Written by David Marsh

The euro was supposed to buttress peace, prosperity, jobs and stability not just in the Old Continent, but across the world. Rarely, if ever, can a monetary project developed to produce so many positive outcomes have become so quickly subverted into a hideous contradiction of the original plan. The euro and its woes have become a scapegoat for manifold ills within and outside Europe, in some ways welcome to world leaders seeking to divert attention from their own economic problems). It has been conveniently blamed by many – including US President Barack Obama, British premier David Cameron and Soviet leader Vladimir Putin – for fresh uncertainties overhanging the world economy.

Amid the outpourings of heat and light on numerous schemes for rescuing economic and monetary union (EMU) over the past two years, very little has been accomplished apart from an increase in political cacophony, a swelling up of social acrimony, and a sharp diminution of Europe’s standing in the world. In each of the five EMU members most hit by fall-out from the souring of the monetary project – Ireland, Portugal, Greece, Italy and Spain – governments have fallen in 2011 as a direct result of economic troubles. In every other EMU state, led by the two biggest economies, Germany and France, the single currency’s travails have become the greatest challenge to government leadership. The destabilising ripples have spread well outside monetary union, with disruptive currency effects felt the neighbouring countries as varied as Switzerland, Hungary and the Czech republic.

Ireland, one of the smallest countries in monetary union, was the first of the problem-hit “peripheral club” to feel the heat. Of these five states most severely affected, Ireland has carried out by far the most convincing restructuring programme and is relatively well-placed to maintain its position in EMU as one of the countries best equipped to meet the high economic policy standards set by Germany and the other “creditor states” at the heart of EMU.
Testimony to this, Ireland – as a result of carrying out an “internal devaluation” earlier and more comprehensively than the other peripheral states, through a firm policy of wage and cost reductions – has re-engineered its economic model and has regained competitiveness over the past three years. According to the International Monetary Fund, Ireland ran a small current account surplus of 0.5% of GDP in 2010, forecast to rise to 1.8% of GDP in 2011. Thus compares with medium-sized or high current account deficits in the other peripheral states as they struggle to balance their books under a blanket of austerity.
A great deal is at stake. EMU has been the emblematic symbol of European unity, the most ambitious project for European integration since the signing of the Treaty of Rome in 1957. Less than three years ago, monetary union was regarded was a beacon of stability in an uncertain world. Even during the recession year of 2009, when the financial overheating of 2007 and the deleveraging of 2008 translated through to a ruinous correction of advanced countries’ economies, EMU was regarded as having saved Europe from the worst fallout of the credit crisis. Only after the election of a new Greek government under George Papandreou in autumn 2009, and the discovery that previously-reported relatively healthy Greek budgetary figures were the result of over-optimistic assessments or downright forgeries, did the bitter realisation start to hit home.

Far from becoming an engine of stability, the euro could become an instrument of economic divergence and wealth destruction on a hitherto undreamt of scale. Yet there was denial, even as the scale of the drama unfolded. As late as March 2010, just a month away from the International Monetary Fund being called in to assist Greece, Klaus Regling, the German civil servant who has now become chief executive of Europe’s EFSF emergency bailout facility, felt able to give his name to a co-authored report (published by the Asian Development Bank Institute in Tokyo) that said, “Thanks to the successful first decade of EMU, the euro area and its Member States are today in a much better shape to weather these truly testing times than ever before.”
What will happen next? It would seem wise for policy-makers to consider the possibility that in a short space of time the euro in its present form may no longer exist. History (particularly in the arena of world money and finance) instructs us that when politicians and officials state that a certain outcome is impossible or absurd, that is not necessarily a good guide to what will actually happen.
Whatever happens to the euro as a whole, a core group of European countries with convergent economies may indeed remain linked by indissoluble bonds of monetary and fiscal orthodoxy. This group would include Germany and the Netherlands as well as other members of the “creditors’ club” of northern European countries which have run current account surpluses for most of the past decade and could easily withstand a higher value of their currency than at present. Crucially, Ireland may be the only member of the “periphery club” that can make a decision, more or less on its own merits, of whether to join the first or the second group of what looks likely to be a two (or more)-speed Europe.
The reason why this monetary shake-out is probably on the way is because the world’s greatest macroeconomic imbalances are not between the US and China, as many believe, but within the not-so-United States of Europe. This is just one result of the currency and competitive distortions caused by EMU.
These destabilizing European current account imbalances are the basic forces that will eventually, I believe, split up the euro area into a creditor and a debtor group. The euro creditors formed around Germany would need to accept a trade-weighted appreciation of 20 percent. In the export sector, this might trigger wailing and gnashing of teeth, but consumers and importers would profit greatly through a marked improvement in the terms of trade. This would be, therefore, a constructive European contribution to alleviating one of the largest sources of global economic uncertainty.
The solution of splitting up the euro into weaker and stronger constituents has always been rejected in the past as unworkable and unworldly. Certainly it would be painful, unpleasant and disruptive to achieve. However, as a result of grotesque turmoil in the international bond markets, it may be less complex and difficult than all the other options – including maintaining EMU as it is now, with all 17 currencies. Thus realisation of a form of “Plan B” seems to be drawing nearer.

As is now glaringly evident, the single currency has been a sadly inadequate device to bridge economic and structural divergence in the euro area. A combination of a substantial currency undervaluation in creditor nations in the north and a deleterious over-valuation for the troubled southern debtor states means the euro's valuation is not right for anyone.

In the first category we see large surpluses in international trade and an inflation rate turning up because of relatively expensive imports: a trend that the German population will be progressively unhappy about.

In the second group the opposite is happening: current account deficits are persisting in spite of sustained deflationary policies needed to curb years of excess.
According to the International Monetary Fund, in 2010, no fewer than seven European countries registered similar or higher current account surpluses, measured by GDP, compared to China, Japan and Russia. They include three members of EMU - Germany, the Netherlands and Luxembourg. In the group we also find Denmark and Sweden, outside the euro bloc but with currencies that have been relatively strong but are still undervalued, as well as the two "special cases" Norway and Switzerland. All with a current account surplus of over 5 percent of GDP, compared to 3.6 percent for Japan, 4.8 percent for Russia, 5.2 percent for China.
It is highly unlikely that this untenable situation can be defended by unlimited expansion of the European Central Bank's balance sheet. Without a tough European political consensus and the associated guarantees of creditor country taxpayers, the ECB cannot be expected to carry out more than smoothing operations on the bond markets for the weaker countries
The bitter message for Europe at the end of 2011 is that the euro has failed to overcome its sternest test. Creative, politically ambitious action will now be needed, complicated though it might be, on working towards a two-speed euro. The good news for Ireland, though, is that it is better placed than most to withstand the undoubted challenges lying ahead in 2012.

David Marsh is author of The Euro – The Battle for the New Global Currency. He is also co-chairman of Official Monetary and Financial Institutions Forum (OMFIF), linking central banks and sovereign funds from around the word.