Trapped in a eurozone currency machine

Lowy Interpreter

Greek voters delivered a dramatic protest vote against austerity on May 6 as support for the country's traditional parties collapsed. The Greeks have not been alone in venting their frustrations: of 17 governments in the eurozone, ten have been thrown out of office in the past year or so, mostly as a consequence of the crisis.

Voters are, of course, dead right in their view that the current policy approach has not only been a failure, but an extremely painful one. The problem is, despite some signs of a rethink in Germany, it's still not clear that there is a viable alternative on offer.

As I first suggested in a series of posts back in 2010, one way to view the euro is as a particular European response to the problems involved in establishing a fixed exchange rate regime.

One of these problems involves establishing the credibility of an exchange rate peg. By opting to fix the exchange rate, a government is simultaneously promising to abandon a great deal of policy flexibility. Most obviously, it's giving up the ability to devalue the nominal exchange rate. Slightly less obviously, and assuming a high degree of capital mobility, it's surrendering the option to run an independent monetary policy. And, as established by the repeated failure of currency pegs across emerging markets triggered by budget deficits incompatible with macro stability, it's also promising to adopt some constraints on the operation of fiscal policy.

Giving up these policy options comes at a cost. If and when things get bad – say the economy is hit by a nasty shock – there's going to be a strong temptation for government to rethink those earlier promises. This is where the credibility problem comes in.

Markets, investors and depositors all understand this temptation, so even when a government promises to stick to an exchange rate peg, it's rational to believe that there is a risk that at some point in the future it will make sense for the government to break this promise.

Deciding whether or not to trust to the longevity of any given exchange rate peg then involves a calculation as to whether the costs involved in sticking to the promise to peg are greater or less than the costs involved in reneging. Inject enough doubt into this calculation, and the peg might well be doomed from the start.

One way to deal with this credibility problem is to send a strong signal about the degree of commitment to the peg, and one way to do this is to make the commitment more binding. In a rough hierarchy of commitment, the lowest might be a standard fixed exchange regime, followed by a currency board, and then full monetary union, like the eurozone.

The euro offers a solution to the credibility problem of a standard fixed exchange rate. By abandoning national currencies altogether and signing up to a regime which does not formally allow for an exit, member economies demonstrate the depth of their commitment to the exchange rate regime, and so boost the credibility of that commitment. Moreover, since the common assumption is that any attempt to exit the euro would trigger the 'the mother of all financial crises' in the departing country, the cost-benefit calculation described above is tilted heavily towards sticking the euro, which further enhances credibility. It's a sort-of roach motel version of a credibility mechanism.

The euro, then, is a machine built to maximise the credibility of an exchange rate peg, in large part by making any exit from that peg incredibly costly and painful.

Problem is, the machine has not been designed particularly well to help countries stay in the euro once they are in trouble. On the one hand, there's all the pain and trauma that an exit would bring to deter leaving. But all there is on the other hand is the recently cobbled together and so far totally inadequate set of instruments designed to stop the whole thing blowing up. Exiting the eurozone is designed to be unthinkably painful. Unfortunately, for some countries, staying in is looking like that too.

Voters across the eurozone periphery are caught inside the cogs of a terrible machine.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.