In memory of Dr. Andreas Höfert

A counterfactual history of the euro

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What if the euro had never been created? Given the current crisis, even some politicians who once defended the common currency now acknowledge that the euro was a mistake. But aren’t we now as blinded by the supposed failure of the euro as we were some years ago by its supposed success? How would Europe and the world look without the euro?

“What if?” In the early 1990s, this question was a starting point to what since developed into the so-called “counterfactual history” methodology. Similar to forecasting, it tries to develop a likely chain of events, which would have happened, if one historical event did not occur as it did.

Many may think this futile. Advocates argue that counterfactual history enables a better understanding of the more and less important, the necessary, sufficient and trivial facts in a causal chain of events.

To build a counterfactual history of the euro means declaring the event which transpired in the night of 31 December 1998 and 1 January 1999 and created the common currency, as something that never occurred. However, this would be too simple. The years before euro creation, when future member states tried to respect the Maastricht criteria to gain their membership also need some adjustment.

We will keep the previous exchange rate mechanism, the European Monetary System (EMS). We do this because since the break-up of the Bretton Woods system in the early 1970s, countries in the European Union have always striven for managed exchange rates regimes, instead of fully flexible ones. The creation of the euro culminated this quest. Also, every other event not significantly impacted or caused by the euro's creation, such as the Asian crisis of 1997, the dot.com bubble of 2000 and the financial crisis of 2007–2008, will be assumed to have also occurred in this counterfactual history.

The creation of the euro had two major impacts, foreshadowed before its introduction in 1999: a convergence of nominal government bond yields and a fixed exchange rate regime. One set of prices, the exchange rate, got institutionally fixed with the creation of the euro, and another set of prices, government bond yields, were pushed towards convergence by market belief that the euro would erase disparities of inflation and credit risk between countries. We can develop our counterfactual history through these two channels. Without the euro, the bond yields would not have converged, but would more likely have reflected inflation expectations in the different countries. Also ex euro, we would have seen adjustments of exchange rates between countries, as was many times the case in the EMS.

The euro story starts in 1992 with the ratification of the Maastricht treaty. Without the intent to create the euro, the most controversial parts of the treaty, especially the Maastricht conditions, would not exist. This implies not having the Danish and French referendums on this treaty; or at least not with the impact markets felt in September 1992. Hence, very likely without the aim of creating the euro, the EMS crisis of 1992 would not have occurred. On a side note, George Soros would not have earned a billion dollars back then by betting against the pound.

The convergence of government bond yields led to historically low nominal and real interest rates (even to negative ones) in the European periphery. Some governments, that in Greece for instance, could live significantly above their means. This would have been more difficult without the euro, as inflation would have been higher, and so the cost of borrowing for the Greek government. More importantly, low interest rates can be seen as a root cause for the real estate bubbles in Spain and Ireland. But here it becomes trickier to assess whether such bubbles would not have occurred without the euro.

Indeed, the Asian crisis had such characteristics of: 1) strong growth of the countries through convergence led to the “tiger” narrative, 2) attractive investment for the rest of the world, led to 3) currency appreciations despite rising current account deficits, leading also to 4) low interest rates and bubbles on the equity and real estate markets, which 5) reinforced the “tiger” narrative. Spain and Ireland, the “Iberian and Celtic tigers,” experienced something similar, which in my view, would very likely have led to their real estate bubbles even without the euro. However, once the Asian crisis hit, many countries drastically devalued their currencies. Neither Ireland nor Spain can do that currently.

This fixed exchange rate is by all accounts the largest single narrative changer. Many economists think Germany entered the euro with an overvalued Deutschmark. Even in 2005, the European Central Bank’s chief economist Othmar Issing said, “Germany is less competitive since the introduction of the euro.” The German model was challenged as obsolete and “old Europe” like. But even without the euro, it is very likely that the Agenda 2010, which boosted German competitiveness, would have been passed because of the EMS.

Years later, due to the dramatic increase of German competitiveness – measured by declining relative unit labor costs – compared with other members of the EMS, we would have witnessed a realignment of exchange rates, likely as a currency crisis in the wake of the financial crisis of 2007/08. Some currencies, like the Italian lira or the Spanish peseta, would have depreciated by 15% or more, while the Deutschmark would have appreciated by 15% or more. This realignment would have led to slower growth in Germany and more expansion in the periphery now.

These are first assessments of a counterfactual history of the euro:  trivially without the euro we wouldn’t have had the euro crisis. However, we would likely have had a currency crisis, and even a break-up of the EMS.