[25/08/2005] Has the Euro GOT a future?

THE TIMES, London, Thursday 25 August 2005

A hard truth: the future of the single currency is now far beyond our Ken

Anatole Kaletsky (Economics Correspondent)

THERE WAS a time when Kenneth Clarke's admission that "the euro has been a
failure" might have dominated the headlines for weeks. It might even have
changed the course of Britain's history. Had Mr Clarke been prescient enough
15 years ago to recognise the fatal flaws in the single currency project,
the Tories might have been spared the humiliation of Black Wednesday and the
suicidal infighting over the Maastricht treaty; they might still be
governing the country.

If the ex-Chancellor had humbly admitted five years ago that he had been
wrong about the euro, he would surely now be the Leader of the Opposition
and the Conservatives might be vying for power with Labour in a hung
parliament. By this week, however, Mr Clarke's public confession about the
failure of the euro was as irrelevant to the future as Macbeth's final
soliloquy comparing himself to "a walking shadow, a poor player who that
struts and frets his hour upon the stage and then is heard no more".

But while Mr Clarke's regrets about the euro may no longer be of any
interest in Britain, they remind us of something extremely significant about
the wider world beyond. The euro has been enjoying a political honeymoon in
the four years since it was introduced. While the Europe's economic
performance has gone from bad to worse almost since the day when the euro
was launched in January 1999, no respectable politician has ever dared to
blame the euro or criticise the single currency project in any way. This
taboo has now been lifted.

In Italy, Silvio Berlusconi has consciously encouraged an anti-euro movement
designed to blame Italy's problems on Romano Prodi, the man who took Italy
into the single currency, who happens to be his main political opponent in
the forthcoming general elections. In the Netherlands, France and Germany,
the euro has started to be blamed for inflation, economic instability and
unemployment - and while some of these charges may not be intellectually
sustainable, nobody can dispute that the European Central Bank has performed
poorly, certainly in comparison with the US Federal Reserve Board, the Bank
of England, the Bank of Japan or the emasculated German Bundesbank.

Why does all this matter? Because the euro, like any other paper currency,
is just an illusion; its power to command people's lives and motivate effort
depends entirely on a suspension of disbelief. People must not only think
that these elaborately printed but worthless bits of paper will be
exchangeable for valuable goods and services. They must also believe that
their intrinsically worthless paper money will continue to be honoured for
the indefinite future by the whole world. That belief, in turn, rests
ultimately on the faith that the value of paper money will be upheld by a
government with the right and the ability to levy taxes on a wealthy nation.

But if the EU is not going to evolve towards a full-scale political union
who exactly is going to guarantee the value of the euro? And if the
membership of the eurozone is never even going to be equivalent to
membership of the EU, with Britain, Sweden, Denmark and other EU countries
remaining outside, then why should a government, whether it is Italy or
Germany, that finds it inconvenient to use the euro not simply opt out and
re-create its own national currency?

The sudden emergence of questions such as this does not necessarily mean
that the eurozone will fall apart or even that the euro will completely
cease to exist, but it does mean that such possibilities may soon be
seriously considered. And if investors ever start to worry about the
long-term viability of the single currency project, scenarios for the total
collapse of the euro will suddenly come into view.

The most plausible such scenario is Italy withdrawing from the euro, under
pressure from mounting unemployment, a weak economy and imploding public
finances, exactly the same combination of pressures that forced Italy out of
the ERM in 1992. If the possibility of Italian withdrawal were ever taken
seriously by the markets, foreign holders of Italy's E:1,500 billion public
debt would face enormous losses, since the Italian Government would simply
convert its bonds into "new lire" and would legally get away with this
conversion.

In fact, such are the financial risks of Italian withdrawal to the European
financial system, that the Italian Government may now be in a position to
blackmail the European Central Bank into reducing interest rates and
devaluing the euro simply by threatening to withdraw. Such an easing by the
ECB would actually be a rational response to the present economic problems
throughout the eurozone. But this is where a multinational monetary
institution would face a fatal problem.

If the ECB were seen as capitulating to Italian blackmail, the euro's
survival would face a new and even more serious threat: a collapse of public
confidence in Germany and the Netherlands, where populist politicians would
start blaming their countries' economic problems on the weakness of the ECB.
Right-wing German and Dutch politicians might well start demanding a
stronger currency - and threaten to leave the euro if the ECB continued to
accommodate Italy's "inflationary" demands.

It is possible to imagine a situation where the Germans and Dutch were
demanding a tighter policy to punish Italy while Italians were demanded an
easier policy to keep their economy afloat - with both sides threatening to
leave the euro if their demands were not met. The game would then really be
up for the euro and the ECB.

A break-up of the euro seems highly improbable in the next year or two. But
anybody who still believes that such a break-up is impossible should bear in
mind the lessons from the break-up of the ERM, the sterling, franc and lira
devaluations of the 1960s, the collapse of the dollar-based Bretton Woods
system in the early 1970s and the prewar abandonment of the gold standard.
In confrontations between politics and financial markets, events can move
straight from "impossible" to "inevitable" without ever passing through
improbable.

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