Viewpoint: The Euro’s Finest Hour?

• Author: Charles Wyplosz
• Position: Professor at the Graduate Institute in Geneva
• Pages: 22-24

Page 22

The euro has proved a safe haven for countries lucky enough to have made it into this exclusive club in time

A COUPLE of years ago, as we were preparing to celebrate the euro’s 10-year anniversary, a common theme was that the new currency had not yet faced a serious challenge. Little did we know! The financial—and now economic—crisis has presented the euro area with a large number of varied tests. Many in Europe believe that the adoption of a single currency has been vindicated and that the euro is now in full ascendancy. I agree with the former but seriously doubt the latter.

The number one reason for creating a single currency has always been to avoid speculative attacks on exchange rates because wide currency fluctuations threaten the European Union’s single market for goods and services. This is why the decision to adopt the euro was made at a time when capital movements were liberalized (Baldwin and Wyplosz, 2009).

The number one lesson from the crisis is that this objective has been achieved. The Swedish krona and pound sterling are down—deeply. Most currencies in central and eastern Europe have been very volatile. Several of these countries have called on the IMF for support, and their troubles are far from over. Meanwhile, some advanced European economies, including Austria, Greece, and Ireland, face extremely difficult times because of bank distress or shaky public finances, or both. But one thing they don’t need to worry about is their currencies, because they don’t have any. The euro works and that is no mean feat.

Safe haven?

And yet the euro has not shielded some member countries from speculative pressure, which has taken the form of large spreads on government bonds. During previous crises, large spreads used to emerge alongside pressure on exchange rates that often resulted in depreciations or devaluations. A common interpretation of the spreads was in terms of the interest rate parity principle: spreads signal expected depreciations (although, as is well known, the empirical success of the interest rate parity principle is shaky at best).

The emergence of spreads within the euro area reflects either a belief in the markets that the country could abandon the euro or that the government might default partially or totally on its debt obligations, or both. The media have discussed the possibility that some countries may leave the euro area, but most observers have dismissed this possibility on the grounds that the costs borne by a departing country would far exceed the benefits, especially in the midst of a crisis. It is likely, therefore, that the spreads reflect mostly default risks, which may or may not be justified. The point is, this is a perfectly normal occurrence within a currency area. In fact, the very low spreads observed before the crisis were sometimes described as an oddity, and some even suggested that the markets weren’t sensitive enough to large public debts. Now it...