Great Expectations

European Monetary Union (EMU) was supposed to be a harbinger of growth and stability for its member states, yet the euro zone debt crisis is now in its fourth year and continues to rumble on, in a seemingly endless cycle of crises, summits and false dawns. The currency union creaks under the deficiencies of the euro zone’s fundamentally flawed design, while its survival and capacity to prosper depend on its ability to fix these design flaws. The stakes are high.

Tom McDonnell

The new single currency was introduced with great pomp in electronic form in 1999, and then in physical form in 2002. This project is arguably the most ambitious experiment in monetary union ever undertaken, and was the latest step in the post-war process of European integration. A group of sovereign European states chose to combine their national currencies and transfer control over monetary policy to an independent institution, the European Central Bank (ECB). The group included some of the largest and most powerful economies in the world. The euro instantly became the second most important currency on the planet, and the euro zone expanded from its original eleven countries to its current membership of seventeen.

According to its proponents, EMU is an indispensable step in the long, slow journey towards integrating the European Union economies. The euro was expected to become a global reserve currency which would rival the US dollar and deliver all the privileges that result from that status. The single currency was also expected to become a stabilising anchor for its member economies, providing a degree of protection against the instability of large exchange rate fluctuations, and embedding lower inflation and interest rates.

However, the sheer persistence, severity and systemic nature of the twin sovereign and banking debt crises have cast grave doubt on the inherent stability and coherence of EMU. Although a misguided and incompetent political response has certainly not helped, it is nevertheless clear that the architecture of EMU, as currently constructed, and its internal inconsistencies have gravely exacerbated the crisis. Many of these architectural flaws can be remedied, and ultimately the success or failure of EMU will come down to political capacity and will. The euro entered its teens on 1 January 2012 and now is the time for reflection. Where do we want the euro to be in 2020 and how can we get it there?

This Time is Different
While there have been a number of successful monetary unions, the history books are full of examples of failed experiments. Experience suggests that having some pre-existing form of centralised political union greatly improves the chances of a monetary union succeeding. Classic examples of resilient monetary unions include the USA, the UK and even the former USSR. Yet the normal fate for currency unions is eventual failure and dissolution. Most such unions around the world are now just historical footnotes.

In Europe, there was a Latin Monetary Union (LMU) based on the French franc, and centred on France, Belgium, Switzerland and Italy, which lasted for most of the late nineteenth century. While the LMU had no single currency, the four main countries all minted their own gold and silver coins that were then considered legal tender in all of the other countries. The union was officially dissolved in 1926, but in practice had failed long before then. The Scandinavian Monetary Union (SMU) between Sweden, Denmark and Norway was a similar venture set up in the 1870s.

Both the LMU and the SMU broke apart because there was no central institution to enforce a common monetary policy and because of divergent fiscal policies. France also attempted to set up a ‘universal currency’ in 1867. The universal currency was intended to be centred on the minting of universal gold crowns of equivalent value. However, France was unable to convince the UK or the USA to take part in the scheme.

The Gold Standard
Perhaps the most famous example of a de facto currency union was the gold standard. The gold standard developed internationally from 1870 onwards and was a system of fixed exchange rates based on convertibility to gold at set prices. The system temporarily broke apart under the pressures of World War I, and then came under severe pressure again following the stock market crash in 1929. The gold standard finally unravelled in the early 1930s, as virtually all countries abandoned gold convertibility. The turbulent 1930s were characterised by floating currencies and by a long sequence of competitive beggar-thy-neighbour devaluations. These race-to-the-bottom policies were blamed for disrupting trade, increasing instability and prolonging the Great Depression.

In a bid to prevent this happening again, there was a movement by the victorious powers of World War II to establish an international monetary system based on the convertibility of certain national currencies into United States dollars. The outlines of this system were agreed in July 1944 at Bretton Woods. The US dollar was itself backed by convertibility into gold, and this effectively meant all participating currencies were indirectly pegged to gold and therefore to each other. A key purpose of the system was to provide the stability needed for post-war economic recovery, although countries could still devalue their currencies under certain conditions.

The Bretton Woods system began to fray in the late 1960s, as the United States became increasingly unable and unwilling to sustain the dollar exchange rate with gold. Dollar convertibility into gold was eventually terminated by the United States in 1971, and the major European economies broke their links with the US dollar over the course of the following two years. The Bretton Woods era was characterised by sustained economic recovery, low unemployment and strong growth in real economic output. As a result, the Bretton Woods system of pegged currencies became associated with macroeconomic strength in the minds of European policymakers.

Stabilising Exchange Rates in the EEC
The years that followed the collapse of the Bretton Woods system were characterised by the shock of the oil crises and by prolonged stagflation.¹ The currency instability of the 1970s prompted a series of attempts to stabilise exchange rates in the European Economic Community (EEC).

The first such attempt was the ‘Snake in the Tunnel’ system which aimed to peg all of the EEC currencies to one another within narrow bands. By the mid 1970s, the Snake had been reduced to a rump zone based around the Deutsche Mark. A renewed attempt at monetary coordination was made in 1979 with the launch of the European Monetary System (EMS). The EMS was based on a system of narrowly fluctuating exchange rates known as the Exchange Rate Mechanism (ERM), which in turn was centred on an artificial currency called the European Currency Unit (ECU).² The Deutsche Mark quickly became the anchor currency of the EMS.