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Europe’s next currency regime – a minimalist approach


Germany’s withdrawal from EMU and return to the D-Mark,

Bundesbank already printing D-Mark to prepare for breakup,

euro breakup into smaller currency unions,

Italy already de facto out of the euro,


contagion from Cyprus.

fears of Spain’s euro exit,

considerations of France leaving the euro to regain monetary sovereignty,

repatriation of German gold reserves as sign of an impending collapse of the monetary union,

the immediate success of a German initiative to abandon the euro,

and an overall rapidly waning confidence in the future of European monetary policy.

—  Considering the headlines, Europe seems to be in standby mode with flight instincts growing every day.

In this situation, anger, frustration and  fear seem to leave no room to develop a constructive European-wide approach to future monetary policy cooperation. But this is exactly what is currently needed most urgently. The euro experiment has failed, and a more or less orderly retreat which allows to contain the damage to the process of European integration requires a clear signal that lessons have been learned and a less ambitious, but viable system will be established paving the way for Europe’s return to “normality”.

Shrinking the union?

Given the often prophesied enormous cost of a return to national currencies, to many observers the most preferable alternative to the status quo would be to maintain the concept but shrink the current euro area to a smaller union of “like-minded” nations. There are at least three reasons why this is not a good idea:

(1)   The first is a practical one. This solution would require a solid and sustainable definition of “like-minded”. Considering the candidates for euro “ins” and “outs”, which in public debates vary almost daily, there is no such definition. One day, France is among the “core” countries, the next day, its economic data makes it an exit candidate in the eyes of commentators.

(2)   One reason for this uncertainty is an underlying conceptual weakness. In general, proponents of a currency union have a vague idea of an “optimum currency area” (OCA) based on similar economies and trade relations. But, we live in a world where markets for goods and services are dwarfed by financial market size. In order to decide whether a group of countries falls in the OCA category, the underlying concept or theory must take into account both financial and “real” influences.

The introduction of the euro was thought to once-and-for-all end the problem of individual countries being targeted by financial speculation. But even under the common currency, markets have found ways to discriminate between members, and to bet on them. There is no theory taking account of this. As I argued elsewhere, under these circumstances monetary unification without a true and full financial and fiscal integration (not meaning eurobonds) must be doomed to fail, and a smaller currency union would only prolong the sufferings.

(3)   Fears of the consequences of a drastic change are no excuse for an ineffectual solution, in particular, if these fears appear exaggerated. Despite all prophesies, probably no one has the slightest idea of how much the termination of this historically unique experiment will cost in comparison to its continuation. To cite one of my earlier articles:

“These arguments neglect the cost the current situation is imposing on the world, eurozone members and nonmembers alike. Many commentators conjure doomsday scenarios. To cite Nouriel Roubini: “ … such a disorderly eurozone break-up would be as severe a shock as the collapse of Lehman brothers in 2008, if not worse.”

How can he know? This statement contradicts all textbook wisdom. In contrast to the Lehman collapse, the euro break-up has long been a foreseeable event with a growing probability of entry (Roubini prides himself to have foreseen a break-up after five years as early as 2006. Had the US authorities had even the slightest suspicion of the Lehman crisis and its possible extent in 2003 presumably it would have passed with much less noise and damage). These days, in Europe business firms are increasingly writing currency clauses into new contracts. … Many banks have written down “toxic” debt … ”

The transition to a new currency regime may be smoother than expected.


Other options

The alternative to a currency union is a return to national currencies under one of the following regimes which differ with respect to the extent to which those currencies are tied to one another:


Currency RegimeSource: Reszat 2005.


One extreme is the clean float where authorities abstain from any form of influence on the exchange rate. In practice, this is a highly unlikely scenario.

The next loosest variant of a currency regime is the managed float: Exchange rates are generally allowed to fluctuate freely but governments or central banks exert a discretionary influence. Relations between the world’s major currencies are managed floats.

