On May 8, 2010 in Brussels, the finance ministers of the 16 eurozone nations gathered to craft a response to the spreading financial crisis in Europe. Two weeks earlier, the credit rating agency Standard & Poors had downgraded Greek sovereign debt to junk status (BB+), pushing its two-year bond yield to 10% and the ten-year bond yield to 19%. Unable to finance operations, and without a pledge of support from within the European Union (EU), Greece had approached the International Monetary Fund for a bailout. On May 2, the EU agreed on a 110 billion euro support package, but e markets were not allayed. Six days later, the EU Council of Ministers convened in order to approve a stabilization mechanism that would provide a more robust response to the Greek debt crisis. Also attending was European Central Bank (ECB) Vice President Lucas Papademos. The ECB formally dealt with monetary policy, not issues of fiscal solvency.
But, unlike other EU institutions, the ECB could act quickly, since it already had the authority to purchase sovereign debt. In this case, it was contemplating a purchase of 60 billion euros in sovereign debt that would be heavily weighted toward Greece. Doing so would also support a core purpose of the bank. To the extent that the Greek debt crisis drove a contagion that undermined confidence in Spanish, Irish, or Portuguese sovereign bonds, it could threaten the very existence of the euro. The ECB’s formal objective was to maintain price stability within the eurozone, and that presumably extended to defending the euro itself. Yet the risks of such a move were also significant. At the European level, a bailout for Greece would send a signal to other indebted member states that the ECB would step in if private lenders became nervous.
Finally, intervening posed risks for the ECB itself. The core function of any modern central bank was price stability. Achieving this required that they push against the economic winds: loosening policy when growth slowed and tightening as enthusiasm built. Former U.S. Federal Reserve Bank chairman William McChesney Martin explained that his role was to “take away the punch bowl just when the party starts getting interesting.” Because this was frequently unpopular, any central bank therefore required insulation from political pressures. This sort of insulation had been built into the governing structure of the ECB. But an overt move to support the debt of a specific member state opened the ECB to political meddling. If it did not draw a line, it would become the first responder for each subsequent fiscal crisis. While the 60 billion euro outright debt purchase proposed for Greece could easily be absorbed into the ECB balance sheet, purchasing the debt of a large country like Spain could have inflationary consequences.
After seven hours of debate, Papademos stepped aside for a conference call with ECB president Jean-Claude Trichet, who was in Basel at the time, and the rest of the ECB Governing Council. A decision had to be made about the Greek bond purchase proposal. French president Nicolas Sarkozy in particular was pushing hard for the ECB to intervene. German chancellor Angela Merkel defended the independence of the ECB and reminded EU leaders that politicians did not have the right to instruct the central bank.1 The ECB itself had been hoping for a political solution to the crisis. The outlines of that solution were emerging. So far, members of the Council had agreed to a 440 billion euro bailout fund, organized as an intergovernmental agreement of eurozone countries and financed through bond issues. The EU would contribute an additional 60 billion euros of emergency funds, and the IMF promised to match half of the final package, providing 250 billion euros.2 With the core elements of a plan now on the table, the ECB had to decide if it would also intervene.
Roots of a Common Currency
The 1957 Treaty of Rome that constituted the European Economic Community (EEC)b did not foresee a common currency in Europe. At the time, European currencies were linked through the Bretton Woods exchange rate regime that fixed the major national currencies to the dollar and linked the dollar to the price of gold. In 1970, as high dollar inflation put pressure on the Bretton Woods system, a committee convened by Luxembourg Prime Minister Pierre Werner first proposed that the EEC move to a single currency.
That vision would not be fulfilled for another generation. When the Bretton Woods regime failed in 1971, after which the dollar was allowed to float freely, European currencies attempted to recreate a fixed exchange rate regime. Its first years were tumultuous, with currencies moving in and out of the fixed regime in order to pursue competitive devaluations. To offer greater stability, a new European Monetary System (EMS), introduced in 1979, set narrow bilateral exchange rate bands and provided a centralized arrangement for negotiated revaluations.
The first step toward the euro came in 1988, when the European Community (EC) adopted a directive requiring free capital flows among EC member states. The combination of fixed exchange rates under the EMS and free capital flows eventually proved explosive. In the absences of capital controls, member states were forced to raise or lower their interest rate in order to make their currencies more or less attractive to foreigners, and thus to maintain the fixed value of their currency.
The instability of this system became clear in 1992, when a speculative attack against the British pound forced the Bank of England to raise interest rates to 12% in defense. Ultimately, such a high interest rate was politically unsustainable, and the pound was forced to withdraw from the EMS. On “Black Wednesday,” September 16, 1992, George Soros’s Quantum Fund earned an estimated $1 billion as the pound was revalued.
The solution, proposed in the 1992 Maastricht Treaty, was to be a single currency for all European countries, to be called the euro. All member states would be eligible for membership in the euro, but only those meeting strict convergence criteria by 1998 could participate in the launch. The criteria included a budget deficit of less than 3% of GDP and a national debt of less than 60% of GDP; inflation within 1.5% of the three EMS economies with the lowest inflation; nominal long-term interest rates within 2% of the three EMS economies with the lowest inflation; and at least 2 years without devaluation within the ERM.
When it became clear that only three member states were likely to meet the 60% of GDP debt limit, this criterion was relaxed. Eleven member states met the convergence criteria by July 1, 1998, and the currency launched, first in 1999 as an accounting unit, then in 2002 as paper currency and coins. The remaining member states were expected to join as they were able to meet the convergence criteria. Exceptionally, the U.K. and Denmark had negotiated provisions that allowed them to remain permanently outside of the eurozone.
