The founders of the euro had little doubt about the common currency’s role as a foundation for European peace and prosperity. Yet, they were not Pollyannas. For years before the start of monetary union in 1999, economists had warned that the member states of the European Union do not constitute an “optimum currency area” (see, for example, Milton Friedman). This means that a single policy interest rate might exacerbate, rather than mitigate, economic differences, creating severe strains among euro area countries.

Since the euro’s beginning, European leaders hoped and expected that as tensions arose, member states would come closer together—integrating their economies and financial systems, sharing burdens and risks. To a considerable extent, experience has borne out these hopes. Despite enormous challenges, no country has abandoned the euro and reintroduced a national currency. Today, an entire generation of people has come of age knowing only the euro. Moreover, as of November 2019, popular support for the single currency among euro area residents was at a record 76%, with sizable majorities in each member state (see Eurobarometer 92, pages 32-33).

And yet, over the past two decades, there has been only grudging progress toward a truly resilient monetary union. Politically and financially, the euro area remains divided. The COVID-19 crisis brings renewed tensions. With it comes a harsh reminder that standing still is simply not an option.

In this post, we review the progress toward completion of the European monetary union, and note key gaps that remain….

Foreign Exchange Trading: 2019 Edition

Every so often, new data provide us a glimpse of parts of the world that few people ever see. Last week, the BIS’s Triennial Central Bank Survey of Foreign Exchange and Over-the-counter (OTC) Derivatives Markets in 2019 provided just such a view. The headline is that average daily foreign exchange (FX) turnover, adjusted for double counting, is $6.6 trillion per day. That is, nearly 8% of global GDP changes hands in FX markets every day! (For a summary, you can listen here.)

Numbers of this magnitude raise a host of questions. In this post, we explore three: first, who is shifting such large volumes of currency around, and what motivates them? Second, history teaches us that disruptions in FX markets can destabilize the broader financial system: are there signs of emerging risks? Finally, what do we learn about the relative position of the U.S. dollar?

To anticipate our conclusions, the fraction of trading involving nonfinancial entities is relatively small, so the bulk of these transactions (like those in most financial markets) are between intermediaries. In addition, there are hints of growing systemic risk in the FX settlement system, so we need to remain attentive. Finally, no other currency is threatening the dominance of the U.S. dollar—at least, not yet….

Italeave: The Renewed Threat of a Parallel Currency

In the March 2018 general election, two Italian political parties (the League and the Five Star Movement) that eventually formed the current government campaigned against many of the structures that are the foundation of the European Union. One part of their agreed policy program, a proposal that resurfaced in the past week, concerns the possibility of issuing mini-BOTs (which stands for Buoni del Tesoro). These would be small denomination “bonds”—non-interest-bearing, tradeable securities—issued by the Italian government to pay debts and usable to pay taxes or purchase goods and services provided by the state. Printed in the size and shape of currency notes, recipients could view them as a new means of exchange.

In this post, we discuss the possibility of Italy leaving the European Monetary Union, and why there is an increased incentive for the government to plan for an abrupt and unanticipated exit. The strategic analogy is to the appearance of a first-strike capacity that undermines nuclear peace. In our view, however, that appearance is misleading: any attempt to exit would not only be a disaster for Italy, as we explained in our post from a year ago, it would be the “mother of all financial crises” ….

Italeave: Mother of all financial crises

After years of calm, fears of a currency redenomination—prompted by the attitudes toward monetary union of Italy’s now-governing parties and the potential for another round of early elections—revived turbulence in Italian markets last week. We have warned in the past that an Italian exit from the euro would be disastrous not only for Italy, but for many others as well (see our earlier post).

And, given Italy’s high public debt, a significant easing of its fiscal stance within monetary union could revive financial instability, rather than boost economic growth. Depositors fearing the introduction of a parallel currency (to finance the fiscal stimulus) would have incentive to shift out of Italian banks into “safer” jurisdictions. Argentina’s experience in 2001, when the introduction of quasi-moneys by the fiscal authorities undermined monetary control, is instructive….

To Form a More Perfect Union

On 31 May 2018, Vítor Constâncio completes 18 years on the Governing Council of the European Central Bank (ECB)—8 as Vice President and 10 as Governor of the Bank of Portugal before that. Ahead of his departure, Vice President Constâncio delivered a valedictory address setting out his views on what needs to be done to make European Monetary Union (EMU) (and what people on the continent refer to as the “European Project”) robust.

Before we get to his proposals, we should emphasize that we continue to view political shifts as the biggest challenge facing EMU (see our earlier posts here and here). The rise of populism in recent euro-area member elections is not conducive to the risk-sharing needed to sustain EMU over the long run. Without democratic support, investor fears of redenomination risk—associated with widening bond yield spreads and, possibly, runs on the banking systems of some national jurisdictions—will continue to resurface whenever political risks spike or local economic fortunes ebb. This latent vulnerability—resembling that of a fixed-exchange rate regime with free movement of capital—diminishes the prospect for strong and stable economic growth in the region as a whole.

Turning to the need for change, the current framework has three significant shortcomings…

Would Italy be better off without the euro?

With Sunday’s election of President Emmanuel Macron, voters confirmed that France remains a bedrock of the euro area, buttressing the region’s financial markets. But political risks to the euro have not disappeared. In coming months, concerns probably will turn to Italy, where the leader of one popular party has called for a referendum on leaving the euro area, and where parliamentary elections must be held before 20 May 2018.

From an economic perspective, Italy stands on a knife-edge. The economy is smaller and less productive than it was in 2001, while government debt has jumped by 30 percent. As long as interest rates remain low, and the government continues to run a primary budget surplus, the situation is only mildly unsustainable (with the debt/GDP ratio creeping higher). But even a small problem at home or abroad could drive funding costs higher and expose Italy’s precarious state.

Would independent Italian monetary policy, controlled by the Banca d’Italia in Rome, be sufficient to bring Italy back from the precipice and promote economic growth? We doubt it. In the long run, the most effective way to ensure debt sustainability is to implement growth-enhancing structural reforms. Nothing about Italy’s membership in the monetary union prevents this. The problem is a lack of political will...

What should Greece do?

Greece faces a stark choice: stay in the euro and implement the policies demanded by its creditors or exit and re-introduce its own national currency. The dimensions of this decision go far beyond economics, affecting Greece’s political and cultural identity for generations. Yet, even in a narrow sense – determining which option will lead to the best economic outcome for Greeks – the decision is complex and fraught with uncertainty...

After Greece: Saving EMU

Euro-area leaders announced yet another agreement with Greece this morning. However, the survival of the euro area has never been about the fate of Greece. Instead, it is whether the Europeans will implement the reforms necessary to keep the euro area together. If they do, the common currency will endure. If they don’t, then the euro may not survive the next big adverse shock...

The Importance of Being Europe

If Oscar Wilde were still around, he could write a wonderful comedy about European Economic and Monetary Union (EMU). Like the life of his protagonist, Ernest John, the evolution of EMU is rarely pure and never simple. But it would take a Wilde imagination to see exactly how EMU gets to a happy ending.

Despite its name, EMU was not and is not primarily an economic endeavor...

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Money, Banking, and Financial Markets