The European Union is currently under public pressure over issues such as migration and Brexit. However, a longer-term malaise continues to rumble on: the difficulties thrown up by currency union. Richard Ferguson charts key events in the history of the Eurozone project and asks what the future holds.

Writing in 1961, the economist Robert Mundell considered that an optimal currency area broadly required four features to function: labour mobility, capital mobility, a fiscal transfer mechanism and, lastly, similar business cycles. His role in the intellectual and academic development of this concept provided him with the moniker “Father of the Euro” and, in 1999, the year of the Euro’s launch, he was awarded the Nobel Prize in Economics.

However, while the technicalities of optimal currency areas might fill many academic journals and graduate theses, relatively few address the political ideals and emotional decision-making that leads to the eventual failure of most currency unions. Bad economics alone doesn’t kill off currency unions and much depends on the political capital invested in any project and whether it might survive.

Last month – August 15 to be precise – saw the 36th anniversary of “The Nixon Shock”, a political decision that abolished one of the institutions which not only defined the post-war consensus but also bore the name of the place where, in 1944 – and mere weeks after the Normandy Landings – allied policymakers had designed the forerunners of the World Trade Organization (WTO), the International Monetary Fund (IMF), and the World Bank, and the currency mechanism that would glue it all together: the Bretton Woods System.

For most people – especially anyone under the age of 60 – the collapse of the Bretton Woods System has become a footnote in modern financial history, eclipsed by wars and obscured by other more dramatic political and economic events. However, its demise led to the evolution of European Monetary Union (EMU) and the creation of the Euro. Its demise also provides some hints over the longer-term prospects for both.


In historical terms, the original Bretton Woods System should be seen as an event of supreme catharsis. The overall Bretton Woods Agreement established many of the supranational institutions and structures of the post-war consensus, most of which still exist today. Despite bearing the name of the town where it was initiated, it is the one institution that has failed to endure in the way that others, such as the General Agreement on Tariffs and Trade (GATT), which transformed into the WTO, and the Bank for Reconstruction and Development which became the World Bank.

The Bretton Woods System established a mechanism to stabilise exchange rates and promote trade after the protectionist impoverishment of the 1930s. In simple terms, all currencies were linked to the US dollar, while the dollar itself was linked to gold (two-thirds of global supply was held by the US Federal Reserve at the end of the Second World War). Central Banks had to buy and sell currency to maintain the exchange rates established under the Bretton Woods Agreement.

For many years the Bretton Woods System endured despite a few minor crises along the way. Germany and Japan were rehabilitated as major industrial economies, consumer affluence increased dramatically across the West throughout the 1950s and by the mid-1960s, the US economy had enjoyed a five-year period in which it grew by a remarkable 33 percent. The confidence that this lengthy boom delivered spilled over into hubris with President Johnson’s “Great Society” by which the federal government made ambitious commitments to healthcare, environmental safety, broadcasting, social security, and student loans.

Simultaneously, in the sphere of global politics, George Kennan’s policy of “containment” from the 1940s had metamorphosed into a determined strategy to combat Communist insurgencies across the world, most notably through the expansion of the Vietnam War. Moreover, Germany and Japan’s emergence as leading economies throughout the 1950s and 1960s meant that a post-war agreed fixed exchange rate mechanism was growing more irrelevant with each passing year as these countries’ export-driven economies demanded increasing amounts of US dollars (or, by design, gold).

To maintain the exchange rate equilibrium established by the Bretton Woods System, the economic response to these additional military and social expenditures should have been an either/or choice. Instead, the political response of the Johnson Administration was to convince the citizens of the Republic that a ‘guns and butter’ strategy was feasible.

None of this proved sustainable. The cost of waging the Vietnam War consumed some US$111 billion of direct military expenditure with a peak of US$25 billion in 1968, representing some 2.3 percent of America’s GDP. In the four fiscal years through to 1969, the Vietnam War cost US taxpayers (and the country’s creditors) some US$75 billion.

Simultaneously, expenditure on social programmes accelerated. Direct spending on social security, Medicaid, and Medicare amounted to US$24 billion in 1963. Five years later, it had grown to US$39 billion, an annual increase of 10 percent. Other indirect federal government spending grew by similar amounts.

Had the either/or principle been applied, it is possible that the country’s rapid economic growth could have carried these additional fiscal challenges, without damaging the underlying exchange rate mechanism.

