Three New Lessons of the Euro Crisis

The most appropriate analogy is with a country like South Korea. In the aftermath of the Lehman Brothers collapse in 2008, South Korea needed dollars, because its firms had borrowed in dollars that domestic savers could not fully supply. Thus, it entered into a swap arrangement with the Federal Reserve to guarantee that South Korea’s demand for foreign currency would be met.

Of course, the euro crisis was not just a liquidity crisis. Several countries in the periphery (Greece, Spain, and Portugal) were responsible for the circumstances that led to and precipitated the crisis, and there may be fundamental solvency issues that need to be addressed even if the liquidity shortfall is addressed.

Finally, a less well-recognized insight from the euro-crisis concerns the role and impact of a currency union’s dominant members. It is often argued that the United States, as the major reserve-currency issuer, enjoys what then French Finance Minister Valéry Giscard d’Estaing famously called in the 1960’s an exorbitant privilege, in the form of lower borrowing costs (a benefit estimated to be worth as much as 80 basis points).

There was always a downside – previously ignored but now highly salient in our mercantilist era – to this supposed privilege. If investors flock to safe US financial assets, these capital flows must keep the dollar significantly stronger that it would be otherwise, which is an unambiguous cost, especially at a time of idle resources and unutilized capacity.

But, in the case of Germany, exorbitant privilege has come without this cost, owing solely to the currency union. Weakness in the periphery has led to capital flowing back to Germany as a regional safe haven, lowering German borrowing costs. But, yoked to weak economies such as Greece, Spain, and Portugal, the euro has also been much weaker than the Deutschemark would have been. In effect, Germany has had the double exorbitant privilege of lower borrowing costs and a weaker currency – a feat that a non-monetary-union currency like the US dollar cannot accomplish.

The future of the eurozone will be determined, above all, by politics. But its development so far has forever changed and improved our understanding of currency unions. And that will be true regardless of whether the eurozone achieves the closer fiscal and banking arrangements that remain necessary to sustain it.

Arvind Subramanian is a senior fellow jointly at the Peterson Institute for International Economics and the Center for Global Development.

Copyright: Project Syndicate, 2013.

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