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What next for the dysfunctional euro as it turns 20?

Earlier this month European Commission president Jean-Claude Juncker announced without hint of irony, that 20 years on from the launch of the euro in January 1999, it had become a symbol of unity, sovereignty and stability. Even the European Central Bank was at it, in a tweet claiming that support for the euro was strong and that 75% of EU citizens in the euro area were in favour of the single currency.

Putting to one side how hollow these types of statement sound to the millions of unemployed people both old and young in southern Europe, President Juncker went on to claim that that the euro had delivered prosperity and protection to EU citizens. Sadly, statements such as these are all too typical of the myopia and nonsense surrounding EU policymakers, as they continue to show little appetite for the types of reforms needed to make the euro work like a proper currency zone should.

The currency has grown from 11 countries at its launch in 1999, to the current 19, and despite its flaws has grown to be the second most-used currency in the world. This, despite what EU policymakers would have you believe, is not because of its success, but down to a naïve political belief that somehow a single currency zone can force closer economic integration in so far that there will be no erosion of political sovereignty.

This is a lesson that the populations in countries like Greece, Italy and Spain have found out to their cost in the last few years, as did Ireland when the ECB held a proverbial gun to the Irish government’s head in 2010, by threatening to cut off Irish bank funding when it forced Irish taxpayers to bail out their broken banking system, to the tune of €67bn, ushering in years of economic austerity, tax rises and spending cuts.

It is true that the euro did start out in a positive fashion for its first decade, however events in the last 10 years have shown it to be a monumental act of folly and a political failure on a scale yet to be determined, and which has already brought widespread miserable economic consequences for millions of people.

You only have to look at the unemployment rates away from countries like Germany, Austria and the Netherlands to understand that it is a house of cards on the brink of being swept away on a tide of populism.

In Greece, unemployment is just below 20% having peaked at a record 28% in 2012, while in Italy it soared above its 1990s peaks to 13% a few years ago, and is now at 11%. In Spain, unemployment also peaked at a record 28% in 2012, while youth unemployment is even worse with figures in the high 30 percentile for all three economies.

Even in France, which should have reaped the benefits of the euro more than others given its size, unemployment is still well over double the rate of the UK. Youth unemployment is even higher, while the continuing protests on the streets of Paris show that ordinary people feel they have missed out on what should have been the benefits of closer economic integration. 

If this be a success, show me a failure. Quite simply, you can’t have a single currency without a single political authority or Treasury, something which a number of EU politicians have belatedly started to acknowledge, but are completely unable to deliver.

Setting an interest rate for a whole region is hard enough here in the UK given the wealth disparities that exist between north and south, but at least in the UK, London and the south east can subsidise the rest of the UK in the form of fiscal transfers.

No such mechanism exists in the euro area, which makes setting policy that much harder with respect to inflation targeting, especially with economies that are at completely different levels of development. Setting a common monetary policy for an island like Malta would ordinarily be a fairly simple matter, however throw Luxembourg, France and Germany into the mix and it becomes somewhat more difficult.

For a start prices and wages differ between countries in Europe, with multiple inflation baskets making it difficult for central bankers to get an accurate picture of inflationary pressures from region to region.

As an example, in the UK the cost of a litre of milk is the same whether it be in Cardiff, Edinburgh or London. Over in Europe the price of that same litre of milk differs from Paris to Rome to Berlin, which means prices can and do rise at differing levels of inflation, along with wages. In Berlin the price of this litre of milk is almost €0.40c cheaper than in Rome. It becomes even more difficult when countries adopt different fiscal policies, without recourse to their own central bank. This is one of many flaws that could well ultimately lead to the euro’s demise.

Here in the UK we had a brief dalliance with the idea of joining a single currency by aligning ourselves with the Exchange Rate Mechanism (ERM) in 1990, by the then Chancellor of the Exchequer John Major, and which ended in tears in 1992, and should have acted as a warning to all those concerned about the risks of aligning significantly different economies under a fixed set of exchange rates.

