Global financial markets are in turmoil, with record volatility on stock markets, unprecedented losses in financial institutions and even whole banking systems being bailed-out. But there is one crisis we have managed to avoid within the euro zone - a currency crisis on top of the credit crunch.
As John Thornhill noted in the Financial Times earlier this month: “The creation of the 15-country euro zone has introduced greater stability into the heart of the European economy, ending the frenzy of competitive devaluations that marked previous financial panics.”
It is easy to forget that not very long ago, a financial crisis in Europe went hand-in-hand with currency turmoil. In volatile financial markets, speculation often focuses on exchange rates, especially in cases where countries aim to maintain a level of parity with other currencies.
To defend their currency, central banks are forced to respond with high interest rates and by spending foreign reserves, which might or might not prove successful. For those central banks not trying to maintain parity, there is a temptation to let their currency devalue to make exports cheaper and give a boost to the economy. This can help in the short term, but it increases inflation and encourages other central banks to follow suit - leading to a vicious circle of ‘competitive devaluations’ which results in upward pressure on interest rates and inflation, further fuelling uncertainty and speculation.
As former European Central Bank Executive Board member Otmar Issing recently put it in The Japan Times: “It is not difficult to imagine what would have happened during the recent financial-market crisis if the euro-area countries still had all their national currencies: immense speculation against some currencies, heavy interventions by central banks and finally a collapse of the parity system.”
This is no longer possible within the euro zone, but we can see it happening on its fringes. To maintain the Danish krone’s parity against the euro, its central bank had to increase interest rates on 7 October and maintain the higher rate subsequently, despite coordinated global interest rate cuts which included the ECB. Other currencies are faring even worse, with the Icelandic krona in free-fall. During 2007, €1 was generally worth 80-90 krona. After steadily increasing in 2008, the currency devalued rapidly from mid-September onwards, reaching a high of 172 on 9 October, with interest rates at over 15% and consumer prices increasing at a rate of 14%.
Even larger economies are not immune: a year ago, a British pound bought well over €1.4. The current rate is below €1.25 and UK inflation has hit 5.2%.
The Growth and Stability Pact, introduced alongside the euro, has also played a positive role. Euro-zone public finances are by no means perfect, but the Pact has left Europe in better shape than the US with its record deficit. This may become even more important in the immediate aftermath of the crisis: spending government money may be the best solution in the short term, but current developments demonstrate that this does not come without a long-term cost.
Better - but not good enough
This is, however, no reason for the euro zone to be self-congratulatory or complacent. Existing financial supervision has not been effective, mostly because of lack of enthusiasm from the Member States. Current responses have been dominated by national interventions in banking systems, with coordinated European action only coming now and not extending to pooling Member States’ resources to stabilise Europe’s financial institutions.
Countries have been first-and-foremost focusing on their own system without taking into account that panic in the markets is contagious. A country’s border is no barrier to global turmoil and national interventions are not sufficient to change global market sentiments. They might create a breathing space, but they do not stop the crisis.
This is not good enough. Opening up the financial sector within the EU’s Single Market has boosted cross-border flows, but the Union has not managed to adapt the regulatory and supervisory regime at the same rate.
The global economic environment remains precarious, but thankfully Europeans have finally decided to act in a concerted manner, seemingly calming the markets. Rules for common action need to be devised in calmer times, but once the immediate crisis has passed, this should be the future priority, to ensure that euro-zone members work together and create effective mechanisms for supervision. There needs to be a framework for joint action and improved supervision at the European level, including a European supervisory body.
With increasingly integrated European financial markets and the emergence of cross-border banks, there is also a need to establish common principles for deposit guarantee schemes. To support long-term stability, stronger policy coordination is vital. A framework for possible future bail-outs and emergency credit provision should be devised at European level before another crisis erupts.
With the impact of the credit crunch now starting to be felt on the ‘real’ economy, weaker global economic growth and higher inflation will be a severe test for all European economies. To strengthen them, it is essential to maintain a strong momentum for structural reforms. The financial crisis has not altered the underlying economic realities in the EU, and governments must resist the temptation to avoid proactively preparing Europe’s economies to meet future challenges and to listen instead to ever-louder protectionist voices.
Benefits of a ‘closer Union’
But we should not ignore the silver lining: the euro’s role in preventing a currency crisis in addition to the credit crunch. We should build on what has already been achieved by Economic and Monetary Union in bringing desperately needed currency stability to a large part of Europe’s economy in these testing times. In times of rising scepticism towards the EU, highlighting the benefits of established ‘core’ common policies is all the more necessary.
More needs to be done to improve Europe-wide supervision and coordination. But maybe the time has come for countries that are not in the euro zone (or indeed those which have not yet joined the EU), to reconsider whether it is better to be outside when coordination and integration inside can offer a degree of additional stability in an uncertain and volatile world.
Hans Martens is Chief Executive and Fabian Zuleeg is a Senior Policy Analyst at the EPC.