Christopher Smallwood: Eurozone's diverging economies are likely to cause a chaotic break-up of the system

The emerging trends are disturbing. They strongly suggest not only that the eurozone is most unlikely to survive in its present form, but that its break-up could take place in conditions of financial chaos.

The fundamental problem is that the economic performance of member states, rather than converging as we were led to believe it would, has diverged steadily. The weaker states, no longer able to restore competitiveness by depreciating their currencies, face long and painful periods of adjustment, which their economic and political structures are unlikely to be able to withstand.

The easiest way to illustrate what is happening is to compare developments in Germany and Italy since 1999. Germany started from a severely disadvantaged position.

In terms of relative unit labour costs, it was 20 per cent overvalued compared with its eurozone partners, and unsurprisingly growth collapsed in consequence, falling towards a mere 1 per cent a year and staying there.

Lacking the ability to stimulate growth by cutting interest rates (now set by the European Central Bank) or depreciating the Deutschmark (now subsumed into the euro), German industry and the German government were left with no choice but to restore competitiveness by cutting costs - or at any rate holding the growth of costs below their competitors'.

As Lombard Street Research has pointed out, they are succeeding to a much greater degree than they have been given credit for. German business, for example, has concluded agreements with the workforce lengthening working hours for the same pay. Gerhard Schröder's government, under its agenda 2010 programme, has begun to tackle labour market rigidities and excessive pension costs.

The result has been the substantial improvement in Germany's relative cost position shown in the first chart. Over the years since the single currency was adopted, Germany's unit labour costs have risen by only 4 per cent - the smallest increase in the EU - and recently they have been falling.

Contrast this with what has been happening in Italy. There, productivity has actually declined during the euro years. But there has been little attempt to follow the German example and compensate for this by cutting wage costs. Structural economic reform is not on the political agenda. Pay has continued to rise and the result, as illustrated in the second chart, has been a widening divergence in unit labour costs not only between Italy and Germany, but between Italy and the rest of the eurozone.

In consequence, Italy now faces a competitiveness crisis. Relative to Germany, Italy's real effective exchange rate has risen by around a fifth since 1999, and its potential growth rate has fallen to around 1 per cent. This growth performance has admittedly been similar to Germany's, but the prospects facing the two countries are utterly different.

As the cost record shows, Germany's reforming efforts are well underway, and as the reform programme continues, the country's cost advantage will grow. As the benefits come through, the fear and insecurity which the reforms have generated, damaging consumer confidence and encouraging high savings, will dissipate, allowing spending to revive. And when this happens, the economy will do well. Germany will have emerged from an extremely difficult decade, once again a powerful competitor. But it will have taken 10 years to achieve this. Italy, from a competitive position now every bit as weak as Germany's in 1999, has yet to start the process.

Italy may try to carry on much as before, putting off radical structural reforms, watching its competitiveness with France and Germany - and with emerging economies, which directly compete with the products of Italy's small companies - deteriorate further, suffering ever higher budget deficits and negligible growth. But if so, as the country ceases to compete, the government will be faced with two choices: leaving the euro quickly so as to allow normal life to continue, restoring competitiveness by devaluing a restored lira; or finally taking its courage in both hands and embarking on German-style cost-reducing reforms aimed at restoring competitiveness while maintaining membership of the eurozone.

It is not at all clear that the Italian political system is up to the challenge presented by the second choice - in which case Italian withdrawal will come sooner rather than later. But suppose it picked up the gauntlet. As we have seen in Germany, structural reforms make things worse before they get better. People spend less and demand falls. The budget deficit spirals away and has to be restrained. Lower inflation means higher real interest rates (set by the European Central Bank), bearing down more heavily on the economy. Unemployment soars in Germany's case to 12 per cent. Can we really believe that the Italian people and the Italian political system will acquiesce in all this for the decade it may take for Italian enterprises to become competitive again?

The odds must be on growing political pressure to leave the euro. The Northern League, one of Italy's political parties, is campaigning for a referendum on Italy's euro membership, and a member of Silvio Berlusconi's cabinet has already argued for withdrawal. At present, these may simply be straws in the wind, but there is a long way to go, and the Italian political establishment could at any point decide that the game is simply not worth the candle.

Were Italy to find the pressures of adjustment within the European monetary system too painful to endure, it is unlikely that Italy's departure from the eurozone would be a one-off event. The first chart shows that other countries too have been losing competitiveness at an impressive rate.

The Dutch have now embarked on their own long, hard slog to make themselves competitive again, and perhaps will see it through. But what about Spain? For the moment, it retains cost advantages, but in a few years' time, it may find itself precisely where Italy is today, facing a decade of austerity. If Italy has by then left the euro, withdrawal will automatically come on to the agenda at that point, as it will when others among the weaker member states find themselves in similar difficulties in the future.

Moreover, politicians who imagine they can conduct an orderly process of withdrawal are kidding themselves - hence my earlier remark about financial chaos. A decision to withdraw from the euro would not be taken overnight. It would be the outcome of an extended campaign, which would be closely followed by the financial markets. As a decision to withdraw became more likely, bond yields would rise in the country concerned (let us say Italy), compounding its economic difficulties, and financial investors in Italy would begin to move their funds out, since they would regard the continuing euro as a better store of value than a depreciating lira. As the decision became imminent, that exodus would become a flood, undermining the Italian banking system and forcing the issue.

The truth is that a monetary system in which interest and exchange rates are removed from the control of individual governments, which at the same time contains members with relatively fragile political regimes, and which allows free movement of capital, is unlikely to survive indefinitely. Italy may be the beginning of the fragmentation story, but it is unlikely to be the end.

Christopher Smallwood is a director of Lombard Street Associates

Stephen King is away