Photo Gallery: Europe's Common Currency Facing Uncertain Future
Castles in the Sky The Fundamental Problem with Efforts to Save the Euro
Next September, the Canadian economist Robert Mundell will celebrate the 50th anniversary of the publication of his work "A Theory of Optimum Currency Areas," which not only earned him the Nobel Prize for economics, but also remains a fundamental point of reference in the debate over the euro. Mundell argued that for a monetary union to function, workers and capital must be able to move about within its borders as freely as possible. For former German Chancellor Helmut Kohl, the idea of "maintaining an economic and monetary union in the long term without a political union" was an "absurd notion."
It is this context that makes Mundell's insights seem more relevant than ever. Politicians in Berlin, Paris and Brussels are currently outdoing each other with proposals for greater coordination of their economic and financial policy. German Finance Minister Wolfgang Schäuble promises "progress in European integration." In the future, says his French counterpart Christian Lagarde, every country will have to "take into account the effects of its economic policy on others." And European Commission President José Manuel Barroso feels that it is his duty to endow the European Union with greater powers, saying: "We must further intensify and strengthen political coordination within the European Union."
The beneficiary of these avowals of community spirit is already clear. Last week it was becoming obvious that Barroso's native Portugal would follow Ireland and Greece and become the third euro-zone country to apply for emergency loans.
It Works or it Falls Over
The status quo still applies when it comes to the affairs of the EU. Whenever something goes wrong in the gears of the community, European politicians call for more integration. They see the crisis as an opportunity and, in doing so, are adhering to the traditional Brussels motto that Europe functions like a bicycle: if it doesn't move forward, it falls over.
For dedicated Europeans, it is self-evident that the road leads to Brussels, and it comes as no surprise that the European heads of state portrayed themselves as great promoters of the European idea at their last summit. They want to beef up their shared bailout fund for the euro , they want an economic government and a competition pact, and the European Commission now has the authority to keep a closer eye on national fiscal policy. According to German Chancellor Angela Merkel, it is a question of "solidarity coupled with soundness and improved competitiveness."
These are laudable concerns, but they are poorly suited to curing the acute sickness of the common currency. Last week's resolutions offer no solution to the continent's debt problems. Instead, they are a largely unconvincing attempt to continue building old European castles in the sky, which require both a more tightly knit political union of the continent and the promise of sound budget management.
The public has long known that the powerful in Europe behave like smokers when it comes to borrowing. On New Year's Eve, they loudly proclaim they will quit their unhealthy habit, but by the morning of New Year's Day they are already lighting their next cigarette.
"3.0 is 3.0"
This pattern of behavior is notorious in the history of the economic and monetary union. When the euro was introduced in the late 1990s, European governments committed themselves to strict budgetary discipline. Under the so-called Stability Pact, those that went too deeply into debt could expect sanctions. To prevent anyone from circumventing the established debt limits with tricks and fraud, then-German Finance Minister Theo Waigel pronounced his famous equation: "3.0 is 3.0," in reference to the 3 percent ceiling on the deficit-to-GDP ratio.
Twenty years later, it is now clear that completely different mathematics apply in Europe. EU countries have exceeded the deficit limit of 3 percent of their gross domestic product (GDP) on 97 occasions, but in not a single case were sanctions imposed.
Instead, an exception clause for economic emergencies was added to the once-strictly worded pact in response to German pressure, under the tacit assumption that Europe is in a constant state of economic emergency.
Given this arbitrary interpretation of the European treaties, it isn't hard to understand why the results were not at all as expected. Since the introduction of the common currency, the euro nations have in fact accumulated more debt, not less. What was conceived as a stability pact has proven to be an agreement that increases instability.
The second project of European governments was related to economic growth. With typical Brussels modesty, the EU set itself the goal, at the turn of the millennium, of transforming Old Europe into "the most competitive economic area in the world" within a decade. The effort, dubbed the "Lisbon process," represented probably the world's only attempt to use the tools of a monstrous bureaucracy to generate economic dynamism.
Pursuing the same old Illusionary Policies
It was an ambitious undertaking. The problem was that European leaders could never agree on what they defined as competitiveness. As a result, in the course of their growth initiative, EU countries not only failed to catch up with but in fact fell behind comparable industrialized nations like Canada and New Zealand, not to mention emerging economies like India and China. A year ago, European Commission President Barroso complained that he had "always felt that the Lisbon goals were unrealistic."
