Loved and loathed in equal measure, the euro reaches its 10th anniversary under greater scrutiny than at any point in its history, as the credit crisis tests member countries’ ability to address their individual problems within EMU.

Since the moment it was introduced with military precision by the governments, banks, stock exchanges and corporations that were adopting it, the euro has battled both the overweening ambitions of its founders and the profound scepticism of some of its neighbours.

Never before had sovereign countries transferred their monetary policy to a supranational central bank, and as a currency, the euro unites more than 318 million people. Despite numerous external shocks, its central institution, the European Central Bank (ECB), has maintained price stability and kept inflation low.

But the eurozone is often accused of being more successful as a monetary union than as an economic one, and of creating an easy scapegoat for politicians in every member country. Within just 20 months of launch, the euro had plummeted by more than 25% against the dollar, shocking Germans used to a strong Deutschmark; as soon as it began to rise, populist Italian politicians used it as an excuse for persistent un-competitiveness.

Some fear that financial meltdown and deepening recession could push the eurozone close to breaking point. As the banking crisis peaked, European co-operation was shown to be skin-deep. National interest quickly overrode the notion of common goals as, first, Ireland broke ranks to guarantee Irish savers’ money, swiftly followed by Greece, Sweden, Austria and Denmark. Just one day after standing shoulder-to-shoulder with French president Nicolas Sarkozy and declaring that Europe’s nations needed to act together to defend the banking system, German chancellor Angela Merkel’s decision to guarantee Germany’s private deposit accounts, and then to backtrack on that promise, sowed confusion in the markets.

And yet the euro has also proven itself a powerful defence against currency attack during the financial crisis. As fears have grown about just how deep the global recession may bite, it is the currencies outside of the eurozone – the Danish krone, the Hungarian forint and the British pound – that have been punished. The debate about the euro’s benefits has been reignited.

So what does the next 10 years hold for the eurozone? Has the euro come of age?

The euro market

The euro has achieved many successes. As a sound currency in the largest exporting area in the world, it is issued by an independent, supranational central bank and associated with large and deep domestic financial markets. International take-up is promising. Figures from Goldman Sachs show that it is now used as the invoicing currency in about 60% of eurozone exports and 50% of its imports. It accounts for a rising share of official reserves – 26.5% in 2007 – and more than 40 currencies are managed against it in some form or other.

In financial market terms, the euro is well and truly established as a liquid, single market in the eyes of the world’s investors. In just 10 years, issuance across sectors has grown to the point where it can rival the US – the most liquid bond market in the world (see Table 1).

That fact is about more than grandstanding. The growing attraction of the euro markets is a clear signal that European monetary union (EMU) is perceived as a success: international investors buying 30-year eurozone bonds will be attracted by the low-inflation regime brought about by EMU only to the extent that they see EMU and the ECB in place in 30 years’ time.

Right now, says Philippe Mills, CEO of French debt management agency Agence France Trésor, the level of credibility and liquidity achieved by eurozone assets is critical. “It is impossible to overstate the importance of being part of a liquid benchmark market in the current environment,” he says. “In a period of high uncertainty and high volatility such as we are experiencing, the euro has been a source of stability and is a big advantage for all the EMU members. There is a huge premium on liquidity right now. The eurozone is considered a safe haven, not only for European investors but also for international investors.”

Economic and monetary union

If the growth, depth and competitiveness of euro-denominated debt markets can be hailed as a triumph, the euro is often accused of failing to inject dynamism into the eurozone’s economic performance. This is a damning criticism, say detractors; it is after all an economic, as well as a monetary, union.

Eurozone gross domestic product (GDP) growth and labour productivity are invariably compared unfavourably with the US and, more damagingly, with that of Denmark, Sweden and the UK, the three established European Union (EU) members to remain out of EMU. But Goldman Sachs economist Kevin Daly says the notion that the US is the engine for global growth while Europe’s economic performance is sclerotic is a misperception. He says that eurozone per capita growth has kept pace with that of other major high-income economies, including the US, over the past 10 years. In a report, ‘The euro at 10’, Mr Daly states that trend GDP growth in the eurozone has averaged 2.2% per year since the start of EMU, lower than the US (2.6%) but higher than Japan (1.3%).

Moreover, he argues that the eurozone’s slower GDP growth is entirely attributable to lower population growth. On a per-capita basis, he maintains that trend eurozone GDP has averaged 1.8% per year versus 1.6% in the US. “Europe’s slow-but-steady ‘tortoise’ has caught up with the US ‘hare’,” says Mr Daly. “If exchange rate movements are also taken into account, on current exchange rates the eurozone is likely to mark its tenth anniversary by overtaking the US as the word’s largest economy.”

