Doom and gloom about the euro abounds. An increasing number of commentators and economists, including here at the Peterson Institute, have begun to question whether the common currency can survive.
The economic and financial problems in the euro area are clearly serious and plentiful. The area is in the midst of multiple, frequently overlapping, and mutually reinforcing crises. A fiscal crisis is centered on Greece but visible across the southern euro area and Ireland. A competitiveness crisis is manifest in large and persistent pre-crisis current account deficits in the euro area periphery and even larger intra-euro area current account imbalances. A banking crisis was first evident in Ireland but is now spreading throughout the area via accelerating concerns over sovereign solvencies.
The lack of confidence in the euro is first and foremost rooted in a crisis of fundamental institutional design. The Economic and Monetary Union(EMU) adopted in the 1990s comprised an extensive (though still incomplete) monetary union, with the euro and the European Central Bank (ECB). But it included virtually no economic union: no fiscal union, no economic governance institutions, and no meaningful coordination of structural economic policies.
It was assumed by the architects that economic union would inexorably follow monetary union. However, there was no pressure to create an economic union during the expansion period prior to the Great Recession. When the crisis hit, the contradiction triggered severe market reactions that continue to this day.
There are only two alternatives. Europe can jettison the monetary union. Or it can adopt a complementary economic union. This brief argues that, for all the turmoil, Europe is well on its way to completing the original concept of a comprehensive economic and monetary union, and that Europe will emerge from the crisis much stronger as a result.
From its creation in the 1990s, the common currency has lacked the crucial institutions to ensure that financial stability can be restored during times of acute uncertainty and associated market volatility. The task before euro area leaders today therefore ranges far beyond putting together a big enough financial bailout to restore market confidence. They must rewrite the euro area rule book and complete the half-built euro house. This means they must combine creative financial engineering, to resolve the immediate crisis, with a wave of new institutions to strengthen the real economy and restore sustained growth.
The key to understanding the evolution of the euro is to observe and analyze what the Europeans do rather than what they say. They have resolved all of the many crises that have threatened the European integration project, throughout its history of more than half a century, in ways that strengthened the institution and moved the project forward. At each key stage of the current crisis, they have in fact done whatever is necessary to avoid collapse. We have complete confidence that, in the crunch, both Germany and the ECB will pay whatever is necessary to avert disaster. The politics of each, as described below, assure this result.
The problem for the markets is that these central players cannot say that this is what they will do. There are two reasons. First, a commitment to bailouts without limit would represent the ultimate in moral hazard. It would relieve the debtor countries of the pressure necessary to compel them to take tough political decisions and maintain effective adjustment policies. Second, each of the four main classes of creditors, Germany and the other northern European governments, the ECB, private sector lenders, and the International Monetary Fund (as a conduit for non-EU governments like China), will naturally try to transfer as many of the financial losses on Greek government bonds or European banks as possible onto the other three, limiting their own costs and risks in the process.
Every policymaker in Europe knows that the collapse of the euro would be a political and economic disaster for all and thus totally unacceptable. Fortunately, Europe is an affluent region with ample resources to solve its crisis. Europe’s key political actors in Berlin, Frankfurt, Paris, Rome, Athens, and elsewhere will thus quite rationally exhaust all alternative options in searching for the best possible deal before at the last minute coming to an agreement. It is a messy and indeed cacophonous process that is understandably unsettling to markets and inherently produces enormous instability. Miscalculation, and thus disaster, is always possible under such a scenario. But the process relies on financial market volatility to incentivize solutions that will ultimately resolve the crisis. Europe’s overriding political imperative to preserve the integration project will surely drive its leaders to ultimately secure the euro and restore the economic health of the continent. The political origins of the Euro
The geographic extent of a currency’s use is generally dictated by the existing borders of the issuing country. Hence it is often the result of prior wars, decolonization or other violent historical incidents. The scope for the use of the euro as a supranational currency union crafted in peacetime, however, has not been dictated by such past events. Rather, it reflects contemporary political decisions made by elected European leaders.
