The Future of Monetary Union

No-one enjoys being reminded ‘I told you so’. In the 90s, when the European currency union was set up, sceptics pointed to the vast differences between the economies in the putative union, suggesting that the one-size-fits-all policy of the ECB would fit none.

For several years, the Euro experiment went well. The Euro was not plagued by the persistent inflation of the Lira or the Franc. The high unemployment and sluggish growth of Eurozone countries was attributed to inflexible and onerous labour laws and a need for structural reform. In the markets, the Euro was a strong and dependable currency, increasingly discussed as a replacement for the US dollar in the vaults of central banks around the world.

Historically, the northern European economies – Germany, the Netherlands and the Scandinavian countries – ran currencies with low inflation, using efficient labour markets to keep costs down, and maintained fiscal discipline by running small structural deficits. By contrast the southern economies – particularly Portugal, Italy, Greece and Spain – registered high levels of inflation (in the region of 5 – 10 per cent year-on-year in the early 90s), due to their reliance on the depreciation of their currencies to keep costs down. In addition, the southern governments were running significant structural deficits as high as 8 per cent of GDP on a regular basis.

As a condition of joining the Euro, Germany required that it would be modelled on the Deutschemark, the model of a stable, low-inflation currency. The Maastricht criteria for joining the Euro were designed to ensure that countries were able to function with the currency. Inflation had to be brought to within 1.5 per cent of the average of the three lowest inflation rates in Europe (in practise, this was in the range of 2.5 per cent), deficits had to be less than 3 per cent, and government bond yields had to reach relatively low levels (no more than 2 per cent above the average of the three lowest inflation states).

The southern nations were bound by treaty to meet these criteria, so they acted quickly to ensure delivery of the right figures by 1999. Sadly, you can have something done quickly, or you can have it done right. Rather than addressing the underlying lack of competitiveness in their economies, these countries chose to use monetary policy, which provided the low inflation needed in the short term to meet the criteria.

In 1999, Greece did not meet the criteria and was not accepted into the Euro, only to be accepted in 2001, on the basis of numbers whose accuracy was later questioned. And, because there was no official sanction, the 3 per cent deficit limit was routinely breached by Euro members.
The difficult circumstances of 2009 turned a distant problem into an immediate crisis. The financial turmoil which started in 2007 and the recession it caused led to a substantial drop in tax revenues, widening deficits. As banks failed, governments were liable for their debts, adding to the stock of government debt. The fall in the growth of Euro economies made a substantial change to the balance of debt sustainability. Within a few years, a country that had been borrowing slightly more than usual found itself on the verge of bankruptcy and its ability to pay questioned.

Since then, the Euro area has lived on a knife edge. Every week, several of the countries in a precarious position – Portugal, Italy, Ireland, Greece and Spain – auctioned debt to the markets. In a debt auction, investors bid the interest rate at which they are willing to lend to the country. If an auction goes badly (and the country needs to pay a high interest rate), it will probably cause the next auction to go badly. If an auction fails (the interest rate is so high the country doesn’t borrow), then investors get badly spooked.

If a country can’t borrow for an extended period of time, it will be unable to pay expenses and creditors, and it will default. In a default, a country either refuses to pay in full or delays payments. As a result, lenders lose some or all of their money. The consequences are potentially catastrophic: First, a defaulted country won’t be able to borrow, so it would only be able to spend what it gathers in taxes. For most Euro countries, this would entail a level of cuts that would dwarf the austerity the UK is experiencing. Secondly, a default would scare investors so much that one default would probably lead to the defaults of several other precarious countries.

Recognising the risk of cascading defaults, EU leaders met and agreed to create the European Financial Stability Facility (EFSF), a fund with €700bn to lend to Euro area countries in need of a bail-out. To date, Greece and Ireland have received funding from this facility (as well as bilateral loans from other countries and the IMF) at a rate below their market borrowing costs.
In this atmosphere of fear, any Euro assets are subject to question. The yield on Eurozone government bonds is rising because the EFSF is guaranteed by Eurozone governments. But most notably, amid fears that countries might leave the Euro, the Euro is weakening significantly.

The mechanics of leaving the Euro would be extremely painful. The initial switch from national currencies to the Euro took two years. In order to return to a national currency, it would have to be printed, bank machines would have to be replaced, prices re-stated and large parts of the financial infrastructure replaced. The country’s debt would still be denominated in more valuable Euros, increasingly expensive in terms of the country’s own currency, which would probably be rapidly depreciating. The shock of the announcement of a return to national currency would cause turmoil on a level that makes the current worries seem mild.

In short, the Eurozone finds itself in a difficult position. In many cases, it seems that any solution would cause far more pain than the current problems with the Euro. It is a cautionary tale for those conceiving a future common currency.