Can the euro maintain its position as a world currency after the sovereign-debt crisis?
Only if the euro area ceases to be a free-wheeling collection of states and is more closely controlled by the creditor nations of northern Europe, led by Germany. This development is likely to impose more stringent and unpopular conditions on the debtor states of southern Europe straggling to come to terms with Europe’s new balance of power.
A summer lull has broken out after the announcement in May of a 750 billion-euro ($950 billion) rescue package for weaker euro members, such as Greece, Spain, Portugal and Ireland. The euro has risen 6 percent against the dollar since early June, and Europe has gained valuable time to put its house in order.
As the bailout costs grow, it is harder for member states to bury their political and economic differences and rediscover a spirit of solidarity to safeguard the euro’s future.
Such solidarity will come at a price. The purse strings are held firmly by the North. And if the North prospers while the South remains mired in debt and recession, it will spell political chaos. It may even herald the splitting-up of monetary union into a stronger northern and a weaker southern component in the next five to 10 years.
The new euro-area borrowing facility, based in Luxembourg and set up under the emergency-aid package, is intended to provide a mechanism for errant states to bypass the financial markets -- but at a penal cost in terms of interest rates -- should the capital market dry up.
This is the intention, too, of a separate 110 billion-euro facility from which Greece is already borrowing to give itself a two- or three-year “holiday” from the capital markets. The problem is that risk premiums for Greece on the secondary market still haven’t declined. Capital-market rates for Greece stand more than 8 percentage points higher than interest rates on German government bonds.
More destabilizing disagreements on the European Central Bank Governing Council are almost inevitable as it grapples with the enormous monetary challenges of austerity, rising debt in the southern euro members and export-led growth among the strengthening northern creditor states, such as Germany.
The results of recent financial turbulence have now, for the first time, been striking home in Europe’s biggest economy. Germany’s reaction to what Chancellor Angela Merkel calls an “existential challenge” for the euro is becoming clearer. The irrefutable message is that the nation of 82 million -- together with other “hard-money” allies in northern Europe -- is seeking to exert control of the European economy in response to other countries’ widespread failure to reduce their deficits.
Causes of Crisis
Let’s look back to understand how this all happened.
The euro’s birth in 1999 took place at a time that was both propitious and disturbing.
It was propitious because a new currency was established, appearing to embody on a European scale the benevolent, low- inflation characteristics of Germany’s deutsche mark: a monetary unit that had become one of the world’s strongest currencies.
It was disturbing because at the same time a large buildup in international foreign-exchange reserves began to take place. The euro’s emergence ushered in a decade when official currency holdings quadrupled from a mere $1.9 trillion in 2000 to $8.1 trillion at the end of 2009, with 63 percent of the total held by the 11 top Asian holders (led by China).
This reserve buildup spelled an increase in liquidity driven by balance-of-payments disequilibria that contributed to driving down interest rates and lending standards across the world. These effects helped fuel the financial excesses that eventually led to the trans-Atlantic credit crisis of 2007-08.
One Size Only
In Europe, these phenomena encouraged excessive borrowing among nations already benefiting from low interest rates under the “one-size-fits-all” policies of the ECB. And this, in turn, helped to cause the sovereign-debt upheavals that broke out among euro members in the first half of 2010.
All these elements were interconnected. In 1999, central banks were anxious to lower their dependence on the dollar and saw the arrival of the euro as an opportunity to diversify their currency holdings into a new unit that covered a much wider economic area than the deutsche mark.
The result was that by the end of last year official reserve holdings of euros amounted to an estimated 27 percent of total currency reserves, according to International Monetary Fund estimates, a sizeable increase on the 1999 share of 18 percent. At the same time, the share of the dollar in world reserves was 62 percent at the end of last year compared with 71 percent in 1999, according to the IMF.
The heady increase in international importance of the euro may have come to a halt after the euro-area currency storms earlier this year. Its success now lies in a renewed solidarity between the region’s northern and southern member states.
(David Marsh is the author of “The Euro: The Politics of the New Global Currency” and is chairman of management consulting firm SCCO International Ltd. in London. The opinions expressed are his own.)
To contact the writer of this column: David Marsh at dmarsh.scco.com