The global financial crisis will undermine both the euro's challenge to the U.S. dollar as the world's reserve currency and the proposed expansion of the euro area.

Resident Fellow Desmond Lachman

Among the more probable long-run casualties of today's global and financial market crisis will be any further expansion of European monetary union. It is also more than likely that today's global financial market crisis will mark the end of any serious challenge by the euro to the US dollar as an alternate international reserve currency.

A deep and long global economic recession will put severe strain on the current 15-country euro area. It will also expose the acute external vulnerabilities of those east European countries which aspire to full euro area membership.

In 1998, when the euro was launched, Milton Friedman famously warned that the euro would be truly tested by the first major global economic recession. He issued this warning in the belief that, lacking labour and product market flexibility, Europe was not an optimum currency area in the sense that was the case of the US economy.

In particular, he strongly believed that at a time of economic difficulty, there would be countries of significance in Europe which would have considerable trouble coping with the euro area's one-size-fits-all approach to monetary and exchange rate policy.

Judging by October's alarming plunge in global equity prices and the virtual freezing up in global credit markets, there can be little doubt that Europe, along with the US, is at the start of its worst economic recession in the post-war period.

And judging by the bursting of Spain's out-sized housing market bubble and by the precarious state of Italy's public finances, there can be little doubt that Spain and Italy will be the two major European economies that will be put to the severest of tests as the global recession deepens. In order to cope with their respective problems, Spain and Italy will need low interest rates and weak currencies that continued euro-membership clearly precludes.

While Spain and Italy's travails pose the most serious threat to the euro's longer-run survival, Europe is faced with the more immediate challenge of stemming the financial market contagion which threatens its eastern periphery.

The abrupt reduction of risk appetite in financial markets has already forced Hungary, Iceland, and Ukraine to go cap in hand to the IMF, while pronounced currency market weakness has affected even those east European countries considered to have sound fundamentals. This could have profound consequences for the Austrian, German, Swiss, and Swedish banking systems, which are the main providers of credit to the region.

East Europe's present acute external vulnerabilities are most vividly underlined by the unusually wide external current account deficits that characterize the region. External current account deficits in Bulgaria and Romania exceed 20 percent of GDP, while in Estonia, Latvia, and Romania they exceed 10 percent of GDP.

Even in Hungary, Poland, and Slovakia external current account deficits are in excess of 5 percent of GDP and these deficits are far from fully financed by foreign direct investment inflows. Making matters worse, up until the present crisis, many of these countries had allowed their currencies to appreciate significantly against a strong euro, which only increased their already high dependence on European export markets.

A further fundamental dimension of east Europe's acute external vulnerability is the very high degree of financial market risk in the Baltic countries, Bulgaria, Hungary, and Romania. All of those countries have mainly foreign-owned banking systems and a high dependence on bank flows from abroad. They also have very high shares of foreign exchange denominated loans in their economies, which implies heightened vulnerability in the event of any substantial depreciation of their currencies.

In the context of a severe global recession, market participants must be expected to become increasingly worried that substantial currency weakness in east Europe will make it very difficult for those countries to meet the Maastricht criteria for full euro area membership anytime soon. And those doubts will be reflected in yet a further widening in east European credit spreads that will make it all the more difficult for east Europe to converge to the rest of Europe.

The east European countries would be making a grave mistake in assuming that the present global economic financial market crisis is but a passing phenomenon. With global credit markets having frozen and global equity prices having now declined by over 40 percent since the start of this year, east Europe should be bracing itself for a prolonged period of pronounced global economic weakness.

The more than probable stress that the global economic crisis will have on east European financial and exchange markets could have a material impact on those countries' longer-run economic growth and inflation prospects. In bailing out troubled east European countries from their present predicament, the IMF would be doing them a great disservice by not attaching appropriate conditions to its lending.

Pride of place in the IMF's conditions should be the insistence that these countries pursue highly disciplined public finance policies. For only then might there be the prospect that these countries' present currency weakness does not translate into higher inflation that could put the Maastricht criteria out of their reach for an inordinately long period of time.

Desmond Lachman is a resident fellow at AEI.