The Economist
11 January 2009
EUROPE'S single currency has been a haven in recent financial storms. But as capital markets become more discriminating, it no longer affords shelter from reform
PAUL VOLCKER once likened global capital markets to a vast sea that cannot escape the occasional big storm. Mr Volcker, a former chairman of the Federal Reserve, who is now an adviser to Barack Obama, counselled that when the waters got choppy, it was far safer to be on a big ship. A stately liner can sail serenely through turmoil that would capsize even the sturdiest small vessel.
Paul Volcker, former Federal Reserves boss
Mr Volcker was speaking a few months after the collapse of the Thai baht set off the Asian financial crisis, and a few months before the launch of the euro, which celebrated its tenth anniversary on January 1. A decade on, the euro has demonstrated the virtue of size in rough seas. As small economies were tossed by the financial storms that followed the collapse of Lehman Brothers in September, the currencies with global clout, such as the euro and the dollar, were the most stable.
In its first ten years, the euro has come through several tests already. Claims that the currency zone would fall apart have proved groundless. Nor is the euro a soft currency, as some had feared. The European Central Bank's (ECB) common monetary policy has drawn on the traditions of its best constituent central bank, the Bundesbank - and has produced an even better record of low inflation.
From the standpoint of economic stability, the euro has been a success. If there is cause for disappointment, it is that sound money and the price transparency afforded by a common currency have not fostered faster economic growth. The hope when the euro was launched was that countries stripped of the licence to cheapen their currencies would be forced to compete directly, and that competition would beget more flexible markets and higher productivity. Yet, there has been little improvement in the euro area's underlying growth rate in the past ten years.
Income per person has remained at around 70 per cent of that in America.
Perhaps, the euro has proved too safe a haven. Partly sheltered from the whims of fickle foreign capital, member states have been under less pressure to shape up. If that is true, the blame may not lie entirely with the single currency.
The run-up to currency union and most of the euro's first decade
coincided with the Great Moderation, a period of economic stability and low inflation - and hence low interest rates - in the rich world. But investors who once underpriced risk are now charging heavily to bear it, which will affect companies and governments inside the euro's embrace as well as beyond it.
As budgetary laxity and weak growth become costlier, reforms are more likely. The crisis has another legacy: despite the weakness of the dollar in recent weeks, the euro may struggle to challenge the greenback as the world's main reserve currency. Lately, it is true, the euro has gained in value against the dollar - partly because the ECB seems reluctant to follow the Federal Reserve's path to zero interest rates.
But the dollar held up better in the eye of the financial storms in October, when investors were most fearful. The American currency still has important advantages over the European newcomer.
Safety in numbers The advantages of euro membership - and the perils to small European countries of being outside - were plain when the crisis was most severe. Last autumn, capital drained from curren-cies that investors saw as risky. That included the paper of countries, such as Iceland, with bloated financial industries, as well as some eastern European states with current-account deficits, heavy public borrowing or (as in Hungary) a dangerous mix of both.
Euro-area countries with similar faults have been spared the currency crisis that plagued others. Eurocrats are quick to point out that Ireland's guarantee of bank deposits and debt would seem threadbare if it still managed its own currency: investors might have taken fright at the scale of the banking sector compared with GDP.
Being part of a big club has made a currency run far less likely (though Ireland's membership of the euro is one reason it became a large financial centre in the first place). Belgium, with its big banks and huge public debt, has benefited from being an insider too.
Spain would have struggled to fund its current-account deficit, the world's second-largest, outside the euro. At the worst point, investors ran from all but four big global currencies: the dollar, the euro, the yen and the yuan. Doubts were even raised (and remain) about the wisdom of holding the British pound and the Swiss franc, which each account for a small share of global foreign-exchange reserves. For some, Britain and Switzerland are Iceland or Ireland writ large, but without Ireland's lifeboat - its membership of a large and liquid currency pool.
Both countries have big banking industries with foreign-currency debts. Leading figures in the European Commission have not been shy to play up the role of the euro as a haven. The commission's president, José Manuel Barroso, said on French radio that "some British politicians have already told me: 'If we had the euro, we would have been better off." Mr Barroso also claimed Britain was "closer than ever before" to joining the euro.
That is an overstatement. There are few signs yet that public or political opinion in Britain has shifted towards signing up to the euro. But the lessons of the crisis have not been lost on many other EU countries that have yet to join.
The three Baltic countries have long been keen to adopt the euro, but have fallen foul of the low-inflation criterion for entry. Hungary abandoned its attempt to join when it became clear it would not meet the public-finance criteria for joining, which include a budget deficit below three per cent of GDP. It is now said to be redoubling its entry efforts and plans to peg the forint to the euro in preparation. With its sound public finances, low inflation and stable exchange rate, Denmark would sail through the euro's entrance exam. Sweden could make the cut too, if it was minded to.
But the rest would be hard pushed to join soon. It is unlikely that the rules for entry will be relaxed. Just as euro outsiders may now see advantages in being part of a global currency, insiders may take a different lesson from the crisis: that a less exclusive euro club, with laxer rules, would dim the currency's allure.
Haven or trap?
In fact, some existing members are struggling with the rigours of a currency union. When a country's wage costs rise too quickly, it can no longer recover lost competitiveness through a lower exchange rate. That is a concern because wages in some euro-area countries look dangerously out of whack. Unit labour costs in the zone rose by 14 per cent between 1999 and 2007, according to a recent article in the ECB's Monthly Bulletin.
But in Greece, Ireland, Italy, Portugal and Spain, they
rose by 10-20 percentage points more. That makes it harder for firms in these countries to compete with rivals in the rest of the euro area.
The lesson that Asian central banks have taken from recent events, says Mr Jen, is that when their currencies come under pressure, they need liquid dollar securities: "It is only in bad times that the mettle of a reserve currency is tested and the dollar met that test better than the euro." The euro may yet make further ground as a reserve currency - at the expense of the smaller European currencies, the pound and the Swiss franc, if not the dollar.
The more important legacy for the euro may be within the currency zone itself. Its status as a haven in the financial storm has quietened voices that habitually blame the euro and the ECB for all economic ills. If that mood is sustained, politicians may look closer to home for solutions to the problems facing their economies. The newly discriminating capital markets may nudge them in the right direction.
Courtesy:The Economist
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