The euro has reached its 20th birthday.
In defiance of Milton Friedman’s doom-laden prediction that it would not survive its first crisis, it has not only survived, but is moving onto the global stage.
Whether the euro could replace the dollar as the world’s premier reserve currency is back on the dinner-table menu.
But underneath the surface, tensions remain.
The eurozone periphery, except for Ireland, remains depressed relative to the core countries. Spain and Portugal are recovering at a glacial pace, but Italy remains mired in a decade-long recession.
In Greece, domestic demand is cripplingly low – growth depends on an external sector, which is still failing to deliver a surplus. Meanwhile, Germany and the Netherlands have ballooning trade surpluses.
The imbalances that caused the eurozone crisis have not gone away. Only tight control from the Brussels bureaucracy prevents them from blowing up the euro again.
As Martin Sandbu, economist and journalist, has eloquently argued, the eurozone crisis was a failure of institutions, not of the euro itself.
The euro’s rollercoaster ride is reminiscent of Pharaoh’s dream: seven years of plenty followed by seven years of famine. That famine was relieved by social institutions charged with fair distribution of resources. The euro lacked the institutions to distribute resources fairly.
Now, there is a scramble to create them.
The euro did not get off to a good start.
The eurozone economy was weakened by West Germany’s struggle to absorb the much poorer East Germany, while the Federal Reserve’s low interest rate policy after the Twin Towers disaster in September 2001 caused the euro’s exchange rate to soar.
By the second quarter of 2003, eurozone growth had fallen to 2.63% per annum.
Over the next few years, however, eurozone growth improved, reaching 6.2% in the first quarter of 2007. As the architects of the euro had hoped, the fastest individual growth rates were in the periphery countries, notably Ireland, Spain and Greece.
It was an encouraging sign that monetary union was indeed pulling poorer countries up to the level of richer countries.
Within the bloc, everything was going according to plan. Interest rates were converging, encouraging inflows of capital to the poorer countries.
Although inflows tended to widen their trade deficits, it was believed that capital investment in poorer countries would eventually flow through into higher productivity, which would improve external competitiveness as well as raising per capita GDP.
Per capita GDP did indeed rise in poorer eurozone countries. But instead of converging, real effective exchange rates between the member states – a measure of competitiveness – diverged.
Capital inflows were going not into productive enterprise, but into real estate, consumer spending and sovereign debt. Periphery countries were becoming less – not more – competitive.
The euro’s rollercoaster ride is reminiscent of Pharaoh’s dream: seven years of plenty followed by seven years of famine
Inflation also remained higher in the periphery than in core countries, not least because of substantial wage growth. The common interest rate set by the European Central Bank (ECB) was too low for the periphery, discouraging saving and encouraging borrowing for consumption.
But the real problem was the banks. Poorly supervised banks chased a toxic combination of yield and safety, helped by the absence of nominal exchange rate differences.
In real estate, rising property prices encouraged banks to invest heavily in construction and mortgages, secure in the knowledge that defaults on loans would be more than compensated by the sale price of property.
Banks also invested heavily in periphery sovereign debt. Despite provisions in the Lisbon Treaty preventing eurozone sovereigns from bailing each other out and restricting the ECB’s capacity to support them, investors believed that they were implicitly backed by eurozone institutions.
This was tacitly encouraged by the ECB, which allowed banks to apply the same risk weight to all eurozone sovereign debt.
Consequently, even as periphery debt increased and competitiveness declined, interest rate spreads on eurozone sovereign debt narrowed.
By 2007, despite stubbornly high twin deficits, Greece could borrow nearly as cheaply as Germany.
Although the eurozone suffered a deep recession after the 2007/8 financial crisis, it bounced back quickly and returned to growth in 2010. But the respite was short-lived.
Both Ireland and Greece were bailed out in 2010. And in 2011, attention turned to Spain and Italy. Spreads on eurozone government debt widened sharply as investors withdrew their funds and banks retreated behind their borders.
For a while, it seemed as if the euro might break up.
Mario Draghi’s ‘whatever it takes’ speech is widely credited as the turning point in the eurozone crisis. The ECB guaranteed to ensure that the euro did not break up.
For the first time, it acted as a lender of last resort not only for banks, but also for sovereigns. But it was not followed by decisive reflationary action until 2015, when the ECB belatedly started quantitative easing.
Inflation throughout the bloc remained stubbornly well below the ECB’s 2% target.
Under Brussels’ supervision, periphery governments imposed austerity measures to rein in government spending and restore balance to the fiscal finances.
In Greece, the austerity measures were so severe that they caused a deep depression from which the country has not yet emerged. Core countries also reined in public spending to balance their budgets and reduce public debt.
Concurrent fiscal tightening with inadequate monetary support locked the eurozone into a low-growth, low-inflation, high-unemployment equilibrium. The years of plenty turned out to be an illusion; the years of famine were all too real.
As risk-averse banks withdrew behind their borders after the crisis, interest rates between core and periphery countries diverged, along with real effective exchange rates.
