The Daily Telegraph, 24th October 2005

By Ruth Lea

On the surface, the eurozone seems solid. Financial markets are not factoring in any significant risks of instability; fund managers tend to treat the debt of the eurozone members as of similar quality and the yield spreads between the government bonds of the different eurozone member states are extraordinarily narrow.

Moreover, any talk of currencies leaving the eurozone or, more apocalyptically, its collapse is dismissed as "extreme" and irresponsible.

But all this seems rather complacent. Under the surface, tensions are building. In the words of the OECD, there is a "chronic pattern of... divergent activity" in eurozone economies as the "one size fits all" single interest rate fails to fit all.

For some economies, including Germany, the interest rate is arguably too high while for others, for example Ireland, the interest rate is too low. These countries would benefit from different interest rates but the ECB simply cannot provide them.

Moreover, the single exchange rate means that individual countries can no longer unilaterally influence the value of their currencies in the foreign exchange markets. Even if one member state is losing competitiveness to another member state, as Italy is to Germany, unilateral depreciation within the bloc is no longer an option.

The question then arises as to what policy options are open to the eurozone member states. In the short to medium term two spring to mind. First, fiscal policy and second, structural reforms including reforms of the labour market.

Fiscal policy is, effectively, a non-starter. Even though the Stability and Growth Pact is in tatters, having been dismissed by commission president Romano Prodi in October 2002 as "stupid", it still acts as a constraint on any fiscally expansionist policies.

This is despite the fact that several eurozone members including Germany, France, Italy, Portugal and Greece (which has provided false official data for years), have persistently breached the 3pc threshold which states that government deficits should not be more than 3pc of GDP. The markets, incidentally, have so far taken a relatively benign view of these persistent deficits.

So this brings us to structural reform, which the British government vociferously promotes by rhetoric if not by example. But, alas, little reform is occurring in the under-performing eurozone economies and little seems likely to occur.

The EU's Lisbon agenda to reform and revitalise Europe's economies, launched with a great fanfare in 2000, is widely regarded as a failure. At member state level the picture is hardly more encouraging.

Ex-Chancellor Schroeder did institute some reforms in Germany but they did little more than contribute to his political downfall. And the new Chancellor, Angela Merkel, is so compromised by her SPD colleagues in the new Grand Coalition that reform is quite simply off the agenda. The French government has tinkered with the worst excesses of the 35-hour week but clearly prefers old-fashioned protectionism to painful reform. And in Italy there is impasse ahead of next year's elections.

In the absence of any short to medium-term policies that can correct the divergent behaviour of the eurozone economies, the question then becomes what should be done to alleviate the problem in the longer term.
Professor Paul de Grauwe, of Louvain University, speaks for many commentators when he states that "a monetary union requires political union to maintain sustainability. If we want to retain the euro in the long run, we need political union."

More specifically, what is required are significant fiscal transfers through a central budget, backed by a true sense of political unity, that can redistribute funds from well-performing regions to the less-well performing as in the monetary unions of the UK and the US.

Such a redistributive mechanism does not operate in the EU at present. The total "federal" budget is small and transfers, disproportionately conducted through the CAP, are unrelated to the recipients' economic performance. Indeed, the irony is that the largest donor, Germany, is performing poorly while major recipients Spain and Ireland are doing very well.

Political union seems a very distant prospect. So what is likely to happen in the meantime?
There is already speculation that Italy will leave the eurozone, if the economic pain of underperformance becomes intolerable and monetary independence becomes "inevitable", despite the costs involved. Interest rates, for example, would surely rise.

In theory there is not a process in place for a country to leave the euro but it could be done. The national banks are still fully operational with systems in place to run national monetary policy from day one. If Italy left others, including Greece and possibly Portugal, are likely to follow.

Such speculations cannot be dismissed lightly even though the markets seem curiously disinterested at present. Markets can, however, turn with frightening speed and power. Italian government bonds are surely a sell.