The Euro: It Seemed Like A Good Idea At The Time

Ten years ago most countries of the European Union abolished their individual currencies in favour of one regional currency, the Euro. There were celebrations and rejoicing at a further step towards European integration and co-operation. It was proclaimed that this would lead to peace and prosperity. Most people gave it little thought beyond the fact it would be handy to use the home currency abroad on holidays. Very little consideration was given to the economic effects the currency might have. Rather it was presumed Europe could only benefit from a single currency. Ten years on and the Euro is facing widespread and possibly even collapse. Where did it go wrong?

In a nutshell, the Euro is in trouble because European economies are too different. In fact their economies are going in two opposite directions. This contradiction cannot work and many analysts are predicting the Euro’s break up.

Under a single currency, countries give up certain powers and give them to the European Central Bank. These include powers to set interest rates, to devalue and to print money. The ECB bases its actions on what is good for the whole Euro zone, rather than any individual economy. If all countries are on the same page this will cause no problems. If however economies are suffering from different problems requiring different (or even contradictory) solutions. Guess which describes the Euro zone?

Around 2001 the main economies of the Euro zone (France and Germany) went into a slowdown and suffered from high unemployment. To solve this problem the ECB cut interest rates to stimulate their economies. Unfortunately Ireland and Spain were experiencing a boom and needed the opposite solution, namely higher interest rates. Instead the ECB made their problem worse and contributed to the crisis the periphery countries suffered. Currently the shoe is on the other foot. The periphery countries (Ireland, Greece, Spain etc) are stuck in recession whereas the core countries (France, Germany etc) are recovering. Therefore the core needs higher interest rates whereas the periphery needs lower interest rates. The choice is either inflation for the core or unemployment for the periphery. Due to their power the core is getting its way.

The euro also exacerbated the boom and bust in the periphery countries. Most of the money to fund the Irish property boom was borrowed from Germany. The Euro greatly helped this capital movement by adding fuel to an all-ready overheating economy.

For an area to share a currency, it must have economies that are similar. For example America works well with only one currency. This is because US states trade a lot with each other and capital and labour can move freely between them, offsetting any imbalance. While on paper this is the case with the Euro zone very few people actually move countries due to differences of language and culture. A significant amount of their trade is done with America and former colonies. Most importantly of all there are no fiscal transfers. If one American states’ economy is declining while another’s’ is booming, rising tax revenue from one will be transferred to pay rising welfare costs in the other. This way the difference between the two states is balanced out and the economy keeps moving in the same direction. The lack of such fiscal transfers is a major cause of the current euro crisis. We have a choice: either a federal EU government with its own taxes or the breakup of the Euro. We cannot go half and half.

This has lead to calls for the Euro to be split in two. One for the richer core countries and one for the crisis periphery countries. As it currency stands the ECB is preventing the periphery from using the very policies it needs to get out of recession as it would cause in inflation. (The ECB also has an irrational and damaging fear/paranoia of inflation). With their own currencies, periphery countries could devalue print money and keep interest rates low, all of which would greatly benefit their economies without damaging the core countries.

The problem is that every country wants to be part of the rich currency and no one wants to be part of the crisis currency. There are several risks involved in changing currency especially if it is unplanned. There could be a market panic or a loss of confidence by investors. This could lead to bank runs, falling investment, capital flight and economic decline only making the problem worse. There would be significant problems regarding national debt if the new currency devalues as bonds are in Euros. All countries would suffer from a loss of confidence and stability, which why many strongly oppose the breakup of the Euro.

The Euro essentially was a one-size-fits-all policy for fundamentally different economies. It simply won’t work as long as the core and periphery countries are heading in opposite directions. While it would probably have been better if Ireland didn’t join, it may be too late to leave. While leaving could be disastrous, it’s hard to see how things can continue. There are no easy options.