Why is the euro crisis different from all other sovereign debt crises? The euro’s exchange rate has remained remarkably stable. The euro has depreciated by only 7 percent versus the U.S. dollar since the start of the crisis in 2010. This pales in comparison to the devastating currency collapses of well over 50 percent experienced during sovereign debt crises in Argentina, Brazil, East Asia, Mexico, and Russia. It’s well within the range of normal when it comes to currency fluctuations. In fact, the European currency is currently trading above its historic average of 1.22 dollars to the euro. Eminent economists such as MIT’s Simon Johnson and Harvard’s Ken Rogoff have predicted an immanent decline in the euro-dollar exchange rate to at least parity. Yet, futures markets foresee a stable European currency. Why the discrepancy? Who’s right? Why has the euro so far remained so stable? Is it likely to last?
There are three explanations for the euro’s surprising stability. One lies beyond Europe and the other two are rooted in the unique characteristic of the euro as a currency for seventeen countries rather than just one.
First, U.S. monetary policy has unintentionally provided support to the euro. Recent exchange rate changes reflect shifts in U.S. monetary policy more than any other factor. The loosening of U.S. monetary policy—in particular, the second round of quantitative easing (QE2) from November 2010 to June 2011—contributed to a striking 19 percent surge in the euro-dollar exchange rate to 1.48 in the midst of the crisis. Subsequent relaxing of European monetary policy and a collapse in European growth expectations brought the euro down, but the recent announcement by the U.S. Federal Reserve Board of a third round of quantitative easing (QE3) has pushed the euro-dollar exchange rate back to the 1.30 U.S. dollar range. In other words, it has been impossible to tell simply by looking at movements in the euro-dollar exchange rate that there has been a euro crisis at all. Other factors fully account for the exchange-rate swings. The euro, moreover, has been surprisingly stable during the crisis. The euro-dollar exchange rate exhibited far bigger swings in the ten years before the euro crisis (e.g., two-year movements exceeding 30 percent). There has been no increase in volatility. The old war horse of monetary economists, the interest parity calculation, accounts for recent exchange rate movements. There is no evidence of a rising risk premium.
Second, unlike any previous sovereign debt crisis, all the imbalances that have led to the euro crisis are contained within a single currency area. Germany’s exports are Spain’s imports. The northern euro members’ historically large current account surpluses and southern Europe’s sizable current account deficits are two sides of the same coin. The euro area as a whole has maintained a balance with its external trading partners. The euro area also has exhibited no maturity mismatches between foreign and domestic lending, which was a principal cause of the Asian economic crisis of the 1990s. As a result, unlike in previous sovereign debt crises, there has been no downward pressure on the euro resulting from excess accumulation of euros in external markets, or a sudden need to sell large quantities of euros to pay short-term loans from abroad.
Third, and most important, the impact of the euro crisis on the currency will be positive regardless of the outcome. If, on the one hand, the euro-member countries finally get their acts together and implement effective reforms that make the current currency area function effectively, the euro is bound to appreciate. If, on the other hand, the efforts to save the euro fail and the more troubled countries drop out of the currency union, the smaller euro area that would emerge would contain Europe’s more robust economies and it would more closely resemble a stable optimum currency area. The improved fundamentals and superior structure of a smaller, fitter euro area would, if anything, drive up the value of the euro vis-à-vis the dollar.
For investors, the euro-dollar exchange rate amounts to a one-way bet. Despite the political Sturm und Drang that has pummeled the single currency over the past three years, the value of the euro, like the Titanic’s Molly Brown, is unsinkable.