The euro at 20: pragmatism underpins success of single currency
Adequate mechanism for sharing risk across euro area still required
“The euro system’s second decade was one of unforeseen turbulence, but it confounded its more strident critics by surviving the anxious years 2011-2012 (and 2015) without losing any member.” Photograph: Michael Sohn/AP Photo
Any assessment of Europe’s monetary union as it completes its second decade should refer to the regimes that preceded it.
For economists, the primary reason to adopt a single currency in Europe was to put an end to the disruptive currency crises and surges of inflation that had marred the decades before the Maastricht Treaty of 25 years ago.
Not only would trade and travel between member countries be free of the costs and uncertainties of currency exchange, but those countries that had long failed to control inflation could at last enjoy price stability by placing management of the currency on a multi-country central bank modelled on the Bundesbank.
There is more to central banking than maintenance of price and exchange-rate stability
And on these dimensions the European Central Bank has not disappointed. Inflation has come in on average right on target at just below 2 per cent per annum, compared with the double-digit annual inflation experienced in Ireland during the 1970s and 1980s.
To be sure, inflation had already been brought under control in most advanced economies worldwide from the early 1990s.
Indeed, in the most recent years there has been a tendency to undershoot the inflation target, with Irish consumer prices at the end of 2018 still below the peak reached in 2008.
But there is more to central banking than maintenance of price and exchange-rate stability.
By linking the monetary systems of member states so tightly together, the single currency introduced new risks that were not adequately addressed in the system’s design.
In particular, by removing devaluation as a safety valve for dealing with other adverse shocks, adoption of the single currency greatly increased the need for governments to make sure their fiscal and other policies would ensure resilience.
Many economists had argued that there should be some form of risk-sharing arrangements among the members of the euro area to help deal with shocks that hit some countries more than others.
But this was not on the cards, due to the trenchant opposition of political leaders who, even after a clear treaty prohibition on such bailouts, still feared that some national government might overspend and create a crisis of over-indebtedness spilling back on to the other members.
It proved impossible to bridge the political gap between those who recognised the heightened risks and those who feared that risk-sharing would be abused at their expense.
The full financial strength of Europe was not brought to bear effectively
The other big design gap was bank regulation. This too had been recognised in advance. A forthright 1998 critique (The ECB: Safe at Any Speed?) published by CEPR, the premier network of European economists, trenchantly declared: “Financial regulation within EMU is at present unsafe . . . [T]here remain flaws in proposals for dealing with insolvency during a large banking collapse . . . centralisation of regulation is essential.”
By moving ahead with an incomplete system, Europe’s leaders must have trusted that the more stable macroeconomic conditions that had prevailed since the exchange rate crisis of 1992-1993 would persist.
Far from exercising greater caution as financialisation of society deepened, most governments seemed content to see their economies surf the tide of credit. The early years of the new system seemed to validate such complacency; but it was about to be tested by the global financial crisis.
The euro area’s management of the aftermath saw numerous missteps, notably in the period 2008-2011. With a deepening fault-line between creditor and debtor countries across the euro area, several policy actions were driven more by an inflexibly conservative ideology – sometimes masquerading as legal doctrine – rather than by evidence-based economic analysis.
As a result, the full financial strength of Europe was not brought to bear effectively, with the result that the recession was deeper and more prolonged than it might have been.
In addition, shaken by the aftermath of the Lehman bankruptcy, policymakers adopted a generally creditor-friendly approach to problems of over-indebtedness.
We felt this in Ireland; though in the end (and after some hesitation) ECB policy had the net effect of containing the servicing costs of the debt accumulated by the Government in what had been a largely home-grown crisis.
Designed, then, for a less stressed economic environment, the euro system’s second decade was one of unforeseen turbulence, but it confounded its more strident critics by surviving the anxious years 2011-2012 (and 2015) without losing any member.
With a view to avoiding the errors of the past there have been some institutional reforms, such as the establishment of the single banking supervisor, and a legal regime for resolving failed banks that is less creditor friendly. But more is needed; in particular an adequate euro area-wide risk-sharing mechanism still awaits agreement.
Above all, though, the experience of the crisis shows how, instead of being boxed in by rigid ideology, policy needs the balanced economic pragmatism that has increasingly characterised euro-area decision-makers since 2012.
Patrick Honohan was governor of the Central Bank between 2009 and 2015