COMMENT: Financial crisis tests mettle of Europe's monetary union

By bne IntelliNews November 6, 2008

Dr. Werner Becker of DB Research -

Since August 2007, the financial market crisis has subjected European Monetary Union to severe stress testing, particularly just recently. So far EMU has worked far better than many sceptics expected. But once again it has clearly emerged that community approaches to problem-solving rather than national action are what increasingly matter, along with the proper political leadership. With global markets so tightly networked, crisis management requires a high degree of international cooperation and coordination between governments and central banks.

The launch of the euro - Europe's answer to globalisation - has eliminated exchange risks within Europe, together with the attendant economic and growth risks. In retrospect these benefits are thrown into even sharper focus. It does not take much imagination to picture how complex crisis management would have been without EMU, with 15 national currencies and a dominant deutschemark. In the days of the d-mark Europe went through several periods of economically hazardous tension in the Exchange Rate Mechanism (ERM)- the last in 1992/93 and 1995 - triggered by a distinct weakness in the dollar versus the d-mark, the second most important investment and reserve currency. Since the d-mark was not only strong in relation to the dollar but also appreciated sharply vis-à-vis the currencies of its main trading partners in Europe, at times Germany's business activity and competitiveness were put under severe strain. What is more, the partner countries then often had no choice but to raise their interest rates to defend their currencies' peg to the d-mark.

A similar scenario would be conceivable today in a Europe without the euro. Strong appreciation of the deutschmark would put pressure on all other countries in Europe to raise their interest rates and devalue - Hungary, as a non-member of the euro area, is a prime illustration of this at this very time. Hungary and the other new EU states unable or unwilling to commit to a specific EMU perspective so far are now experiencing the downside of standing on the sidelines. That may spur the political will there to work consistently towards joining EMU. In some countries the euro is increasingly being used in the corporate sector even without the prospect of EMU accession. But the gloomier outlook on economic convergence - in prices and interest rates, for example - which is the condition for EMU membership, could prove a problem.

Even in the Eurozone, there are differences in the degrees of contagion from the credit crunch and economic downswing. And this time they are reflected in a limited widening of spreads on government bonds (to almost one percentage point at times between Germany and Italy). But this also means that markets still assume in the present financial crisis that EMU will rally round to support any euro members in difficulty.

It is thanks to the euro that at times when the American currency was weak during the period 2003 to 2008, Europe was spared a situation in which the dampers on economic activity already imposed by the dollar exchange rate were exacerbated by intra-European exchange rate tension. With escalation of the financial market crisis in these weeks of autumn 2008, this has become particularly important as economic activity slows sharply in Europe.

Lender of last resort

As far as the ECB is concerned, Europe's central bank has assumed important crisis management functions in providing liquidity, in monetary policy and as a mediator to governments. And it has made a good job of this.

From the very outset of the crisis the ECB was called on to step up to the table as "lender of last liquidity". The central bank repeatedly provided large amounts of liquidity to stabilise the money and financial markets in the wake of crashing confidence in August 2007. Throughout, the ECB was able to draw on a financial toolkit assembled with great foresight, for example with regard to the flexible use and broad availability of eligible marketable assets. It has flexibly adjusted its instruments to the flow of events on several occasions (eg. with regard to the timing of liquidity provision). Other currencies were also included in the ECB's liquidity backups - for example to plug temporary dollar gaps at banks in Europe and tide euro-area banks active in Hungary over funding bottlenecks in Swiss francs.

The relentless turmoil on the financial markets necessitated close international cooperation and coordination on liquidity and monetary policy between central banks. The beginning of October saw the first internationally coordinated round of interest rate cuts since September 11, 2001, featuring the ECB and the Federal Reserve as the major players with the ECB acting as the US' central monetary contact in Europe. In so doing, it filled a gap that the former US Secretary of State Henry Kissinger had pointed to back in the 1970s.

In the balancing act between its primary mandate to safeguard price stability and its responsibility for financial market stability the ECB has to tread a fine line. When, in September, it became increasingly clear that monetary policy tools and the micro-treatment of problems on a case by case basis would no longer do the trick, the ECB made a particular point of stressing the need for political action by EU governments to restore stability to the financial system.

As a community of states, the EU has in effect had two executive layers in the Exofin Council since introduction of the euro: the Eurogroup of (15) EMU finance ministers decides on all issues relating to EMU ahead of the joint meeting of the 27 EU finance ministers. Since 2005 the Eurogroup has developed discernible leadership qualities under its president Jean-Claude Juncker and raised its profile with the general public, for instance with regard to better coordination of fiscal policy under the reworked Stability and Growth Pact. The Eurogroup has also turned out to be a useful initiative and coordination forum, smoothing the way after heated debate for EU-wide rules on bank bail-outs by member states once it had become apparent that national go-it-alones were leading nowhere and a package at EU level failed to drum up majority support.

Not that many years ago, Anglo-American observers were the very ones to identify construction errors in Europe's monetary union and to prophesy its premature end. This contrasts with the perception that EMU has so far stood the test in terms of management of the financial market crisis. And it renders all the more incomprehensible the French notion that it would be a good thing to continue running the EU and EMU under the presidency of heavyweight countries, thereby placing a question mark over existing institutional arrangements.

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COMMENT: Financial crisis tests mettle of Europe's monetary union

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