The euro may yet head for the dustbin of history as another
grand vision that proved too much for frail human beings. Given the enormous
political costs of reform, it may prove simpler merely to "start
over." The prewar gold standard broke down under the strain of the Great
Depression. The US in 1971 went off the postwar Bretton Woods system out of a
desire for greater flexibility in the face of mounting macroeconomic imbalances.
The European currency crises of 1992 highlighted the difficulties of
maintaining exchange rate pegs in the face of speculative attacks. While the
disintegration of the euro zone would entail enormous costs, a sharp market
correction would ultimately pave the way for renewed growth. After all, this
was the recurrent pattern of emerging market crises back in the day when they
were still the weak point of the global economy.
But the euro's demise is far from certain. No formally
defined mechanisms exist for exit and the process of re-establishing a national
currency is far from easy. The reputational and economic costs of leaving would
be enormous for all concerned. Those departing would see the value of their
foreign debt and servicing costs go up, leading almost inevitably to defaults.
Bond-holders would incur major losses, with the consequences of bank
insolvencies and even broader macroeconomic instability. Countries would almost
certainly resort to competitive devaluations in a bid to alleviate the pain caused
by domestic austerity. Much of the progress made by European integration would
be at least temporarily reversed and Europe's global standing undermined. Much
of this scenario would likely prove unavoidable even in the event of just one
or two countries exiting. This might invite others to follow or the markets to
test their resolve.
Under the circumstances, the European Union has every
incentive to keep the euro zone intact, as indeed they have sought to do, in
spite of confusion and recurrent delays. Nor is it clear that abandoning the
euro would offer a real solution to countries struggling with significant
structural problems such as private sector leverage, insolvent pension systems,
rigid labor markets, etc. They will still have to figure out ways of ensuring
basic welfare provision on a sustainable basis. Higher taxes could be a
short-term answer but hardly good news for growth prospects. Restoring external
competitiveness would not significantly help countries that do not export much.
Devaluation would be the wrong remedy for the struggling
euro zone members. The seeming flexibility would be a sign of weakness, not of
strength. The vulnerable euro-zone members need to address their structural
weaknesses in a way that triggers sustainable growth, not short-term relief
that, by making the problems easier to bear, ends up perpetuating them. The
European Union can help countries make the right choice by providing relief
during the period of fiscal consolidation. In an extreme case, this could
involve strictly controlled renegotiation of payment terms and schedules on at
least some debts.
As battered as the euro now looks, it should be recognized
as a work in progress, as indeed is any currency. The dollar has gone through
many ups and downs, since 1971 — mainly downs, while maintaining its reserve
currency status. The euro's weakness should not distract from its very real
accomplishments. It has fostered regulatory harmonization and corporate
consolidation but above all, deep and liquid financial markets. Properly
controlled, these remain a major competitive advantage for Europe and a
foundation for the reserve currency status of the euro.
Many European countries now need to fundamentally reinvent
their competitiveness in a way that involves little short of a cultural shift.
But many of them did this before by embracing European integration in the first
place. Moreover, post-unification Germany and the Scandinavian countries in the
1990s, while benefiting from some exchange rate flexibility, went through fundamental
and comprehensive reforms in their labor markets, the corporate sphere, and
regulations. If the euro zone can duplicate this experience, it can hope to
regain its competitiveness in the face of the rapidly shifting global balance
of economic power.
(Jarmo T. Kotilaine is chief economist at NCB Capital.)
