The Interdependence of Macroeconomic Conditions under a Metallic Standard
The Trilemma under Any Fixed Exchange Rate Regime
Introduction of the Euro

What the Future Holds for the Euro

Considering the sovereign debt crisis of the early 2010s, the European Union (EU) and the Euro-zone are facing formidable challenges. This crisis has sparked questions regarding the long-term viability of the euro.

Sovereign debt crisis taking a toll

In terms of the timeline, following the U.S. financial crisis in 2008, the European sovereign debt crisis started in 2009. It included the Euro-zone member countries Greece, Ireland, Italy, Spain, and Portugal. In some of these countries, bank bailouts or nationalization of some of the private banks and related recessions led to a significant increase in sovereign debt.

Although these decisions were costly, they prevented a systemic failure of the banking system in these countries.

Nominal interest rates decline after countries enter the ERM and the Euro-zone. But recently, increasing sovereign debt led to increasing interest rates and spreads on these countries’ sovereign bonds. The crisis was visible in 2012, when nominal interest rates in Greece, Ireland, and Portugal diverged significantly from rates in the rest of the Euro-zone.

In Greece, long-term interest rates reached almost 30 percent in 2012, while they remained around 12–13 percent in Ireland and Portugal. Spread is defined as the difference between the interest rate on a debt security and the interest rate on a riskless debt security with comparable maturity.

If Germany’s bond rate is considered the riskless rate of borrowing, in late 2010, the spread over Germany’s interest rates started increasing to 9 percent in Greece and 3 percent in Ireland and Portugal.

Creating the EFSF

Some people argue that the EU acted indecisively at first, which led to the depreciation of the euro in early 2010. Then, realizing that the crisis couldn’t end on its own, the EU introduced the European Financial Stability Facility (EFSF), which implied borrowing €750 billion from world financial markets and the IMF.

In addition to the commitment from the IMF, all Euro-zone countries contributed to the EFSF, where their contributions to the EFSF reflected the size of their economy (as measured by their GDP or Gross Domestic Product). Therefore, Germany, France, and Italy have been the top three contributors to the EFSF, in that order.

The alternative to the EFSF would have been troubled countries raising funds through issuing debt at higher interest rates, which were deemed to be unacceptable. The decision was to have the EFSF raise funds by issuing bonds and other debt instruments.

The funds raised have been used to recapitalize banks and buy sovereign debt of troubled Euro-zone countries. The ECB also reversed its “no bailout” policy and started buying government papers of the crisis countries, to avoid panic and illiquidity (lack of cash) in financial markets.

Utilizing the EFSF

A Euro-zone member can apply for the EFSF if it can show the difficulty of borrowing at reasonable interest rates in financial markets. Additionally, the country must work out an austerity program and present it to the European Commission (the 27-member executive body of the EU) and the IMF. Then the Euro-zone’s finance ministers must unanimously accept the program.

Between 2008 and 2012, more than €490 billion was distributed to Greece, Hungary, Ireland, Latvia, Romania, and Spain. Greece received almost half of these funds. The €110 billion of the bailout to Greece in 2010 wasn’t part of the EFSF; it came partly from the IMF and partly from bilateral lending by some of the Euro-zone countries.

The situation of Greece was particularly severe, with higher unemployment rates, a ratio of budget deficit to GDP of 10 percent, and a ratio of debt to GDP of more than 100 percent. Ireland also received a sizeable package of more than €65 billion in late 2010.

Although downgrading Greek bonds was severe (down to a position reflecting default of the issuer), Greece wasn’t the only country whose bonds major rating agencies have downgraded. Rating agencies initially assigned an AAA rating to EFSF bonds, but in 2012, Standard & Poor’s downgraded the sovereign bonds of eight Euro-zone countries, as well as the EFSF bonds.

Pain of political (and fiscal) integration

The sovereign debt crisis in the Euro-zone hasn’t been kind to intra-Euro-zone political relationships. By 2012, the financial stress caused frictions between Germany and France, much like during the 1992–1993 period, when the EMS was in trouble. Such difficult times have always fueled skepticism regarding the European integration (called Euroskepticism).

One function of a common currency is to promote international risk sharing within the common currency area. With risk sharing, one usually means fighting against the same shocks. In the case of the European sovereign debt crisis, the shock originated in a handful of countries as home-made problems. Therefore, instead of bringing the Euro-zone members together, the national nature of the underlying problems caused frictions among the EU and Euro-zone members.

It seems that certain structures aren’t yet in place in the Euro-zone, in particular, and in the EU, in general. The EU has made great progress in such areas as environmental and judicial cooperation and competition policies, but fiscal issues have remained untouchable.

This fact may be surprising because two of the Maastricht convergence criteria are related to the budget deficit and public debt. Although countries are expected to implement these criteria to be included in the Euro-zone, not much oversight on fiscal policies may occur after countries enter the Euro-zone.

Another sign of missing guidelines is the fact that the ECB changed its mind about bailing out countries in the Euro-zone. The Eurosystem (the ECB plus the NBC in the Euro-zone) was prohibited from granting loans to other EU bodies or member countries’ public sectors, to protect monetary authority from the influence of fiscal authority.

To be fair, the Maastricht Treaty of 1992 and the Stability and the Growth Pact (SGP) of 1997 were against bailouts as well. At the end, the Euro-zone backed down from this rule and provided one of the largest bailouts in financial history.

An important reason for this making-rules-as-events-unfold attitude is Europe’s fundamental quarrel regarding the nature of fiscal policy coordination. The European sovereign debt crisis revealed the lack of fiscal policy coordination, which, in turn, reflects the EU’s struggle with political unification.

Some countries and some groups in almost all European countries strongly oppose fiscal federalism. It seems that no country is ready to limit its control over fiscal policy or partially hand it over to a supranational or federal fiscal authority.

In a way, having a supranational central bank such as the ECB as the monetary authority and a number of national fiscal authorities may put continuing political pressure on the ECB, despite its dedication to price stability and independence.

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The Impact of the Bretton Woods Conference in 1944
The Decline of the Bretton Woods System (1950s and 1960s)
The End of the Bretton Woods System (1971–1973)
The Bimetallic Era (until 1870) of Currency
The Currency Standard of the Interwar Years (1918–1939)
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