There are other, stricter arrangements such as a unilateral peg of one currency to another, or to a basket of currencies. The exchange rate can be fixed once and for all or take the form of  a crawling peg with adjustments made in regular or irregular intervals. (As Steve Hanke emphasised, Milton Friedman further distinguished between fixed and pegged exchange rates with monetary authorities aiming for more than one target at a time under the latter.)

Again, there is a conceptual problem: Setting parities and fluctuation margins requires some ideas about the short- and longer-term influences determining the exchange rate. Traditionally, the focus is on economic indicators such as foreign trade, price and non-price competitiveness and inflation differentials. But the greater the influence of financial markets, and the greater the use of currencies in foreign exchange markets independent of trade relations, the less sustainable are respective arrangements.

The predecessors of monetary union in Europe were multilateral systems of fixed but adjustable exchange rates, first the “snake in the tunnel” – a system of narrow fluctuation limits within the wider exchange-rate bands of the Bretton Woods system established in 1972 – and later the European Monetary System (EMS). Eventually, they proved unsustainable which was one reason why European countries sought to eliminate the possibility of exchange-rate fluctuations once-and-for-all. The timeline of the EMS crisis, which I published earlier, and which I add once again at the end of this article, gives an impression of the struggles involved.


With over 40 years of instutionalised monetary policy cooperation, Europe’s experience in this field is outstanding and, at the same time, shattering. Sticking to a failed regime far too long, even after its weaknesses have become apparent, has brought poverty and discord to member countries and jeopardised the achievements reached in other areas and the overall integration process.

Two lessons can be learned from this experience.

(1)   The exchange rate is no policy instrument.

The way the foreign exchange market functions differs fundamentally from the ideas of policy makers and most economists advising them. This is largely a wholesale market, a huge money market in foreign currency, which is only loosely related to international trade, developments of national economies and markets for goods and services. It is the biggest of all international financial markets with an estimated daily turnover of 3,981 billion US dollar in April 2010. By comparison: World annual exports in 2010 were $14,950 billion. The stock of foreign exchange reserves worldwide was $10,791 billion at the end of 2010.

With luck, central bankers and policy leaders may manage to impress this market transitorily. But they are competing with many other, more spectacular influences and their coffers are never big enough to enforce their intentions lastingly.

(2)   Currencies are unsuitable means of integration policy.

Both fixed exchange rates and a common currency require a high degree of economic and political integration. Their establishment can only stand at the end of a successful integration process, including both goods and financial markets, not at its beginning. True, European economies benefited from periods of low exchange-rate variability in earlier years, and a common currency later on, but these advantages came at a high price.


After 40 years experience with regional currency regimes, which eventually all failed, maybe the time has come for European monetary policy to choose a minimalist approach returning to national currencies and focusing on sporadic coordinated discretionary measures to influence market conditions and expectations, and to content themselves with being one stabilising element among others in times of turbulence. Mitigating transition effects, regaining flexibility, and slowly and patiently restoring credibility and trust in European institutions and processes, taking along all member countries on an equal footing, should be the primary objective. Over 60 years of successful European economic and political integration would be worth it.


