How durable is the hard peg of the euro? Lessons from the classical gold standard

by Kris James Mitchener & Marc Weidenmier

VOX
June 30, 2010

The Eurozone crisis has led some to seriously consider the prospect of a breakup of the euro. This column presents evidence from the classical gold standard era (1870-1913) suggesting that even then investors doubted the credibility of emerging market countries sticking to a hard currency peg – with higher premiums on sovereign debt as a result.

At the time of adoption of a single currency for much of Europe, many policymakers believed that exit from the euro would not only be politically difficult, but also undesirable in the sense that the new hard peg would confer greater benefits than costs. But the recent rise in sovereign spreads and the prospect of default among some Eurozone members has given credence to the view that highly-indebted countries such as Greece might leave the euro. This is despite economists having long warned that the economic consequences would be catastrophic.

Among researchers, the turmoil in European sovereign debt markets has rekindled interest in understanding how market participants perceive the durability of hard pegs and the extent to which the adoption of hard pegs enhances credibility. For example, countries may be able to borrow at lower rates if the adoption of fixed exchange rates confers credibility. Establishing regime credibility may be particularly important for emerging-market countries since their rates for borrowing tend to be higher than those for high-income countries. Lower interest-rate spreads for emerging-market countries can in turn stimulate investment and economic growth.

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