ECON102: Principles of Macroeconomics (2021.A.01)

It was the most dramatic development in international finance since the collapse of the Bretton Woods system. A new currency, the euro, began trading among 11 European nations - Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain - in 1999. During a three-year transition, each nation continued to have its own currency, which traded at a fixed rate with the euro. In 2001, Greece joined, and in 2002, the currencies of the participant nations disappeared altogether and were replaced by the euro. In 2007, Slovenia adopted the euro, as did Cyprus and Malta in 2008, Slovakia in 2009, and Estonia in 2011. Notable exceptions are Britain, Sweden, Switzerland, and Denmark. Still, most of Europe now operates as the ultimate fixed exchange rate regime, a region with a single currency.

To participate in this radical experiment, the nations switching to the euro had to agree to give up considerable autonomy in monetary and fiscal policy. While each nation continues to have its own central bank, those central banks operate more like regional banks of the Federal Reserve System in the United States; they have no authority to conduct monetary policy. That authority is vested in a new central bank, the European Central Bank.

The participants also agreed in principle to strict limits on their fiscal policies. Their deficits could be no greater than 3% of nominal GDP, and their total national debt could not exceed 60% of nominal GDP.

The fact that many of the euro nations had disregarded these limits became a major problem for the new currency when the recession and financial crisis hit in 2008. The biggest "sinner" turned out to be Greece, but there were others, such as Italy, that also had not adhered to the agreement. The fiscal situation of other countries, such as Ireland, went sour as the recession and financial problems deepened. The countries that seemed most at risk of being unable to pay their sovereign (government) debts as they became due came to be known as the PIIGS - Portugal, Ireland, Italy, Greece, and Spain - but there was a period in 2011 when even the interest rate on French bonds was abnormally high. The whole world seemed to be waiting throughout most of 2011 to see if the euro would hold together and, in particular, if Greece would default on its debt.

Finally, in early 2012, the situation seemed to calm down. The European Union nations (excluding the United Kingdom and the Czech Republic, which are not part of the eurozone) agreed to a new treaty that again requires fiscal discipline but this time has more enforcement associated with it. The European Union was setting up the European Stability Mechanism: a fund to help out with short-term liquidity problems that nations might encounter. Greece agreed to tough demands to reduce its deficit and then became eligible for a second EU bailout. It also managed to negotiate a debt-restricting deal with its private-sector lenders.

The euro has been a mixed blessing for eurozone countries trying to get through this difficult period. For example, guarantees that the Irish government made concerning bank deposits and debt have been better received, because Ireland is part of the euro system. On the other hand, if Ireland had a floating currency, its depreciation might enhance Irish exports, which would help Ireland to get out of its recession. The euro exchange rate has probably benefited German exports, since a German currency would probably trade at a premium over the euro, but it has hurt exports from countries whose single-nation currencies would likely be weaker.

Also, even though there is a single currency, each country in the eurozone issues its own debt. The smaller market for each country's debt, each with different risk premiums, makes them less liquid, especially in difficult financial times. In contrast, the U.S. government is a single issuer of federal debt.

Even with general regulation of overall parameters, fiscal policy for the 17 nations is largely a separate matter. Each has its own retirement and unemployment insurance programs, for example. In the United States, if one state is experiencing high unemployment, more federal unemployment insurance benefits will flow to that state. But if unemployment rises in Portugal, for example, its budget deficit will be negatively impacted, and Portugal will have to undertake additional austerity measures to stay within the EU-imposed deficit limit.

As of mid-2012, the fate of the euro was again dominating news on a nearly daily basis, and the currency experiment was still not out of the woods. Even with the restructuring and bailouts, would Greece be able to meet its debt obligations? With some EU countries slipping into another recession, would the austerity measures they were taking to meet the EU guidelines be self-defeating by making government budget balances even worse as tax revenues fell with the worsening states of their economies? Were countries taking on the market-orienting reforms that might increase their long-term growth rates and productivity? This last possibility seemed the most likely to help over time, but implementation was certainly not a foregone conclusion.