How to ensure the eurozone does not unravel

The euro has to be a success if Europe is to flourish. Unfortunately, diverging trends in competitiveness within the eurozone threaten its stability. If they persist, a break-up of economic and monetary union cannot be ruled out, raising questions over the future of the single market - Europe's most important force for improved economic performance.

Within a currency union, a country cannot devalue its currency to regain competitiveness but must alter the relative prices of its goods and labour. There is scant labour mobility between eurozone members and no sizeable central budget to even out performance differentials. If the euro is to succeed, members must have flexible labour markets so that real wages (nominal wages adjusted for inflation) can fall relative to other member states and workers can move rapidly from declining to fast-growing industries. Competition must be strong so that companies have to innovate and search for ways to boost productivity. The participating economies also need to be fully integrated so that trade and flows of capital prevent differences in inflation becoming entrenched. Lastly, public finances must be sound so that an economic downturn can be temporarily offset by stronger public spending.

Though the eurozone was far from meeting these criteria at its launch in 1999, it was assumed progress would be rapid. Unfortunately, membership of Emu has, if anything, reduced pressure on governments to undertake reforms. Italy and Germany illustrate this paradox most starkly. Freed from the risk of currency crisis and higher debt service costs, Italy has done little to strengthen its public finances, make its labour market more flexible or boost competition. The result has been a steep decline in productivity growth, higher than average inflation and a loss of competitiveness.

Italy is not solely to blame for its predicament. German real wages grew by an average of just 0.3 per cent a year from 1999 to 2005, massively boosting the country's competitiveness and exports but depressing domestic consumption. The result has been a dramatic rise in Germany's trade and current account surpluses and a steady increase in the proportion of these surpluses accounted for by trade with other eurozone economies. Within Emu, Germany has been able to rely on exports for economic stimulus, reducing pressure on the German authorities to address the poor performance of its domestic economy.

Germany's dependence on wage restraint and exports leaves other eurozone members in an invidious position. If they try to regain competitiveness by depressing wage growth, Germany's economy will weaken, prompting tighter wage restraint in the country. This would further depress German domestic demand and, with it, demand for imports from other eurozone economies. While investment in Germany has strengthened this year, a lasting recovery in domestic demand is not possible without stronger wage growth.

Could the eurozone disintegrate? The signs are certainly ominous. Suppose that German wage restraint remains robust, preventing the current acceleration of economic growth in eurozone being sustained. Against a background of sluggish growth, Italy's reforms of labour and product markets are insufficient to improve the country's competitiveness. The financial markets eventually lose confidence that Italy can contain its public borrowing, causing its debt servicing costs to rise very sharply. With its economy stagnating and public debt rising rapidly, the perceived economic costs of staying in the eurozone start to outweigh those of leaving. Italian public opinion turns against the euro, casting doubt over the country's continued membership.

The costs of Italy being forced out of the eurozone would be great, and not just for Italy. Pressure on countries such as Spain and Portugal to leave and devalue their currencies would build as the financial markets speculated that their membership was no longer viable. The remaining members might also impose tariffs on imports from the countries forced to leave to protect themselves against "unfair competition". An unravelling of the eurozone could place the success of the single market in doubt.

Eurozone governments must convince voters that the reforms needed to ensure the success of the euro are also those that will boost economic