The entire European project was of course driven by the existential geopolitical goal of halting the intraEuropean carnage that had persisted for at least a millennium and reached its murderous zenith in the first half of the 20th century. The postwar European leadership, driven primarily by Germany and France, chose the policy instrument of economic integration“to make future wars impossible.”The project has experienced repeated severe crises over its initial half century but each was overcome, indeed giving way to renewed forward momentum for Europe as a whole. The overriding security imperative drove successive generations of political leaders to subordinate their national sovereign interests to the greater good of maintaining, and in fact extending, the European project.
The concept of a common currency was always an element in the region’s vision of the ultimate goals of that project. Concrete thinking about an economic and monetary union in Europe goes back to 1970, when the Werner Report laid out a detailed three-stage plan for the establishment of EMU by 1980. Members of the European Community would gradually increase coordination of economic and fiscal policies while reducing exchangerate fluctuations and finally fixing their currencies irrevocably. The collapse of the Bretton Woods system and the first oil crisis in the early 1970s, however, caused the Werner Report proposals to be set aside for a time.
By the mid-1980s, following the creation of the European Monetary System in 1979 and the initiation of Europe’s internal market, European policymakers again took up the idea of an economic and monetary union. The Delors Report from 1989 envisioned the achievement of EMU by 1999, moving gradually (in three stages) towards closer economic coordination among the EU members with binding constraints on member states’ national budgets and a single currency managed by an independent European Central Bank (ECB).
Optimal Currency Area (OCA) theory prescribes the characteristics required for a geographic area to obtain maximum economic benefits from adopting the same currency. It can offer guidance to economically rational leaders about whether it makes sense for their country to join a common currency. But it was not a carefully considered and detailed economic analysis that ul- timately led to the creation of the euro. It was geopolitics and the completely unforeseen shock of German reunification in October 1990 that provided the political impetus for the creation of the Maastricht Treaty, which in 1992 laid the legal foundation and detailed design for today’s euro area.
With the historical parity in Europe between (West) Germany and France no longer a political and economic reality, French president Francois Mitterrand and German Chancellor Helmut Kohl intensified the EMU process as a political project to complete the integration of the French, German, and other European economies in an economic and monetary union that would accomplish full and irrevocable European unity.
This political imperative for launching the euro by 1999 frequently required that politically necessary compromises, rather than theoretically unambiguous rules, make up the institutional framework for the euro. OCA theory, and the earlier Werner and Delors reports discussing the design of EMU, had been explicit about the requirement to complement a European monetary union with a European economic union complete with binding constraints on member states’ behavior. Political realities in Europe, however, made this goal unattainable within the timeframe dictated by political leaders following German reunification.
Europeans continue to selfidentify primarily as residents of their home country. Hence the realization of European federalism, as it is practiced in the United States, is impossible. Consequently, European institutions do not rest on the same degree of direct democratic legitimacy as the US federal government. Crucially, this makes the collection of direct taxes to fund a large centralized European budget (similar to the US federal budget) politically impossible. The relatively high willingness of Europeans to pay taxes does not “extend to Brussels.” The designers of the euro area were consequently compelled to create the common currency area without a sizable central fiscal authority that would have the ability to counter region-specific (asymmetric) economic shocks, or re-instill confidence through the deployment of large fiscal resources to private market participants in the midst of a crisis.
Similarly, the divergence in the economic starting points among the politically prerequisite “founding members” of the euro area made the imposition of firm fiscal criteria for membership in the euro area politically infeasible. The Maastricht Treaty in principle included at least two hard convergence criteria for euro area membership―the 3 percent limit on general government annual deficits and the 60 percent limit on general government gross debt limit. However, in reality, these threshold values were anything but fixed as the Maastricht Treaty Article 104c stated that countries could exceed the 3 percent deficit target if “the ratio has declined substantially and continuously and reached a level that comes close to the reference value” or “excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value.” Euro area countries could similarly exceed the 60 percent gross debt target provided that“the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace.”
