On the eve of the American Civil War, Abraham Lincoln famously said that “a house divided cannot stand.” Today, the European Union -- committed for decades to the quest for “ever closer union” -- must confront an agonizing truth. Lincoln’s maxim must be inverted. For the EU to survive, the euro must divide.

Between the Treaty of Rome in 1957 and the Single European Act in 1986, Europe’s governments brought about the one great peaceful revolution the continent has seen in its long and troubled history. The creation of a single European currency would build on this remarkable success. It was the next vital step to greater unity and prosperity. The economic crisis in southern Europe shows that the euro system, at least in its current form, has instead become a mortal threat to both.

Greece, Spain, Portugal, Italy and Cyprus are trapped in a recession and cannot restore their competitiveness by devaluing their currencies. The euro area’s northern economies have had to join in repeated bailouts and put aside their notions of prudent finance. A vicious circle of resentment and populism in the south and strengthening nationalism in the north is tearing the union apart.

And the crisis isn’t yet abating. France, Europe’s second-largest economy, is now sinking into a grave economic slump. Like the southern countries, it must restore its competitiveness; like them, as part of the euro system, it lacks the means. Because of its size and because of the guiding role it has played in the EU’s development, France, we’ll argue in Part 2 of this article, will be crucial in breaking the vicious circle.

Competitiveness Gap

First, though, what went wrong? The single European currency was expected to smooth the functioning of the European economy. By fixing the nominal exchange rate and eliminating currency risk, the euro would achieve convergence between the euro area’s stronger and weaker economies -- the so-called core and periphery. Capital would flow from countries with external surpluses to countries that needed to borrow, boosting productivity and growth.

The reality has been different. The single currency entrenched -- indeed, worsened -- the competitiveness gap caused by differences in inflation rates and unit labor costs. External imbalances grew. In 1999-2011, unit labor costs (wages per unit of output) in Greece, Spain, Portugal and France increased relative to Germany by a range of 19 percent to 26 percent.

In the less-competitive countries, this produced current-account deficits of 2 percent to 10 percent of gross domestic product in 2010, and a current-account surplus in Germany of 6 percent of GDP. With devaluation ruled out, these imbalances can be addressed in only two ways -- through cross-border transfers or “internal devaluation.”

Internal devaluation means that deficit countries try to restore competitiveness by reducing government expenditure and increasing taxes, which they hope will lower prices and wages. The short-term effect will be to weaken domestic demand.

Unless there is an offsetting increase in external demand - - with surplus countries, notably Germany, undertaking a reflationary stimulus -- such “austerity” will undermine economic growth and hence the public finances of the deficit countries. There is no prospect, however, of Germany -- along with other economically similar countries in the northern euro area -- agreeing to provide such stimulus, as this would run counter to their political and economic culture. This will increase doubts about the financial sustainability of the deficit countries’ public debt and the political sustainability of their internal-devaluation policies.

Latvian Example

Latvia and Iceland show how steep the economic and social costs of internal devaluation can be, compared with the costs of external devaluation. From 2008 to 2010, GDP contracted only half as much in Iceland (external devaluation) as in Latvia (internal devaluation).

Employment fell 5 percent in Iceland compared with 17 percent in Latvia. Euro advocates may argue that internal devaluation is starting to work -- real wages in troubled euro-area countries such as Greece have started to decline fast and structural reform to boost productivity has started. Whether Latvia’s political tolerance for collapsing output, employment and incomes can be reproduced elsewhere, however, is unclear.

The main alternative is transfers. Deficit countries can cushion their contraction with transfers from surplus countries, rather than internal devaluation. The problem is that such transfers will no longer be painless.

Before 2008, they took the form of cross-border private lending to governments and banks, which in many cases lent the money on to borrowers offering real estate as collateral. Since the credit bubble burst in 2008, these private financial flows have been replaced by state budget transfers, ballooning budget deficits and growth in the implicit liabilities of peripheral countries in the European Central Bank’s settlement system (known as Target2). The fiscal position of many uncompetitive euro-area economies has become unsustainable without transfers from Germany and the others.