Dr Otmar Issing, one of the key architects of the ECB, and an executive board member and chief economist of the ECB during its first eight years, agrees that the eurozone’s performance far outweighs the perception. For example, its labour market performance has been far superior to that of the US. The eurozone employment rate has risen +0.9% per year over the past 10 years, while the US employment rate has fallen 0.2% per year. “It is astonishing that nobody has noticed that more jobs were created over the past 10 years in the eurozone than in the US,” says Dr Issing. “True, unemployment is still too high. The reason results are not totally satisfactory can largely be explained by the rigidities that still exist in markets. Greater flexibility, especially in labour markets, is needed to fully exploit the benefits of the stability-oriented single monetary policy.”

Problems are looming

Surprising economic performance notwithstanding, the biggest financial crisis and the mother of all global recessions looks set to be the crucible in which the euro will thrive or wither.

EMU critics say their biggest bugbear has largely been borne out: the one-size-must-fit-all approach meant policies that suited the low inflation priorities of the eurozone’s biggest economy helped to fuel unsustainable booms in others. Now that the booms have turned to bust, the constraints of EMU membership leave those most vulnerable to the downturn without the freedom to devalue their currencies, reduce interest rates or even print their way out of recession.

Several eurozone members have to wrestle with this thorniest of issues. Spain and Ireland are two among them. Over the past year, Spain has gone from creating more than a third of new jobs in the EU to destroying more than France, the UK and Italy put together. Like Spain, Ireland is reeling from a property bust. At its height, the construction sector accounted for more than a tenth of Ireland’s national income, and it, along with related activities such as DIY and property services, has come to a crashing halt.

According to the Organisation for Economic Co-operation and Development’s latest Economic Outlook, Ireland’s general government fiscal position will move from a surplus of 3% of GDP to a deficit of 7.1% between 2006 and 2009.

Likewise, Spain’s fiscal deficit is forecast to move from a surplus of 2% to a deficit of 2.9% over the same period. Yet Spain is still running a large current account deficit of about 10%. Should that shrink faster than expected, it is likely that the economic slowdown and the hike in the fiscal deficit will be even larger.

They are not the only vulnerable economies. Greece and Portugal, for example, are running big current account deficits while Italy, Belgium and Greece have high public sector indebtedness.

Relax or rewrite the rules

According to economist George Irvin, some of these most vulnerable member states have little or no room to take the action needed to avoid deflation. “The lesson from the 1930s and from Japan was that when no one else will spend, the government must do so or face a decade or more of stagnation. But with fiscal spending constrained at the member state level by the Stability and Growth Pact, member states have very few options,” he says.

“At the very least, rules will have to be relaxed for five to seven years,” adds Mr Irvin, one-time UHD professor of economics at the Institute of Social Studies in The Hague, and now professorial research fellow at the School of Oriental and African Studies, University of London.

In fact, he fears that the gravity of the situation may call for more drastic action. “What happens when monetary policy proves ineffective? The eurozone’s economic architecture may need to be drastically redrawn or else the very existence of the eurozone will be in doubt.”

Mr Irvin thinks the crisis could well reignite the debate about the need for a eurozone treasury. “The EU’s great structural weakness is that it has no fiscal centre. It has a budget, but this is meaningless because it has to balance every year, so it cannot be used counter-cyclically. If the eurozone is to survive, it needs closer political co-operation. That means closer economic co-operation – and that means thinking about the creation of a federal treasury,” he says.

He is not alone in thinking that the scale of this crisis may lead to the adoption of dramatic measures. In September 2008, the Securities Industry and Financial Markets Association published a discussion paper which did a cost-benefit analysis of a common European government bond. The paper highlights the scope for bigger volumes and the lower cost of borrowing, particularly for small to medium-sized issuers.

No doubt the paper was inspired by the evidence that when it comes to government bonds, not all eurozone countries are equal. In recent months, spreads of several eurozone sovereign bonds over benchmark German bunds have widened dramatically. According to data from UBS, the cost of buying credit protection on some member states has also ballooned this year: on Austria by 1512%, on Ireland 1393%, and on Spain by 548%. The cost of credit protection on Turkey, Colombia and Kazakhstan, by contrast, has risen by 254%, 256% and 275%, respectively.

