On 1 January 2002, the euro was officially minted. People in every country within what became known as the “eurozone” started using the same bills and coins.
Bold predictions expected the new currency to help usher in a new era of prosperity and economic strength for Europe. It was not unusual at the time to hear forecasts of how the euro would replace the U.S. dollar as the world’s reserve currency.
Today, it is hard to find any of the ‘europhoria’ of 20 years ago. News reporting on the anniversary reflects a mixed image of the euro. Many eurozone countries have been through economic hardship and protracted austerity policies. Overall economic growth has been slow, and inflation is now on the rise.
It is easy to find mixed reviews of the first two decades with the euro. Euractiv offers just that, although they also largely avoid discussing the challenges that eurozone countries have faced over the past 20 years.
A more positive message comes from Catalan News, which concludes that Spain and Catalonia are better off thanks to the euro. The Irish Times, however, takes a measured approach as it discusses Ireland’s experience with the euro.
An unprecedented economic experiment
News reports provide a good measure of what the prevailing opinion of the currency union happens to be, but to really understand the effects of the euro it is essential to turn to scholarly research. The reason is simple: the common European currency is the biggest economic experiment in modern times. It cannot be properly evaluated without at least a glance at the depth offered by the academic literature.
There are many research contributions on the currency union, from academic books to peer-reviewed journal articles. Most of this literature, especially within economics, is of a rather eclectic technical nature, relying heavily on econometrics. As a result, it is often of only scant interest to the general public. However, there are highly informative contributions to the literature that give a good picture of how the currency union has performed thus far. A small sample is analyzed below; a later article will do a more comprehensive review.
As mentioned, the euro is probably the biggest economic experiment in modern history. The closest comparison, from a technical viewpoint, would be the creation of the Soviet Union and its satellite states after World War II. However, that comparison has very limited merit due in no small part to the artificial and totalitarian nature of the Soviet economy.
In short, the eurozone comes with virtually no precedent in economic history, especially not in the context of modern, advanced economies. The currency union explicitly or implicitly forced the reconfiguration of sophisticated markets and highly developed economic institutions.
The project of creating a currency union was preceded with a wealth of scholarly research. In fact, the idea of a European currency union had been discussed in the academic literature already in the early 1960s. It is unclear to what degree the political interests promoting the present currency union actually took that research into account.
At the heart of the academic contributions was the concept of an “optimum currency area.” Its coining is often credited to Robert Mundell, a Canadian economist who won the Nobel Memorial Prize in Economics for his research on how to create a currency union. His work was often cited in support of the euro, but it is equally often forgotten that prior to the creation of the euro, there was never a consensus reached among economists on whether Europe would be an optimal area for a common currency.
In short, there was no shortage of either supporters or critics in the 1980s and 1990s, when the euro went from concept to reality. Today, at the 20th anniversary of the minting of the euro, it looks like the scholarly critics may have edged out the supporters.
The ECB says one thing, does the opposite
Some critics are hard, such as a 2019 report from the German think tank Centrum für Europäische Politik. Based on an interesting method that is usually overlooked by conventional economists, the authors of the report conclude that only Germany and the Netherlands are better off as a result of the euro. All other eurozone members would have benefited from keeping their national currencies.
One reason why the eurozone structure has been a negative experience is that many countries were subject to tough austerity measures during the Great Recession. The purpose behind those measures was to prevent fiscal imbalances from causing fractures in the eurozone. Ostensibly, those countries would have been better off if they could have accommodated their budget deficits by devaluing their own currencies.
It is ironic that the euro has prevented the use of exchange-rate policies against budget deficits. The currency union was designed to help prevent excessive deficits in the first place. When the European Central Bank, ECB, was created, one of its missions was to prevent frivolous budget deficits in eurozone countries. It would do so by steadfastly refusing to purchase sovereign debt; if governments knew that they would never get help from the ECB, they would be left borrowing money on the sovereign-debt market. Theoretically, that would discourage excessive deficits.
In practice, the opposite happened. The bastion of monetary independence and money-supply restraint initially expanded its money supply as the eurozone was growing, but then switched to a more conservative regime. However, during the Great Recession the central bank lost what can best be described as a political chicken race against indebted governments. A comparison of data from the ECB and Eurostat shows that the eurozone money supply has expanded considerably faster than money demand (proxied as gross domestic product).
In plain English, for several years now the ECB has printed more money than the economy needs in order to operate. That extra money has been pumped into, primarily, two channels: to the banking system in the form of credit to private businesses, and to governments with large deficits.
