Storm Clouds over the Euro

The creation of the European Monetary Union (EMU) was an unprecedented achievement, promising deeper and larger markets. The stimulus to trade and investment is manifest. But will the Euro last?

Two current developments will shape the answer. The first is the outcome of battles raging in France, Germany, and elsewhere over social security reform. The second is the debate over the inclusion of ``social rights'' in the EU's draft Constitution.

Welfare state entitlements are vastly different from country to country in Europe. These differences portend intense conflicts within EMU. France, Germany, and Italy must scale back their social commitments, raise taxes, or borrow. But in the Eurozone's increasingly competitive environment, raising taxes would drive away business, while cutting benefits may be tantamount to political suicide. So the temptation to borrow is high.

The Stability and Growth Pact is designed to block that temptation by keeping budget deficits below 3% of GDP. But the Pact is already straining, and today's serial violations may appear mild when the baby boom generation begins to retire and public pension and health liabilities become cash demands. Some national deficits may rise to twice the Pact's limit.