The Treaty of Maastricht, signed in 1992, brought the birth of the euro in 1999. The currency has been a success in the view of many but the financial crisis has exposed cracks in the currency as certain European countries saw their economies spiral downward faster than others. Now UBS economist Paul Donovan takes a provocative look at the pluses and minuses for the world’s second largest reserve currency.

What is the matter with the euro?

In 2010 we have seen the single currency fall in value, bond spreads widen out and extraordinary measures established to aid Greece and potentially other sovereign states. The “irrevocable monetary union” that was established by the Treaty of Maastricht has even had some commentators suggest that it might be time to revoke membership for some of the participants.

In fact, much of what we see this year is the symptom of the disease, not the cause. The Greek fiscal woes, the volatility of financial markets and the divergence of growth are all in response to a single underlying problem– the euro does not work.

Three Critical Elements

Three basic criteria were necessary to make the euro an economic success. First, there had to be a political desire to participate. That was the easiest hurdle to membership as most countries wished to join (the exceptions were Denmark and the United Kingdom).

The second criterion was a reasonable balance sheet. Government debt and deficit levels had to be at manageable levels. Levels were actually spelled out in the Treaty of Maastricht – a maximum 3 percent gross domestic product (GDP) deficit, and a maximum 60 percent GDP debt level. However, these were arbitrary and glossed over.

The most critical criterion for a successful euro was that the participants had to have economies that were fairly similar in their structure and growth patterns. In a currency union, the components share a single interest rate and a single exchange rate. Setting an appropriate single interest rate to be shared by one country or region that is growing at 3 percent a year, and another that is growing at 3 percent a year is pretty much impossible. The real economies need to converge and stay converged. On this basis, the euro could probably have comprised six economies – Germany, France, Austria, Netherlands, Luxembourg and, with some generosity as to debt criteria, Belgium. Beyond that, the euro is doomed to fail economically.

So, if the monetary union does not work, does that mean it is about to fragment? Absolutely not. The issue with the euro and indeed any monetary union, is that even if it is inadvisable to join, it is even more inadvisable to leave once one is inside.

Severance Costs

The costs of departure are huge. A weak economy that leaves would almost certainly default on the national debt. The debt is denominated in euros, of course. Leaving would mean that the exiting country has a new national currency – the nuova lira, or the new drachma or the nouvelle franc. With no tax revenue in euros, it is almost impossible to pay even a part of the national debt. However, countries can default or restructure debt within the euro. Indeed, there is a distinct possibility that at least one weak economy will restructure in the next few years.

What makes a euro exit even worse is that the corporate sector will in all probability have to default. Corporations will have euro liabilities to overseas banks, or in the form of bond issues. Their domestic revenue streams are now in the new national currency. A default event, and the subsequent banishment from international capital markets, seems inevitable.

The default story is bad enough, but it does not stop there. The domestic banking system is likely to be debauched in advance of any euro exit. Depositors who fear that a country may exit the euro are likely to turn up at their banks in advance of the exit, clutching large suitcases and demanding that the contents of their bank accounts be handed over in euro notes. In short, a run on the banking system precedes the departure from the monetary union.

Finally, departure from the euro almost inevitably means departure from the European Union (EU). Certainly, that is the conclusion of the European Central Bank’s (ECB) legal advice. Trade ties with all an economy’s key trading partners are broken. Any attempt by the exiting country to devalue the new currency will be met with tariffs from the remaining EU members. (Tariffs cannot, of course, be applied within the EU as it is all effectively “interstate commerce.”)

So, a euro exit means sovereign default, corporate default, a major negative growth shock, a debauched banking system, exit from the EU, tariffs against one’s exports to eurozone countries and the ending of most major trade relations. Considering that, major civil unrest has to be thought likely as well – but that is perhaps left to one side in the analysis; it would not do to be too pessimistic.

The euro does not work, but departure seems unlikely given the horrific consequences. Does this mean that the euro area is condemned to a dire economic future? Not necessarily.

The Right Road

There are three routes to making the euro work – routes followed by the United States in the 1930s after the effective collapse of the U.S. monetary union in 1933. The first is labor flexibility or pay restraint. If areas with high unemployment restrain wages they eventually become more competitive and balance is restored to the monetary union. This has happened in parts of the eurozone, but it is unlikely to be a universal solution. Germany and other north European states may pursue this. There is little evidence of the southern European states embarking on such a course of action. France, in this context, should probably be classified as a southern European state.

If labor flexibility does not apply, there is always labor mobility as a second option. Unemployed workers move in search of jobs. Europe, sadly, has no John Steinbeck to urge the process on. Workers are not moving across national boundaries.

The third option remains – and this is the path that Europe is tentatively embarking upon. Europe, like the United States 80 years ago, needs a fiscal union if it is to make its monetary union more effective. That does not mean that weak governments are subsidized, but rather that weak economies receive a stimulus they do not have to pay for, and strong economies are restrained. This makes the economy more homogenous and a single monetary policy more effective. The U.S. fiscal union does not mean the government of California receives direct assistance from the taxpayers of New York, for instance – but it does mean that the citizens of California receive welfare benefits funded in part by the federal tax receipts from New York residents.

Can Europe do this? Probably. Fiscal confederation is the way to think about it – a simple redistribution mechanism without a strong central government. It will require more integration, however. This is where the difficulty comes in. Europe has achieved a great deal of integration over the past half century but most of it has come out of a crisis. The current crisis provoked further integration such as the various bail-outs. For Europe to get to a fiscal confederation, it would likely require a series of additional crises. Europe can solve its dysfunctional monetary union, but it will take time, five years or more. The current crisis is just the first in a series over that period.

Practically, what does this mean? The periodic crises of Europe are likely to keep downward pressure on the euro. Growth implications suggest the ECB will keep interest rates lower for some time. More significantly, perhaps, it means that the international confidence in the existence of the euro will remain weak. The ongoing debt problems of southern Europe keep the structural flaws of the euro at the forefront of investors’ minds. Constant reminders of the fault lines in the euro will be an effective deterrent for euro appreciation. This is not to say the U.S. dollar is a good currency in the coming years – the problems of the dollar make it a bad currency. The problems of the euro make it a worse currency, however.

Paul Donovan is managing director and deputy head of global economics at UBS. He is responsible for formulating and presenting the UBS Investment Research global economic view, drawing on the bank’s world-wide resources.