Challenges for the Euro Exchange Rate in Times of Crisis

Since its introduction as a circulating currency in 2002, the euro has fast grown to become one of the world’s most important currencies. More than 330 million people use the euro everyday, more than any other currency. With over 800 billion euros in circulation, the euro has the largest total value of circulating currency in the world. As a result, the euro is the second most traded currency in the world.

Initially, the introduction of the euro reduced risk and increased stability for exchange rates within the Eurozone. After a few initial hiccups shortly after its introduction, the euro stabilized and became reliable. It weathered the early credit crunch and toxic mortgage investments of 2007-9 well. However, new challenges face the euro as a result of the continuing financial crisis.

The economic difficulties faced by Greece, Ireland, Spain, and Portugal continue to put a strain on the Eurozone and the value of the Euro. Thus far, both Greece and Ireland have received large bailouts from the European Union. Although Greece’s problems were partly caused by lack of financial discipline, the same is not true for Ireland. According to conventional economic wisdom, Ireland did everything right. That still didn’t stop Ireland from getting hit hard by the global credit crunch. Spain and Portugal may be next.

The bailouts to Greece and Ireland kept the euro from going into a freefall. However, uncertainty over the need for further bailouts continues to keep the euro exchange rate low.

The euro has not fallen below parity with the U.S. dollar since 2002, after the circulating coins were introduced. For the 3 years prior to that, the euro had only been an accounting currency, which was initially introduced at a floating exchange rate of $1.18 USD. As of December 2010, the euro is hovering in the $1.3 USD range. It would be even lower if the USD itself was stronger.

The bailouts to Greece and Ireland and possible future failouts to Spain and Portugal are increasing the financial strain on the other countries of the EU. Many of them already have heavy debt loads of their own. Some, such as Great Britain, may be facing a debt wall. These issues may cause the euro to take a new tumble in 2011 and 2012.

These problems won’t go away until the Eurozone implements structural reforms to tighten financial discipline across all the countries of the Eurozone, but that’s not going to be enough. Ireland’s troubles show that individual countries of the Eurozone are vulnerable to global trends.

After its severe bank crisis, Iceland may also be looking toward the EU for future stability, despite its earlier reluctance. At least the fallout from its banks’ investment and lending practices won’t be an EU problem.

Another problem which is not going to go away anytime soon is that countries in the Eurozone differ widely in their real economic performance. This is a problem that has existed for a very long time.

Countries in the European Union which join the Eurozone are required to keep their currency-euro exchange rate stable for 2 years before switching. Estonia joins the Eurozone in January 2011. Other EU countries may have difficulty meeting the requirements until the global financial crisis is over.

Due to the euro’s prominent role in the world economy, the European Central Bank may also be forced to step in to help restore global financial stability. The results of such an action on the euro exchange rate will depend on how well the EU has resolved its own domestic problems at that time.