Despite the strains which are now looming, in some ways the euro has done relatively well, although this may have masked the crisis which may not be far off. The euro has become firmly established as a major world currency in which a large amount of borrowing and lending takes place. As with all common currency arrangements, there have been advantages in the apparent certainty that there is no currency risk, making transactions across a wide area easier to handle. Inflation across the eurozone has been fairly low, although this has also been the case in most of the rest of the world. The euro and the eurozone have not, however, been without their serious problems. The strength of the euro, underpinned by the power of the Germany economy, has caused widespread problems of uncompetitiveness, leading to major deflationary problems in many eurozone economies. Having the same interest rates for all countries with the euro as their currency has encouraged booms and then slumps in a number of them. Reflecting these conditions, inflation has been much higher in some eurozone countries than others. Growth rates across the eurozone have languished as problems with unemployment as well as trade and government financial deficits have multiplied.
The risks to the EU from the establishment of the euro are thus very similar to those which in the end sank previous attempts to lock the parities of EU countries together in the Snake (from 1969 to 1975) and the Exchange Rate Mechanism (ERM) (from 1979 to 1993). During this earlier period, however, there was always a safety valve available for the weaker economies in the form of devaluation, if their economic situations became intolerable and the markets no longer expected the currently established exchange rates to hold. One of the objectives of the euro, however, was to make this escape route no longer possible. The problem, however, is that, if devaluation to restore competitiveness is no longer an option there is then no choice for countries determined to stay in the euro but whose exports have become uncompetitive other than drastic deflation of the sort that the Irish are currently experiencing. The as yet unanswered question is whether determination to pursue these sorts of policies will lead to unmanageable social and political conditions, causing at least the most fragile economies in the eurozone to drop out of it altogether.
It might, therefore have been better if those who were so determined to bring the eurozone into being had spent more time than evidently they did looking at the history of currency unions covering areas which were not unitary states. Of course, all areas with the same money are currency unions. The big difference between single countries and amalgamations of several of them, however, is that single countries have a much higher level of internal cohesion, making it possible for their governments' taxation and spending systems to even out economic differences. This does not apply to organisations such as the EU which, even now, only has taxation and spending powers over about 2% of EU GDP. The history of currency unions of this second sort is that, almost without a single exception, they all fail - for exactly the same reasons as the Snake and the ERM did. Sooner or later, the cost bases - the cost of producing everything which is sold abroad - between constituent members becomes so far out of line that currency readjustments become essential and unavoidable. The currency union then breaks up. If the countries taking part have all kept their original currencies this is not too problematic in operational terms. If, on the other hand, they have adopted the same currency, the break up is much more difficult.
Given the dismal history of currency unions like that of the eurozone, why ever did the EU embark on establishing the euro? The answer is that there never was a credible economic case for the eurozone. The reason for its establishment was purely political. Having the same currency covering as many EU countries as possible was seen as an important step towards building a European equivalent to the United States of America. It is true that some of the architects of the euro system could see some of the dangers to which it would be prone. They therefore tried to avoid these materialising by establishing rules which would keep all the eurozone economies in line with each other. These rules - The Stability and Growth Pact in particular - were never taken seriously, however, by any of the countries involved. Even the major ones, who were most likely to have to come to the aid of the system if it came under strain, such as Germany and France, simply flouted the rules when it suited them to do so. This left the eurozone prone to all the entirely predictable risks which have now materialised.
The problems which have now come to the fore are that several eurozone countries have had much higher levels of inflation, affecting their international competitiveness, than others. Part of the reason for this is that the very stability which the euro initially created allowed interest rates to remain very low for a long period, generating unmanageable booms and asset inflation in some countries. Other factors were the rate at which different countries responded to internal cost pressures. As had happened a generation previously, Germany was far better at responding to these challenges than almost all other eurozone countries. The Germans kept their costs down and thus maintained a stellar export performance both to other EU countries, although of course causing them to have corresponding balance of payments deficits, and to the outside world, thus making the euro a very strong currency. The strains are now beginning to show all too clearly, particularly in Greece, Italy, Spain, Portugal and Ireland.
The symptoms are there for all to see. Unemployment is now running at almost 20% in Spain. Labour costs in Italy are now 18% higher compared to Germany than they were in 2005 and 15% higher in Spain. There are also major problems in Eastern Europe where, although these countries are not in the eurozone, there are huge euro borrowings in anticipation that they soon would be. It is the Greek economy, however, which is the existing eurozone country in the most immediate trouble. The Greek state has lost its top tier credit rating, with two recent downgradings and very probably more to come. Other of the weaker eurozone countries may soon follow. The interest rate on Greek government bonds is now more than 2.5% higher than on those issued by Germany although both are in euros. Government debt as a percentage of GDP is rising rapidly in all the countries in trouble and in some cases - including Greece - it is getting close to the point where it is unsustainable. In Greece's case it is already 113% of GDP. The EU Commission expects it to rise to 125% by the end of 2010 and 140% by 2012. The savage deflation now being asked for by the Commission is unlikely either to make the Greek economy more competitive or to improve the government's finances. As with Argentina in 2001, which faced similar problems, the only alternative to ever more unemployment and deficits may be for Greece to leave the euro. Although very disruptive, this could be achieved by passing a law switching all internal euro debt into drachmas and then immediately devaluing the currency. Foreign debts would have to be renegotiated, with the Greek government probably defaulting on its external debts and converting them into devalued drachmas.
The EU Commission and the European Central Bank are - understandably from their perspective - desperate to avoid default by Greece and other countries, which would undoubtedly not only hugely undermine the Single Currency but which would also be a major set back for the whole EU project. The problem they have, however, is how to shore up countries such as Greece without the costs of doing so - which would fall largely on Germany - escalating to unbearable levels as all the other weaker economies - if Greece was the first to go - followed its example. If cost base inflation is inexorably rising faster in these countries than it is in Germany, sooner or later this is very likely to happen as the difference in competitiveness - with all its consequences - between the strong and the more fragile economies gets wider and wider. German public opinion is very definitely not in favour of financing one bail out after another. It is not, therefore, likely that Germany will take on the debts of one weak government after another in the eurozone. The European Central Bank may - at huge cost - manage to cope with one or two currency crises, but sooner or later the German public will have had enough. The eurozone is then likely to shed most of its weaker economies, leaving only a core round Germany.
The major conclusion to draw from the saga unfolding in the eurozone is that we unquestionably took the right decision in not joining the euro when we had the opportunity to do so. If we had done so, there would have been no possibility of achieving the relatively gentle slide in the value of sterling which has happened over the last year or two, thus enabling the UK economy to start adjusting to the position in which it now finds itself, with the balance of payments now consequentially improving. Without this fall in the value of the pound, we could very easily have got ourselves into the same straitjacket as all the other weaker eurozone economies are currently experiencing. Britain faces daunting enough problems as it is in containing our government deficit and our international credit rating. At least, however, we have the freedom to take the decisions required to get the situation back under control without the main policy instrument being unavailable for us to use. Indeed, it is the fall in the value of sterling which - more than anything else - may have provided the government with the space to ride through the countries current economic difficulties without unduly harsh public expenditure cuts and the truncation of the welfare system from which so many other EU countries are now suffering. It is only because we are not in the euro that this is possible.