The European Central Bank
A common currency required a common decision-making body to set monetary policy, and that role was given to the new European Central Bank. Rather than eliminating national central banks, the ECB would coordinate policymaking among them. Its core goal, laid out in the 1992 Maastricht Treaty, was to maintain price stability. The 1998 Statute of the European System of Central Banks defined price stability as “a year-on-year increase in the Harmonized Index of Consumer Prices for the euro area of below 2%.”3 The new eurosystem operated through a division of labor. The ECB issued euro notes, set monetary policy, and interacted with international and European monetary institutions.4 National central banks executed monetary operations, managed foreign reserves, operated payment systems, and assisted the ECB in collecting economic and financial data.5
Decisions about interest rate changes were based on a “two pillar” analysis that focused on both the price (interest rates) and quantity (monetary aggregates) of money.6 The main decision-making body of the ECB, the Governing Council, consisted of a six-member Executive Board appointed by the Heads of State or Government of the member states, along with the governors of the national central banks of the sixteen member states of the eurozone. Governing council interest rate decisions were made by unanimity.
The ECB’s main monetary tool was the provision of liquidity via a weekly variable rate tender called the main refinancing operation (MRO). At each tender, eligible counterparty banks submit bids that include the volume and interest rate of liquidity they desire. The ECB sets the volume of allotted credit, plus a minimum “benchmark” bid rate below which bids are discarded. Bank bids are then accepted beginning with the highest interest rate until the liquidity allotment is exhausted. Liquidity is provided via repurchase agreements, secured against qualified collateral. MRO allotments were used to target an interbank lending rated called the European Overnight Index Average (EONIA). In addition to the MRO, the Governing council also set separate rates the overnight deposit facility and for an emergency marginal lending facility.c Under normal conditions, the deposit facility rate was set one percentage point below the MRO rate, and the marginal lending facility was set one percentage point above the MRO rate. The Governing Council met twice monthly in the Eurotower in Frankfurt am Main, Germany, to set these rates.
The Early Years of the Euro
The euro launched in 1999 to a chorus of criticism. Two main concerns dominated. One set of observers worried that a single Europe-wide interest rate would be poorly suited to specific domestic economic conditions of individual member states. If some states were growing and others were in recession, no single interest rate would satisfy both kinds of states. Monetary economists such as Milton Friedman, Henry Kaufman, and Martin Feldstein warned that, without greater economic alignment of the member states, a single currency could precipitate a civil war in Europe.
8 A second set of observers emphasized the risks of centralizing monetary policy while fiscal authority remained under the control of member states. Because the benefits of fiscal stimulus were local and the costs of monetary tightening were felt across Europe, critics warned that individual states had an incentive to over-stimulate their economies through fiscal imprudence. This would force the ECB to impose higher interest rates than might otherwise be necessary to meet their inflation targets, resulting in slower economic growth across the eurozone.
In the early years of its existence, these misgivings about the euro seemed to be mostly unfounded. The currency was introduced at a rate of $1.17 against the dollar in 1999, but only as an accounting currency. Its value fell to a low of 83 cents in 2000,9 on the eve of the launch of the new paper currency. Although some consumers claimed that retailers had used the move to the euro to boost their prices, the transition otherwise went smoothly, and the euro had by late 2003 increased by 50% against the dollar from its 2000 trough. This relative strength was in part a reflection of the growing spread between euro and dollar interest rates. Whereas the Fed moved quickly to lower the federal funds rate in the wake of the dot.com bust, the ECB responded both more slowly and less aggressively.
By mid-2003, the ECB MRO rate was 2%, compared to a U.S. federal funds rate of 1%. In the spring of 2004, the Fed began a deliberate slow increase in interest rates that eventually peaked at just over 5% in 2006. The ECB MRO rate at the time was still only 3%. Yet the value of the euro continued to surge. In April 2008, the euro hit a record high of $1.60.10 Eurozone inflation averaged slightly above 2% and 3% per year. (See Exhibits 7 and 8) This stability seems to have impressed foreign central banks, which began to convert a share of their foreign reserves into euros.11 By 2008, 33% of all international debt securities and 27 percent of global foreign exchange reserves were denominated in euros.d
Looking back over the first ten years of the euro, ECB president Jean-Claude Trichet summarized: “The euro is a very stable currency, and all the institutional requirements are in place to preserve its solidity in the future. This is what defines success in monetary affairs.”12
Although the EU controlled relatively few resources, it included a mechanism for coordinating national fiscal policy called the Stability and Growth Pact (SGP).13 Adopted in 1997, the SGP took effect with the launch of the euro in 1999. The SGP was meant to ensure that, even under the pressure created by a shared currency, member states pursued “national budgetary policies [that supported] stability oriented monetary policies.”14 Specifically, the pact set a public sector deficit limit of 3% of European Central Bank, The Internatioanl role of the Euro (Frankfurt: ECB, 2010), p 11.
SGP enforcement was an area of ambiguity. In 2001, Portugal, France, and Germany received “early warning” that they were breaching the SGP’s fiscal deficit limit; only Portugal corrected its deficit.19 In 2003, the EU debated whether, as the European Commission suggested, Germany and France ought to be sanctioned for their refusal to follow the SGP, or whether, as the Economic and Financial Affairs Council (EcoFin) insisted, the SGP should not be applied to Germany and France for the time being.20 The latter camp won the debate, resulting in a 2005 reform that deficit hawks derided as the “emasculation” of the SGP.21
According to the revised plan, countries were permitted to run deficits over the 3% of GDP limit under what the document specified as “exceptional circumstances.”22 It also created an “excessive deficit procedure,” requiring increased surveillance for countries exceeding SGP limits and correction of any breach “in the year after its identification, unless there are special circumstances.”23 In October 2008, as the financial crisis deepened, the leaders of the four largest economies in Europe (France, Germany, Britain, and Italy) requested exemptions under the “exceptional circumstances” provision.