Sunday, November 9, 2008

Will the Euro Survive?

I was a little puzzled last week after reading Wolgang Munchau's column in the FT. He noted that some of the European countries outside the Eurozone--specifically Denmark, Hungary, Iceland--are now wishing they were members and probably will become so in the near future. Based on these developments he argued the global financial crisis should actually lead to an enlargement of the Eurozone. While his argument makes sense in the case of the few countries mentioned above, what about the broader Eurozone? Does not the global financial crisis add more stress to the viability of the Eurozone? In a reply to Munchau, Desmond Lachman says yes:
Sir, Wolfgang M√ľnchau seems to be very wide of the mark in asserting that the present global financial crisis will lead to the early expansion of the eurozone... For, as the marked widening in interest rate spreads on Italian and Spanish government bonds would suggest, the more pressing question raised by the crisis is not so much whether the eurozone will expand but rather whether or not the euro can survive in its present form.

In 1998, when the euro was launched, Milton Friedman famously warned that the euro would be truly tested by the first major global economic recession. He issued this warning in the belief that, lacking labour and product market flexibility, Europe was not an optimum currency area in the sense that was the case of the U.S. economy.

Judging by October's alarming plunge in global equity prices and the virtual freezing up in global credit markets, there can be little doubt that Europe, along with the United States, is at the start of its worst economic recession in the postwar period. And judging by the bursting of Spain's outsized housing market bubble and by the precarious state of Italy's public finances, there can be little doubt that Spain and Italy will be the two major European economies that will be put to the severest of tests as the global recession deepens.

For in order to cope with their respective problems, Spain and Italy will need low interest rates and weak currencies that continued euro membership clearly precludes.
In short, Lachman is questioning whether the Eurozone in its current form is an optimal currency area and, thus, whether it can truly survive. Apparently, so are some investors thinking this way. Over at intrade.come there is a contract on whether "any country using the Euro to announce their intention to drop it on/before December 2010." Here is the latest figure--where price equals probability-- from the contract (click figure to enlarge):

Currently the probablity of say Spain or Italy leaving the Euro is between 30-35%. Although not very high, it is a sizable increase from when the contract was introduced in early 2008. So what is the future of Euro?

Update: Here is a related post from Naked Capitalism. Here are some papers from a conference on the future of the Euro hosted by The Economist magazine and CATO.


  1. I am confused about what the widening interest spread on Spanish and Italian bonds has to do with anything. I would think Michigan bonds have a "widening spread" over Texas bonds but that does not lead me to expect Michigan to abandon the dollar anytime soon.

  2. ECB,

    One wonders if Michigan would have been better served by having its own currency over the past decade or so. Not that it would solve all the structural problems, but it surely would have lowered its real exchange rate. I have a paper where I actually argue as much.

  3. ECB,

    just to be clear, in my paper I argue that the rustbelt region--not Michigan specifically--could benefit from having its own currency.

    Regarding your question, I think a reasonable view is that there is more support for the U.S. Dollar currency union than the Euro currency union. As I recall, there was some Italian offical a few years back questioning the Euro. There haven't , however, been calls for Michigan or other rustbelt states to abandon the dollar from state officials.

  4. Interesting. Is the paper available on the web? So you are putting forward the idea that the US is not an optimal currency area. One big difference with the eurozone is that fiscal policy is more unified here in the US, and of course labor flows are easier. But the housing slump is crimping that labor fluidity unfortunately.

  5. ECB,

    I don't have it posted, but will be glad to send you a copy. Email me at

  6. I would be horrified if the UK joined the Euro. It seems, last week, as thought the Machiavellian figure of Lord Peter Mandelson is skulking around the corridors of Brussels in an attempt to surreptitiously shoehorn us into the single currency.

    Everything that has been achieved in "The European Project" has been achieved by subterfuge, deceit, stealth and trickery, and always in the face of hostility or suspicion.

    One of the convergence criteria of member states was that inflation should not exceed 5%. About 4 years ago, I heard a BBC reporter, in a despatch from Athens state that across Greece, prices were rising daily, indicating inflation in the hundreds if not 1000's of per cent. Yet they reported to the ECB that inflation was...? 5%!

    As the British people suspected, whether the UK joins the Euro is nothing to do with Mr. Brown's "5 tests" of fiscal or monetary suitability, but this quote:- "The single currency is the greatest abandonment of sovereignty since the foundation of the European Community... It is a decision of an essentially political character." Felipe Gonzalez, Spanish Prime Minister May 1998.