TCS Daily


Europe's Economic Fantasy

By Desmond Lachman - March 24, 2006 12:00 AM

One of the more enduring myths in Europe is the idea of a common currency area that would extend from the Atlantic to close to the Ural-mountains and that would make Europe by far the most important economic bloc on the planet. Not content with the idea of having the current 12 member countries participate in the euro, European leaders keep alive the pipedream of having another 15 countries, mainly from the former Soviet bloc, join the hitherto exclusive club. Yet pursuit of this dream runs the very real risk of accelerating the unraveling of the present currency union, which is already straining under the weight of its internal contradictions.

The daunting challenges to the euro experiment are perhaps best exemplified by the response I got from a former Salomon Brothers' emerging-market trader when I asked him where the next emerging market debt crisis would occur. Without missing a beat, he replied that it would take place in Greece, Italy or Portugal. All three of these countries suffer from government deficit levels and public debt ratios that would make any emerging market debt trader feel distinctly at home. These traders would also get the distinct feeling that they had already been to this movie before about a country unsuccessfully struggling with the rigors of a fixed exchange rate system.

The present travails of Italy, the euro area's third largest economy, should provide a sobering lesson as to why the euro area is unlikely to survive in its present form. They should also underline why from a strictly economic viewpoint it is not a good idea to extend the present union to a group of 15 countries whose economic structure is so markedly different from those already in the union. For despite having joined the euro as early as 1999, Italy has not made the structural changes to its economy so sorely needed to meet the optimum currency requirements of a rigid currency union.

Italy's incapacity to reform, especially in its labor market, has already resulted in it having lost around 15 percentage points in international competitiveness to Germany and France over the past five years. This loss of competitiveness is in turn being mirrored in Italy losing export market share to these countries and it is sapping vitality from the Italian economy. As a result, over the past three years, Italy's economy has significantly underperformed that of the rest of Europe, while since the summer of 2005 its economy has been mired in virtual recession.

By having abandoned the lira in favor of the euro in 1999, Italy gave up all macro-economic policy flexibility to stabilize its economy. No longer having its own currency, Italy cannot engage in periodic exchange rate devaluations, as it did in the past, to rectify losses in international competitiveness. And no longer having its own monetary policy, Italy has to accept the interest rates set by the European Central Bank even though these rates might not necessarily conform to Italy's particular circumstances.

As if no longer having an independent monetary and exchange rate policy were not bad enough, under Europe's fiscal Stability Pact, Italy is committed to strengthening its public finances at a time of cyclical weakness. Italy's public finances are in a real mess. With a public debt to GDP ratio in excess of 105 percent, Italy is the most indebted of the major European countries. And with a government budget deficit of around 4 percent of GDP, Italy is in clear violation of Europe's Maastricht criteria despite the relatively low interest rates at which that deficit is still financed.

The only real way out for Italy is for it to restore competitiveness through far-reaching structural reforms, especially in the labor market. However, if the present Italian election campaign is any indicator, such painful reforms are not likely. In the absence of real reform, the most likely scenario for Italy will be a prolonged period of economic stagnation, if not recession, and an ever increasing public debt. This will likely lead the rating agencies to again lower their Italian outlook and it will also create increased political opposition at home for Italy to indefinitely accept the euro's straightjacket on domestic policy flexibility.

A similar story could be told of the poor prospects of deficit-ridden Greece, Portugal and Spain's ability to conform to the exacting requirements of euro-membership. This begs the question as to how much sense it makes to extend the euro to the former transition countries, when the existing members are having so much trouble getting the euro to work. Would not the inclusion of the transition countries merely add to the euro's present strains and accelerate its eventual demise by radically increasing the diversity of its membership? How much more likely is it that a Poland, a Hungary, or a Czech Republic will conform the rigorous requirements of the currency union than will the euro's struggling Mediterranean member countries?

The author is a Resident Fellow at the American Enterprise Institute.

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