In other words, it was a wholly political decision whether a country could become a member of the euro area or not. Membership was not objectively determined by the fundamental economic strengths and reform record of the country in question. And it was politically inconceivable to launch the euro without Italy, the third largest economy in continental Europe, or Belgium, home of the European capital Brussels. Hence both countries became members despite having gross debt levels of almost twice the Maastricht Treaty reference value of 60 percent in 1997-98.
As a result, Europe’s monetary union was launched in 1999 with a set of countries that were far more diverse in their economic fundamentals, and far less economically integrated, than had been envisioned in the earlier Werner and Delors reports or would be dictated by OCA theories. Moreover, shortly after the launch of the euro, European political leaders further undermined the credibility of the rules-based framework for the coordination of national fiscal policies in the euro area.
Building on the euro area convergence criteria, the Stability and Growth Pact (SGP) was intended to safeguard sound public finances, prevent individual euro area members from running unsustainable fiscal policies, and thus guard against moral hazard by enforcing budget discipline. However, faced with breaching the 3 percent deficit limit in 2002?04, France and Germany pushed through a watering down of the SGP rules in March 2005 that, as in the Maastricht Treaty, introduced sufficient flexibility into the interpretation of SGP that its enforcement became wholly political and with only limited reference to objective economic criteria and data.
In sum, the euro area by 2005 was, as a result of numerous shortcuts taken to achieve and sustain a political goal, a common currency area consisting of a very dissimilar set of countries without a central fiscal authority, without any credible enforcement of budget discipline, and without any real deepening of economic convergence.
Initially, however, none of these fundamental design flaws mattered. The financing costs in private financial markets of all euro area members quickly fell towards the traditionally low interest rates of Germany.
It is beyond the scope of this policy brief to interpret the causes of this colossal and sustained mispricing of credit risk in the euro area sovereign debt markets by private investors in the first years after the introduction of the euro. But the financial effects were obvious: Euro area governments and private investors were able to finance themselves at historically low interest rates seemingly irrespective of their economic fundamentals.
European policymakers’ initial denial and self-congratulations, coupled with financial markets’ failure to properly assess the risk of different euro area countries and tendency to ignore the common currency’ s design flaws, thus conspired to ensure that the euro area, when it was finally struck by its first serious financial crisis in 2008-09, was hit by a double whammy of huge precrisis public and private debt overhangs and a faulty institutional design that prevented an expeditious solution that would be credible to those same markets.
The political fight between the ECB and governments to save the Euro
During its first decade, the euro area institutional framework was that of a “fair weather currency.” The area entered the Great Recession woefully under-institutionalized as a common currency flying on just one engine, the ECB, but without the unified fiscal entity that traditionally plays a critical role in combating large financial crises. The euro area leaders have had to build their crisis-fighting capacity and bailout institutions (the European Financial Stability Facility/European Stability Mechanism (EFSF/ESM)) from scratch, and in the midst of crisis, to prevent their immediate financial predicament from getting out of control while simultaneously reforming the flawed foundational institutions of the area. Achieving the dual policy goals of solving a current crisis while trying also to prevent the next one, and using the same policy tools to do both, is rarely easy.
This marks a crucial difference from the United States. Once the Troubled Asset Relief Program (TARP) was finally passed, close collaboration between the multiple existing institutions in the United States (Treasury, Federal Reserve, Federal Deposit Insurance Corporation) ultimately restored market confidence and stabilized the situation in March 2009. In the United States in 2008?09, the economic crisis compelled the Fed to immediately apply the so-called Powell Doctrine, overwhelming firepower, to restore shaken market confidence and give the federal government time to formulate a longer-term response in fits and starts through the TARP. This is a fairly well established crisis response function. The central bank comes out with monetary guns blazing and then sits back and prays that the politicians do the right thing. (Congress did pass TARP after initially rejecting it but has of course not yet chosen to institute a sustainable fiscal response for the United States.)
