Speaking at a press conference following the European Central Bank (ECB) governing council meeting on Jan. 14, president of eurozone’s central bank, Jean-Claude Trichet said that no country should expect special treatment, or special help, in the current economic crisis. He then added that “Belonging to the euro, you are helped, because you have easy financing of your current account deficit and you have a credible currency. So the problem is not help, the problem is to do the job, to take the appropriate decisions. That is what is at stake.”

The financial crisis sweeping across of Europe has raised fears that severe economic problems on eurozone’s periphery, in countries like Greece, Ireland and Portugal, could adversely affect the euro and therefore the eurozone as a whole. The economic imbroglio in Greece -- to which Trichet was directly speaking to -- has put this fear into focus of investors, governments and eurozone leadership.

To understand the current crisis, and the potential side-effects for the eurozone, Stratfor looks at the underlying consequences that euro adoption has had on member states of the eurozone.

History of the Euro

The creation of the euro draws its roots in the collapse of the Bretton Woods system in 1971-72. Bretton Woods was a global economic system created out of the ruin of the Second World War which established the U.S. as the world’s central banker. World currencies were pegged to the dollar, while the U.S. dollar was pegged to gold (for credibility sake). The idea was to establish a competent global monetary system that would encourage trade, which itself was seen as crucial for post-War global economic integration and therefore the preservation of world peace.Managing exchange rate was a way to prevented countries from using devaluation of currency to undercut exports, “beggar-thy-neighbor” policies that profligated in the aftermath of the Great Depression.

Bretton Woods system of fixed exchanges failed under the stress of theU.S. economic imbalances, primarily the result of large defense outlays caused by the Vietnam War in the 1960s and early 1970s. For the fledgling EU (then called the European Economic Community), this created a problem because large currency fluctuations -- which make it difficult to properly price foreign goods -- would impede trade between member states, which was its reason for existence.

The fear was that volatile exchange rates could put in danger 20 years of post-war economic progress and seed potential future conflicts. Europe therefore created its first attempt at currency coordination in 1971, albeit still pegged to the dollar, and later established the European Monetary System (EMS) in 1979, which un-pegged Europe from the dollar by setting up a peg against a basket of European currencies of which the German Deutschmark was the unofficial anchor by being the currency of the most powerful European economy.

In the early 1990s impetus developed to take the currency coordination further into the actual European Monetary Union (EMU), creation of a common currency. The primary reason for this step was German reunification. Reunification, prompted by the withdrawal of Soviet Union from Central Europe, worriedGermany’s neighbors who felt that they needed to create an institutional mechanism by which Germany was locked down into the EU. The answer was the EMU, which would give Germany de facto control over Europe’s monetary policy -- by creating the European Central Bank (ECB) in Bundesbank’s image -- while making sure that Berlin does not become “bored” of the EU project and go off on its own whims, a major fear in early 1990s of France, U.K. and other European countries.

There

that with the collapse of the Soviet Union, already evident in 1990, Germany was taking steps to reunify. A reunited Germany was feared by

The peg to the currency basket dominated by the Deutschmark actually gave German Bundesbank inordinate policy power throughout the 1980s. An impetus therefore developed to move towards a coherent monetary union, one that would include a single currency and a single bank.

Impetus for EMU:

  1. German unification
  2. Need to somewhat temper power of the German Bundesbank
  3. Sovereignty would be preserved, but under strict rules of monetary policy
  4. Some (Italy) saw future EC curbs on national fiscal policy as great way to get their budget problems under control
  5. Commission argued that savings on transaction costs would amount 0.3 to 0.4 percent of GDP

There were also problems:

  1. Labor cannot move
  2. There were no automatic stabilizers in the euro area as a whole

Trouble with the Euro:

Even before it was put in… the exchange rate system almost failed in the early 1990s because of German economic policy. Germany maintained high interest rates

German were in manufacturing… Purging of the Thatcher, manufacturing…

Germans liked interest rates to keep a high capital formation, to overhaul their industry and in order to build up a high capital information for investments in Eurasia.

Ultimately, the problem was fixed by expanding the band to 15 percent around --

When Austria, Sweden, Finland -- All three countries:

Open ended co-sign. Cosigning with kids. Germany is the parent.

VISA with a $500 credit limit. It doesn’t force them to spend more. ``

Euro leads to:

Easier access to spending

They

The system also experienced its first shock when high German interest rates in 1992 -- put in place to encourage investment in East Germany -- started to flood the system with funds from US. Mark rose in value, which created problems for the band of exchange rates. Italian lira was particularly in trouble and the Germans had to spend to prop it up.

dominated by the German Deutschmark by default