It would have been better if he had listened to politician and sociologist Ralf Dahrendorf, a member of the European Commission from 1970 to 1974. A great proponent of European unity, Dahrendorf was strongly opposed to a unified economic and fiscal policy, even though the EU consisted of only about a dozen Western European countries in the late 1990s. At the time, Dahrendorf felt that the economic cultures of the member states were "too different" for a shared economic policy.
Today the EU has almost twice as many members, and the euro zone itself is a sizeable collection of nations. It stretches from Cabo da Roca in Portugal to Tallinn in Estonia, and it unites such varying economies as tourism-centric Slovenia and industrial giant Germany, the stability-oriented Netherlands and Italy with its notorious inflationary problems. A strict set of rules is not well suited to such a colorful club, prompting Dahrendorf to warn against "chasing chimera" in European monetary policy even before the launch of the euro.
His successors are apparently determined to do just that. To safeguard Europe's currency, they are pursuing the same illusionary policies as they did when the euro was introduced. There is talk of a stability pact once more, and again it is governments and not independent authorities that would rule on possible sanctions. Allowing the perpetrator to perform the role of judge isn't exactly a code that guarantees independent decision making.
The "Divisiveness Pact"
Chancellor Merkel has also worked out a new competition pact, which would pursue reforms of wages, pensions and taxes across national borders. The agreement is for the most part not legally binding, the German chancellor pointed out before the summit. Nevertheless, her European counterparts removed virtually all concrete requirements from the text, ensuring that the supposed pact would not commit any European leader to anything. This prompted the London-based Economist to derisively dub it the "divisiveness pact."
Even die-hard proponents of integration are now convinced that this is not the way to promote progress in Europe. Former European Commission Presidents Jacques Delors and Romano Prodi, as well as ex-Belgian Prime Minister Guy Verhofstadt, call the plans for a competition pact "ineffective" and say that they will "not produce any results."
They recently announced their own proposal, which is indeed of a different caliber. If this experienced trio of European politicians had its way, the Commission would have the power, in the future, to impose strict rules on member states with regard to retirement age, corporate taxes, wages and R&D expenditures. They propose adding new EU commissioners to monitor compliance with these rules and impose penalties when national governments fail to cooperate. The European Commission needs to finally get "access to economic policy," the authors write, to enable it to force Europe onto "the path of convergence."
This sounds like a clear concept, but it is also reminiscent of Gosplan, the central state planning committee of the former Soviet Union. The European Commission has already introduced a strict regimen of quotas for products like light bulbs and biofuel, angering many consumers. Under the concepts devised by Delors, Prodi and Verhofstadt, the principle would be applied to virtually the entire economy. It would be a sure-fire way to further increase the public's disenchantment with Brussels.
Preventing Sanctions being Imposed
It is an affliction of European policy that its protagonists in the national governments are generally split personalities. They call for a unified economic policy, and yet they refuse to cede any power to Brussels. They demand penalties for debt sinners, and yet they prevent sanctions from being imposed. And they invoke the European spirit while stubbornly pursuing national interests. Udo Di Fabio, a judge on Germany's Constitutional Court in Karlsruhe, speaks of "conceptual limits that can in fact only be exceeded by taking a spirited step in the direction of the federal state."
But neither governments nor citizens are prepared to take such a step. As a result, the center of power in Brussels is distancing itself from the needs and perceptions of its base. European politicians are still pursuing a path to integration that citizens have long since abandoned.
Since the euro crisis gripped the continent, this divide has grown even more. The political union of Europe is now no longer seen as the distant goal of a few dreamers in the European Parliament in Strasbourg, but as a requirement for the survival of the common currency. Politicians in capitals across the continent are asking themselves: Can the euro survive if there is no EU-wide economic and fiscal policy?
For the architects of the European common currency, the answer was obvious. They were convinced that each country had to be responsible for its own debts, or else the common currency would amount to an open invitation to get rich at the expense of others. This attitude explains the response made in the early 1990s by Horst Köhler, then a secretary of state in the Finance Ministry and later the German president, to the question of whether a euro country could go bankrupt: "Why not?"
