Facing the most severe economic strains since its birth 11 years ago, the euro zone looks likely to hold together for now but the exit of some of its weaker members cannot be ruled out in the long term.
Tumbling stock and bond prices in Greece, Spain and Portugal this week underlined investors' fears that heavily indebted countries in the south of the zone may be unable to cope with the fiscal and monetary demands of membership.
Many analysts expect the European Union — or the International Monetary Fund, which said it would help Greece if asked — to intervene with some kind of aid for weak members if that proves necessary to keep the zone intact.
But economies are diverging so sharply that even if weak members are bailed out, their problems could hurt growth in the zone for years, and conceivably prompt them to abandon the euro later this decade if the costs of membership seem too high.
"For a while it looked like things were fine, but now we are seeing divergence," said IMF chief economist Olivier Blanchard.
"We're seeing Spain, Portugal, at one hand, and Germany at the other end, and there's no easy adjustment."
The weaknesses of the euro zone's southern members were masked in its early years by a benign global environment, cheap credit and housing booms. In the financial crisis of 2007-2009, membership protected countries from the worst market turmoil.
In the last few months, however, the costs and benefits of membership have shifted. Public debt mountains and unemployment have risen so high that countries need a burst of growth to reduce them — but as euro zone members, countries can neither cut interest rates nor depreciate their currencies.
The monetary straightjacket is only likely to become tighter as economic recovery among stronger members, such as Germany, increases pressure for the European Central Bank to withdraw its ultra-loose policy this year or next.
The second decade of monetary union will be the opposite of the first one, with interest rate policy centered this time on the big economies at the heart of the zone, warned Daniel Gros, head of the Center for European Policy Studies.
"The ECB will make policy for the core. The periphery will be left out in the cold," said Gros, who thinks that although monetary union will survive, the exit of a small country is no longer unimaginable.
Speculation about an early exit by any country is probably misplaced. Countries remain some way from the threshold at which membership of the euro would be intolerable; though Spain's jobless rate is nearing 20 percent, it lived with a rate of 20 percent or more in the mid-1980s and mid-1990s.
The process of leaving the euro would be so painful and difficult, practically as well as politically, that governments could be expected to exhaust almost any other option first.
Among the many challenges, countries would have to find ways to hive off domestic bank deposits from the euro monetary system to prevent capital flight, switch almost overnight to paying wages in a new currency, and pay euro-denominated home loans that could suddenly become much more expensive.
Also, the 16-nation euro zone is an historic political achievement which its richest members, including Germany and France, are likely to try to defend.
Although officials in EU governments continue publicly to rule out emergency aid to Greece, they concede privately that the hard line is intended to pressure Athens into making tough fiscal reforms; informally, some have started to consider the idea of aid if that proves absolutely necessary.
"I do not expect the euro zone to collapse under the pressure — it's way too valuable," said economist Michael Spence, a Nobel laureate in 2001.
He predicted "ad hoc interventions" and "creative solutions on the spot" by officials to see the zone through the crisis. Theoretically, interventions could range from early disbursement of EU "structural" aid for countries to the issue of a common euro zone bond.
But while such aid could stave off debt crises in the near term, it would not remove the big, long-term divergences in economic performance that make life difficult for the weaker members of the euro zone.
Measures of relative competitiveness have diverged in recent years as unit labor costs have soared in countries such as Spain, Ireland and Greece, while Germany has made itself more competitive by keeping a lid on wage rises.
While the euro zone's current account has been near balance for much of the past decade, that disguises a glaring gap between export-driven Germany's large surplus and deficits across the high-consumption peripheral economies.
Monthly Purchasing Manager Index surveys of factory activity show a return to manufacturing sector expansions in France and Germany, but continued contraction in the periphery.
These divergences were behind a European Commission report last month that found the real effective exchange rate for Greece, Spain and Portugal was overvalued by more than 10 percent — an indication of how much wages there would have to fall, or productivity rise, to make them competitive again.
"The persistence of large cross-country differences jeopardizes confidence in the euro and threatens the cohesiveness of the euro area," the EC said.
Addressing parliament last month, German Economy Minister Rainer Bruederle was even more outspoken, saying weakness in some countries "may have fatal effects on all states in the euro zone."
Gross Domestic Product growth in the euro zone would have averaged 1.6 percent annually in 2000-2007 rather than 1.9 percent without above-average contributions from Spain, Ireland and Greece, estimates Deutsche Bank economist Gilles Moec.
That gives an idea of the drag on euro zone growth that is now in store while those economies struggle, he said.
"Some countries will average low growth but the adjustment doesn't mean monetary union cannot function," Moec said.
But he noted that those three small countries combined bought almost as many German exports in 2007 as the United States, and twice as many French exports. So their slumps could have a significant impact on the big euro zone members.
Spence said events of the last few months showed the euro zone needed to build up an institutional framework for dealing with Greek-style crises.
"At some point the fiscal fragmentation of Europe will have to be dealt with."
© 2024 Thomson/Reuters. All rights reserved.