Such transfers will be of taxpayers’ money -- provided either directly through the European Stability Mechanism or indirectly via banks in the creditor countries. (In the event of creditor banks having to agree to some form of sovereign-debt restructuring, those banks would have to be recapitalized with money provided by taxpayers in their home countries.)

This prospect is political dynamite. Such transfers are therefore made conditional on strict budgetary discipline and structural reform. Despite that tough conditionality, taxpayers/voters in creditor countries such as Germany might never be reconciled to the idea, creating the risk of an anti-EU backlash. Such a backlash would become certain in the all-too-likely event that the rules were bent or shelved.

Printing Money

Many debtor governments would prefer their transfers in the form of money printed by the ECB -- with fewer, if any, strings attached. French officials have said as much explicitly. But the best they can hope for is ECB purchases of short-term government bonds (known as outright monetary transactions). If they happen at all, these will be subject to the same tough fiscal conditions as apply to transfers from the ESM.

So the outlook for the euro-area debtor nations is one of relentless fiscal tightening and years of deficient demand. This will result in shrinking or, at best, stagnating output and living standards. Meanwhile, anti-EU and specifically anti-German sentiment is building -- witness the scenes on the streets of Nicosia after Cyprus fell into crisis.

Could a United States of Europe save the day? Some early proponents of the euro acknowledged in the late 1990s that the project involved “economics getting ahead of politics.” They saw the single currency as a way to put the continent on an irreversible course to full political union -- a goal that Europe’s electorates would have rejected had it been put to them directly.

Greater labor mobility might be one feature of such a union. One could imagine the populations of depressed countries such as Greece, Portugal, Spain and Italy migrating to rich Germany and Finland. In this scenario, whole countries could end up resembling depopulated rural regions -- such as those in France, which the young and well-educated largely abandoned in the postwar years, moving to the cities and leaving behind an aging population heavily reliant on social insurance. Language and cultural barriers make this form of economic adjustment unlikely, however.

Instead, euro enthusiasts are pinning their hopes on a fiscal union. Transfers would take the place of migration -- and a new framework of political accountability would prevent abuse (the so-called free-rider problem) and deal with the resulting tensions. Unfortunately, even if this could be done, divergence in competitiveness would remain.

Consider the cases of eastern Germany and southern Italy. On German unification in 1990, the former East Germany’s wages were converted into West German deutsche marks at 1-to-1, making eastern Germany enormously uncompetitive at a stroke.

German Transfers

In every year since reunification, eastern Germany has received transfers of 4 percent of German GDP. Yet convergence hasn’t happened -- young and educated people continue to migrate to western Germany. Southern Italy, despite decades of transfers, hasn’t converged, either. Unemployment is twice as high as in northern Italy, and private GDP per capita is less than half.

And then there are the politics. Uncompetitive euro-area countries cannot hope to receive transfers worth 25 percent of their GDP every year, as eastern Germany did, or even 16 percent of GDP, as in southern Italy.

Something has to give -- and it will have to be the euro system itself. To preserve the EU, the monetary union must be dismantled. The all-too-relevant historical parallel is the defense of the gold standard in the interwar period, which came close to destroying democracy all across the world. Only one country can plausibly take the lead in advocating a controlled segmentation of the euro system by means of a jointly agreed exit of the most competitive countries. That country is France.

Once again, as we will explain in Part 2, Europe’s fate lies in the hands of the French elite. In line with its finest political traditions of “fraternite,” France should champion a new strategy under the banner not of nationalism but of European solidarity.

A splitting of the euro system would be in the best interests of both France and Europe because it would speed the EU’s return to economic growth -- the only sure guarantee of European stability and unity.

(Brigitte Granville is a professor of international economics and economic policy in the School of Business and Management at Queen Mary University of London. Hans-Olaf Henkel is a professor of international management at the University of Mannheim and a former president of the Federation of German Industries. Stefan Kawalec is chief executive officer of Capital Strategy and a former vice minister of finance in Poland. The authors are signatories of the European Solidarity Manifesto. The opinions expressed are their own.)

To contact the writer of this article: Brigitte Granville at b.granville@qmul.ac.uk

To contact the editor responsible for this article: Clive Crook at clive.crook@gmail.com