ABSTRACT
Before the euro was introduced, each European country had its own currency. These currencies were integrated into fixed exchange rate regimes after the end of the Bretton Woods system. European currencies floated freely against the US dollar and the Japanese yen, but moved only inside pre-determined bands against each other. Central banks guaranteed solvency of national governments by financing the budget, either directly or indirectly. This meant that even relatively high levels of public debt could be financed without difficulty. This is not to say there were no problems – of course there were, for example in regards to interest rates and the current account. Countries with relatively weak annual rates of increase in per capita productivity experienced a relative increase of the price of their products over time, compared to similar products produced more efficiently elsewhere. Foreign competition gained a price advantage over domestic producers, and this shifted production and jobs abroad. Rising unemployment led to political pressure to adjust. This often entailed devaluation of the currency. A cheaper currency meant that foreign products would increase in price, while domestic products would become relatively cheaper. Employment started to rise again as domestic production substituted for imports, and production returned. However, the owners of financial assets denominated in the devaluating country’s domestic currency lost out in these devaluations. This is why a country with relatively weak productivity growth had to offer an additional incentive to international investors to hold their assets (corporate shares, government bonds, etc.), given that the danger of another devaluation always lurked: an attractive interest rate, higher than what could be found in jurisdictions with more stable currencies. This higher interest rate, however, had the downside that it also kept domestic investment subdued.
