Tharindra Gooneratne scrutinises a monetary union that’s on a collision course with reality

Picture a train with 19 different engines; some with massive horsepower, others so weak that they literally exert reverse thrust. It isn’t difficult to imagine the fate of the train; it will continue to chug along for a while but at some point, the locomotive will derail.

The Eurozone is a 19-engine locomotive. It’s powered by economic behemoths such as Germany while simultaneously being dragged backwards by periphery states like Greece. The zone comprises countries such as Luxembourg and the Netherlands – which are global benchmarks for fiscal prudence – as well as others like Italy and Portugal, which are case studies in economic mismanagement.

So will the locomotive derail?

To answer this question, travel back in time to 1992 when the Eurozone was created as part of the Treaty of Maastricht. Its proponents identified multiple benefits like lower funding rates, increased intra-regional trade and most importantly, political stability in the region. In the words of the late German Chancellor Helmut Kohl, “the euro is a synonym for Europe. Europe, for the first time, has no more war.”

‘Euromania’ was so strong that prominent figures such as the ex-Federal Reserve Chair Alan Greenspan predicted that the euro could replace the US Dollar one day.

Fast forward 25 years and Greenspan’s prediction could not have been further away from reality. The very existence of the Eurozone has been threatened by a debt crisis that has left five member states requiring bailouts while unemployment remains paralysingly high in countries like Greece (23%) and Spain (18%).

Economic growth also continues to be benign and trade between member states (as a share of total trade) has been on a steady decline while anti-euro parties have gained prominence across the region.

Why is the grand project unravelling like a ball of yarn?

Both monetary and fiscal integration are essential for a common currency. The Eurozone achieved monetary integration with the establishment of the European Central Bank (ECB) that has the sole authority to set interest rates and issue banknotes in the region.

However, fiscal integration has been a far more elusive goal. Governments correlate fiscal authority with national sovereignty. So it is unsurprising that moves to transfer such authority to a supranational organisation in the vein of the ECB have met with resistance.

It is the lack of fiscal coordination that first led to the Eurozone’s debt crisis with welfare states like Greece, Portugal and Cyprus running large budget deficits, and racking up national debt. At the same time, more conservative member states such as Germany maintained budget surpluses.

Despite the severity of the crisis, true fiscal integration remains a distant dream. Instead, the zone has had to contend with half-baked attempts at integration – e.g. peer reviews of national budgets, and pre-agreed limits on deficits and national debt.

But this in itself leads to the second criticism of the euro because integration benefits some members at the expense of others.

A key argument against the currency bloc is that it has disproportionately benefitted Germany at the expense of other countries. While many Eurozone members stagnate, Germany has achieved strong economic growth, and low unemployment and inflation.

The most significant boon of the euro to Germany has been its impact on trade. The euro is far weaker than a stand-alone Deutsche Mark due to the drag-down effect of periphery states such as Greece. A weak euro has been pivotal to the German growth story, having made exports cheaper and thus enabling the country to achieve record trade surpluses (US$ 300 billion surplus last year) without running the risk of significant currency appreciation. At the other end of the spectrum, the euro remains too strong for periphery states that do not have autonomy over monetary policy. So it cannot reap the benefits of currency devaluation to boost trade or as a solution to a debt crisis.

In the words of a former chief economist of the International Monetary Fund (IMF), “the problem is [that] since peripheral countries do not have their own currencies, they are forced to increase competitiveness by decreasing their wages instead of devaluation.”

Therein lies the paradox of the euro with integration being both the curse and cure. Stronger integration is essential for its sustenance but integration will always create winners and losers. So stronger integration today could lead to disintegration tomorrow as disgruntled losers exit the union.

And will the alliance crumble?

Eighty percent of the Eurozone’s GDP is controlled by five countries, two (Italy and Spain) of which remain in financial turmoil. There are several smaller members with serious structural problems as well.

It is difficult to imagine a sustainable future for the Eurozone without extensive changes to the status quo. At the same time, too much is at stake for members like Germany and France to simply accept defeat. Will they be strong enough to weather the storm? Will the alliance crumble? Or will we see a trimmed-down Eurozone with fewer members?

Perhaps the locomotive merely needs a few strong engines…