Stephen King: The euro is unlikely to disappear, but its benefits are increasingly difficult to spot

"Obsession about budgetary constraints means that the people forget too often about the political objectives of European construction. The argument in favour of the single currency should be based on the desire to live together in peace." You perhaps won't be surprised to know that this quote came from Jacques Delors, the arch-federalist.

"Obsession about budgetary constraints means that the people forget too often about the political objectives of European construction. The argument in favour of the single currency should be based on the desire to live together in peace." You perhaps won't be surprised to know that this quote came from Jacques Delors, the arch-federalist.

Delors' comment, made at the beginning of 1996, reveals an ambiguity about the single currency, a possible fault-line that has been in place since its very inception. The Maastricht convergence criteria - the fiscal and monetary checklist that prospective euro members supposedly had to complete before joining the single currency - fostered the illusion that monetary union was an economic club: countries had to ensure that their economies behaved in certain ways before entering the single currency.

But if the euro was an economic club, how could Delors claim that the "obsession" with aspects of the convergence criteria meant "the political objectives of European construction" were ignored?

The answer, of course, is that while the euro symbolised economic convergence for some, political convergence was the key issue for the federalists who provided the real momentum behind the project.

How, for example, could Italy, original signatory of the Treaty of Rome, be left out of the first wave of countries joining the euro? The level of its government debt may have been way above the levels required by the Maastricht Treaty to enter the euro but, in federal eyes, this was a trivial objection in the grander scheme of things. As a symbol of political - as opposed to economic - convergence, Italy simply had to be there.

Following Robert Mundell's pioneering work in the early Sixties, a large body of literature about optimum currency areas has sprung up. A currency area is economically optimal if labour, goods, and capital markets within the area are flexible, if a large amount of total trade takes place within the area and if different parts of the area respond in similar ways to external shocks. Drop those assumptions - which, within the eurozone, is the right thing to do - and the currency area is no longer optimal: in other words, nominal currency adjustment might play a useful role from time to time, as might fiscal transfers (the debate about Britian's rebate and the Common Agricultural Policy's subsidy to French farmers is an example of the latter).

Most nation states are not optimum currency areas. After all, nation states are political manifestations, not economic constructs, so their chances of also being optimum currency areas are rather low. And this, I suppose, is Delors' point: if the US is not an optimum currency area (different parts of the US respond in different ways to common shocks - Silicon Valley is hit a lot harder than Texas if the bottom falls out of the technology market) then why force the euro area to be one?

The federalists could also argue that economic convergence might materialise after monetary union set sail. Countries previously reliant on the occasional exchange rate adjustment would soon discover that, with the permanent removal of that option, they would have to change the habits of an economic lifetime. No longer would it be possible for workers to pay themselves inflationary wage increases, or for companies to jack up prices. The single currency would, instead, exert discipline on price-setting behaviour, automatically delivering the flexible markets that would be crucial to the euro's longer-term economic success.

Yet flexible markets have been hard to come by. Germany has had a partial success: its competitive position has improved hugely since joining the euro, suggesting that even if the Deutsche Mark entered the system at too high a level, this problem has now been partially resolved.

This success, though, is distinctly qualified. Downward pressure on German workers' incomes has led to real wage reductions and high unemployment, hitting consumer spending.

And Germany's success has come about partly because of Italy's failure: Germany's competitive improvement has not so much been against countries elsewhere in the world, but rather against other members of the euro, notably Italy. Abolishing currencies should have dealt a decisive blow to "beggar-thy-neighbour" policies but the relationship between Germany and Italy suggests that the euro masks significant sources of strain.

Indeed, Italy's competitive loss is in danger of leaving its economy in an unholy mess. In the bad old days, Italy used to have a terrible fiscal position which, from time to time, would trigger a currency devaluation. Of course, with devaluations occurring every so often, Italian interest rates were a lot higher than those elsewhere, but the extra growth that came along as a result of the occasional drop in the exchange rate just about kept the economy going.

When Italy initially joined the euro, it benefited from a one-off drop in debt-service costs as a result of the narrowing of interest rate spreads throughout the euro area. But rather than saving the benefits, Italy spent them. Now, with a renewed loss of competitiveness, the Italian economy has stagnated, implying a further deterioration in its fiscal position. Interest rates may still be low by Italian standards but that hasn't meant that the fiscal arithmetic adds up. And now there is no bail-out through devaluation.

Of course, if the euro is a political rather than economic construct, it could be argued that this deterioration need not matter: Italy may be in a bad way economically, but it will never be allowed to become a "failed state".

France's "non" and the Netherlands' "nee" suggest, however, that this conclusion is no longer quite so secure. Although the European constitution could be seen as no more than a tidying-up exercise, a way to make existing institutions work more effectively, the no votes may represent the high-water mark for European integration. If this is the case, the euro is less secure.

Nation states that choose to re-assert their nationhood are, in some ways, trying also to re-assert their economic independence. The French government, desperate to distance itself from Anglo-Saxon capitalism, is beginning to look closely at the so-called Danish model (where unemployment benefits are high but where the pressure to return to work is immense, the result of a tried and tested social contract that's been created over the past 100 years and which, therefore, is unlikely to be easily applicable to countries elsewhere).

The Dutch are opposing free labour markets, manifested in their desire to limit immigration and, more specifically, to prevent Turkish membership of the EU. And what could the Italians do? Faced with an inability to improve competitiveness, the options are hardly attractive. Default on their government debt? Impose capital and exchange controls and then leave the euro? Neither of these is feasible in the short-term but they become more likely if the nation states that make up the eurozone cannot agree on the "right" economic system.

Delors was wrong. The obsession with budgetary constraints was not the economic equivalent of trainspotting. It was a recognition that, in the absence of wholehearted political co-operation, a lack of economic convergence would drive countries apart. That European countries still disagree about the appropriate economic systems to use says a lot about the weakness of the fundamental political foundations that underpin the euro.

The euro itself is unlikely to disappear but the economic benefits that should have derived from its introduction may be increasingly difficult to spot; and the absence of those benefits may eventually imply that Delors' dream of living together in peace could turn into a political nightmare as nation states attempt to re-assert their independence.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com