25 years of the euro

The euro was conceived in Madrid in December 1995, as a way to put an end to the crisis of the exchange rate mechanism of the European Monetary System (EMS) that had begun in September 1992 with the pound sterling crisis. And it had a long gestation, until four years later when, on January 1, 1999, the currency parities were irrevocably fixed — those with enough age and memory will remember that the conversion of the peseta to euros was 166,386 pesetas = 1 euro — and the ECB took control of monetary policy. The birth of the euro lasted 24 months — a transitional period during which only the peseta circulated but prices were announced in both pesetas and euros — until January 1, 2022, when euro banknotes and coins were put into circulation. The peseta stopped being legal tender on February 28, 2002, although the exchange of pesetas for euros could be carried out until June 30, 2021.

Lots has happened since then. Contrary to the dire forecasts of renowned economists, such as Milton Friedman or Martin Feldstein, who predicted the failure of the euro due to the imperfection of its structure and the economic and political risk that this entailed, the single currency has not only survived, but has steadily added members to it club: the recent incorporation of Croatia brings the number of euro countries to 20, almost double the initial 11 countries. And four more countries — Andorra, San Marino, the Vatican and Monaco — use the euro and can issue their own euro coins. But it hasn’t been an easy journey. Mistakes have been made, some avoidable, others the result of inexperience or perverse political dynamics, which brought the euro very close to the precipice during the crisis, and which have limited the eurozone’s capacity for growth.

From a historical perspective, the history of the euro is the history of its crises. The German economic boom generated by unification was an asymmetric shock for Europe, leading the Bundesbank to adopt a strong anti-inflationary position in 1991-92 that, although necessary for Germany, ended up being excessively tight for the rest of the EMS, and which led to the departure of the sterling from the EMS and the devaluation of several of the EMS currencies, including the peseta.

The euro began trading on January 1, 1999, at an exchange rate of 1.18 against the U.S. dollar, but quickly depreciated by almost 30 percent, to a low of 0.82 euros per dollar in October 2000 — due to high interest rates in the U.S. and the rebalancing of foreign currency reserves of the euro countries — which caused the ECB to intervene in the foreign exchange markets to stabilize the newborn currency.

From there, an almost uninterrupted appreciation, boosted by the euphoria in the eurozone’s periphery that encouraged capital flows but also the accumulation of imbalances — remember that the Spanish current account deficit reached 10% of GDP — until reaching 1.60 euros per dollar in 2008. The first signs of the global financial crisis, with the suspension of liquidity withdrawals in some French funds and the capital shortages of several German banks arising from losses in their investments in U.S. subprime mortgages, marked the maximum of the euro.

The culmination was the Greek fiscal fraud: its fiscal deficit, which was already a hefty 6% of GDP in 2006, turned out to be much larger, reaching 15% of GDP in 2009 and creating serious doubts about its fiscal sustainability and viability within the euro. At that moment, the possibility of debt restructuring and exit from the eurozone arose, amplified by Merkel and Sarkozy’s fateful decision in Deauville to involve the private sector and the hesitations of the ECB. There was no turning back. Analysts and markets put together their lists of countries ordered by fiscal and external imbalances, the categories of debtor and creditor countries were created, sovereign risk spreads appeared, and the euro was never the same. Strong countries benefited from growth in external demand and low interest rates, weak countries struggled to stay afloat. The economic convergence that the single currency should generate disappeared, giving way to divergence, fragmentation, and the reduction of shared risks.

But, against the odds, the euro continued to be valued positively: in the end, fending off some strong attempts to force their exit, the countries that suffered the most during the crisis decided to remain in the euro.

The history of the euro began with misgivings between France and Germany and concerns about Italian fiscal indiscipline, and the euro crisis amplified these concerns to the rest of the periphery. It is the story of a mistrust, justified or not, amplified by an incomplete economic architecture that generates the need to spend more time debating systems of tremendously complicated rules to reinforce internal controls rather than designing instruments to increase potential growth and address external challenges.

The pandemic, and the shutdown of the global economy, forced the frugal countries to realize that this time they could not count on external demand to continue growing, and refocus their objectives towards the euro’s internal resilience. Suddenly, something that had been declared politically impossible for a decade — Eurobonds — appeared in just a couple of months to finance the NGEU and sustain European domestic demand. The energy crisis caused by the Russian invasion of Ukraine once again strained the seams of European solidarity, until those most affected by the absence of Russian energy finally reluctantly accepted that virtue is cyclical and does not always reside in the same place.

The euro has improved with each crisis, and the ECB has steadily improved and gained credibility, but it remains an imperfect currency area. Its role as an international reserve currency remains unclear. The aftermath from the pandemic and the energy crisis has endangered the internal market, due to the desire of some frugal countries to confront geostrategic challenges by prioritizing subsidies to national industry to gain competitive advantages, instead of promoting European public goods.  Beware that today’s subsidies do not end up being like the competitive devaluations of before.

Eppur si muove, as Galileo Galilei would say. Despite its imperfections, the euro has proven to be better than the alternative of not having it, and has created an area of stability where countries that take advantage of it to improve the structure of their economies flourish. Let’s celebrate these 25 years, and continue improving it.

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