The euro was an incomplete currency to start with. In 1992, the Maastricht Treaty established a monetary union without a political union. The euro boasts a common central bank but it lacks a common treasury. It is exactly that sovereign backing that financial markets are now questioning and that is missing from the design. That is why the euro has become the focal point of the current crisis.
Member countries share a common currency, but when it comes to sovereign credit they are on their own. This fact was obscured until recently by the willingness of the European Central Bank (ECB) to accept the sovereign debt of all member countries on equal terms at its discount window. This allowed the member countries to borrow at practically the same interest rate as Germany, and the banks were happy to earn a few extra pennies on supposedly risk-free assets by loading up their balance sheets with the government debt of the weaker countries. These positions now endanger the creditworthiness of the European banking system. For instance, European banks hold nearly a trillion euros of Spanish debt, of which half is held by German and French banks. It can be seen that the European sovereign debt crisis is intricately interconnected with a European bank crisis.
The first clear reminder that the euro does not have a common treasury came after the bankruptcy of Lehman. The finance ministers of the European Union promised that no other financial institution of systemic importance would be allowed to default. But Germany opposed a joint Europe-wide guarantee; each country had to take care of its own banks.
At first, the financial markets were so impressed by the promise of the EU finance ministers that they hardly noticed the difference. Capital fled from the countries that were not in a position to offer similar guarantees, but the differences in interest rates on government debt within the eurozone remained minimal. That was when the countries of Eastern Europe, notably Hungary and the Baltic States, got into difficulties and had to be rescued.
It is only this year that financial markets started to worry about the accumulation of sovereign debt within the eurozone. Greece became the center of attention when the newly elected government revealed that the previous government had lied and the deficit for 2009 was much larger than indicated.
Interest rate differentials started to widen but the European authorities were slow to react because the member countries held radically different views. Germany, which had been traumatized by two episodes of runaway inflation, was allergic to any buildup of inflationary pressures; France and other countries were more willing to show their solidarity. Since Germany was heading for elections, it was unwilling to act, but nothing could be done without Germany. So the Greek crisis festered and spread. When the authorities finally got their act together they had to offer a much larger rescue package than would have been necessary if they had acted earlier.
In the meantime, the crisis spread to the other deficit countries, and in order to reassure the markets the authorities felt obliged to put together a €750 billion European Financial Stabilization Fund, with €500 billion from the member states and €250 billion from the IMF.
But the markets are not reassured because the term sheet of the Fund, i.e., the conditions under which it operates, was dictated by Germany. The Fund is guaranteed not jointly but only severally, so that the weaker countries will in fact be guaranteeing a portion of their own debt. The Fund will be raised by selling bonds to the market and charging a fee on top. It is difficult to see how these bonds will merit an AAA-rating.
Even more troubling is the fact that Germany is not only insisting on strict fiscal discipline for weaker countries but is also reducing its own fiscal deficit. When all countries are reducing deficits at a time of high unemployment they set in motion a downward deflationary spiral. Reductions in employment, tax receipts, and exports reinforce each other, ensuring that the targets will not be met and further reductions will be required. And even if budgetary targets were met, it is difficult to see how the weaker countries could regain their competitiveness and start growing again because, in the absence of exchange rate depreciation, the adjustment process would require reductions in wages and prices, producing deflation.
To some extent a continued decline in the value of the euro may mitigate the deflation. But as long as there is no growth, the relative weight of the debt will continue to grow. This is true not only for the national debt but also for the commercial loans held by banks. This will make the banks even more reluctant to lend, compounding the downward pressures.
The euro is a patently flawed construct, which its architects knew at the time of its creation. They expected its defects to be corrected, if and when they became acute, by the same process that brought the European Union into existence.
The European Union was built by a process of piecemeal social engineering: indeed it is probably the most successful feat of social engineering in history. The architects recognized that perfection is unattainable. They set limited objectives and firm deadlines. They mobilized the political will for a small step forward, knowing full well that when it was accomplished its inadequacy would become apparent and require further steps. That is how the six-nation Coal and Steel Community was gradually developed into the European Union, step by step.
Germany used to be at the heart of the process. German statesmen used to assert that Germany has no independent foreign policy, only a European policy. After the fall of the Berlin Wall, Germany’s leaders realized that unification was possible only in the context of a united Europe and they were willing to make considerable sacrifices to secure European acceptance. When it came to bargaining they were willing to contribute a little more to the pot and take a little less than the others, thereby facilitating agreement. But those days are over. Germany doesn’t feel so rich anymore and doesn’t want to continue serving as the deep pocket for the rest of Europe. This change in attitudes is understandable but it did bring the process of integration to a screeching halt.