Instead the US budget deficit accelerated to 2 percent of GDP by 1971, while the current account moved into deficit for the first time since the Second World War. Unemployment rose sharply, nudging 6 percent, again for the first time in the post-war era. Inflation at 6 percent was at a record post-war high and significantly higher than the 1-2 percent range that had characterised the first half of the 1960s.

This shift into US twin deficits and stagflation resulted in a conundrum; the US dollar was now in decline but with an official gold exchange ratio of US$35 per ounce, non-US governments demanded to exchange their US dollars for gold at the official rate. On August 15 that same year, the Nixon Administration, recognising the economic consequences of waging war in peacetime, broke the US dollar’s link with gold and the Bretton Woods System ceased to exist.


The embryo of European Monetary Union began in 1979 with the advent of the European Monetary System (EMS), a platform that was itself born of the failure of the Bretton Woods System and which was designed as a mechanism to tame the growing inflationary pressures experienced across the European Economic Community (EEC) throughout the 1970s.

A key element of the EMS was the Exchange Rate Mechanism (ERM), which restricted currency fluctuations to 2.25 percent up or down in the European Currency Unit (ECU), a quasi-currency weighted according to the eight original European member currencies. However, by 1990-1992, when the ERM had up to 13 members at various times, this proved unsustainable and a more flexible regime of up to 6 fluctuations on either side was tolerated for Italy, Spain, Britain and Portugal.

Towards the end of the 1980s the bigger decision was taken to move towards Economic and Monetary Union (EMU). Three stages were envisaged:

(1) Stage 1 (1990-1993) – the removal of capital controls; reduction of interest rate differentials and inflation; stabilisation of intra-European exchange rates.

(2) Stage 2 (1994 -1998) – convergence of ERM members’ national economic policies pegging their currencies; transition managed by the European Monetary Institute (EMI)

(3) Stage 3 (1999) – replacement of EMI by the European Central Bank (ECB); exchange rates would be irreversibly fixed before a single currency (the Euro).

Britain joined the ERM in October 1990. Early optimism was swiftly dampened by the economic realities and consequences of German unification. The enormous costs involved, accentuated by the political decision to convert East Germany’s Ostmarks into D-Marks at an inflationary exchange rate of 1:1, forced the Bundesbank to maintain a high interest rate policy.

This was exacerbated by a flagging US dollar, which, despite the efforts of the Louvre Accord in 1987, which was established by the G-7 to prevent further declines in the US dollar, had continued to weaken. Simultaneously capital flows into the deutsche mark strengthened the West German currency. To maintain exchange rate stability Britain was also forced to adopt a high interest rate policy, which had a severe impact on economic growth. By the end of 1990, Britain’s debt-driven housing boom was in full retreat and the country entered a prolonged recession.

Matters came to a head on 16 September 1992, so-called “Black Wednesday”, when the government and the Bank of England attempted to keep sterling within its ERM bands by selling its foreign exchange reserves and increasing interest rates from 10 percent to 12, with a promise to raise them to 15 percent. The latter move never occurred because the political decision was made to withdraw the pound from the ERM.

Similar currency crises followed notably with the Italian lira, the Spanish peseta, and the Portuguese escudo. This led to the widening of ERM margins to 15 percent up or down from August 2 1993 (Germany and the Netherlands excepted). From January 1 1999, with the Euro coming into existence, ERM was replaced by ERM II, wherein a national currency was allowed to float within a range of 15 percent on either side.

The bookends to this currency crisis proved decisively how EMU was not simply an economic project designed to establish a credible successor to the Bretton Woods Agreement. Instead, it demonstrated the wider political ambitions of a project in which huge sums of non-economic capital were invested across many EU member states. Had the EMU venture been a purely economic endeavour, the decisions taken by several EU governments in 1988 and1989 to advance the EMU agenda might have run aground along with the West’s faltering economies. Instead it seemed to reinforce the project and give it additional impetus.

The UK’s awkward relationship between the disparate – and perhaps competing – political and economic visions of Europe came to the fore with the Maastricht summit of December 1991 where the entry criteria for the single currency were established and the UK negotiated an opt-out clause.