The ERM was just such a system of fixed exchange rates under which currencies could move around within a set margin, with currency fluctuations contained to a 2.25% move either side of a fixed rate, though the pound had a slightly wider margin of 6%, along with the Italian lira, Spanish peseta, and Portuguese escudo.  

This attempt to fix currencies around a set level proved too much for the Bank of England and the UK’s fundamentally different economy. Consequently, in an event known as Black Wednesday the pound slid out of the ERM, but not until billions of pounds had been spent defending the pound’s floor against the German Deutschemark at 2.7750, while interest rates were also raised to 10%, then 12% and then to 15%, in an attempt to keep the pound within its band. This also had the unintended effect of knocking an already weak housing market flat on its back, something it wouldn’t start to recover from for another five years, while hundreds of businesses went under.

Soon afterwards the ERM currency bands were widened to 15%, along with adjusted central rates, and this had the effect of fending off further speculative attacks on the Italian lira and French franc, however the events of 1992 should have acted as a salutary warning to those arguing that a move to a single currency would be a success.

It soon became apparent that the events of 1992 and 1993 would do nothing to deter the march towards a single currency, proving that politics and hubris are never that far apart. 

On the 1st January 1999 the euro became a reality and while the UK was kept out by Chancellor Gordon Brown’s so called five tests, there were and still are some within the UK political mainstream who want to join the euro. This was in spite of the warnings from 7 years previously, and these voices continued to drive the political conversation along those lines, citing the early economic successes, of Greece in joining in 2001, followed by Cyprus, Slovenia and Latvia. 

Of course, the early sceptics were denounced as Cassandras, as the southern Europeans saw a significant expansion of economic activity, however this shouldn’t have been totally unexpected given that these countries were now able to borrow at significantly lower interest rates given that they were in a currency union with Germany, and markets, not unreasonably took the view that there would be a lender of last resort, in the form of the ECB, backed up by the more prosperous nations.

With Greece, Italy and Spain now able to borrow at significantly lower rates than previously, this fuelled a significant consumption boom, and it was only a matter of time before this rise in asset prices produced a banking crisis, which began with the Greek debt crisis of 2010.

Since then it has morphed into a battle between creditor countries like Germany and the Netherlands and the southern debtor nations of Greece, Spain, Italy and Portugal over whether fiscal transfers should be allowed to ameliorate the worst effects of fiscal consolidation.

When the euro was formed central banks like the Bank of Italy and Bank of Spain gave up their right to set interest rates to the European Central Bank which is based in Frankfurt and run along fairly conservative lines akin to the German Bundesbank model.

With no independent local central bank, the reform process of southern Europe had to be done without any significant central bank intervention of the kind that was used by the Bank of England post 2007, as a result of the financial crisis.

As a result, countries in Southern Europe are in now what can effectively be described as a debtor’s prison, unable to reflate their economies with lower interest rates and monetary stimulus, while the less indebted members of the Eurozone effectively wield a veto on any attempts to harmonise towards closer integration.

In fact, the European Central Bank actually raised rates, twice in 2011 in response to German concerns about inflation, rather than worry about the effects that such a move might have on the weaker countries in the region.

Quite simply the euro as it is currently designed will never work effectively until the political pygmies in Brussels acknowledge the fact the currency is broken and needs radical reform. If this nettle is not grasped then the populism that is currently spreading across Europe will only get worse, something that could well be reflected in this year’s forthcoming European elections in the summer.

As things stand interest rates are already deep in negative territory and the euro boom of 2017 is looking like a distant memory. If the current slowdown continues into 2019, we’ll soon find out whether the ECB has anything left in its armoury to prevent an even bigger crisis.

They certainly won’t be raising rates any time soon despite some of the signals coming out of Frankfurt that we could see one by the end of the year.

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