Why the euro will continue to weaken

If you want to unnerve a European, the revelation of a secret dinner of New York-based hedge funds conspiring against the euro is hard to beat. Europeans are right to worry - but not about the collusion itself. They should be much more concerned that some of the world's smartest investors are convinced the euro has only one way to go: deep down.

At first sight, this flies in the face of a previous consensus. In Europe, in particular, the predominant view has been that the infidels at the Federal Reserve and the Bank of England will ultimately inflate themselves out of their debt, while the European Central Bank will hold firm. That scenario would be consistent with an overvalued euro.

So what has prompted some sophisticated investors to think the opposite? Greece? Probably not. This is a story about what will happen to the eurozone beyond Greece.

Without political and legal constraints, this would be much easier. The eurozone would prescribe itself a crisis resolution mechanism, a procedure to manage internal imbalances, and perhaps move towards a common eurozone bond. Several economists have made concrete proposals: Daniel Gros, director of the Centre for European Policy Studies, and Thomas Mayer, chief economist of Deutsche Bank, have argued the case for a European Monetary Fund. Yves Leterme, the Belgian prime minister, has proposed a European debt agency.

While all of this sounds sensible, none of it may ever happen because of political and legal constraints. Some member states would argue that a new European treaty would be needed to implement such proposals. The route to getting the Lisbon treaty ratified was so tortuous that Brussels would rather go to hell and back than negotiate and ratify another treaty. In any case, German constitutional law imposes such tight constraints that any dilution of the no bail-out clause in the Maastricht treaty or the price stability target of the ECB might trigger a forced German exit. The most one can hope for during the next 10 years is improved voluntary co-ordination in the European Council.

So the question then becomes: what economic adjustment mechanisms are feasible against this political and constitutional backdrop? The options are limited. The one policy response we can almost take for granted will be an attempt to reduce budget deficits back towards the Maastricht treaty's upper ceiling of 3 per cent of gross domestic product. This will be achieved, if not by 2012, then a year or two later. Meanwhile, Germany has unilaterally prescribed itself a deficit-to-GDP ceiling of 0.35 per cent from 2016. There will be some slippage here as well. But there can be no doubt that the eurozone will try - and probably succeed - to consolidate its fiscal position. The budget committee of the German Bundestag started last Friday, in fact, by cutting the finance minister's 2010 budget by almost €6bn ($8.2bn, £5.4bn).

If we assume further budgetary consolidation as a given, how then will the eurozone economy adjust? It is an economic fact that the sum of public and private sector balances must equal the current account balance. So forcing up public sector balances implies either an offsetting fall in private sector balances, an offsetting improvement in the current account balance, or some combination of the two.

In scenario one, the eurozone's current account balance remains broadly unchanged, and all the adjustment comes through a fall in private sector balances. In a similar way, Greece last week solved its fiscal problem by creating a private sector problem of identical size. The Greek state - the sum of its public and private sectors - is just as bankrupt today as it was a week ago. This means that, by following the fiscal policy rules, the eurozone would risk a private sector depression, which would almost certainly be concentrated heavily in Europe's south. This scenario would greatly increase the probability of a eurozone break-up at some point in the future. Investors who believe in this scenario would be very afraid to hold euros.

In scenario two, all the adjustment comes through the eurozone's current account balance, which would turn from slightly negative to strongly positive. It is difficult to see how this could be done without a significant further devaluation of the euro. The euro would join the long list of currencies that have seen their problems solved through competitive devaluation. So the consequences would be a significant devaluation of the euro against the dollar and a reversal of its appreciation against sterling. It would make life more difficult for the British. But, most importantly, it would contribute to a resurgence in global imbalances.

Whichever scenario you choose, the euro is going to be weak. Even if the eurozone were to allow more serious slippage in budgetary consolidation than I have suggested, that would probably not help the euro either, as markets would start to doubt the longevity of the currency union for political reasons.

We have always known that a monetary union cannot exist without political union in the long run. Those smart New York investors are betting that the long run is closer than we thought.

This piece first appeared in The Financial Times.