Unlike the Bretton Woods System, EMU did not enjoy a sustained period of relative stability after the project began on 1 January 1999. At the outset, the new currency had an exchange rate of approximately US$1.18. Within eighteen months of its inception, it had declined to $0.85 cents. Recovery did follow as the newly competitive exchange rate promoted Eurozone exports to the US. One school of thought believes that a “parallel” rather than a “hard” introduction of the currency in 1999 might have saved the Eurozone from five years of stagnation.

The “Stability and Growth Pact” (SGP) was key to meeting two of Robert Mundell’s conditions to buttress an optimal currency area: firstly, provision of a fiscal transfer mechanism and, secondly, similar business cycles. However in 2005, the inconsistencies and challenges of running the SGP across 25 very different economies became apparent. Although the convergence criteria of the Maastricht Treaty had seen fiscal deficits among members decline from 5.5 percent of GDP to 3 percent by 1997 when the deadline for adherence was set, it proved a temporary alignment. Portugal’s fiscal deficit exceeded 3 percent as early as 2001. Even the mighty Germany and France, cornerstones of the EMU project, followed in 2002. Italy managed to hold the line until 2004 but by this time, many member states were in breach of Maastricht Criteria.

The response to this development, published in 2005, has had lasting effects on the credibility of EMU. New medium term objectives introduced “preventative” and “corrective” arms, designed to re-set broken rules. To see how quickly these amendments were likely to be steamrollered by reality, consider one of the new corrective measures for reducing budget deficits. This suggested the deadlines for correcting excessive deficits was “a year after its identification, unless there are special circumstances”. A condition, no doubt, that came in handy, when the global financial crisis and its somewhat special nature erupted less than three years later.


The travails of the global financial crisis and their impact on southern Europe and the Eurozone are well documented. There is no need to repeat them here. Suffice to say, the 2005 SGP reforms proved temporary and a further re-assessment was made in 2012 with the advent of the “fiscal compact” which has complicated the SGP still further by introducing a multitude of additional medium-term targets.

Meanwhile the crisis in the Eurozone persists. In June 2017, participating countries and the IMF approved a €8.5 billion loan tranche to meet debt repayments due in July 2017. This is part of the third bailout programme totalling €86 billion, which will conclude in August 2018. No debt relief commitments exist for now, but “will be implemented at the end of the programme, conditional on its successful implementation”. The IMF has also approved “in principle” its participation in this programme despite its unwillingness to do so unless some debt relief is provided.

There are two obvious and immediate problem areas for the Eurozone now. The first is Greece but it is the second, Italy, which, by virtue of size and the duration of its involvement in the EU and EMU projects, which provides a more worrisome prospect. In June 2017, Italy paid about €5 billion in cash – and provided €12 billion of guarantees – to help wind-up Veneto Banca and Banca Popolare di Vicenza. In July, the EU approved a €5.4 billion bailout for Monte dei Paschi which had been in special measures since last December. Germany remains unhappy with this arrangement as it would prefer investors rather than taxpayers to take losses.

The Euro sculpture in Frankfurt, the 12 stars representing members of the European Central Bank. Image: Jim Woodward [CC BY 2.0]

Separately, Italy’s wider financial sector is still estimated to have non-performing loans of approximately €300 billion. Throw in Italy’s large sovereign debt of €2.1 trillion (around 130 percent of GDP), and note that almost €400 billion of that has to be rolled over this year. It is then that the magnitude and current nature of this crisis becomes apparent. We have still to see its nadir.

What complicated this grim outlook was not just the financial monster created but who helped to create it. According to data provided by the Basle-based Bank for International Settlements, by December 2009, German banks had lent a staggering US$704 billion to Greece, Ireland, Italy, Portugal and Spain. The exposure of two alone – Deutsche Bank and Commerzbank – amounted to US$201 billion. Specifically, Greece’s biggest creditors just before its economy crashed in 2011 were French institutions whose exposure to the country totalled US$67 billion. When identifying the problems that lie at the heart of the Eurozone, it is simplistic – flippant even – to conclude that the Greek tragedy that followed could be distilled into a struggle between good and bad. In truth, the story is blemished by a multitude of compromised parties.


In their embryonic phases, the Bretton Woods System and the EMU project shared a common objective as mechanisms designed to provide long-term monetary stability and promote wider economic goals. Ironically it was the catastrophic consequences of war and a need to combat political tumult that gave birth to the Bretton Woods System, while, the more politically driven EMU project was a part response to the economic disorder of Europe in the 1970s.

