Is the euro good for all?

Europeans should decide if they will utilize the magic of reserve currency without really understanding how it creates prosperity for all.

With the COVID-19 crisis, again the ECB is on the spot. As a reserve currency, the euro is a great chance for Europe to recover from crises. However, not all countries agree on an active policy encompassing fiscal and monetary transfers.

The ECB is a kind of gold mine. Likewise the US dollar, the euro is a currency, which does not need another currency or gold to back. To be clearer, the ECB can create euros in return of a debt paper issued by a government or business.

Via the euro’s reserve currency feature, the ECB can help Europe recover from any crisis through cheap funding as the Fed did in 2008 and is currently doing. In the absence of the euro, it would take years to beat the COVID-19 stagnation for most of Europe.

Regional effects of a currency union vary. Single currency widens the gap between underdeveloped and developed regions. Productivity is lower in underdeveloped regions. Since they need more labor to produce the same output, their labor cost per hour should be lower. If regional currencies existed, regions with lower productivity would lower the cost of labor by depreciating their currency. Since devaluation is not an option under the single currency, a region must lower wages in nominal terms, which is a political suicide for the regional government.

Creation of the euro led to a similar pattern. In the euro zone, countries with lower productivity could not lower wages nominally. Losing competition, they became net importers. In accordance, countries with a higher level of productivity have attracted more investment and, thus, created more jobs. As a result of this process, interregional migration has been a phenemenon in the EU. Eastern Europeans migrated to western and northern countries.

Countries with low productivity have financed imports through cheap debt. This practice continued until the global financial crisis in 2008 when interest rate margins widened between EU countries. As the issuer of a single currency in the US, the Fed responded to the crisis by expanding the money supply. While doing this, no body questioned which regions of the US benefited from the Fed funds more. Before taking action, the ECB had to wait for the negotiations regarding how the ECB funds were going to be distributed. Time lost meanwhile invoiced years-long recessions to European countries.

In 2020, the EU appears to have learnt lessons from 2008. Germany and France have initiated a joint fiscal expansion program whereas the ECB introduces a serial of asset purchase programs with its own initiative. However there is still no unanimity among countries in terms of the joint fiscal and monetary policy. For many EU countries, fiscal and monetary transfers are unsustainable.

Fiscal and monetary transfers are the very nature of a single currency. To be realistic, some euro zone governments will raise wages above the productivity level. Those populist policies serve other euro countries’ exports, which are financed by the debt borrowed from the ECB. In fact, this is a win-win situation for entire Europe. Is it sustainable? Well, it has been sustainable for the US for decades.

The ECB is a kind of gold mine. Likewise the US dollar, the euro is a currency, which does not need another currency or gold to back. To be clearer, the ECB can create euros in return of a debt paper issued by a government or business. Via the euro’s reserve currency feature, the ECB can help Europe recover from any crisis through cheap funding as the Fed did in 2008 and is currently doing. In the absence of the euro, it would take years to beat the COVID-19 stagnation for most of Europe. In the mean time, European countries with a better performance would also suffer from lower exports due to the continuing stagnation in the rest of Europe.

The COVID-19 performance of the ECB and EU will determine the euro’s future. If a joint monetary and fiscal policy does not accelerate recovery, countries suffering persistent recessions would exit the euro. In that case, the best scenario would be the survival of the euro with the countries at the same level of development. If the euro loses its reserve currency feature, this would be a great loss for entire Europe.

Welcome to the magical world of reserve currency. Europeans should decide if they want to play with this magic without really understanding how it creates prosperity for all. Yes, it is a possibility that the magic may suddenly fade away one day.