Could the eurozone disintegrate?

The stability and growth pact had already collapsed at the end of 2003. And a report by the investment bank Morgan Stanley warned that the markets may start to target the government bonds of the weaker states in the eurozone in 2004, ultimately causing interest rate spreads within the eurozone to widen so far that monetary union itself could unravel.

Entitled Euro Wreckage?, the report said the twin debacle over the stability pact and the European constitution late in 2003 has ushered in a new era of disunity where states could reclaim power from Brussels.

"With hindsight, 2003 was the year when serious cracks in the European political compound became apparent. Looking ahead, I believe 2004 could be the year when markets begin to price in some dire consequences: the return of the 'country factor' in bond markets, and a higher risk of EU secession and EMU.

"Investors who make decisions for the long-term should allow for the risk of the euro falling apart."

Morgan Stanley said it would be easier for countries to pull out of the eurozone than generally assumed since the national central banks remain intact, issue their own euro notes and coins, and still hold most of their foreign reserves.

The posibility of the eurozone disintegrating emerged again in June 2005 just after French and Dutch voters voted against the EU constitutional treaty.

Paul De Grauwe, a Belgian economics professor who advises Jose Manuel Barroso, said the situation in the wake of the rejection of the proposed EU constitution by French and Dutch voters was "dangerous".

"Without political integration the eurozone is a roofless house that becomes increasingly uncomfortable," he told a Belgian newspaper. "Many inhabitants will want to leave the house sooner or later. The euro does not offer clear advantages to some countries and is considered there to be a source of economic slowdown."

This warning came a day after a German magazine claimed the country's finance minister and central bank governor had discussed the possible failure of the entire European monetary union project.

The authorities were quick to deny the story. Hans Eichel, the German finance minister, described the idea as "absurd". Jean-Claude Trichet, the president of the European Central Bank, picked up the theme, saying: "I don't comment on absurd questions ... yes, complete nonsense."

The eurozone is heading towards disintegration as surging labour costs render Italy, Portugal, Greece and Spain unable to compete with a resurgent Germany, according to papers published in June 2005 by Lombard Street Research.

Charles Dumas, head of the firm's world service, warned that Italy faced economic asphyxiation inside monetary union after allowing wages to spiral upwards - and productivity to stagnate - causing an almost irreversible loss of competiveness.

"Italy is odds on favourite to fall out of monetary union. We have a clear-cut case of disintegration of monetary union," he said, predicting that the bond markets would ultimately trigger a crisis.

Mr Dumas said it may now be too late for Italy to restore competitiveness within the eurozone, advising it ''to get out of EMU" before its industry was decimated.

Figures released by the European Commission in June 2005 showed unit labour costs (including productivity changes) have fallen 1.3% in Germany since 1995, while rising 38.7% in Italy.

Mr Dumas said Germany had "hammered labour resistance into the ground" through deflation, leaving German companies lean, fit and highly profitable.

However, Italian industrial output and exports are now in free fall as the delayed effects of lost competitiveness start to bite. Fiat sales plunged 26% in May 2005 from a year earlier. The economy is in its third quarter of recession, and bankruptcies loom in the textile, footwear and tile industry.