Euro-Division?

By Peter Gumbel

Judging by the way the Euro has tumbled on currency markets in the past few weeks, you might think that voters in France and the Netherlands had rejected the six-year-old European currency rather than the planned new European Union constitution. Propelling the decline was a report--quickly denied--in the German newsmagazine Stern that at a meeting in late May, Finance Minister Hans Eichel and Axel Weber, head of the German central bank, had discussed the prospect of dissolving Europe's monetary union. Weber dismissed the report as "absurd," and most market watchers and economists agreed. "The talk will continue for a week or two, then go away--the euro's here to stay," says William Davies, head of European equities for the London-based fund manager Threadneedle Investments.

In one key respect, however, the new focus on the euro underscores an increasingly troubling economic reality: the tensions caused by growing economic divergence among the 12 countries that use the euro. That is a sharp reversal from the 1990s, when candidates for the single currency moved aggressively to bring their economies in line by slashing budget deficits and keeping a tight lid on spending to lower inflation. At the time, advocates of the single currency argued that it would give a boost to Europe's economy and help make it more competitive. Now Europe has entered a period of "deconvergence," in the jargon of some economists, as spendthrift habits creep back in. A recent European Commission report notes that while Belgium, Finland and Ireland have balanced their budgets, four members--Germany, Greece, France and Italy--have allowed their budget deficits to grow beyond the 3% limit laid down in the rules of the single currency. The overall debt level of the euro countries, which is not supposed to exceed 60% of gross domestic product (GDP), is creeping up again, from 70.8% of GDP in 2003 to 71.3% in 2004 and a projected 71.7% this year.

The euro zone is seeing a growing disparity in performance among its members too. Finland, Greece and Spain are expected to enjoy growth of almost 3% this year, while Ireland is likely to see more than 4%. But Italy is in recession, and most economists have been slashing their forecasts for Germany and France to only a tad in excess of 1% growth this year. Such differences create a dilemma for Jean-Claude Trichet, president of the European central bank, the body that sets monetary policy for the entire euro zone. Economists say the bank's 2% benchmark interest rate is far too low for the strongest economies, providing them with plentiful cheap money and helping fuel both a credit boom and, especially in Spain, a potential housing bubble.

But the same interest rate is almost certainly too high for the European Union's weakest economies. Germany's Economics Minister, Wolfgang Clement, recently urged Trichet to cut rates--so far, to no avail--and Italy's Welfare Minister, Roberto Maroni, even suggested that Italy should call a referendum on whether to readopt the lira. But after a meeting of the European central bank's council earlier this month that left policy unchanged, Trichet said the current rates were "appropriate" and "fully in line with what would be best to ... foster growth and job creation." The talk about Europe's dumping the euro, he added, was as ridiculous as contemplating the likelihood that Alaska, California or Florida might ditch the dollar.

Some regional variations are usual in a monetary union; not every state in the U.S. grows at the same rate, for example. "It's no surprise that [monetary union] is not optimal for all countries. That was always going to be the case," says Ian Stewart, chief European economist at Merrill Lynch in London. Still, he adds, the probability of the euro's collapsing "is greater than zero. This monetary union doesn't yet have the characteristics of all other durable monetary unions: that they developed into a political union." Switching to a political union with a fully federal government would make it all but impossible for a European country to drop the single currency. That possibility has faded away with the recent votes. If the euro isn't to suffer a similar fate, it needs to show that it brings a real benefit to Europe's economy.