The European Central Bank

Ten years on, beware a porcine plot

The euro has been a success, but its biggest test is still to come

GIVEN the dark muttering at its birth, the European Central Bank could be forgiven a degree of smugness as it celebrated its tenth anniversary this week. Plenty of economists, especially in Britain and America, predicted that neither the ECB nor Europe’s single currency, the euro, would fly. Yet today the ECB‘s reputation stands sky-high—and the euro rose once again this week on expectations of a rate rise in July.

Partly through luck, but more through skill, the ECB coped strikingly well with the credit crunch. Its hawkishness over inflation has recently been vindicated, too. And contrary to conventional wisdom, the performance of the euro area has broadly matched America’s, with similar rates of growth in GDP per person and even more net job creation (albeit with far slower productivity growth). Yet the next decade seems likely to be a lot harder for the ECB and the euro (see article).

Sceptics about the euro insisted that its members did not constitute an “optimal currency area”. Yet they were proved wrong over the efficacy of the ECB, and they seem also to have exaggerated the drawbacks of a one-size-fits-all monetary policy. The United States is probably not an optimal currency area, either; indeed, it suffers from broadly similar internal disparities in both growth and inflation to the euro areas. But America has some big advantages: greater fiscal transfers, a more mobile workforce and more competitive markets, which are essential to economic adjustment in the absence of independent monetary and exchange-rate policies.

Those who hoped for great things from the euro when it was launched argued that it would unleash a wave of competitive, supply-side reforms across Europe. These would both boost the continent’s flagging productivity growth and make it possible for the euro-area economies to cope better with the discipline of living inside a single currency. Some countries—Austria, Finland, the Netherlands, to some extent even Germany—duly implemented reforms to make their economies more flexible and more competitive. But others, including France and, especially, the Mediterranean quartet of Portugal, Italy, Greece and Spain (sometimes described as the PIGS), have not done so.

PIGS in a trough

The performance of these countries has by no means been the same. In recent years France has grown modestly, Greece and Spain have boomed, but Portugal and Italy have been stagnant. Yet in broad terms, all have been misled by a similar fallacy. This was that they could make strenuous efforts to qualify for the euro, slashing public spending and holding down wages and other costs, and then relax as soon as they got in. In effect, the Mediterranean group (and, to a lesser degree, France) treated the adoption of the euro as the end of their reforms, when it should have been only the start.

The results of this are now becoming starkly clear. Although the overall performance of the euro area has been satisfactory, the divergence among its members is growing. Even as Germany, the biggest euro-area economy, has picked up speed, Spain (like Ireland) is suffering a painful property bust. Unit labour costs in all four PIGS have risen, whereas they have fallen in Germany, producing a sharp deterioration in competitiveness and in current-account balances.

The medicine for these ills is simple to prescribe, but painfully hard to administer: structural reforms to deregulate labour and product markets. Such measures should raise productivity growth, but wage restraint will still be needed to restore competitiveness. This is something Germany has borne in the past decade. But there is little sign that any of the PIGS are ready to undergo the necessary pain. Indeed, in a deeper irony, euro membership itself partly protects them from the discipline of the financial markets, which might otherwise be helping to impose reforms.

This should worry those who have been gaily celebrating the ECB‘s tenth birthday, for two reasons. One is that the economic outlook for the euro area, as for the world economy, is darker than it has been for many years. The other is that the euro remains unloved by most citizens (in opinion polls, less than half consider it to be “a good thing for their country”). Many folk still blame it for raising prices, especially during the introduction of new notes and coins in 2002. It would not be hard for populist politicians in, say, Italy or France to exploit this hostility to launch fresh attacks on the ECB and the euro. That is why the next decade of monetary union is likely to be much more testing than the first.

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