A euro in Spain was no longer worth the same as a euro in Germany. Locking the eurozone member states into a fiscal straitjacket kept the eurozone together, but it didn’t restore the monetary union. That required institutional reform.
Bank reform was the most urgent need. Capital inflows during the ‘plentiful years’ had overwhelmed some smaller countries, notably Ireland and Cyprus – bailing out their oversized financial sectors cost them more than they had to give.
In Spain and Italy, a dangerous dependency had developed between banks and governments – banks bought government debt, which helped to support its price, but meant that when a government hit an iceberg, the banks went down with it, forcing an already distressed government to recapitalise its banks.
Capital market reform was also a high priority. Eurozone capital markets were underdeveloped and fragmented – companies depended on borrowing from local banks.
The ECB’s single interest rate could not eliminate interest rate spreads arising from higher risks in periphery countries.
A company in Spain faced higher borrowing costs than a company in Germany, undermining its competitiveness.
Mario Draghi’s ‘whatever it takes’ speech is widely credited as the turning point in the eurozone crisis
In 2012, the eurozone agreed to create a banking union. Big banks would be supervised by a central authority, rather than by national regulators.
There would be a single standard approach to resolving failing banks, which would – by imposing losses on private-sector creditors – limit the cost for governments.
The eurozone also embarked on an ambitious programme to harmonise capital markets and reduce dependency on banks.
But both the banking and capital markets union depend on fiscal union – and that remains incomplete and contentious.
Germany balked at the notion of common deposit insurance, which would ensure that a deposit in Spain was as safe as a deposit in Germany.
And although the eurozone created an emergency fund, the European Stability Mechanism, which would be able to recapitalise banks as a last resort, this would be conditional on the sovereign accepting Brussels-defined fiscal austerity.
Even though large banks are now supervised at eurozone level, recapitalising them is seen as financial assistance to individual sovereigns.
The dangerous dependency between sovereigns and banks is by no means eliminated, and neither is the unfair dumping of the liabilities of large banks onto the taxpayers of small countries.
Germany also remains implacably opposed to any form of risk sharing.
But countries that have no control of monetary policy and increasingly little control of fiscal policy cannot defend themselves from a shock like that of 2008.
If the euro is to survive, risks must eventually be shared.
The Greek crisis of 2015 showed that the eurozone is still a conglomerate, not a country.
It would be unthinkable for, say, Michigan to be presented with a stark choice between submitting to the demands of the federal government or leaving the US. But that was the choice presented to Greece.
The Greek government chose to stay and submit, but the precedent had been set. There is now political acceptance that a country could leave the euro – or be kicked out.
Would a country leaving the euro cause its breakup?
During the eurozone crisis it was widely believed that if Greece left the euro, the whole bloc would break up, effectively ending the euro as a currency.
But institutional reforms since then appear to have convinced people that a country could leave without causing a domino-like collapse.
Refined in the fires of the eurocrisis, the euro now has an identity independent of the countries that make up the eurozone.
The eurozone remains fragile, held together only by political will to abide by strict rules. But there is growing popular anger at the unfairness of a monetary union that benefits some countries at the expense of others.
A populist, eurosceptic wave is sweeping across Europe. As it passes, one or more countries might leave the eurozone.
However, Greece has chosen to stay in and fight for reform; other countries, most recently Croatia, are joining.
German chilliness towards other states may give way to a more cooperative approach. And there are hopeful signs that the Brussels elite is beginning to understand that economic rebalancing needs to be actively pursued as a matter of policy rather than left to market forces.
Against all the odds, the euro could still have a global future.
“Unless there is more integration on tax and social issues, I think it is likely we will see some kind of breakup or two-tier eurozone in the future.
“Some countries are deriving a bigger benefit of being part of the EU than others. The strength of the currency against the US dollar has been a surprise.
“It is essentially driven by the strength of the German economy. There are still big issues in southern Europe that are being glossed over.”
FTSE 100 treasurer
Electronic first
Treasurers will recall that the euro was introduced via electronic payments first, in 1999. The first notes did not appear until 2002.
US dollars and euros
Only the US dollar surpasses the euro in terms of international trading volumes.
Prior to the euro’s introduction, 80% of the world’s currency reserves were held in US dollars, compared to 62% in 2018. The euro’s share for 2018 was 20.5%.
FOR…
“The strongest institution in the hands of the EU is the euro.”
Viktor Orbán, prime minister of Hungary
AGAINST…
“A single currency entails a fixed interest rate, which means countries can’t manage their own currency to suit their own needs. You need a variety of institutions to help nations for which the policies aren’t well suited. Europe introduced the euro without providing those structures.”
Joseph Stiglitz, economist
“I was sure we would never see the adoption of the euro. Countries giving up their currencies for a common tender was, it seemed to me, completely out of tune with currency being a carrier of people’s cultural identity, celebrating national heroes and events, as it had been for hundreds of years.”
John Naisbitt, futurist
Frances Coppola is an economics and finance commentator and speaker
This article was taken from the Cash Management Edition 2019 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership