By Amol Agrawal, the writer teaches at the National Institute of Securities Markets
As the world ushers in a new year on January 1, 2026, Bulgarians will wake up with anxiety. The New Year shall kick-start a process of the European nation giving up its currency, lev, for the euro. In 1999, the monetary world witnessed a grand experiment where 11 European nations united to give up their monetary policy to a common central bank and adopt a common currency. In 26 years, 10 more countries including Bulgaria have joined euro. This popularity of euro points to an interesting paradox: While the currency seems to be working, Europe is faltering.
How and why did select European countries adopt a common currency? To answer the question, we need to read monetary history. One major struggle for most economies has been to find an appropriate exchange rate system. Before the Second World War, economies fixed currencies to gold. In 1944, under the Bretton Woods (BW) agreement, countries decided to fix exchange rates against the US dollar which was fixed against gold.
In 1971, then US President Richard Nixon dismantled the BW system by delinking US dollar from gold. Most economies were used to being a part of some form of fixed exchange system; they had to now scamper for alternative choices. The pertinent debate was whether one should remain in a fixed exchange rate system or switch to a floating/flexible exchange rate system. The pros of fixed exchange is its predictability and simplicity; the cons are that monetary policy becomes ineffective. The benefit of a flexible exchange is that monetary policy becomes effective; the drawback is its unpredictability.
In 1961, economist Robert Mundell provided another idea that member countries can have a common currency and form an optimal currency area (OCA). An OCA will lead to lower transaction costs and facilitate higher trade. His condition for OCA was the presence of high labour mobility in member nations. If there is a negative shock in one country, labour can move freely to a less impacted member nation. Later, researchers also added capital mobility and tax transfers as prior conditions.
The European countries, which had in any case formed an economic union for fostering trade post-World War II, decided to become an OCA by forming a monetary union. A common euro would also provide a platform to challenge the hegemony of the US dollar. They also formed a common central bank (European Central Bank) to frame monetary policy for the member economies. However, to achieve OCA they followed a different strategy. As labour and capital mobility would take a long time, they came out with macroeconomic convergence criteria, hoping to achieve mobility over time.
The convergence criteria had four components. First, price stability where the joining member country’s average inflation should not exceed the inflation rate of the three best-performing EU member states by more than 1.5 percentage points. Second, fiscal stability, where government deficit and debt does not exceed 3% and 60% of GDP respectively. The third and fourth components were that the stable exchange rates and long-term interest rate should not exceed those of the three best-performing member states in terms of price stability by more than 2 percentage points. While 11 major European countries joined the euro, other major economies such as the UK, Denmark, and Sweden opted out.
From 1999-2008, Euro area countries fared well. The transition to euro was relatively smooth and macroeconomic conditions were stable. The members did violate the convergence criteria, especially in terms of high debt levels, but the risks were ignored. The 2008 recession followed by the 2010 European debt crisis exposed the high debt risks, leading to a major economic crisis. The common monetary policy could not focus on the concerns of individual countries, while a common fiscal policy was absent. There was criticism about ignoring Mundell’s criteria and also not adhering to their own macro criteria.
After many policy trials and errors, Eurozone countries did recover but scars of the crises remain. The woes of Eurozone (and larger Europe) have only gone worse after Brexit, Russia-Ukraine war, and Trump tariffs. Growth during 1999-2007 for the US and Eurozone averaged 2.9% and 2.3% respectively. It has declined to average 2% in the US and 0.9% in Eurozone in 2008-25. The leading economy of Europe, Germany, has barely grown since 2019.
There are articles and research aplenty that argue how European growth rates and productivity have declined and stagnated over the years. The International Monetary Fund’s June 2025 quarterly Finance and Development was devoted to reviving Europe. Two committees under former former Italian Prime Ministers Mario Draghi and Enrico Letta have provided a road map for a more competitive and productive Europe. Europe’s political economy has become highly divided with a rising anti-immigration sentiment which will make it even more difficult to achieve growth based on integration.
Summing up, the paradox of a popular euro and a struggling Europe is an interesting one. The recent European Commission survey showed that 83% of Eurozone respondents favour the common currency. Economic theory suggests that eventually a currency will reflect the fortunes of the economy. European policymakers need to urgently work towards reviving the European economy. Else they will lose the gains made by euro.
