Euro faces tough adolescence

Euro faces tough adolescence

Character weaknesses are usually evident by the time people hit their twenties and become hard to fix by their thirties. The euro celebrates its twentieth birthday saddled with flaws dating back to its conception.

There were early successes in financial market terms as bond issuance and trading volumes took off, and its share in foreign exchange reserves grew. However, that gave way to a teenage crisis of existential proportions, which dented official reserve managers’ desire to hold the single currency. Temporarily covered up by the drug of cheap central bank money, the weaknesses retain their power to ruin the single currency’s adulthood.

This dangerous fault line is budget policy. Countries who join the euro are supposed to have achieved enough economic convergence to cope without being able to devalue their currency or set their own monetary policy. They certainly aren’t supposed to need bailouts from their peers. That’s the reasoning for a fiscal deficit cap of 3 percent of GDP, which the European Commission is responsible for policing.

Yet the reality has fallen short: 2018 may be the first time in a while that all euro members actually achieve the deficit cap. And even then, Italy is on a collision course with the European Commission, which views the budget plans of the euro zone economy’s third biggest economy as too profligate, especially after adjusting for economic swings.

Realpolitik is the main hurdle to a strict application of the budget rules. Many countries are wary of being heavy-handed with peers. Playing hardball may also damage popular support for the single currency project. Italian backing for the euro has already fallen sharply since 1999 – in contrast to increased enthusiasm in Germany.

Nor can policymakers leave it to bond vigilantes to impose discipline. True, a blowout in bond yields in 2011 and 2012 posed an existential threat to the euro, but markets imposed next-to-no discipline in the years before the financial crisis, and have been pretty forgiving since European Central Bank President Mario Draghi began buying assets.

Financial markets were enthusiastic adopters of the euro in its infancy, with forex trading volumes and bond issuance in the euro quick to take off. But they also nearly forced out one of its members, Greece. To avoid a breakdown later in life, the euro’s big birth defect will have to be fixed. [Reuters]

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