The shadow on the euro and its vulnerability

Gwynne Dyer, London

How fast the tide turns. Back in February, a report that the South Korean central bank was planning to keep a bigger share of its foreign currency holdings in euros and a smaller portion in U.S. dollars set off speculation that the euro would soon overtake the dollar as the world's preferred reserve currency. Five months later, the speculation is about how long the euro will survive.

Last Thursday, Italian prime minister Silvio Berlusconi publicly blamed the euro for all of the Italian economy's ills: Recession, high prices, joblessness, the lot. "Italy is not a disaster" he said, "but Prodi's euro has ripped us all off." (Romano Prodi, who defeated Berlusconi in 1996 and brought Italy into the euro, will be the opposition's candidate for prime minister again in next year's elections.)

Italy's current economic miseries date approximately from the time when the euro replaced the lira. Since that was also about the time when Berlusconi took over the management of the economy, it makes good political sense for him to blame all those problems on "Prodi's euro." last month, another senior minister in his coalition government, Roberto Maroni of the Northern League, even called for a referendum on pulling Italy out of the euro and bringing back the lira. But it's not just Italians who dislike the euro.

The French and Dutch "no" votes on the new European constitution in May and June have cast a shadow over the whole European project. Although the referendums were not about the euro, French and especially Dutch voters listed the new currency as one of their major grievances against Brussels. A recent poll showed that 56 percent of German voters want the mark back. Could the euro really just fall apart? International currency arrangements have a habit of falling apart whenever the going gets rough. The last time it happened was 1972, when the Bretton Woods system of fixed exchange rates, in which each major Western currency had a predictable value in every other currency, collapsed under the inflationary pressures caused by the Vietnam war and the first oil-price shock. That collapse, after much turmoil, led to the floating exchange rate regime that has lasted until today.

The euro, which replaces the old francs, marks, guilders, pesetas, escudos, drachmas, and liras of the European Union, is not yet five years old. It depends, as all currencies do, on people believing that it will hold its value over the long run. That credibility is now in danger.

What makes the euro so vulnerable is the fact that there is no government behind it. There are twelve governments behind it, to be sure, but they have not submitted themselves irrevocably to a single decision-making authority. If a major political or financial crisis hits, there is always the chance that one or more of those governments will decide the joint currency is no longer in its interest.

The euro is a one-size-fits-all straitjacket that does not serve all the countries that have adopted it equally well even in non-crisis times. For example, it imposes the same interest rate on Germany (which needs a lower rate to help it escape from a long economic downturn) and on Spain (which should be raising the interest rate to cool the inflation caused by its booming economic growth). Only a large range of benefits from this single currency would compensate for its obvious costs, and most eurozone citizens don't see those benefits.

No single government sets policy for all twelve countries that use the euro. The European Central Bank has day-to-day responsibility for running the currency, but the separate national governments of the EU retain their sovereignty and in a crisis could override the ECB. That means the euro could fall apart in theory. Is it likely to do so in practice?

Not this time around. Italian politicians may play with the idea of bringing the lira back to distract an angry electorate, but it would be "economic suicide," as ECB chief economist Otmar Issing put it, for Italy alone to abandon the euro. The real danger for the euro will come much later, perhaps in the next recession but one, around 2015-2018.

By then 22 countries with wildly diverse economies will be using the euro, for all the recent entrants to the EU also plan to adopt the currency. More importantly, by then other big EU countries besides Italy may also have concluded that the euro does not serve their purposes.

European governments rushed into the euro in the 1990s, knowing full well that the political foundations for a single currency did not yet exist, as an emergency response to the collapse of the Soviet empire and the reunification of Germany. They intended closer political integration to follow, but that project has now stalled. If it is not re-started, then sooner or later (but probably later) the euro is doomed.

The writer is a London-based independent journalist.