The Euro’s Final Countdown?

Euro Notes

The introduction of the euro in 1999, it was claimed, would narrow the economic differences between the member countries of the monetary union. Unemployment rates would converge, as would other important macroeconomic variables, such as unit labor costs, productivity, and fiscal deficits and government debt. Ultimately, the differences in wealth, measured in terms of income per capita, would diminish as well.

After the common currency’s first decade, however, increased divergence, rather than rapid convergence, has become the norm within the euro area, and tensions can be expected to increase further.

The differences between member states were already large a decade ago. The euro became the common currency of very wealthy countries, such as Germany and the Netherlands, and much poorer countries, such as Greece and Portugal. It also became the currency of the Finns, runners-up in innovation and market flexibility, and of Italy, which lacked both, earning the apt moniker “the sick man of Europe.”

Such differences were a highly complicating factor for the newly established European Central Bank (ECB), which had to determine the appropriate interest rate for all members (the so-called “one size fits all” policy). The larger the differences have become during the euro’s first decade, the more the ECB’s policy could be described as “one size fits none.”

We have compared the performance of the best-performing and worst-performing euro-zone countries between 1999 and 2009. To avoid comparing apples and oranges, we have compared the data for the 11 countries that were included in the first wave in 1999, supplemented by Greece, which joined shortly thereafter. (All data are from Eurostat, the European statistics bureau.)

Because the ECB was given the sole task of achieving and maintaining price stability in the euro area, inflation rates seem the most logical starting point for comparison. In 1999, the difference between the euro-zone countries with the lowest and highest inflation rate was two percentage points. By the end of 2009, the difference had almost tripled, to 5.9 percentage points.

As for economic growth, we have made an exception. For that variable, we looked at the average yearly GDP growth in the first five years after the introduction of euro banknotes and coins in 2002. The difference between Ireland and Portugal in the first half of the decade was 4.8 percentage points. By 2009, it had increased to six percentage points. Moreover, the productivity difference increased from 25 index points in 1999 to 66.2 in 2008; the difference in unit labor costs went from 5.4 percentage points to 31.8; and the difference in the unemployment rate rose from 10.1 percentage points to 15.4.

Nor could we find any convergence regarding government deficits and debt. In 1999, Finland boasted the smallest government debt, equal to 45.5% of GDP. The difference with the largest debtor in the euro area, Italy, was 68.2 percentage points. Despite the most severe financial and economic crisis in almost a century, the Finnish national debt actually decreased by 2009, to 39.7%.

Italy, meanwhile, failed to use the significant windfall from the steep decline in long-term interest rates caused by the introduction of the euro and a decade of rapid economic growth to repair its debt position. Italy’s debt barely budged and stayed well above 100% of GDP. As a result, the difference between the debt positions of Finland and Italy, the most prudent and most profligate euro-zone members, shot up to 73.3 percentage points in 2009. (The situation is even worse for government deficits.)

The implications of these increasing differences could be severe. Increasing tensions between the euro countries on economic policy are likely, as are growing rifts within the ECB governing council in the coming years. We might get a sneak preview this year and in 2011, when European leaders must select a new ECB president and vice-president. As always, those seats will be hotly contested, but, with more at stake than ever, the fight for them could be fiercer than it would otherwise.

Tensions at the ECB and between the euro-zone countries do not bode well for the stability of the common currency, both externally, vis-à-vis other currencies, and internally, in terms of inflation. The ECB will be scapegoated for that. If it keeps its interest rate too low for too long, countries like Germany and the Netherlands will protest. If it hikes the interest rate, the southern euro-zone countries will complain. In any case, support for the euro, already fragile, will erode further, weakening the common currency and fueling even greater tensions.

In 1990, the Italian singer Toto Cutugno won the annual Eurovision song contest with his passionate call to Europeans to unite. The refrain of his winning song, “Together: 1992,” was “Unite, unite Europe.” Almost 20 years later, the Swedish band Europe’s hit song, “The Final Countdown,” seems more appropriate for the euro area with every passing day.

Sylvester Eijffinger is Professor of Financial Economics at Tilburg University in the Netherlands.  Edin Mujagic is a monetary economist at ECR Euro Currency Research and Tilburg University.  This essay was previously published in Project Syndicate.  Photo by Flickr user ScriS under Creative Commons license.

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