Thinking About the Euro in 2012

As the most anxious year in the history of the euro draws to a close, and with dire predictions about the euro’s fate in 2012, it is an irresistible option for this author to take stock in a more realistic way. Despite all this year’s drama, the value of the euro is almost exactly where it was at the beginning of 2011. Indeed it seems 2011 and its attendant turmoil might just as well not have happened. It was certainly no annus horribilis for the value of Europe’s currency. As Figure 1 shows, the real effective euro exchange rate today is above what it was in May–June 2010, when the crisis was only about Greece, and even slightly above what it was when the crisis spread to Ireland and Portugal in late 2010. After the prolonged decline in the real trade weighted value of euro1 following the revelation of the fraudulent Greek fiscal data in October 2009, it is almost as if investors actually stopped worrying, as it became clear by May–June 2010 that in the euro area (like everywhere else) the bailout that some doubted did happen.

figure 1

Remarkably, the large increases in interest costs for systemically important and arguably too-big-to-bail-out Italy and Spain in July and August 2011 had next to no impact on the value of the euro. The common currency merely continued the slow decline that started several months earlier. Causality is always dangerous to allege. But Figure 1 suggests that the acknowledgement in April by the German finance minister, Wolfgang Schäuble, that Greece needed to restructure its government debts, with losses imposed on the private creditors of an Organization for Economic Cooperation and Development (OECD) country for the first time in decades, was more important than the rise of Italy’s borrowing costs to levels that would be unsustainable if maintained over many years. That "broken taboo" against debt write-downs, and the fear that it might spread to other euro area countries, stressed the euro more than Italy’s temporary funding costs and indeed more than anything else in 2011.

The European Central Bank (ECB) and others that had warned against that haircut, known as the Private Sector Involvement (PSI), were proven right about its immediate contagious effects. This was true even though Greece’s debt sustainability required substantial debt write-downs. Although the likely imminent implementation of PSI provides political cover for continued official sector (especially euro area) financial support for Greece, euro area leaders must now convince markets that it will not be repeated. As European Council President Herman van Rumpoy said [pdf] in the early morning of December 9: "Our first approach to PSI, which had a very negative effect on the debt markets, is now officially over."

When you are in a hole, the cliché goes, it advisable to stop digging. But at least some shoveling by euro area leaders during 2011 will continue into 2012. That does not mean that no political response was undertaken this year. The main problem was one of policy coordination and sequencing for different parts of the responses.

The euro area crisis is multifaceted. It encompasses a fiscal crisis (Greece), a competitiveness crisis (the Southern periphery), a banking crisis (Ireland, Spain, Germany, and others), and a design crisis (the flawed initial design of euro area institutions). Coordinating these elements is critical. Too much austerity to deal with a fiscal crisis will depress economic growth, which might itself depress government revenues, although this is disputed by the ECB and the European Commission’s doctrinal oxymoron of "expansionary consolidation." The ECB president, Mario Draghi, at least made a welcome admission that there was a fallacy at work when he said in a recent Financial Times interview that "I would not dispute that fiscal consolidation leads to a contraction in the short run."

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