Economists have expressed concern over a possible collapse of the single currency in the early stages. Yet Europe has no fallback, says David Smith.
The die is almost cast. The special European summit on the single currency from 1-3 May, which fixes the number of participants and the rates at which they will convert their currencies to the new euro, will be followed in early July by the formal establishment of the European central bank.
Events are moving rapidly and 1 January 1999 will soon be on us. British companies will be invoiced and invoicing in euros. European pricing strategies will change. European economic and monetary union, the other Emu that many said would never fly, will be a reality, permanent and irreversible.
Or will it? Rudi Dornbusch, the outspoken Massachusetts Institute of Technology economist, once told a European audience that what most concerned him about Emu was that there was no 'plan B'. What would Europe do if the single currency project collapsed?
January '99 is only the start
It was a good question. But surely, by getting to 1 January 1999, with the irrevocable conversion of its currencies to euros, and their inextricable linking, Europe will have proved the doubters wrong? Not exactly. While a combination of tough policy and creative accounting has allowed three-quarters of the EU's members to get to the Emu starting date, many economists believe that the 'plan B' question does not end there.
Walter Eltis, former director general of the National Economic Development Office, first raised the issue of Emu instability and even collapse between the start of 1999 and mid-2002, the date that marks the end of the six-month period during which national currencies are physically exchanged for euro notes and coins. Before that date, the euro will be a contract and electronic currency, widely used in transactions of every type but not actually on the streets in physical form.
During this period, the financial markets would have every incentive to try to exploit weak links in the euro chain, Eltis argued, possibly bringing down the whole project. Suppose, for example, that Italy's apparently successful policy of fiscal austerity proved a mirage and, next year, its budget deficit rises alarmingly. Holders of Italian government bonds and other financial assets could sell out in a big way. The normal response of national authorities in this context - raising interest rates - would not be available. The Italian government would be unable to borrow to fund its budget deficit. The flooding out of capital from Italian assets would result in a credit crunch, and a slump, for which the only solution could be leaving the euro.
A new book from the National Institute of Economic and Social Research, Thinking the unthinkable about Emu - coping with turbulence between 1998 and 2002, is entirely devoted to the possibility of an early single currency failure and Europe's lack of a fallback.
'The risks of a major political upset occurring at some point during this extensive transition to a single currency may be small but the consequences, both for individual member states and for the EU as a whole, could be extremely grave,' writes John Arrowsmith, the book's editor and a former senior Bank of England official. 'Yet, this possibility has, until now, attracted scant attention and still less has any thought apparently been given to what action might need to be taken, either to reduce the risk or to contain such a setback to the Emu process ...'
The threat of internal politics
Stated threats also include the internal political pressure that could arise if Emu is seen as locking participating countries into high and rising levels of unemployment, and the risk that countries, constrained in terms of monetary policy (interest rate levels being set by the new central bank), will attempt irresponsibly to expand their way out of trouble through fiscal means. Equally, what happens if Germany, right at the euro's core, finds itself outvoted in interest rate decisions by Italy, Spain, Portugal and France, so that the euro becomes a soft currency unacceptable to German public opinion?
Beneficial growth effects
The prolonged changeover to the euro will be a risky period from now on. One helpful factor, I suspect, will be the European economic cycle.
As the chart shows, European economies are picking up. After 1 January 1999, there are likely to be beneficial growth effects, and not only from the reduction in transaction costs that will result from the euro's introduction.
But the project is hardly risk-free, particularly in the longer term, when the real test will be whether having a single currency produces genuine economic convergence or savagely exposes the fundamental differences between participating currencies. Only then will the absence of a plan B be most keenly felt - nobody knows how to break up a monetary union without massive disruption once national currencies have ceased to exist.
Over the next few years, Britain has the luxury of spectator status.
The Government's fallback position is straight-forward: if the project is seen to be getting into serious trouble, the question of joining it will be shelved, with no bones broken and no loss of face. Of course, arguably, the very act of a big currency such as sterling entering could be the factor that helps spark the big Emu crisis. It happened, after all, with the ERM in 1990-2. Let us hope that was not a taste of things to come.