FLORENCE – For months, an increasingly frenetic, even apocalyptic, debate about the fate of the euro has been the major driver of global instability. Can Europe’s common currency survive? No less a figure than former United States Federal Reserve Chairman Alan Greenspan has now declared that it cannot.
But the euro also seems surprisingly resilient in the face of this woe. Unlike in the early summer of 2010, it has been largely stable relative to the dollar on foreign-exchange markets. That stability is puzzling.
Skeptics have plenty of ammunition for their critique of the euro. European governments’ high-level crisis diplomacy and new and ever more complex mechanisms sometimes briefly calm the markets, but the tide of doubt quickly sweeps back in. For a day, or sometimes only for a few hours, traders succumb to the illusion of stability, fueling a euphoric but ephemeral financial-market rally. Then they awaken to the reality that not much has really changed, and that in a few weeks or months the problems will reappear in a seemingly even more intractable form.
All manner of new legal and constitutional difficulties constantly arise. Is an amendment to the EU treaty required? Isn’t that politically unthinkable? One is ineluctably led to the conclusion that governance of the eurozone is irredeemably flawed.
But the persistence of these difficulties sheds light on why the eurozone was established in the first place. Market turbulence demonstrates a need for some institutional mechanism that can ensure greater currency stability. An international currency is the most obvious solution.
The euro originated from the harmful effects of international currency instability in the wake of the collapse of fixed-exchange-rate regimes in the early 1970’s. Whenever the dollar was weak, capital surged into alternative currencies, notably the Japanese yen and the German Mark. But exchange-rate appreciation put great strain on the export industries that were central to these countries’ economic performance; and both countries tried desperately to avoid becoming reserve currencies.
Today, the major “beneficiaries” – in fact, victims – of dollar doubts are economies that are much smaller than Japan or Germany. Nowadays, capital flows are driving up the Swiss franc, the Swedish and Norwegian krone, and the Canadian and Australian dollars, causing profound dislocations in these small economies as their products and services become uncompetitive.
The managers of these new safe-haven currencies are now desperately seeking at least a temporary peg or some system of bands relative to the exchange rates of their big neighbors. Such a policy is fraught with danger; indeed, it is inherently self-defeating, as the establishment of a peg or a band provides an obvious target against which speculators can take huge positions.
The current turmoil eventually will lead smaller European countries to look for ways to tie themselves much more closely to the euro. That is what happened in the 1970’s, during the original wave of currency turmoil: the Scandinavians and the Swiss negotiated to associate themselves with a European currency regime. Today, the logic of that strategy has become even more compelling.
The benefits of euro membership are also clear to many other small economies. Slovenia, which entered the eurozone in 2007, and Slovakia, which joined at the beginning of 2009 – just as the cresting financial crisis slammed shut the door to further euro enlargement – have enjoyed much greater financial stability than their untied neighbors.
Part of those neighbors’ problem was that domestic borrowing costs looked so high that many small borrowers, including many house buyers, turned to low-interest Swiss-franc loans and were then hit by the franc’s massive appreciation. The turbulence reinforces the lesson – fundamental to the rationale of establishing the euro – that ordinary people and businesses should not be exposed to exchange-rate risk.
Even in larger countries, the costs and benefits of membership in a currency union are under renewed consideration. In the initial aftermath of the financial crisis, it was widely assumed that currency flexibility gave the United Kingdom an advantage over eurozone members like Spain. But Spanish exports recovered more quickly than British exports, and inflationary pressure via the exchange rate is now a major constraint on future British monetary policy.
Of course, there are obvious governance problems with the eurozone. Most glaringly, the question of how to allocate the costs of some member countries’ unsustainable debt overhang has not been adequately addressed. It is easy to conclude that no one is in charge: not the national governments, and certainly not the ineffective European Commission in Brussels, with which the large member countries seem to be practically at war.
And yet, paradoxically, the absence of control is what makes the euro attractive. Unlike the US dollar, there is no obvious way to put pressure on the European Central Bank to depreciate the currency in order to obtain a competitive advantage over other economies. European governments are not in a position to instruct the ECB to purchase government bonds.
The more the eurozone’s ineffective governance is criticized, the greater becomes the euro’s importance as a non-political currency that represents a secure store of value. In a stable world of confident markets, small countries can rest easy with their own monetary regimes. In a turbulent world of market volatility, however, they risk being overwhelmed.
There is thus a surprising resilience in the European project. A bundle of logs lashed together in a raft – even if it lacks a rudder – has a clear advantage over a single storm-tossed trunk. The higher the waves of doubt and uncertainty become, the more the common approach is needed.
Harold James is Professor of History and International Affairs at Princeton University and Professor of History at the European University Institute, Florence. He is the author of The Creation and Destruction of Value: The Globalization Cycle.