The significant risks faced by some countries in the euro zone have thrown the debate open on the suitability of a single currency in the absence of a high level of political integration.
Speculation is rife about Greece either abandoning the euro or being booted out of the euro zone. The implications for the EU's overleveraged nations, Portugal, Ireland, Italy, and Greece have yet to be fully determined. In a recent speech, European Central Bank President, Jean-Claude Trichet, floated the idea of a common European Finance Ministry coupled with veto power for European institutions over national budgets.
Euro unlikely to go
Martin Feldstein, Chairman of the US Council of Economic Advisers under President Reagan and currently a Professor at Harvard, firmly believes that the creation of the euro was an economic mistake. Right from the start it was clear that imposing a single monetary policy and a fixed exchange rate on a heterogeneous group of countries would lead to higher unemployment and persistent trade imbalances.
Further, the single currency coupled with independent national budgets inevitably produced the massive fiscal deficits in countries like Greece, while the sharp drop in interest rates in several countries in the wake of the launch of the euro caused excessive private and public borrowing that eventually created the current banking and sovereign debt crises in Spain, Ireland and elsewhere.
Even though the survival of the euro will require large fiscal transfers from Germany and other core nations to those euro-zone countries with large debts and chronic trade deficits, the euro, according to Feldstein, is likely to survive for both political and economic reasons.
The political protagonists of the euro visualise the zone evolving into a federal state with greater political power.
As regards the economic reason, while hard-working German voters may resent the transfer of their tax money to other countries that enjoy earlier retirement and shorter workweeks, the German business community supports paying taxes to preserve the euro as it recognises that German businesses benefit from the fixed exchange rate that prevents other euro-zone countries from competing with Germany by devaluing their currencies.
In fact, several investors had been quietly diversifying their investment funds to euros before the crisis began in Greece. They eventually recognised that the problems of the peripheral countries were not a problem for the euro and should be reflected in country-specific interest rates rather than in the euro's value.
The result was a rising euro and a renewed shift of portfolio balances to euros from dollars.
Pedro Solbes, Executive Chairman of FRIDE (a European think-tank for global action) and former Spanish Minister of Economy, however, hails the euro as a joint success that has enabled a long period of growth and price stability in Europe.
Without the euro, Europe would have witnessed an increase in protectionism, which would in turn have aggravated the impact of the crisis on Europe and elsewhere.
Sorting out imbalances
According to Hans-Werner Sinn, President of Germany's Ifo Institute of Economic Research and the CESifo Group, survival of the euro depends on whether European countries implement political and private debt constraints that effectively limit capital flows.
While huge capital exports brought a slump to Germany, the countries at the euro zone's southern and western peripheries overheated with the bust and boom resulting in current account surpluses and deficits, respectively.
According to Sinn, what Europe needs is a crisis mechanism that helps to prevent a crisis in the first place and mitigates it when it occurs. Such a system has recently been proposed at the European Economic Advisory Group at the Centre for Economic Studies and the Ifo Institute for Economic Research. The plan envisages a three-stage rescue mechanism that distinguishes between a liquidity crisis, impending insolvency, and full insolvency, and offers specific measures at each stage.
The system is expected to allow Germany to gradually appreciate in real terms by living through a boom that generates higher wages and prices and thus reduces the country's competitiveness, while cooling down the overheated economies of the south such that the resulting wage and price moderation would improve their competitiveness. As a result, European trade imbalances would gradually reduce.
According to Barry Eichengreen, Professor at the University of California, Berkeley, Europe's budget deficits are largely a result of the continent's ‘festering banking crisis.' The whole euro area would benefit from stronger discipline on borrowers and lenders. He cautions that this cannot be achieved by imposing Germanic debt ceilings continent-wide. Only if the banks are adequately capitalised, can the ECB refuse to buy more Greek, Irish and Portuguese bonds.
(The author is former staff member of the International Monetary Fund.)