Welcome Back, Euro?

Crisis for the Common Currency

10 euro note close up

Welcome back, euro! For a while there, you looked like a goner. During those debt crisis days when Greece was imploding and Spain’s banks were teetering and the Germans were asking why they had to pick up the bill, there was a serious wobble. Common European currency? Remind us, please, what Europeans actually have in common. And now that economic growth in the countries sharing the euro is stagnating, there’s a reminder of how many problems it caused. The question is being raised again: Are the flaws in the world’s most ambitious financial experiment fixed for good?

The Situation

Countries like France and Italy are pushing the European Union to relax budget rules or give them more leeway to boost spending and help sagging economies. The 18-nation currency bloc is forecast to expand just 0.8 percent in 2014, less than half the 2.2 percent pace in the U.S. European banks are still reluctant to lend. Unemployment is close to the record 12 percent reached in 2013, with about a quarter of young workers unable to find a job. What’s emerging is a multispeed recovery, with newer members like Estonia and Latvia creeping forward, while Italy contracts again and growth in France is halted. The slump has prompted the European Central Bank to cut a key interest rate below zero and buy securitized debt to help boost lending. Europe emerged from its longest-ever recession in 2013, when the euro had its biggest annual gain in six years and investors flooded back in. Ireland, Italy and Spain sold government bonds at record low yields in 2014. Even Greece, which briefly flirted with the idea of bringing back the drachma at the height of the crisis, ended a four-year exile from international markets with a bond sale in April 2014.

Source: European Commission estimates as of November, 2014
Source: European Commission estimates as of November, 2014

The Background

The European Union was set up in 1958, as the continent’s leaders vowed to make another war between them all but impossible. The euro came 41 years later, when Germany and France led a group of 11 countries that jettisoned marks, francs and lira and turned control of interest rates over to a new central bank. The scale of the common currency provided better access to world markets and more exchange-rate stability. It did not, however, impose uniform financial discipline; to avoid surrendering national sovereignty, politicians largely sidestepped a unified approach to bank regulation and government spending. While there were some rules, they were flouted. The crisis that brought the euro to its knees came during the global rout in 2009, when Greece acknowledged its budget deficit would be twice as wide as forecast. Investors started dumping the assets of the most indebted nations and borrowing costs soared. The shared euro made it impossible to devalue individual currencies of weaker countries, limiting options for recovery. Politicians lurched through bailouts for Greece, Ireland, Portugal and Cyprus plus a rescue of banks in Spain, with the EU and the International Monetary Fund committing a total of 496 billion euros ($687 billion). The panic fueled fears of a breakup as high debt, real estate bubbles and fragile banks exposed the common currency’s flaws. Banks and companies began to prepare for the return of currencies that might fall out of the euro. The firestorm didn’t abate until July 2012, when ECB President Mario Draghi pledged to do “whatever it takes” to preserve the euro. The promise bolstered confidence that conditions for funding backstops would be met.

The Argument

Euro-area leaders say the worst is over. New systems have been put in place to centralize bank supervision and build firewalls between troubled debtors and taxpayers. They still may not have gone far enough. Proposals for a deeper union, including more oversight of national budgets, binding agreements to make economies more competitive and the pooling of debt have not been realized and could sow the seeds for another crisis. The diverging fortunes among countries highlights the challenge for the ECB, which is battling the threat of deflation, or a drop in prices, which could be a drag on growth for years. Adding stimulus to aid laggards could undermine efforts to make them rein in spending, or fuel more asset bubbles. Though the bloc has survived the crisis so far and existential doubts about the common currency have faded, the euro still faces plenty of longer-term risks.

The Reference Shelf

First Published April 10, 2014

To contact the writer of this QuickTake:

Ian Wishart in Brusssels at iwishart@bloomberg.net

To contact the editor responsible for this QuickTake:

Leah Harrison Singer at lharrison@bloomberg.net