essays The euro at ten: Is its future secure? By Simon Tilford ★ The euro is riding high on the foreign exchange markets, and the financial crisis has graphically illustrated that euro membership provides a safe haven. On the face of it, this would seem to be a strange time to question the stability of the currency union. But this essay argues that the euro is about to face its first serious test, and that the stability of the eurozone cannot be taken for granted. ★ The trade imbalances within the eurozone continue to widen. Meanwhile, the pace of the reforms that are needed to increase flexibility and prevent these economic imbalances becoming entrenched has slowed. The problems of the most vulnerable countries – Italy, Spain, Portugal and Greece – stem partly from their own policy failures, but also from the economic strategies being pursued by other eurozone members. Economic growth in Germany – easily the biggest economy in the currency bloc – has become even more reliant on exports to the rest of the currency union. ★ The current economic crisis threatens to exacerbate the tensions within the eurozone. There is a serious risk that the growth prospects of struggling eurozone economies will be handicapped for many years by their inflexibility and the external surpluses of other eurozone member-states. If so, investors will lose confidence in the credit-worthiness of governments and firms in these countries, leading to a dramatic increase in their borrowing costs. ★ A number of scenarios are possible. The most straightforward – accelerated political integration within the eurozone and a move to some form of fiscal federalism – is the least likely. Another would be a bail-out of the affected member-states by the rest of the eurozone. This is unlikely, but not totally inconceivable, especially if a bail-out were accompanied by IMF-style conditionality. An insolvent member-state could also default on its debt, but remain in the eurozone, or go for the ‘nuclear option’, which would be to default and leave the eurozone. ★ However, the most likely outcome is that the hardest-hit countries will be forced into wrenching fiscal adjustment and that Germany and others with large external surpluses will take modest steps to rebalance their economies. Eurozone economic growth will be weak, and some member-states will experience prolonged stagnation. Governments will struggle to manage the political strains caused by fiscal austerity at a time of anaemic economic growth, and political tensions between the member-states will rise. Introduction Ten years have passed since 11 of the EU’s member-states swapped their national currencies for the euro. The single currency has confounded its critics, many of whom said it would fall apart, citing the lack of lasting economic convergence between the participating economies and the 1 On a trade-weighted basis. absence of a political union. As of late December 2008, the currency was trading at an all-time high on foreign exchange markets.1 The eurozone has now embraced 16 memberstates, with Slovakia the most recent to join, on January 1st 2009. Several others want to join. The European Central Bank (ECB) has won plaudits for its sure-footed handling of the financial crisis. The euro has even started to challenge the dollar’s status as the world’s principal international reserve currency. The adoption
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