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Euro in the Twilight Zone: Past Lessons, Implications and Policy Options (part 2)

Inci Otker-Robe's picture

In a previous installment, we explored one particular past financial crisis which resembles the current tensions in the Euro Zone in key aspects—specifically, the 2001 collapse of Argentina’s currency board. Taking history as our guide, we discuss the lessons that can be learned from past crises and potential steps policymakers can take.

Implications for the euro zone

Until even as short as a month ago, the possibility of a breakdown of the European monetary union triggered by an exit of one or more of its members had been considered no more than a tail risk scenario. The odds of such an outcome are now seen to have grown, as market concerns continue to focus on economic and financial fundamentals of the peripheral Euro Area members that, similar to Argentina, failed to satisfy the preconditions of a sustainable membership in the currency union. Given the significant economic and financial interlinkages within the Euro Area, and the key role of Europe in the global economy (Figure 1), potential fallout from such a breakdown would be much more profound for the region as a whole and the rest of the world, compared to any crisis experienced in the past.

Figure 1. Exposure to Peripheral European Countries

 

Euro in the Twilight Zone: Past Lessons, Implications and Policy Options

Inci Otker-Robe's picture

The very foundations of the European monetary union have been severely shaken by the ongoing financial crisis and doubts surrounding its future have intensified. In this two part series, we explore the following issues: What are the key vulnerabilities underlying a shared currency union? What can we learn from past experiences and what would the impact be if the crisis escalates? And what policy measures should be taken?Photo Credit: dasroofless, Flickr Creative Commons

Fragility of “hard” exchange rate pegs

A monetary union can bring large benefits in terms of trade, low inflation, and lower borrowing costs, but it comes with tight strings attached. As an extreme form of a hard exchange rate peg, it is vulnerable to “sudden stops” (De Grauwe, 2009 ). History is full of illustrations of the demands placed on an economy by hard exchange rate pegs, such as dollarization and currency boards. To be sustainable, a hard peg must be accompanied by fiscal discipline and labor and product market flexibility, since monetary and exchange rate policies can no longer be used to respond to shocks and safeguard competitiveness. The lack of these preconditions not only undermines the sustainability of the regime, but also impedes the recovery from an ensuing crisis in the wake of its collapse.