Black hole at the heart of the euro zone

The Business published the following editorial on the euro zone in October 2004.

German unemployment has hit a five-year high. French and Italian industry are nosediving. Greece has failed to control its Olympic Games spending and quadrupled its budget deficit. German unions pledge a struggle against vital restructuring needed at the country's ailing car plants. In other words, a normal week in the economic tragi-comedy of the euro zone.

The storm of dire economic figures presents tough choices for several euro members; but most agree on one thing. Of the 12 euro zone members, six have decided to tear up their promise to abide by its economic rules - and to hell with the consequences. Others are likely to follow. The euro zone's stability and growth pact is now held in as much observance - if not contempt - as the speed limits on Greek or Italian motorways. But attempts at reforming the pact are thwarted by the sense of economic emergency.

The system designed to hold the euro zone together is yielding to fiscal anarchy. At its inception in June 1997, the pact was intended as a holy grail: if all countries agreed various targets, most controversially the 3% budget deficit limit, their economies would converge. Only then would the one-size-fits-all interest rate work. The pact died in November 2003 when the European Council voted that France and Germany should not be punished for breaking the rules. The knife-edge ballot was decided by the superior voting power of France and Germany.

Instead of reforming the pact with a new set of rules, the intention now is to make phrases so vacuous that they are tantamount to a fiscal free-for-all. Rules can be suspended, goes the proposition, in "exceptional circumstances". What the draftsmen seem to have ignored is that the survival of a euro zone framework depends on a precise definition of "exceptional" - and on taking decision-making out of the hands of politicians. There is zero chance of either happening, so euro zone discipline is imploding.

Greece feels confident enough to admit that it fooled the European Commission (unintentionally, of course) by saying its deficit was below the 3% level. As it turns out, extra borrowing has been "discovered"; it has been in breach of the pact since 2000. The outcome is that with the billions spent on the Olympic Games, Greece's deficit could even hit 5.3% this year, way above the supposed limit which means that Greece has been free-riding on a currency made relatively strong by the economic sacrifice of others. While this has drawn a chorus of tut-tutting from Greece's neighbours, who will cast the first stone?

Certainly not the Netherlands, whose deficit is set to be 3.5% this year and 4% next year. Portugal? No, its deficit will hit 3.4% this year and 3.8% next. Not Italy either whose deficit will be 3.2% this year and 4.0% next. Now that dodgy Greek book-keeping is a legitimate excuse to violate the economic rules, Italy's Silvio Berlusconi has not been slow in coming up with a new proposal: he reckons Italy's motorway budget should not count as "spending".

It is clear from all this that the pupils are in charge of the school now: the European Central Bank (ECB) and European Commission are powerless to enforce such rules. The restraining force of the pact has evaporated. When faced with a choice between saving their economies or saving the blushes of Brussels, nation states have understandably chosen the former. Indeed, the stimulus from spending by European governments has proven a rare glimmer of hope.

Last year, government consumption across the euro zone grew at twice the rate of private consumption. This has managed to alleviate some of the symptoms, but the disease remains endemic. How different all this is to the brave new world the people of Europe were promised before voting for the euro. Eliminating exchange rate risks and transaction costs would be good for business, they were told. The euro means jobs. How nave that pledge looks now.

Germany's jobless total last week hit a scandalous 10.7% - its highest since February 1999. The euro zone is becoming synonymous with joblessness. Some 8.8% of the continent's workforce are on benefit. Economic growth has been sclerotic. The euro zone grew by 0.5% last year, against the world economy's 3.7%. This year's forecast was downgraded to 1.9%, against a world average of 4.8%. Its prospects are that of relative decline - permanently.

What about rapid price convergence? A study released last week by Dresdner Kleinwort Wasserstein showed consumer goods prices nearly as far apart as they were before the euro. The average price differential still stands at 14.5% across six euro zone cities. But the biggest miscalculation was the idea underpinning not just the stability pact but the entire euro project: disparate countries could become one economic zone by agreeing to common goals and a common interest rate. There is no sign of that happening. Across the euro zone, each patient has a different malady.

