In an effort to maintain price stability, the ECB president recently signaled an interest rate bump that could further hurt damaged economies including Italy

by Jack Ewing

It may soon be time to cue the euro-skeptic chorus—the minority of economists and businesspeople who believe the European common currency will eventually fail because of its own internal contradictions. But they're wrong: Europe has way too much invested in the euro to back out, and there would be serious consequences if it did, such as much higher borrowing costs for governments and corporations in countries like Italy.

It's true, though, that the stresses inherent in the European Monetary Union have come into painful relief. Since its launch 10 years ago, the European Central Bank has often struggled to craft a monetary policy to fit a grab bag of 15 national economies that refuse to grow at the same pace. A few years ago, Germany was poking along and Spain was growing nicely; today it's the other way around.

Now, ECB President Jean-Claude Trichet faces an additional dilemma. At 3.6% in May, euro zone inflation is way outside the ECB's comfort zone. Yet a rate hike risks hastening a slowdown and could be poisonous for countries such as Italy whose economies already are hurting.

"This is obviously a very dangerous situation," Stephane Deo, European economist for UBS (UBS), told investors and reporters on June 12. "Everybody has in mind the '70s when you went into a wage-inflation spiral" triggered by rising oil prices.

"A SERIOUS SHIFT"
To widespread criticism,Trichet signaled on June 5 that the central bank will risk hurting growth in order to remain true to its prime directive, maintaining price stability. His comments at a press conference in Frankfurt indicated the bank is likely to boost the benchmark rate to 4.25% in July from 4%. Some economists expect as many as two additional increases in the months to follow, as the ECB attempts to prevent a self-fulfilling inflation mentality from taking hold amid European businesses and labor unions.

"We think this is signaling a serious shift in the ECB's approach," Jacques Cailloux, chief European area economist for Royal Bank of Scotland (RBS), told ECB watchers during a conference call on June 10. "The economic slowdown has taken a backseat, and inflation expectations are key."

PUT TO THE TEST
Few mainstream economists expect the euro to collapse amid the current stresses. But the economic situation, coinciding with the ECB's 10th anniversary celebrations, is arguably the toughest test for the central bank yet. "It's one of the most difficult moments for Europe and the European economy," says Claudia Broyer, senior economist at Allianz (AZ) Dresdner Economic Research in Frankfurt. "You have a lot of factors coming together."

There will be other serious consequences for Europe short of a demise of the euro. The governments of Spain, Italy, and some other countries will have to pay higher interest rates when they issue bonds. "We are already seeing higher risk premiums for some sovereign bonds," says Meyrick Chapman, euro zone rates strategist at UBS.

In addition, Eastern European members of the EU may have more trouble meeting the price-stability criteria to join the common currency, and also may be more cautious about doing so now that they've seen some of the negative consequences of membership. Slovenia, which adopted the euro last year, saw a spike in inflation in part because the country had artificially held down prices beforehand in order to qualify for membership in the currency club.

LIKE IT OR NOT
Economists at Vienna's Erste Bank (ERST), which watches the region closely, don't expect countries such as the Czech Republic or Hungary to join until well into the next decade (though Slovakia is on track to join next year). The delay in expansion of the euro zone could in turn have a negative effect on some Western European countries, particularly Austria, whose economy is intertwined with its eastern neighbors.

But while the expansion of the euro zone may slow, it will continue. One reason is that whether they like it or not, European countries are yoked to each other. "For small countries like the Czech Republic or the Baltics there is very little room for having independent monetary policy," says Juraj Kotian, Erste Bank's co-head of macro and fixed-income research for Central and Eastern Europe. "They have to follow the cycles of the euro zone."

For all the common currency's drawbacks, it still offers powerful advantages. It eliminates exchange rate risk within the euro zone and lowers the cost of cross-border transactions—an important consideration in a region where all countries depend on foreign trade. Countries also benefit from lower rates than they would have as riskier, independent entities. The zone will probably never function perfectly, but continue to function it will.