National self-interests could see euro fail

Economics: Measures to boost trade between member states are required if the single currency is to be a success.

Last week's rejection of the proposed European Union constitution in France and the Netherlands has prompted some speculation about the future of the euro.

One UK financial analyst has gone so far as to suggest that the debacle signals the inevitable collapse of the single currency by 2020, with a 50 per cent probability of its demise by 2008. Such certainty! Such precision!

How can one calibrate the probability of an event like the collapse of the single currency? I think it stretches credulity to suggest that one can.

Still, it would also stretch credulity to suggest that the fate of the euro and the fate of the EU constitution are not somehow connected. Given the important political dimension of economic and monetary union (EMU), it stands to reason that they must be.

Part of that political dimension, part of the political purpose of the euro, is to act as a lever for forcing the pace of political integration in Europe. Looked at in this way - and to the extent that the French and Dutch referendum results mark a serious setback for political integration - the result of those referendums represent a failure of the single currency project. And, to the extent that failure is a step closer to demise, one may think of the constitutional debacle as an event that does raise the probability of the single currency's eventual collapse, even if it's to a level not much above remote.

Of course, this sort of argument would not travel very far if the single currency were delivering on its economic objectives. So, now seems like an appropriate juncture to have a look at the economic dimension of the euro's performance.

In economic terms, the ultimate purpose of introducing the single currency was to boost output and employment in the EU. Here, the early evidence is disappointing. Gross domestic product (GDP) growth in the euro zone has averaged less than 2 per cent per annum since the euro was introduced.

This is a clear deceleration from the growth rates achieved over the two previous decades. It also represents an accentuation of the euro zone's underperformance vis-à-vis the US, where GDP has risen by more than 3 per cent per annum over the same period.

This sort of evidence is nowhere near being conclusive, of course. For one thing, it is difficult to say how the euro zone economy would have performed in the absence of the single currency. Also, it is too early to pronounce definitively on the question of the euro's effect on the growth rate. The channels through which this influence was expected to play out are slow-acting and the benefits are unlikely to be strikingly visible after just six years.

What are those channels? Well, essentially there are three.

First, it was expected that EMU would enhance the credibility of monetary policy, essentially by extending a Bundesbank-type anti-inflation regime to the euro zone. This would allow low inflation to be maintained without having to engineer costly recessions from time to time.

Second, it was expected that the euro would be an instrument for more fully achieving the gains associated with the single market. The mechanisms that were seen as working to this end include the greater price transparency and the elimination of exchange rate variability that arise from the adoption of a single currency, mechanisms that would stimulate trade between euro zone members and enable the exploitation of economies of scale.

Third, it was expected that the existence of the euro would act as a catalyst for structural reforms, especially to European labour markets. Essentially, the thinking was that individual member states, deprived of the possibility to maintain competitiveness by devaluing their currencies (some would say deprived of the illusion that competitiveness could be sustained by currency devaluation), would look to activate other, more enduring means of sustaining competitiveness, such as more flexible and less costly labour market practices.

How have things been developing in each of these three respects? As far as the credibility of monetary policy is concerned, there has been some measure of success. Euro zone inflation has been kept close to the European Central Bank (ECB) target of 2 per cent, and available indicators suggest that people expect this to remain the case over the long term. However, one can't help remarking that the euro zone's satisfactory inflation record to date has occurred against a background of sub-par growth. The ECB has yet to prove that it can deliver in circumstances of sustained economic expansion.

What about the stimulation of trade? Here, the story is less reassuring. Yes, it seems that trade between euro zone members has expanded impressively in recent years (at least in manufactured products). However, protectionist instincts are getting stronger and are limiting further expansion. This has been especially evident in the fate of the European Commission's proposed Services Directive, the core purpose of which was to open up national markets in non-financial services to competition from other member states. The directive has been effectively derailed by a protectionist alliance of business lobbies and trade unions.

And what of structural reform? Certainly, there have been brave efforts on this front, not least in Germany, where Chancellor Gerhard Schröder has made a programme of extensive labour market reforms a central part of his policy agenda. But such efforts are deeply unpopular with influential elements of the electorate. Again, Schröder's experience is a case in point. After a string of setbacks in regional polls, he has called an early general election, the result of which is likely to see him lose office.

If the euro is to be successful in boosting Europe's economic performance, it needs to be accompanied by measures to boost trade between the member states and to make member-state economies more flexible. For such measures to be adopted requires the abandonment of national and sectional self-interest as guiding principles in policy design.

Indeed, if these principles continue to determine which policies are adopted and which are not, the euro project will fail to deliver on its economic objectives. And, if the euro fails to deliver on its economic objectives, the question will be asked with increasing frequency: why does it exist at all?

Jim O'Leary is currently lecturing in economics at NUI-Maynooth. He can be contacted at jim.oleary@nuim.ie