After the Lehman Brothers bankruptcy, having this much confidence in the traditional principles of the market economy was considered outdated. Preventing the insolvency of an important bank or a member of the euro zone became standard policy worldwide. Governments were determined to ensure that the bankruptcy of a large borrower would not bring down the entire financial market with it.
Postponing a Bankruptcy can Generate Costs
As long as the banking world was in flames, the large-scale bailouts of borrowers and lenders were justifiable. But part of the idea of putting out a fire is that it remains the exception and not the rule. The public cannot be convinced of the value of ongoing bailouts at taxpayer expense, which eventually become a threat to the rescuers themselves.
The €700 billion bailout fund created by European leaders for the euro zone last week may be sufficient to protect Greece, Ireland and Portugal from having to admit complete failure. But if Spain and Italy run into trouble, the fund will have to be expanded to such an extent that it will become too heavy a burden for those contributing to it. Germany and France, as the most important financiers of the euro zone, might even find themselves having to beg for money.
Besides, it's a known fact in economic life that both a bankruptcy and the postponement of a bankruptcy can generate costs. When applied to the euro crisis, this means that there is a point at which delaying the bankruptcy of the European community of nations becomes more costly than an orderly insolvency of its most delinquent borrowers. There are reasons to suggest that this point could soon be reached:
- Debt servicing is threatening to overwhelm some crisis-ridden countries. Greece is cutting wages, pensions and government spending to an unprecedented extent, and yet the country's debt will continue to grow to 165 percent of GDP by 2015. Portugal is imposing one austerity measure after the next, and yet this is only stifling the economy even more. Prime Minister José Socrates resigned in frustration last week. But the longer the governments in Athens and Lisbon delay a presumably unavoidable debt restructuring, the more they will have to pay in interest and the greater the burden for the euro bailout fund.
- The European banks are in better shape than they were a few months ago. When the debt crisis erupted, governments funnelled large amounts of liquidity and equity capital into the banks. At the same time, lenders benefited from favorable conditions in capital markets. They could borrow money from the central banks at extremely low rates and then lend the money to crisis-ridden countries like Ireland or Greece at much higher rates. As a result, the banks benefited from the crisis in two ways. On the one hand, they profited from the high returns being offered for the bonds of threatened countries. On the other hand, they assumed almost no risk, because Europe's bailout funds guarantee debt service.
- A so-called debt haircut would impose burdens on lenders and borrowers in the short term. The banks would have to show losses on their balance sheets, while the governments would be denied access to new loans for a fairly long time. In the long term, however, a debt restructuring would have a beneficial effect on capital markets. Countries with a high default risk would be forced to tighten their belts because of their rising interest costs. And lenders would invest less money in high-risk countries, because they would be forced to incorporate losses into their calculations. It would be a strategy that combines overcoming the old debt crisis with preventing a new debt crisis.
Of course, more is needed to make such a crisis concept a success than merely the goodwill of governments. Europe has to set priorities. Measures to overcome the debt crisis are the most urgent. If a country can no longer service its loans, banks and other financial institutions must also make sacrifices, and must do so regularly and not on a case-by-case basis, as called for under the summit resolutions.
The politics of symbolism to support the European cause is unnecessary. The community doesn't need an overinflated economic government or an empty competition pact, nor does it need Europe-wide rules dictating retirement ages or a Brussels commission to harmonize gross income levels.
What is urgently needed, however, is an institution to monitor Europe's debtor nations, provide assistance in times of need, implement austerity programs and, if necessary, restructure debt. What is needed is a European monetary fund, paid for by the members of the euro zone and as free from the influence of governments as possible.
Such an institution would benefit Europe more than an instrument to manage credit crises. The fund would be a symbol. It would show that private lenders are involved in the consequences of a crash and that politicians cannot shift their responsibility to Brussels. In the future, it would become clear once again that there is a relationship between risk and return, and that decisions on budgets, taxes and debt are made by the institutions with the democratic authority to do so: the national governments.
This would also be in keeping with the writings of Robert Mundell, whose 50-year-old essay might still be used to support the theory that the common currency requires a political union. Ironically, Mundell never supported such a position. On the contrary, in his essay he writes specifically that a monetary union can also function within a confederation of states if labor and capital, as well as wages and prices, are only adequately flexible. For this reason, the question of whether the euro can survive cannot be decided in an abstract way. It is, as Mundell wrote in typically academic language, "an empirical question."
