The euro: a man-made disaster

In the early 1990s, while eastern Europe was emerging from the man-made disaster of communism, in western Europe the seeds of a new man-made disaster were being sown.

The euro - the European Union's common currency - was designed to draw the countries of Europe together. In practice, it is now driving them apart.

The Maastricht Treaty signed in 1992 by the member states of the European Union (EU) paved the way for the introduction of the euro as the sole legal tender in most EU countries in 1999 (currently the eurozone includes 17 of the EU's 27 members). The project was controversial from the start. Not because it was political in inspiration: it was always understood that the common currency was a major instrument to pursue the goal of 'ever closer union' to which the EU (then the 'European Economic Community') had committed itself in 1958, in its foundation Treaty of Rome, and which had acquired special significance after Germany's national unification in 1991 and its emergence as by far the weightiest EU member.

The doubts arose from the euro's lack of secure institutional underpinning.

True, the EU's so-called Stability and Growth Pact required members of the eurozone to achieve

• an annual total public sector budget deficit no higher than 3 percent of GDP; and
• a national debt lower than 60 per cent of GDP or approaching that value.

On the other hand, the European Central Bank (ECB), set up to administer the euro and to determine the single policy interest rate throughout the eurozone, was not to act as 'lender of last resort' in the way that national central banks do: it could not decisively bail out eurozone governments that threatened to go bankrupt.

Given the present crisis of the eurozone, it is deeply ironic that this institutional weakness should have mainly reflected Germany's well-founded fears that its price stability and sound public finances would be compromised by the inflationary tendencies in the eurozone's less competitive members in southern Europe: an ECB empowered to guarantee the bonds of all eurozone governments might ignite inflation and generate 'moral hazard', that is, it could encourage less competitive economies to become addicted to regular fiscal transfers from the more successful ones (like Germany).

The standard response to these fears was that the single currency would encourage 'convergence' among the eurozone's economies as they imported via the euro the benefits of Germany's monetary and fiscal discipline. This was a superficially plausible argument for public consumption. But for such convergence to happen, at the very least the Stability and Growth Pact would have had to be rigorously enforced.

In practice, it was a dead letter more or less from the start. In the 1990s some countries were allowed into the eurozone with national debts well in excess of 60 per cent of GDP, and showing very ambiguous signs of 'approaching' that limit. Worse, when in the early 2000s France and Germany ran budget deficits above the limit of 3 per cent of GDP, they quickly changed the rules to avoid the fines they would otherwise have been obliged to pay. This gave the green light to other eurozone members to go their own ways.

The eurozone interest rate, which the ECB set primarily with reference to the needs of the German economy, was too low for most of the others, encouraging various forms of delinquency. Some countries - such as Greece, Belgium and Italy - simply ignored the official limits on budget deficits or national debt while avoiding the structural reforms their economies needed. Of those countries that did retain some control over their public finances, some - notably Spain and Ireland - experienced property boom-bust cycles and banking crises. All countries had to forgo both the benefits and the disciplines of exchange-rate flexibility. Monetary union has thus in practice presided over a divergence rather than a convergence of the eurozone economies.

Faced with the near-bankruptcy of some eurozone members, the EU has organised bailouts, but not - so far - primarily through the European Central Bank. The ECB has helped individual governments by buying their bonds, but it has avoided any 'lender of last resort' guarantee of national debts of the kind that could restore confidence and growth to the eurozone.