The Euro at 25 – Conversable Economist

The euro technically started in 1999, when the 11 founding European members of the currency agreed to keep their exchange rates fixed and to hand over monetary policy to the European Central Bank. The euro then became the actual currency that people and firms used in 2002. I confess that, back in the early 1990s, I did not expect the euro ever to happen. My logic was simple: I reasoned that the euro would not take off without Germany, and Germany would not surrender the deutschmark. I was wrong.

So how is the euro going? Giancarlo Corsetti and Marco Buti  provide an overview in “The first 25 years of the euro” (CEPR Policy Insight 126, February 2024).

As the authors note, “the euro effectively sailed on with an incomplete constitution.” That is, when the euro began it had the European Central Bank, a promise from the member countries that they wouldn’t run overly large budget deficits, and a “no bailout” pledge if they did. But the consequences of violating these promises and pledges were unclear. It wasn’t clear to what extent the new monetary order would be enforced from above, or would bubble up from below. It wasn’t clear what would happen in a debt or financial crisis. It was not clear if there would be a “safe asset,” similar to US Treasury bonds, with the full backing of the euro area, or just separate bonds from different countries. There was no centralized European budget.

But there was a sense that if the European Union was to be an economic success, with free movement of workers, goods and services, and capital across national borders, the euro was part of the solution. Indeed, Europeans had for some decades had various agreements to limit or block movements in their exchange rates, so to at least some, the euro just seemed to formalize earlier arrangements and make them permanent. And indeed, for the first 10 years or so, the euro worked remarkably well. It was “the 2% decade,” with the economies of the euro-zone countries on average grew about 2% per year, with annual inflation staying low at about 2%, and average government budget deficits across the euro area at about 2%.

Then it went sideways. The European Union was first hit by the Great Recession of 2008-9, with many EU countries having their own versions of credit and housing bubbles and financial crisis. But for a time, global credit markets were pricing debt from all EU countries at very similar levels: that is, countries that seemed to have worse problems with credit bubbles, bank failures, and government debt were paying pretty much the same fairly low euro-based interest rates as everyone else. As a result, these higher risk countries (Greece, Portugal, Spain, Italy, Ireland, others) just kept dramatically over-borrowing.

Around 2010, the EU powers-that-be made clear that the neither the EU nor the European Central Bank was standing behind such loans. The interest rates for the most debt-ridden EU economies spiked. A decade followed of debt rescheduling, bankruptcies, emergency loan packages, and uncertainty. For the decade from 2009 to 2019, the annual GDP growth rate for the euro-area countries was only 0.8%–which implies that a number of countries had growth rates of zero or less during this period.

Corsetti and Buti go over the many, many summits and announcements and policy proposals through this difficult decade for the euro. Looking back on it now, I would emphasize that the problem wasn’t just slow growth and a sense of slow-motion crisis in the euro area, but a sense that the countries within the euro area were diverging. The author provide this useful figure, comparing the “interquartile range” of unemployment rates across US state and the EU-15 countries: that is, it’s the range of unemployment rates from the state or country at the 25th percentile up to the state or country at the 75th percentile.

Notice that the interquartile range for US states is comparatively small. The range across the EU countries looks as if it’s getting smaller for the first decade of the euro, but then appears to be getting much bigger from about 2012-2015. The gap then declines to a smaller, but comparatively still large, levels.

But by 2020, as the EU was having some success in gradually building institutional structures to deal with sovereign debt issues and to support the euro and the European Central Market, the pandemic hit. From the standpoint of the euro, the pandemic had two big effects: one clearly positive and one potentially negative.

The positive effect was that the pandemic offered a crystal-clear case for economic coordination and support, along with additional institution-building, across the countries of the EU. The negative effect was that fiscal deficits across the euro-area countries spiked as they sought to reduce the economic shock of the pandemic, and together with supply-chain problems, the reality of too much spending power chasing too few goods led to the euro’s first experience with widespread inflation, averaging 7% in 2002-2003. As Corsetti and Buti point out, the euro-area seems to innovate only in times of crisis:

[A]gainst all odds, EMU has proven to be resilient … The political drive underlying its creation, which seemingly withers away in normal times, resurfaces powerfully, especially when crises threaten the survival of the common currency. Indeed, historical records confirm the leitmotiv in the EU narrative: the ‘true reaction function’ of Europeans emerges only in conditions of extreme distress. But the same records also show that steps forward only come at higher-than-necessary and social costs. Looking forward, to keep counting on the idea that the right decisions are (eventually) made only under distress is risky. At 25, the key challenge for the euro area is to learn to design and implement the necessary reforms in ‘normal times’.

Some steps are happening. For example, during the pandemic the EU issued bonds backed by the European Union as a whole, not by individual countries, with the proceeds used to support economies and labor markets. Thus, countries could be less tempted to run huge budget deficits on their own. There is also discussion of European-wide funding of European public goods, like certain kinds of infrastructure or reductions in carbon emissions. The EU is working on a “banking union,” where there will be a common set of rules and supervision across all EU banks. (And yes, the euro was launched without a common set of bank rules or euro-wide banks supervisors.) A more general “capital markets union” is under discussion. It’s now clear that the European Central Bank will play a role in addressing financial crises. (And no, that wasn’t clear when the ECB was created.)

The euro was an incomplete work-in-progress when it started, which is part of why skeptics like me could barely believe it. But while the push toward further European integration has its pauses and jolts, the forward momentum continues, which means that the institutions surrounding the euro continue to evolve, as well.

For those who would like to dig more deeply into these issues, farther than the Corsetti-Buti discussion will take you, I can recommend a couple of symposium from the Journal of Economic Perspectives, where I work as Managing Editor. The Spring 2021 issue included a four-paper Symposium on the European Union:

Leave a Comment