The ECB, as the only euro area institution capable of affecting financial markets in real time, is a uniquely powerful central bank. Its institutional independence is enshrined in the EU treaty and it is not answerable to any individual government. This has enabled it to function as a fully independent political actor, interacting with elected officials during the crisis in a manner inconceivable among its peers. Quite unlike normal central banks, which always have to worry about losing their institutional independence, in this crisis the ECB has been able to issue direct political demands to euro area leaders, as with the reform ultimatum conveyed to Silvio Berlusconi in August, and demand that they take action accordingly.
On the other hand, the ECB has not had the luxury of adopting the straightforward crisis tactics of the Federal Reserve and the US government within a fixed set of national institutions. The ECB cannot perform a “bridge function” until the proper authorities take over because no euro area fiscal entity exists. Moreover, to commit to a major “bridging monetary stimulus,” as some have called for, would undermine chances of a permanent political resolution to the euro area’s underlying under-institutionalization problem. Were the ECB to cap governments’ financing costs at no more than 5 percent, for instance, euro area politicians would probably never make the painful but essential decisions.
It is imperative to understand that it is not the primary purpose of the ECB, as a political actor, to end market anxieties and thus the euro area crisis as soon as possible. It is instead focused on achieving its priority goals of getting government leaders to fundamentally reform the euro area institutions and structurally overhaul many euro area economies. Frankfurt cannot directly compel democratically elected European leaders to comply with its wishes but it can refuse to implement a “crisis bazooka” and thereby permit the euro area crisis to continue to put pressure on them to act. A famous American politician has said that “no crisis should be wasted” and the ECB is implementing such a strategy resolutely.
So far the ECB has been reasonably effective in this strategic bargain-
problem becomes Italy and Spain, however. The ECB and euro area governments have therefore for some time been engaged in a new round of strategic bargaining to put together a sufficiently large financial rescue package, secure structural reform of the two big debtors (especially Italy) and, perhaps most importantly, to complete the euro area institutional house. The EU Summit on December 9, 2011 represented the latest round in this game of political poker. The remaining agenda
Even the most successful financial engineering in the euro area will ultimately fail, however, if the debtor countries, and indeed the region as a whole, are unable to restore at least modest economic growth in the fairly near future. This requires at least three major steps.
The borrowing countries must adopt convincing progrowth structural reforms, especially in their labor markets, as well as budgetary austerity.
The strong economies in the northern core of Europe, especially Germany, must terminate their own fiscal consolidations for a while and adopt new expansionary measures, i.e., they should buy more Italian and Greek goods and services rather than debt instruments.
The ECB must promptly reduce its policy interest rate by at least another 50 basis points and buy sufficient amounts of periphery bonds through the SMP to help push their interest rates down to sustainable levels.
There has been much talk about the infeasibility of achieving the needed“internal devaluations” of the periphery countries. Germany has achieved just such an adjustment over the past two decades, however, probably amounting to about 20 percent of the (overvalued) exchange rate at which it entered the ERM/euro, through a combination of budget tightening and structural changes like the Hartz labor reforms. At the other end of the size spectrum, Latvia achieved an even speedier and more spectacular correction of its huge current account deficit of 25 percent of GDP and, only three years later, is now combining renewed growth with an external surplus. Italy has previously achieved dramatic adjustment, notably to qualify for the euro in the first place. (Greece never did so and its ability to remain within the zone is clearly more problematic.)
It took ten years for the first serious economic and political crisis to arrive after the euro was introduced. The most challenging part of today’s crisis is to use the political opportunity it presents to get the basic economic institutions right and complete the euro’s half built house for the long term. In this process the euro will develop in a different manner from the full economic and monetary union established in the United States. It will require additional substantial treaty and institutional revisions in the future. But as the US Constitution’s 27 current amendments clearly show, faulty initial designs need not preclude long-term success. If the history of the integration exercise and its crisis responses to date are any guide, Europe will emerge from its current turmoil not only with the euro intact but with far stronger institutions and economic prospects for the future.