But in jittery and volatile markets, nobody is immune. In 2008, Germany suffered an unprecedented six failed government bond auctions (where the bid is lower than the offer rate). Others came close to that ignominious result.

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In November, UK and Italian government bond auctions almost failed, and to prevent its bond issue from following suit, the Republic of Ireland was forced to pay 118 basis points over the German five-year bond in November. “Governments are paying a massive premium to get their debt away,” says Meyrick Chapman, head of Europe strategy at UBS.

Risk of failure

However unlikely these scenarios seem now, it is certain that we will see governments grappling with a great many unpalatable choices in the coming months and years. In the eurozone, the dreaded words ‘fiscal crisis’ have been uttered. If member states were unable to refinance their debt, and outside help is not forthcoming, they would be forced to default.

Given current rates of interest, this is not immediately likely; but stalled or failed government bond auctions are not a sign of good health. Moreover, markets are mercurial, and they change with breakneck speed, so a problem with riskier sovereign bonds is not impossible. Who would have predicted Iceland’s fall a few years ago?

There can be little appetite in Europe for a sovereign rescue; particularly for states which failed to carry out the structural reforms it was hoped the euro would usher in. “I’m sure that euroland would not want to bail out a country like Italy, which is suffering from many problems that are of its own making,” says Jeffrey Frankel, professor of capital formation and growth at the Kennedy School of Government, Harvard University.

So would a member of the eurozone be allowed to default? If there was a bailout, who would do it and at what cost? Mr Issing is unequivocal. “The treaty has a clear rule: no bailouts. This rule must be observed,” he says.

Many agree with him, if for other reasons. Moritz Kraemer, managing director, Europe, Middle East and Africa (EMEA) sovereign ratings at Standar & Poor’s, believes a lateral bailout of EMU sovereigns is not likely, for constitutional, political and economical reasons.

In practical terms, he argues, it would be relatively easy to bail out a small sovereign such as, say, Malta or Slovenia. But it is not those whose spreads have broken out dramatically over recent months, but relatively big issuers such as Spain, Ireland, Italy, Belgium and Greece.

“Supporting one of them – for example, by guarantee of a more solid EMU sovereign – would be economically hard to imagine due to the large volumes, which would come on top of the flood of sovereign AAA and AAA-guaranteed paper,” says Mr Kraemer.

Notwithstanding the difficulty of persuading the electorate of such a move and the difficulty of achieving co-ordinated action, there would be a domino effect, he says. “Imagine the difficulties when EMU sovereigns would need to bail out one of their peers, jeopardising their own creditworthiness. If one sovereign were to be supported this way, investors would most likely shun the securities of the next weakest sovereign, which would then need support as well, and so on. This would simply overwhelm the capacity to support of the stronger sovereigns that will have huge financing needs for themselves anyway.”

There are those, however, who fear that we may find out just how far core eurozone countries would go to protect their great currency experiment.

Make not break?

There is an alternative scenario. It is conceivable that the crisis will make, not break, the euro. Its strong performance during the recent turmoil has already prompted several countries to think again about monetary union. Since Denmark’s currency crisis, its prime minister has called for another euro referendum, and Sweden has become less belligerent in its opposition.

Hungary, which stands as evidence that the EU is prepared to go some way to support member states when it participated with the International Monetary Fund (IMF) in a $25bn rescue plan in October, is keen to speed up entry.

Moreover, Ireland’s politicians believe the country would be suffering much more severely outside of the euro. Prime minister Brian Cowen recently argued that were it not for access to the resources of the ECB, Ireland would likely have experienced the same kind of meltdown as Iceland.

Harvard’s Mr Frankel – who argues that if central bank reserve trends continue on their current trajectory, the euro will overtake the dollar as the world’s reserve currency within 10 to 15 years – believes in some ways, the crisis will encourage further European integration. “Experience from the current crisis will clearly strengthen the case for smaller countries entering the euro. In fact, the crisis may compel smaller neighbours to join.”

UBS’s Mr Chapman agrees that adversity will drive Europe together, not apart. “In extremis, eurozone leaders will pull together. In fact, you could end up having a more integrated eurozone because it is just too important to fail.”

Of course, it is not just the crisis that will help to determine the euro’s fortunes. Historically, economic and sometimes political integration has often been a response to persistent threat; for example, the emergence of great external powers. The rise and rise (current problems notwithstanding) of Brazil, Russia, India and China may encourage further, and maybe faster, European integration.

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