To judge by the success of the European Central Bank (ECB) in maintaining average eurozone inflation between 1.6-2.5% since 2000 it may seem unwarranted to question the sustainability of the euro. It is only when we examine the inflation and output performance of individual countries that the strains in the eurozone become evident. Moreoever, there is nothing that the ECB can do about this. The following table reveals the problem.

	Bel	Den	Fr	Ger	Ir	It	Lux	NI	Port	Sp	UK	EU
Price	14.3	18.6	13.6	4.8	31.0	18.8	22.8	19.9	23.1	29.3	18.0	14.7
GDP	16.0	14.9	14.9	10.6	43.8	10.0	32.6	14.6	9.4	27.7	20.2	15.2

  Percentage Growth of Price and Output 1999-2006

  The table shows that some countries have experienced large increases in their price and output levels, while others have had small increases. At one extreme we have Ireland whose price and output levels have increased by 31% and 44%, respectively. At the other extreme we have Germany which has price and output increases of 5% and 11%. Thus, although Ireland has experienced a loss of competitiveness compared with Germany of 26%, its relative output gain is 33%. In contrast, the UK, which is not a member of the eurozone, has an inflation and growth performance similar that of the EU average. EU inflation and growth have both been 15% while the corresponding UK rates are 18% for inflation and 20% for growth. Thus, over this period, through having an independent monetary policy, the UK has maintained its competitiveness with the eurozone—though currently at the cost of a 1.75% interest rate premium.

  Two additional pieces of evidence are pertinent. First, the higher the level of inflation on joining the euro, the greater has been the increase in the price level. Second, since the start of the euro, there has been no tendency for country inflation rates either to converge or to diverge.

  How can we explain this evidence? One explanation is the "one-size-fits-all" monetary policy. According to this view setting a single nominal interest rate for all eurozone countries implies that high inflation countries will have a low—even a negative—domestic real interest rate, while low inflation countries have a higher—and positive—domestic real interest rate. Since domestic economic activity is negatively related to the real interest rate, and inflation is positively related to economic activity, high inflation countries will have greater economic activity and higher inflation, and hence price levels. This view also suggests that country inflation rates will diverge. This argument does not therefore explain the evidence. Although it accounts for the diverging price and output levels, it is not consistent with the observed lack of divergence in inflation rates.

  Taking the argument a step further, countries with more rapidly growing price levels will be losing competitiveness to those with slower growing pricing levels. This, together with the greater economic activity in higher inflation countries, should act to raise the exports of the lower inflation countries to the higher inflation countries. Thus activity would be reduced in high inflation countries and increased in low inflation countries. The widely-held expectation is that these effects will be strong enough to act as an automatic corrective to the divergence otherwise inherent in having a common monetary policy. Unfortunately, the evidence suggests that this has not happened. At best it has prevented inflation rates from diverging, but has not resulted in inflation and output growth rates converging.

  Mindful of Ronald Reagan's inadvertantly insightful dictum about economists—that they are people who see things working in practice and try to explain them in theory—Wickens (2007) provides a theoretical explanation for why the two automatic correctives do not result in inflation and output growth convergence.

  This leaves two problems for the eurozone, one for the long term and one for the short term. The long-term problem is that, sooner of later, the divergence of price and output levels will threaten the sustainability of the euro. What, therefore, needs to be done in order for the eurozone to survive in the longer term? The short-term problem is that, having given up two of their three macroeconomic policy instruments—namely, control of their interest rate and their exchange rate—countries have only their fiscal instrument left to stabilise their economies. This suggests that eurozone countries require greater fiscal policy flexibility in the short term and not less, as prescribed by the Stability and Growth Pact.

  The solution to the long-term problem is to find other ways to regain competitiveness. This could take the form of improving productivity—the Lisbon agenda—or of switching out of economic activities in which competitiveness has been lost. This is what has happened in the UK, and recently in Ireland. In the 1960's, UK manufacturing comprised over 60% of GDP; now it is only 15%. The enlargement of the EU will accelerate this process; manufacturing will inevitably gravitate to the accession countries due to their lower real wages. The high wage countries will therefore need to rely increasingly on innovations as this will give them permanent respite through a series of temporary monopolies. The broader implication is that it is only by improving the single market for goods, labour and capital that the single currency will survive in the long term.

  The problem in the short term has been recognised by M. Sarkozy but, apparently, not by other EU countries. The Stability and Growth Pact has constrained both deficits and debts when what is needed in the short term is greater flexibility in using fiscal policy for stabilising the real economy. The recent amendments to the SGP, with their fines and deficit reduction requirements, therefore went in the wrong direction. The SGP was originally designed to prevent countries running up large debts which they might then be tempted to seek to monetise or default on, thereby imposing costs on other eurozone countries, but it is based on the wrong fiscal principles.

  The correct framework for fiscal policy is to tax-finance permanent expenditures and debt-finance temporary expenditures. For example, increases in state health and education expenditures should be financed through higher tax revenues, generated either through economic growth or higher tax rates. But higher expenditures associated with the business cycle, such as unemployment benefits, should be debt-financed. There are two reasons for this. First, it is neither easy nor sensible to vary tax rates in the short run. Second, debt finance maximises the stabilising benefits of these temporary expenditures. There is, however, an important condition that must accompany these fiscal rules: subsequent fiscal surpluses must be used to repay the extra debt, and not used to pay for additional expenditures, or for tax cuts. In this way, greater fiscal flexibility in the short term will not compromise long-run fiscal sustainability, and should therefore result in the SGP being satisfied in the long term.

  In summary, there are inherent problems with the euro that, in the long term, could even threaten its existence. One solution may be to leave the euro and, like the UK, have an independent monetary policy. Since this solution comes with a cost—in the case of the UK an interest rate premium of 1.75%—there will be a strong preference among eurozone countries to find a solution in which the euro is sustainable. That solution does not lie with the ECB, which is unable to do anything about the problems, but with individual countries and with EU rules. In the long term it requires a strong commitment to the single market, and in the short term re-fashioned fiscal rules are required that give greater flexibility to achieve economic stabilisation.

Mike Wickens, "Is the euro sustainable?" CEPR Discussion Paper no. 6337, June 2007.

July 2007