s, the benefits of supply-side reforms earlier in the decade were bearing fruit: there was an investment boom and capital flowed into Britain. But interest rates were kept too low in an attempt to "cap" sterling against the deutschmark, the boom got out of hand and led to the inevitable bust.
When an economy has lost competitiveness and its public finances begin to deteriorate, the real exchange rate has to depreciate, but the single currency rules out nominal depreciation. Nonetheless, a country inside Emu that becomes "uncompetitive" can still only restore its position if it improves its inflation and labour costs relative to others. Unless these costs rise elsewhere within the single currency area, they have to be forced down below those of other economies by deflating the uncompetitive economy. If a country in the eurozone gets into this position, fiscal policy will have to be tightened, expenditure cut, or taxes increased. As time goes by, the squeeze on the economy will force inflation down to the level of competitors, but it has to go further than that to make up for the initial loss of competitiveness. Inflation and wages have to fall below the level of competitors by a significant amount and for a substantial period. The result is an even more depressed economy, rising budget deficits and ultimately the risk of an economic crisis.
This is essentially what happened within the ERM when the French embarked upon the so-called franc fort policy and screwed their economy into the floor at huge cost to output and jobs. It's what Germany has had to do in recent years, and it's the route that now beckons Italy.
Under the impact of very high unemployment, Germany's relative labour costs have fallen sharply. However, if the improvement in its competitiveness does not feed through into German domestic demand, it won't help much and this is quite likely since the relative disinflation of prices that has accompanied the falls in German labour costs has meant relatively high real interest rates in Germany because nominal interest rates are set outside the its economy. Furthermore, the improvement in German competitiveness has to some extent been at the expense of the trade performance of other countries in the EU. Italy was in difficulty anyway, but this threatens to become worse as the effects of Germany's improvement in competitiveness feeds through to output growth, unemployment and the worsening budgetary problems of Italy. Italy is not the only economy in trouble, but it has been brought centre stage by suggestions within the country that it should leave monetary union.
Italy has reached a deal with the EU commission that puts off the crisis for a while: Italy has to get its budget in order by 2007 - after its election - rather than by 2005. Leaving, or being forced out of, the euro would not be without its difficulties, but as Charles Goodheart pointed out in recent letter to the Financial Times, it need not be apocalyptic, even for a country with large debt. Budget tightening without accompanying stimulus to expenditure provided by devaluation is deflationary and politically disastrous, though this is something a Prodi-led government might attempt should it win the election. However, one way or another, the genie is out of the bottle: the euro, at least in its present form, may not survive, and Italy may not be the only country that needs to consider its options in the next few years.
