The Shadow of the Strong Euro

LONDON—The currency of the moment, the euro, celebrates its 10th birthday this month. But most Americans can be excused if they don't rush over to Europe to join the party—it's too darn expensive, given the euro's recent strength and the dollar's relative puniness.

Freshly minted euro coins

It takes around $1.55 to buy a euro these days. When the European currency launched, you could buy one for a buck, and the price dropped to about 83 cents by late 2000. The current exchange rate has sent European tourists flocking to the United States on shopping sprees, while Americans travelers feel like Third World visitors in Europe's capitals.

In a recent progress report, the European Commission calls the euro "a resounding success" that "changed the global economic landscape." Some observers, including former Federal Reserve Chairman Alan Greenspan, say that the euro could even depose the dollar as the world's leading reserve currency.

Given that euroskeptics predicted it was doomed to failure when it was launched, that's pretty impressive, right?

Well, as economists like to say: yes and no.

To be sure, the euro's been a reliably stable currency, and it's certainly led to a better integrated financial-services sector within the 15-nation Eurozone. The European Central Bank has kept inflation low, around 2 percent, on average. And jobs have been created.

Now comes the "but" part. On the downside, Eurozone economic growth has been disappointing, about 2 percent a year, and productivity stagnant. Per capita income has remained flat, too. Moreover, the euro posted that so-so record during 10 years of global economic prosperity—something that's rapidly coming to an end as the credit crunch continues to bite. "In the short term, it's been quite a successful birthday party," says Harold James, a professor of history and international affairs at Princeton University. "But in the medium to long term, there are real worries."

For instance, inflation has returned—it recently hit 3.5 percent—and some economists predict that Eurozone growth this year and next will slow to just 1.7 and 1.4 percent, respectively. But the real problem for the Eurozone is that the economies of its 15 individual members are widely disparate. Derek Scott, a former economic adviser to British ex-Prime Minister Tony Blair, notes that "a 'European economy' doesn't exist...and there is an increasing divergence among its different economies."

That makes economic downturns hard to manage. For many of the euro's early years, the ECB was able to keep interest rates at 2 percent, a help to the union's biggest member, Germany, whose economy at the time needed a boost. That low rate created a flood of cheap money that fueled boom times in countries like Spain and Ireland, particularly their housing markets. But the credit crisis—and more recent rate hikes—popped those housing bubbles. Now they and other so-called Latin members, like Italy and Portugal, could use the kind of pick-me-up that lower rates could bring. But if the ECB lowers rates to help them, countries like Germany and the Netherlands could be hit with stingingly high inflation. Conversely, if the ECB hikes rates to wring out inflation—which it indicates it plans to do—Spain and some other countries could face default, unable to issue bonds to service their debt.

Moreover, if any Eurozone countries do fall into a recession, the European Union's ability to help them is about nil. America, of course, has a huge federal budget, about 20 percent of gross domestic product. When regions of the United States are hit by hard economic times, the government can transfer money to those areas to help ease the pain. But the EU, with a federal budget that, at about 1 percent of GDP, is all but nonexistent, doesn't have that as an option.

Europeans, meanwhile, have been pouring into the United States, scooping up bargains on the strength of their currency.

But not all in the Eurozone are happy about the strong euro. It's a source of distress for manufacturers reliant on the American market—German carmakers and breweries, for example.

To maintain market share, most are trying to avoid passing along higher costs to consumers, but that's an increasingly difficult option. BMW, which sells 22 percent of its cars in the United States, took a charge of nearly $366 million in the first quarter because of losses linked to the weak greenback. Accordingly, it just raised U.S. prices by 1 percent.

Despite its current muscle, could the euro collapse, as some skeptics still predict? "It's a remote possibility, but probably not," Princeton's James says. Member countries have invested too much political capital into the euro to let it die. "There are growing strains, but there is a political willingness to put up with the consequences," says Patrick Minford, an economist at the Cardiff Business School.

That willpower will be sorely tested, however. Say Scott: "The second 10 years will be considerably rougher than the first 10." Inevitably, after a birthday celebration comes the hangover.