Timeline EMS Crisis*

March 13 1979 Start of EMS with two fluctuations bands of + 2.25% (Belgium, Denmark, France, Germany, Ireland, Luxembourg, the Netherlands)  and + 6% (Italy)
October 4 1981 French franc devalued 8.5% against D-mark
June 14 1982 French franc devalued 10% against D-mark
March 21 1983 French franc devalued 8% against D-mark
April 7 1986 French franc devalued 6% against D-mark
June 19 1989 Spanish peseta joins ERM (wide band + 6%)
January 8 1990 Italian lira moves to narrow band
October 8 1990 Sterling joins ERM
December 20 1991 “German interest rate raised”, “Marching to the German drum”
April 5 1992 Portuguese escudo joins ERM (wide band + 6%)
July 17 1992 “Germany lifts discount rate”, “Europeans impeded by policies ‘made in Frankfurt’”
July 18/19 1992 “World financial markets tumble”
July 21 1992 “Huge operation to save dollar”, Lira falls to record low against D-Mark”
July 22 1992 “Italian lira: the sick currency of Europe – If Rome opts for devaluation others may follow and the EMS could fall apart”
August 12 1992 “Central banks step in to prop up dollar”
September 14 1992 Lira devalued 7%
September 16 1992 Lira and Sterling leave ERM, peseta devalued 5%
September 18 1992 “Speculators find new ERM targets after lira and peseta”
September 29 1992 United interventions of the Bundesbank and the Bank of France to stop franc devaluation, “Pound  hits new low against D-Mark as franc rallies”,  “French franc pays price for partnership with D-Mark”
October 2 1992 “Bank of France spent FFr80bn supporting franc through crisis”
October 16 1992 “Danes seek opt-outs from Maastricht”
November 3 1992 “French weaponry secured win in battle for franc”
November 20 1992 “Speculators force Sweden to drop link with ERM”
November 23 1992 Spanish peseta and Portuguese escudo devalued 6%, “Irish punt, Danish krone seen as targets for selling”, “Bundesbank under new rates pressure”
November 24 1992 “EC governments raise interest rates in effort to protect ERM”
December 2 1992 “Schlesinger calls ERM an incentive to speculators – Bank of France forced to intervene to support franc in tense trading”
December 3 1992 “French franc struggles in spite of intervention”
January 5 1993 “French franc under pressure”
January 6 1993 “Germany joins France to support embattled franc”
January 9/10 1993 “Costly siege of the franc fort – The defense of the French currency is putting a severe strain on the economy”
January 21 1993 “Counting the cost of weathering ERM storm – Battle for punt leaves long list of casualties – ‘Franc fort’ squeezes jobs, growth and prices”
February 1 1993 Irish punt devalued 10%, “Dealers warn of new ERM pressures”
February 4 1993 “Speculators push Danish krone to floor in ERM – European crisis deepens as currencies weaken and slow growth threatens EMU”, “Pound hits record low in heavy trading”
February 12 1993 Hard-core currencies under pressure in the markets, “Dealers scare the D-Mark’s Belgium shadow”, “France urges faster move towards EMU”
February 25 1993 “Spain warns of tax on currency speculators”
May 14 1993 Peseta devalued 8%, escudo devalued 6.5%
May 27 1993 “Peseta in sharp fall against D-Mark”
July 10/11 1993 “Franc falls closer to ERM floor”, “Intervention fails the franc”
July 14 1993 “Franc’s ERM parity defended”
July 15 1993 “Franc Spends Bastille Day Under Siege” (International Herald Tribune)
July 24/25 1993 “Lines of defence keep falling”, “French lift rates to defend franc”, “Commission confident ERM will hold”
July 29 1993 “Bundesbank cut raises ERM hopes”
July 30 1993 “Bundesbank ½ point rate cut fails to bolster ERM”
August 2 1993 Widening of ERM bands to + 15% (exception: D-mark/Dutch guilder which retained + 2.25%)
August 7 1993 “Paris sind keine Devisenreserven geblieben” (Frankfurter Allgemeine Zeitung)
April 2/3 1994 From the FT LEX COLUMN: “There is a refreshing candour about Deutsche Bank’s admission that it does not expect much by way of earnings increase this year. Last year’s 23 per cent jump in group net profit owed much to special factors that will not easily be repeated.”
* If not noted otherwise citations refer to Financial Times headlines.
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From → Policies

  1. What would be pros and cons of keeping the Euro but allowing each member state to run its own “domestic” currency in parallel to relieve the pressures?

  2. Eventually, this boils down to the question under which conditions a parallel currency will be accepted – and whether it will be doing more good than harm. In principle, parallel currencies mean further fragmentation of the already strongly disintegrated financial markets in Europe. The problem is comparable to those related to the introduction of eurobonds which I discussed earlier: In my view, there is no way to have a common currency without full market integration on all scales. Each non-integrated financial segment leaves a leeway for markets to test unity – a game which, as experience shows, policy must lose.

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