The Future of the Euro

I was recently involved in a panel discussion on the euro at  the Cass Business school on March 3rd 2014, hosted by the London Irish Graduate Network. Tadhg Enright was in the chair and the other participants were  Graham Bishop and Martin Wolf from the FT.  Although there were no set speeches I took the opportunity to gather some thoughts on the euro, produced below.

The euro is now well into its second decade, having survived what appeared to be an existential crisis, and by most attributes of a sound currency can be viewed as a success. This is particularly true for the euro as a store of value; its internal purchasing power has been supported by stable and low inflation around 2% per annum and its external value has also been broadly maintained over time-the trade weighted exchange rate is currently about 5% above its level at birth according to BIS data. Yet few would argue that the original eleven members fulfilled the criteria normally required for an optimal currency area and the economic performance across those countries has hardly been uniform; Finland recorded a 20% rise in real GDP per head from 1999 to 2013 according to IMF data, followed by Germany (19%), Austria and Ireland (18%), in contrast to the zero growth experienced by Portugal over that period and the 3% fall seen in Italy. Of course we will never know how they would have performed absent the euro but it is clear that monetary policy at least has been far from optimal for individual countries- a simple Taylor rule, for example, would suggest that rates were far too low in Ireland in the first half of the noughties. Adjustments to imbalances are also clearly asymmetric, with the burden solely on debtor countries to shift resources to the external sector while creditor countries are not required to expand domestic demand to make that adjustment less painful. The notion of punishment for miscreants is a strong undercurrent in creditor country thinking and the penal rates on the original official loans from the Troika to those in bail outs were only abandoned as the threats to solvency became stark.

Differences in regional growth rates are not unusual of course and can persist for long periods. One can point to the fifty US States as an example, although a shared culture, language, legal and education system allows for mobility of labour and capital, which is not the case for the euro. The Federal budget in the US also acts as an automatic stabilizer, providing a partial cushion for weaker States in a way that is impossible in Europe given that the EU Budget is only around 1.5% of GDP.

Currency unions generally evolve from political initiatives rather than any compelling economic case and the euro clearly fits that model-remember all EU members are supposed to adopt the currency when meeting the entry requirements (although currently 2 have opt outs and a third, Sweden, an implicit opt out) which implies a membership of at least 25 over time, from the current 18. The flaws in the original construct have also been exposed: the monetary union created is part of an economic union but each country was left with fiscal sovereignty and control of its own banking system and, crucially, without a Lender of Last Resort such as the Fed or the BoE. Consequently the eruption of the global financial crisis from 2008 put huge stress on euro peripheral bond markets as, to some degree, those governments were borrowing in a ‘foreign’ currency, backed only by their ability to raise tax revenue in euros, as they had no mechanism to print euros to meet debt obligations. The ECB and the main government players also saw the explosion in fiscal deficits as the cause rather than a symptom of the crisis and confused investor concern about specific credit risks with an attack on the currency, pledging that ‘no euro bank will default’, so compounding the sovereign debt issue and the ‘doom loop’ between sovereigns and banks. That view had a particularly profound implication for Ireland, with the State injecting €64bn or some 40% of GDP into the banking system, with equity holders and sub-debt holders shouldering some of the bank losses. Ireland also had ‘first mover disadvantage’ as it is now proposed that senior debt holders can be ‘bailed in’, a policy then prohibited by the ECB.

The euro crisis precipitated a series of emergency, ad-hoc and sometimes contradictory policy responses  by the Eurogroup and the ECB, with the latter eventually promising to do ‘whatever it takes ‘ to save the currency, including  a conditional pledge to buy secondary market sovereign debt in unlimited amounts, in contrast to the misconceived and half-hearted Securities Market Programme. The commitment has never been tested but the market response indicates that investors probably perceive that the euro now has a Lender of Last Resort, at least of a sort, and is comforted by that fact, shrugging off doubts about its legality and degree of support within the Governing Council, although that sanguine view may change as events unfold. The fall in peripheral bond yields  may also be driven by investors giving some probability to  QE eventually emerging from the ECB.

The conventional view among commentators is that the euro project has now to evolve into a banking union and ultimately a full fiscal union. Steps have been taken in terms of the former, albeit hesitant ones, with the burden of bank resolution still State dependent for up to a decade. The tide of public opinion in Europe also appears to have shifted away from Federalism and so the concept of debt mutualisation is a long way from realization. Moreover, new euro fiscal rules will further limit discretionary budgetary policy within member states, so leaving governments and hence electorates with no macro tools to affect aggregate demand; domestic policy levers can now solely impact the supply side of the economy given the loss of sovereignty over fiscal, monetary and FX policies.

The conventional wisdom on banking and fiscal union requires political agreement on the way forward and it is by no means certain that electorates will support these moves. Indeed, the risk remains that debt fatigue or creditor fatigue will eventually result in the election of governments willing to risk leaving the single currency even though the costs of exit are seen as high and the outcome uncertain. What would Ireland do, for example, on a break up- a floating punt is unlikely so would it anchor again with sterling or adopt some range against the DM, as in the ERM? That uncertainty and perceived costs of exit may well continue to trump discontent within most or all the debtor members of the euro and the stagnation evident in the French economy may help precipitate a more expansionary monetary and fiscal mix in Europe – the respective performances of the US and UK economies relative to the euro area since the Great Recession surely cannot be put down to supply side responses alone.  One can never say that the fear of euro exit will always be the case, however, and that the single currency will inevitably survive in its present form.  Yet it is foolish, as some have done, to predict the date and time of exits as it will be political events that will determine the euro’s fate, which is appropriate for what is, after all, a political construct.