France's exports plunge. Domestic demand is poor in Germany, yet exports there are up 16% over three years, amid high unemployment. Spain's economy is growing eight times faster than that of The Netherlands - yet the same interest rate applies to both. The idiocy of this arrangement has a human cost, from inflation in Ireland or dole queues in Dresden. One by one, the reasons for introducing the euro are demolished.

The nations who originally voted for the European single currency did so as a leap of faith. When Swedes rejected it last year, they did so based on hard evidence. The 10 accession countries who joined the European Union (EU) in May will be nervously detecting a theme. Promises are broken. Small countries are bullied. You hand over power over interest rates and get a whole lot of heartache in return. Look at Portugal. It has frozen public sector wages since 2001 and introduced tolls on all big motorways. No one told Jose Manuel Durano Barroso, its former prime minister, the rules could be torn up once the big boys hit similar trouble. His loyalty has made him head of the European Commission, but the Portuguese may well wonder why they had to suffer all the pain when there is one rule for the inner-club members, another rule for the outer-club members.

Progress depends on economic reform - and braving the pain Britain felt in the 1980s. The euro zone countries accepted this when starting the Lisbon Process four years ago. But the Lisbon goal - to make Europe "the most competitive economy in the world by 2010" -- is as much of a joke as the stability pact. As the commission's autumn report said: "Rising unemployment has dented enthusiasm for major change." It's catch-22. Without change, no jobs. Without jobs, no change.

The volley of bleak economic figures will continue to come in; the euro zone will cling together and sink together like exhausted swimmers. The ECB is watching in horror as both candidates in the American presidential election pledge to halve the US deficit. If either was to prove as good as their word, this would mean fewer European imports and a weaker euro. Inflation would increase, interest rates would rise, firing a bullet into the corpse.

Tackling the US deficit of the 1980s torpedoed Japan's economy. It is the export-reliant euro zone that is now dependent on American profligacy. Are workers and managers pulling together to help the euro zone out of its malaise? Not a chance. German labour leaders, who have watched union ranks dissipate as Europe's industrial power shifts to a service society, are taking any shot they can at management, including the cheap ones.

Ursula Engelen-Kefer, vice-chairwoman of the German Federation of Labour Unions, told a German newspaper that Berlin's disapproval of the Gulf war is the real cause for the recent planned job cuts at General Motors' Opel unit. "Washington's irritation over the clear and proper position of the German government on the war in Iraq is surely not without influence on business," Engelen-Kefer said, adding that General Motors investments will now be focused on "new Europe".

The fact that workforce may be better and cheaper in those countries seems to have escaped her attention. General Motors needs to cut costs. It has lost money in Europe for virtually the past decade. Germany is too expensive. That is why countries to the east are attractive. If Opel's workers want to keep their jobs, they need to work longer hours at less pay. Berlin needs to cut taxes and help companies reduce employer's contributions. But, of course, no one is listening.

In London, the dire EU economic data will be cascading into the Treasury as regularly as it does to this newspaper's office. This can only serve to underpin the hostility which Gordon Brown, the UK Chancellor, feels towards the euro zone. Yet this is precisely what Tony Blair does not see. He is blind to the economic morass, doubtless considering it cyclical. Like almost all supporters of the euro project, Blair's aims are entirely political. His fantasy is to see Britain as the leader of Europe, supported by accession states and heading off the federalist tendencies of France and Germany.

With the EU Constitution, he would forever anchor Britain to the centre-left Brussels consensus. Thankfully, the British public are not so nave. This is the crucial downfall for the pro-euro camp: people are not as blind to reality as politicians often think they are. It does not require much effort to sense the agony of French and German unemployment. It is not surprising that the flawed stability and growth pact should collapse - but a disaster for the euro zone that no successor system is in prospect. Without one, a black hole has appeared in the euro zone universe. It is not a place any country would wish to enter.