Viewpoint: Stress Test for the Euro

• Author: Barry Eichengreen
• Position: Professor of Economics and Political Science - University of California, Berkeley
• Pages: 19-21

Page 19

Countries tempted to abandon the European currency face formidable barriers

IF the ongoing credit crisis is the most serious economic shock to hit the world economy in 80 years, then it is certainly also the most serious problem to confront the euro area in its inaugural decade. It is precisely the kind of “asymmetric shock” warned of by early euro-skeptics and highlighted by the theory of optimum currency areas.

Although housing prices have fallen euro area wide, they have fallen more dramatically in some countries than others (see Chart 1). Although the crisis has meant large losses for banks throughout the euro area—often on those same housing-related investments—it has produced larger losses in some countries than others. It has led to rising unemployment throughout the euro area, but more in some countries than others. The result is more deflationary pressure, actual or potential, in some euro area countries than others. There are also more strains on the public finances of some euro area countries, as reflected in the widening of spreads on sovereign bonds and their associated credit default swaps (see Chart 2).

Under these circumstances, different euro area countries presumably would prefer a different monetary policy response. But the members of the euro area are necessarily subject to a one-size-fits-all policy, such being the intrinsic nature of monetary union. This tension has revived the pre-1999 debate over whether monetary union in Europe is a good idea. It has also given rise to chatter and speculation about the possibility that one or more euro area countries might now choose to abandon the euro. This article weighs the implications of such a move and, although finding it risky, costly, and complicated, concludes that it is not inconceivable.

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Temptation is there

Since April 2008, the online prediction market Intrade has offered for trading a contract that pays off if any euro areaPage 20 country announces its intention of dropping the currency on or before December 31, 2010. As of mid-April, the pricing of that contract implied a 20 percent probability—in an admittedly thin market—of that event (see Chart 3).

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No doubt the temptation is there. Policymakers in the countries where domestic demand is now weakest can imagine how, if they still possessed a national currency, they might allow it to depreciate or even actively push it down to encourage exports. Those with the most serious worries about failed government bond auctions can imagine how, if they still possessed an autonomous national central bank, they might enlist it as sovereign bond purchaser of last resort.

But for each of these arguments for contemplating the reintroduction of the national currency, there is a counterargument. Although the gain in competitiveness from...