If, as we suggested earlier, EMU is a direct descendant of the Bretton Woods System then it is reasonable to see both as successive pillars of the post-war consensus. If so, then perhaps just as we might recognise the collapse of the Bretton Woods System as the first pillar of the post-war consensus to be demolished, then perhaps the destruction of EMU might be among the next? In short, is EMU, like Bretton Woods, past its time?

When comparing both platforms, an awkward feature is that the major economic distortion of the 1970s took place with the oil crisis of 1973-1974 and therefore after the collapse of the Bretton Woods System, whereas EMU became effective before the defining cataclysm of our era, the global financial crisis. This has an effect on how we might view both mechanisms and how their respective ends might differ. Is it possible that the political capital invested in the EMU project and an eventual successful navigation of the current financial crisis, strengthens the project in the long term?

But we are not there yet. EMU is fundamentally a political construct in which significant sums of political capital have been employed. One might conclude by saying that there are three potential outcomes for the project:

(1) An unravelling of the Eurozone. Ultimately this would be driven by political decisions made in Berlin and, to a lesser extent, Paris, and would be dependent on several factors: (i) the level of fiscal transfers made by northern Eurozone members to southern Eurozone members (ii) the extent to which Germany has to bear the ongoing costs associated with EMU in addition to its parallel EU obligations and (iii) a sea-change in the outlook of the German electorate.

It’s worth noting that it was action in Washington which broke the US dollar link to gold and brought about the end of the Bretton Woods System. However, an often-unnoticed detail was that West Germany’s decision to leave the Bretton Woods System preceded the Nixon Shock by three months. The commitment of France is likely to be crucial with any of these options.

(2) Back to the core. The similarity of the Northern Eurozone economies around Germany, such as those of the Netherlands, Austria, and Belgium, fulfils a key criterion of Robert Mundell’s optimal currency area. A “core” itself may or may not include France. Under this scenario, most southern European states and other members would rescind their status within the Eurozone.

(3) Continued integration. The difference between this option and the previous one is that continued integration assumes that most, or all, southern member states remain committed to the EMU project. This maintenance of the status quo is also fraught with challenges. For a start, it implies that several northern Eurozone states must inject hundreds of billions of Euros into the southern member states to recapitalise their banking systems, replenish fiscal coffers, and write off substantial sovereign, corporate, and personal debts.

Other challenges remain considerable. The further deepening of economic relationships are always a suggested possibility, despite this clearly having had illusory benefits in recent years. A number of states – both northern and southern, debtor or creditor – have to address some uncomfortable truths. Among these truths is the need to acknowledge that fudged entry criteria enabled member states such as Greece to embrace EMU. Germany, and perhaps France too, would have to acknowledge that a fundamental restructuring of the Eurozone was as much to recapitalise its own reckless banks as  it was irresponsible states. Above all, the question can be asked: does greater economic integration capture the cultural and economic zeitgeist?

Whichever of these options becomes policy, all three offer a strategic route beyond the current impasse. A major flaw of the EMU project is that it has had to adapt to many broad variables, including a wide and diverse membership as well as traumatic events such as the global financial crisis. In other words, it has a “crisis mentality” and strategic vision is obscured by the need to fight constant, and enduring, tactical skirmishes. If the Eurozone – and Europe generally – wants to flourish, it has to avoid inaction, the only outcome of which will be long-term decline and irrelevance.

What cannot endure, however, is a situation where, thanks to a currency union, the citizens of one export-focused member state (Germany) enjoy the benefits of a trade surplus of over €250 billion per annum while several other states in the same currency union endure youth unemployment rates in excess of 40 percent.

On December 8 1999, Robert Mundell concluded his Nobel Prize Lecture with the observation: “It remains to be seen where leadership will come from and whether a restoration of the international monetary system will be compatible with the power configuration of the world economy. It would certainly make a contribution to world harmony.” Almost 18 years on, these words have lost neither relevance nor resonance.

Richard Ferguson is the founder of Ferguson Cardo, a Glasgow-based consultancy which provides strategic advice, independent consulting, and research across the food, agriculture and biosciences sectors to a range of companies, governments, financial institutions and NGOs. He has lived, worked and studied in Asia, Africa, Continental Europe, Latin America, and the UK, and has written for a wide range of publications, policy institutes, and think tanks. Richard is on Twitter at: @richard_agri

Feature Image: Scrutinising the Euro. Image: [CC BY 2.0]