The current financial crisis is the first real test that the Euro area has faced since its launch in January 1999. While the idea of sharing one currency sounds very good from the perspective of lowering transaction costs and uncertainty, it comes with a cost. There is always the fear that individual members will not be able to cope with recessions as they have lost their ability to decide on their monetary policy (and the exchange rate).
For some, the current crisis is already showing the large costs of sharing a single currency. In a recent column, Paul Krugman argues that for a country like Spain, the fact that they do not have their currency and they cannot simply devalue it to get out of the current recession means that they will endure a bigger pain over the coming years. Some go further and forecast that several countries will soon leave the Euro area.
The economic logic behind these arguments is standard and one can find it in any macroeconomic textbook: facing a recession, monetary policy needs to be aggressive (lower the interest rate) which is likely to lead to an exchange rate depreciation. Both the lower interest rate and the depreciated currency increase the demand for domestic goods and allow the economy to escape the recession faster.
Let me question this logic and argue that a country like Spain would be in a much more difficult situation if it still had its own currency (the Peseta). Just to be clear, this is a difficult debate (whether sharing a common currency is good or bad) and there is a very large academic literature out there that I will ignore in this note (apologies). My goal is simply to share a few facts and arguments supporting the common currency arrangement.
Let’s first think about what the Spanish Central Bank would be doing if they still had power over their interest rate. It is unclear that they would be choosing a lower interest rate than the ECB has chosen. In fact, according to the IMF GDP growth forecasts, the Spanish economy is expected to grow at rates which are almost identical to those of the Euro area as a whole, it is therefore unclear that the Spanish economy needs an interest rate which is different from that of the Euro area (of course, we can argue that the ECB is not choosing the right interest rate and the Bank of Spain would be better at it, but that’s a very different argument).
GDP Growth Rates
| Spain | Euro |
| 2008 | 1.2 | 1.0 |
| 2009 | -1.7 | -2.0 |
| 2010 | -0.1 | 0.2 |
Source: IMF World Economic Outlook
But what about the exchange rate? Wouldn’t it be nice if Spain could devalue its currency to boost their exports? Maybe, but it is unclear that this would translate into a stronger GDP growth and it could have damaging long-term consequences. Some anecdotal evidence: a country like the UK is “lucky” enough to have the Pound. In fact the Pound has depreciated very strongly relative to the Euro and the US dollar. This means that the UK economy should benefit from this and be able to escape the recession faster, right? Well, the IMF forecasts for the UK economy are marginally worse than for the Euro area (or Spain). I am aware that there are many other factors to consider and that this is not a (scientific) proof that exchange rates are not powerful, but I think that the numbers make clear that the assumption that a depreciating currency is powerful macroeconomic stabilization tool should be, at least, questioned. Another interesting case is the US where despite the fact that they have their own currency, the currency has appreciated in recent months and following the logic above this should be hurting the US economy rather than helping it (i.e. even if you have your own currency, it might move in the “wrong” direction).
GDP Growth Rates
Source: IMF World Economic Outlook
Finally, if Spain still had their own currency and the currency had depreciated, we would have likely observed two very damaging outcomes in financial markets. First, the Spanish government as well as some of the Spanish multinational companies and banks would have seen their foreign-denominated liabilities explode because of the depreciation of the Peseta (as it is likely that they would have been borrowing in foreign currencies in previous years). In addition, when issuing new debt Spain would have faces a much higher interest rate. The Spanish government is already facing today an interest rate that is about one percentage point above the one, faced by the German government. This is all because of the fear of default; there is no uncertainty with respect to the value of the currency (both of them are denominated in Euros). If the bonds were denominated in the Spanish currency, it is very plausible that this differential would be even higher.
So having the King of Spain (or the Queen of England) printed on your bank notes is, for some, a strong sign of independence and of your ability to decide on your own destiny. But how much can a depreciation of these pictures of the King or the Queen help us getting out of a recession is much less obvious when one looks at the data.
Antonio Fatás