The idea behind the ECB’s accommodating monetary policy was that it would keep the economy afloat through the Great Recession, recover from the deep slump and then survive the COVID pandemic. Unfortunately, there is little to suggest that this strategy has been successful. In 2013, three economists with the European Central Bank published a working paper (Ciccarelli et al., 2013) critical of the results of the ECB’s monetary accommodation. While the ECB helped indebted governments borrow money more cheaply, their lower interest rates and more readily available credit did little to help businesses.
This is not surprising: a business needs a growing economy in order to sell its products. If people in general do not have money to buy their products, it really does not matter if a firm can borrow cheaply to build another factory.
The Irish financial crisis
Beyond monetary conservatism, the ECB was also supposed to be the anchor of a currency union that brought financial stability to its jurisdiction. Economic theory speaks in its favor: a common currency eliminates the risks that come with exchange rates between country borders, while the free flow of capital harmonizes interest rates. The result is greater financial stability.
Again, reality disagreed with theory. There is no better example of this than the Irish financial crisis. In 2011, a group of economists published a comprehensive analysis of its causes and effects (Bergin et al., 2011). The crisis originated in a risky banking strategy that was directly enabled by the euro. Centered around mortgage lending, it became an acute problem for the Irish economy because banks were given a false sense of security by the common currency.
The analysis by Bergin et al. is somewhat technical; in a nutshell, it consists of two parts, namely the banking strategy itself and the role that the euro plays.
To start with the first part, suppose a bank in Ireland lends money to a home buyer at an interest of 5%. To finance this mortgage loan, the bank borrows money at a lower interest rate. Suppose they do so in France at a 3% interest rate.
So long as these rates remain stable, the bank will safely pocket a 2% margin. (We assume, of course, that the home buyer makes all payments on time.) It is reasonable to expect that the bank ensures that both their asset and their liability come with predictable terms. The interest rates should be locked in, and the maturities of both loans should be synchronized.
In other words, if the mortgage runs over 30 years, the loan funding the mortgage should also have a 30-year maturity.
As Bergin et al. explain, Irish banks did not follow this logic. They took out foreign loans with a very low interest rate compared to the mortgages they were selling, but those loans matured faster than the mortgage loans. Since their mortgage assets were still years from maturity, they had to take out a new loan to pay off the old foreign loan.
If the new loans cost less than the interest on their mortgage assets, the banks are in the clear. However, if interest rates are higher at the time of refinancing, the banks have a problem.
The euro enabled the crisis
This is exactly what happened. Interest rates are almost always lower on short-maturity loans. A short-sighted bank seeking to make big, fast profits will therefore borrow cheaply under short maturities and sell expensive, long-term mortgages.
Before the common currency, a bank looking at this profit-maximizing strategy would have to factor in the risk that comes with two different currencies. If, say, the franc rises in value versus. the Irish pound, the Irish bank will have to pay more money to honor its obligations on the French loan. This would deter them from taking out foreign loans, even if interest rates are low.
In theory, a bank could use financial-market instruments to protect themselves against currency fluctuations, but the market for such ‘insurance instruments’ is limited, especially when currencies and interest rates are volatile. Therefore, the combination of national currencies and interest-rate risk provide for an effective deterrent against excessive risk taking.
The euro eliminated the currency risk, making international borrowing look more attractive than before. Furthermore, standard economic theory prescribes that interest rates will harmonize under a currency union; the risk diminishes of, say, a rise in French interest rates while Irish rates remain steady.
In short, it was easy for banks to expect that it would be almost risk free to take out short-term foreign loans to finance long-term domestic lending.
Alas, theory was not confirmed by reality. As noted by Bergin et al., Irish banks found themselves facing higher interest rates abroad. To make matters worse, as explained at length in a paper for the American National Bureau of Economic Research (Boivin et al., 2008), the euro seems to have disconnected short-term interest rates from long-term rates. This limited the opportunities for the Irish banks to compensate rising liability costs with higher asset revenue.
Plainly, the Irish banks were trapped by a reality that did not work as theory prescribed. The euro had given them a false sense of security.
All in all, the common currency was a gigantic economic experiment, an application of political preferences rather than the product of sound scholarly research. As is always the case with grand government plans, for every problem they solve a new one is created. In the case of the euro, the reduction in transaction costs for international trade and financial investments has been outweighed by the problems with obscured risk highlighted by the Irish example.
The currency union has another item on its resume, namely its failure to curtail excessive budget deficits. In a coming article we will examine how not only the ECB, but the mechanics of the eurozone itself, contribute to excessive budget deficits, where the intention was the exact opposite.