Is The Euro At Risk?

Is the death of the euro possible? As the global recession deepens, investors are certainly starting to worry that Europe's most ambitious integration project to date, the common currency shared by 16 sovereign nations, could break apart under the strains. The fact that the euro zone, far from decoupling from a U.S. recession, is now contracting at least as fast as the U.S. and the U.K. has added to the concerns. But the notion of a full-scale euro breakup looks vastly overblown.

The key reason the euro zone is not doing well is external, not homemade. Because companies around the world can slash their investment plans in times of uncertainty much faster than households can scale back their expenditures, the traditional exporters of top-quality machinery such as Germany are now suffering the brunt of the global downturn. This, in turn, weakens the euro. At some point, however, the worst of the global crisis will be over—with luck, sometime later this year. Once that happens, trading nations with a focus on investment goods, like Germany, should be able to recover lost ground.

The medium-term outlook for core Europe is still encouraging. German consumers had never joined in the credit-fueled party thrown by U.S. and U.K. consumers. While these consumers will probably need to restrain their consumption for years after the crisis, core continental Europe, as well as China and Japan, could enjoy an almost normal consumer upswing once the crisis is over.

Of course, we have to get to the medium term first. The global turmoil has hit the euro zone as a symmetric shock. All economies in the region are now contracting. In this sense, the euro area looks more and not less cohesive than it did a year ago, when regional real-estate booms were already turning to busts in some euro-member countries such as Spain, Greece and Ireland, while Germany was still enjoying strong export growth.

That said, markets are still shunning all kinds of perceived risks, and thus drawing a much clearer distinction between supposedly strong countries such as Germany and supposedly weak euro members such as Greece, Ireland, Italy and Spain, whose governments now have to pay much more than Germany to borrow on global capital markets.

This has led to speculation that some weaker nations might drop out of the euro, perhaps even solving funding problems the Zimbabwean way, by printing all the money the government wants in a new national currency. But Zimbabwe, which has taken this tactic to its extreme and is now reeling under hyperinflation and economic collapse, proves that this strategy doesn't work. Any country leaving the haven of the euro would risk devaluing its new national currency, and bond markets would demand very hefty risk premiums. These countries would thus find it much more expensive to borrow.