Germany now wants to treat the Maastricht Treaty as the scripture that has to be obeyed without any modifications. This is not understandable, because it is in conflict with the incremental method by which the European Union was built. Something has gone fundamentally wrong in Germany’s attitude toward the European Union.
The German public does not understand why it should be blamed for the troubles of the eurozone. After all, it is the most successful economy in Europe, fully capable of competing in world markets. The troubles of the eurozone feel like a burden weighing Germany down. It is difficult to see what would change this perception because the troubles of the eurozone are depressing the euro and, being the most competitive of the countries in the eurozone, Germany benefits the most. As a result Germany is likely to feel the least pain of all the member states.
The error in the German attitude can best be brought home by engaging in a thought experiment. The most ardent instigators of that attitude would prefer that Germany leave the euro rather than modify its position. Let us consider where that would lead.
The Deutschmark would go through the roof and the euro would fall through the floor. This would indeed help the adjustment process of the other countries but Germany would find out how painful it can be to have an overvalued currency. Its trade balance would turn negative and there would be widespread unemployment. German banks would suffer severe exchange rate losses and require large injections of public funds. But the government would find it politically more acceptable to rescue German banks than Greece or Spain. And there would be other compensations: pensioners could retire to Spain and live like kings, helping Spanish real estate to recover.
Let me emphasize that this scenario is totally hypothetical because it is extremely unlikely that Germany would be allowed to leave the euro and to do so in a friendly manner. Germany’s exit would be destabilizing financially, economically, and above all politically. The collapse of the single market would be difficult to avoid. The purpose of this thought experiment is to convince Germany to change its ways without going through the actual experience that its current policies hold in store.
What would be the right policy for Germany to pursue? It cannot be expected to underwrite other countries’ deficits indefinitely. So some tightening of fiscal policies is inevitable. But some way has to be found to allow the countries in crisis to grow their way out of their difficulties. The countries concerned have to do most of the heavy lifting by introducing structural reforms but they do need some outside help to allow them to stimulate their economies. By cutting its budget deficit and resisting a rise in wages to compensate for the decline in the purchasing power of the euro, Germany is actually making it more difficult for the other countries to regain competitiveness.
So what should Germany do? It needs to recognize three guiding principles.
First, the current crisis is more a banking crisis than a fiscal one. The continental European banking system was never properly cleansed after the crash of 2008. Bad assets have not been marked-to-market—i.e., valued according to current market price— but are being held to maturity. When markets started to doubt the creditworthiness of sovereign debt, it was really the solvency of the banking system that was brought into question because the banks were loaded with the bonds of the weaker countries and these are now selling below par—the price at which they were issued. The banks have difficulties in obtaining short-term financing. The interbank market—i.e., for borrowing and lending between banks—and the commercial paper market have dried up and banks have turned to the ECB both for short-term financing and for depositing their excess cash. They are in no position to buy government bonds. That is the main reason why risk premiums on government bonds have widened, setting up a vicious circle.
The crisis has now forced the authorities to disclose the results of their stress tests of banks, which assess the extent to which their resources are sufficient to meet their obligations. We cannot judge how serious the situation is until the results are published, presumably before the end of July. It is clear however that the banks are greatly overleveraged and need to be recapitalized on a compulsory basis. That ought to be the first task of the European Financial Stabilization Fund, and it will go a long way to clear the air. It may be seen, for instance, that Spain does not have a fiscal crisis at all. Recent market moves point in that direction. Germany’s role may also be seen in a very different light if, in recapitalizing its -Landesbanken, it becomes a bigger user of the stabilization fund than contributor to it.
Second, a tightening of fiscal policy must be offset by a loosening of monetary policy. Specifically, the ECB could buy Spanish treasury bills, an action that would significantly reduce the punitive interest rates, set by the German-inspired European Financial Stabilization Fund, that Spain now must pay on its bonds. This would allow Spain to meet its budget reduction targets with less pain. But that is not possible without a change of heart by Germany.
Third, this is the time to put idle resources to work by investing in education and infrastructure. For instance, Europe needs a better gas pipeline system, and the connection between Spain and France is one of the bottlenecks. The European Investment Bank ought to be able to find other investment opportunities as well, such as expanding broadband coverage or creating a smart electricity grid.
It is impossible to be more concrete at the moment but there are grounds for optimism. When the solvency situation of the banks has been clarified and they have been properly recapitalized, it should be possible to devise a growth strategy for Europe. And when the European economy has regained its balance the time will be ripe to correct the structural deficiencies of the euro. Make no mistake about it: the fact that the Maastricht criteria were so flagrantly violated shows that the euro does have deficiencies that need to be corrected.