The fate of the euro Vanguard Research July 2018 Peter Westaway, PhD; Alexis Gray; and Eleonore Parsley ■ The fate of the euro is not yet sealed. Despite flaws in its initial design, the euro is likely to survive with most, if not all, member states for many years given the strong political will for its existence. Based on analysis of current developments and of previous monetary unions, we believe that risks to the euro area come from two directions. Without further integration and better crisis management tools, there may be a partial or full breakup of the euro. But too much integration too quickly could lead to the same outcome. ■ The risk of an immediate “euro crisis” is low. Indeed, we place a 95% probability on the survival of the euro area over the next five years. We think a partial breakup is possible but also unlikely in the short term (0%–5%). ■ We are less sanguine about the outlook for 30 years and beyond. The chances of the euro’s survival with the full complement of existing members dwindles to around 60%–70%, with a meaningful 20%–30% chance of a partial breakup and a still meaningful 10%–15% chance of a full breakup. For professional investors only as defined under the MiFID II Directive. Not for public distribution. In Switzerland for professional investors only. Not to be distributed to the public. This document is published by The Vanguard Group, Inc. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments. It should be noted that it is written in the context of the US market and contains data and analysis specific to the US. Introduction despair and the financial system came crashing down, In 1999, 11 countries from across Europe left behind bringing the economy with it. Some of the damage was their domestic currencies to form the largest international caused by outside factors, but the crisis also exposed currency union in history, the euro.1 In the 18 years that flaws in the initial design of the monetary union. Many followed, eight more countries, mostly from Eastern of these had been highlighted by economists before the Europe, joined the euro (see Figure 1). inception of the euro. In the early years of the euro, the so-called honeymoon The euro managed to avoid collapse, and the euro area period, the euro area appeared to thrive. The economy economy appears to be thriving once more. But how grew at a good pace, the housing market boomed across sustainable is this currency union in the long term? many countries, and there was applause all around for Have the underlying issues been addressed, or are the euro’s success. This all changed following the 2008 further crises around the corner? global financial crisis, when optimism gave way to Figure 1. Composition of the European Union and the euro area The European Union ■ Countries that use the euro (euro area) ■ Countries that do not use the euro 1. Austria 15. Italy 27 9 2. Belgium 16. Latvia 3. Bulgaria 17. Lithuania 8 4. Croatia 18. Luxembourg 16 7 5. Cyprus 19. Malta 17 20 6. Czech Republic 20. Netherlands 28 2 21 11 7. Denmark 21. Poland 14 6 24 8. Estonia 22. Portugal 18 1 13 9. Finland 23. Romania 10 23 10. France 24.Slovakia 25 4 3 11. Germany 25. Slovenia 26 22 15 12 12. Greece 26. Spain 13. Hungary 27. Sweden 19 5 14. Ireland 28. United Kingdom (leaving in 2019) Source: Vanguard. 1 The euro is the largest single currency in terms of the member countries’ combined GDP. For professional investors only as defined under the MiFID II Directive. Not for public distribution. In Switzerland for professional 2 investors only. Not to be distributed to the public. The euro was many years in the making however, Denmark has a legal opt-out, and the United The euro area, also known as the Economic and Monetary Kingdom, which also has a legal opt-out, will leave 2 Union (EMU), is a currency union with 19 members that in 2019. falls under the umbrella of the European Union (EU). To understand the history and motivation behind these The EEC, and later, the EU, made several attempts countries’ choosing to adopt the euro, one must also to manage exchange rates. The first attempt was the understand the EU. “currency snake” in the early 1970s, where exchange rates were required to remain within a tight band around The EU was formally established in 1992 (see Figure 2); a central rate. The currency snake soon collapsed and its predecessor, the European Economic Community was replaced in the late 1970s with the European 3 (EEC), was constructed in 1957 under the Treaty of Monetary System, another peg system. This system Rome in an effort to reunite Europe after World War II. also faced pressures, particularly in the early 1990s after The EU is an economic and political union that has free the reunification of Germany and following speculative movement of people, goods, services, and capital. In attacks on the UK pound, which prompted the United effect, it is the largest free-trade zone in the world. The Kingdom to abandon the system (Chown, 2006). euro was introduced in 1999 as the next step in the process to converge members of the EU into a tighter In 1992, after many years under the troubled peg system, economic and political union. The intention had been for the European leadership decided to replace it with a single all 28 members of the EU to join the euro at some point; currency, the euro, which was formally introduced in 1999. Figure 2. Timeline of the euro 2002 1972 Euro notes and coins “Currency snake” introduced begin to circulate 1957 1992 Treaty of Rome signed Maastricht Treaty established 1960 1980 1999 1950 1970 1990 1968 European free trade area and customs union established Birth of the euro € 1979 European Monetary System created Source: Vanguard. 2 Seven other countries, mostly more recent EU member states, do not currently use the euro but are legally required to do so in due course, as will any future EU members. There is no strict timeline on euro adoption; however, after the United Kingdom leaves the EU there may be a renewed push for integration to avoid another exit and increased pressure for all EU members to adopt the euro. 3 A currency peg system describes the type of exchange rate regime applied to a currency to keep its value stable against a reserve currency or a basket of currencies. For professional investors only as defined under the MiFID II Directive. Not for public distribution. In Switzerland for professional investors only. Not to be distributed to the public. 3 • 1957: The Treaty of Rome was signed by Belgium, the introduction of the euro. The ERM is based on the France, Italy, Luxembourg, the Netherlands, and West concept of fixed currency exchange rate margins but Germany, establishing the EEC (the predecessor of the with exchange rates variable within those margins. European Union) in the hope of laying the foundation for This is also known as a semi-pegged system. Before an even closer union among the European people. The the introduction of the euro, exchange rates were EEC was based on a series of institutions: the European based on the ECU, the European unit of account, Commission, the European Assembly, the Court of whose value was determined as a weighted average Justice, and the Economic and Social Committee. of the participating currencies. Economic integration set the path for progressive • 1992: The Maastricht Treaty, ratified by all member political integration. The EEC aspired to create a states, formally established the European Union, common market and free movement of capital and granting EU citizenship to every person who was labour. Policymakers agreed to dismantle all tariff a citizen of a member state. The treaty also helped barriers over a 12-year transitional period, which ended introduce a central banking system and implemented up being shortened to an end date of 1968. common foreign and security policies. It created the • 1967: The European Communities (EC) were three-pillar structure of the EU and led to the creation created, merging the executive bodies of the European of the euro. One of the treaty’s obligations was to Coal and Steel Community, the European Atomic keep “sound fiscal policies, with debt limited to 60% Energy Community, and the European Economic of GDP and annual deficits no greater than 3% of Community into a single institutional structure. GDP”. The pillar system was the result of many member states’ desire to extend the EEC to areas • 1968: A full customs union was created in the EC, of foreign policy, military, criminal justice, and with member countries removing customs duties judicial cooperation. The Maastricht criteria4 were in intracommunity trade. The common customs tariff the characteristics the EU member states needed was introduced to replace national customs duties to meet to adopt the euro as their currency. in trade with the rest of the world. This meant that goods could flow frictionlessly across borders within • 1999: Birth of the euro. Eleven countries took a the EU, facilitating greater economic integration. historic step by forming the monetary union officially known as the euro area (but often also known as • 1972: The currency snake was the first attempt at the euro zone). At the same time, the “Eurosystem”, European monetary cooperation. Currencies could which consists of the European Central Bank (ECB) move in bands of ±2.25% relative to their central rate and the national central banks of all EU member against the US dollar.