The Euro: One Size Fits None


Too much political capital is at stake -- especially in Germany and France, the euro zone's key economies -- for the euro ever to crumble. But as Germany's economy slumps into its second year of recession, the difficulties of designing a single monetary policy for 12 different countries are increasingly evident.

That's worrying many of the senior businessfolk gathered in Davos, Switzerland, for this year's World Economic Forum. "The euro zone's monetary policy isn't a case of one size fitting all but of one size fitting none," says the chief financial officer of one Spanish company. "The result is that Germany is having to cope with higher interest rates than it needs, and its economy is slowing as a result. And that's affecting everyone across Europe."

SPENDING LIMITS. The problem is the Maastricht Treaty mandates that the European Central Bank maintain price stability across the entire euro zone. It can't take conditions only in Germany into account when setting rates, even though Germany is the Continent's largest economy and is a drag on growth in other countries. The ECB's key interest rate stands at 2.75%, whereas economists say Germany really needs a rate as low as 1% to stimulate demand, investment, and growth.

Fiscal policymakers in Berlin are powerless to kick-start the sputtering economy because the Stability & Growth Pact puts tight limits on state spending. In particular, they may not run a budget deficit above 3% of gross domestic product. Germany's euro-zone partners have just censured it because it breached the 3% limit last year and will probably do so again this year.

Some eminent economists, such as Robert A. Mundell, professor of economics at the School of International & Public Affairs at Columbia University, argue that the Stability Pact should be scrapped and that the ECB should be given a broader mandate. Yet many European business executives take the opposite line. Gerard J. Kleisterlee, president and chief executive officer of Dutch manufacturing giant Royal Philips Electronics, says the single currency needs to be underpinned with sound state finances. Ironically, German government officials agree. Caio Koch-Weser, Germany's Secretary of State of Finance, says it would be a mistake to abolish the pact.

"SUPPLY-SIDE PROBLEM." This is the background against which the ECB is reviewing its monetary policy strategy. Thomas Mayer, chief European economist at Deutsche Bank in London, believes the ECB will opt to put more emphasis on medium-term rather than short-term price developments. That means it may be prepared to tolerate higher inflation in the short term, and it might be more willing to cut rates to stimulate demand even when inflation is around or above the 2% limit the bank considers consistent with price stability.

"At the end of the day, though, the euro zone doesn't have a demand-side problem, it has a supply-side problem," says Jürgen von Hagen, professor of economics at the Center for European Integration Studies at the University of Bonn. Kleisterlee agrees: "Germany and other highly regulated economies need to reform their labor markets and make other structural changes that will allow growth to happen." He's among the business leaders who insist that strong growth in Europe -- even Germany -- is achievable if the politicians take action. "What's needed is flexibility," he says.

The euro zone's woes seem to be persuading Britain, Sweden, and Denmark -- the three EU countries that don't yet use the single currency -- to stay away. The betting on the Continent is that the Swedes will reject introducing the euro when they vote on Sept. 14. And opposition is mounting in Britain -- especially among business executives, who have so far been generally in favor.

WAITING FOR REFORM. "Britain has a higher growth rate than the euro zone in general and Germany in particular," says von Hagen. "It's hard to see why they would want to tie themselves more closely to the Continent. If I were them, I wouldn't join until Germany has reformed and shown it is capable of growing at a much higher rate than we have seen for the past decade."

The euro may not crumble, but it still has some major hurdles to clear before it truly becomes the currency of the EU. By David Fairlamb at the World Economic Forum in Davos


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