Europe: mending a bad marriage

The euro has been a disaster. No other word will do. A project intended to strengthen solidarity, bring prosperity and weaken German economic domination of Europe has achieved precisely the opposite: it has undermined solidarity, destroyed prosperity and reinforced German domination, at least for a while.

For all its cultural and economic achievements, Europe has a long history of catastrophic errors, which have usually been the result of blind arrogance and wishful thinking bordering on insanity.

The world is mourning the centenary of perhaps the most significant of all of Europe’s follies: the first World War, which led, not inevitably but ultimately, to the second. Then, over half a century of patience, under US protection, the Europeans brought forth upon their continent peace, prosperity and partnership, only to succumb to a far less calamitous piece of arrogance: the idea that an irrevocable currency union among sovereign states with diverse economies and different cultures could work smoothly.

The economic crisis has made clear how foolish this view was. For all their mistakes in running the euro zone, German policymakers and economists, to their credit, understood the risks. The only other large European country to do so was the UK. Thoughtful Germans, particularly those working at the Bundesbank, realised that in the modern world a currency is a product of a state and a polity. It must come after their creation, not before it. But other Europeans decided to put the cart before the horse by creating the monetary union before a proper union of states.

In this crisis five member countries – Greece, Ireland, Italy, Portugal and Spain – fell into deep depressions, with extremely high rates of unemployment and soaring public debt. In Greece and Portugal the youth unemployment rate has exceeded 55 per cent. Not just a decade is being lost but sizeable parts of an entire generation.

By early 2014 one could see signs of a feeble recovery, but unemployment is likely to remain very high until the end of the decade or even later. Trust in European institutions has fallen sharply. Extremist political forces are emerging in some countries; resentment among the peoples of Europe is emerging everywhere.

Think of the euro zone as a polygamous monetary marriage entered into by people who should have known better, in haste and with insufficient forethought, without any mechanism for divorce – deliberately so, as the more unfeasible a divorce, the less credible it becomes.

Honeymoon illusions

In the happy honeymoon years up to late 2008, countries that had previously suffered from weak public finances, high interest rates and vulnerable currencies enjoyed some happy combination of low interest rates, fast economic growth, rising real wages and growing current-account deficits. They did not all have all of these things: Italy and Portugal did not enjoy fast economic growth, for example. But, overall, this was a contented period.

The honeymoon came to an end in the midst of a global financial crisis. Suddenly market participants, policymakers and the people realised they had made huge mistakes: Greek public debt was not as good as German debt; current-account deficits of about 10 per cent of GDP and net external debts of close to 100 per cent of GDP (as in Greece, Portugal and Spain) were unsustainable even in a currency union; countries did not become rich by building houses that potential purchasers did not want or could not afford; economies did not become enduringly competitive by expanding their construction, property and financial sectors. In sum, it had been worse than 10 wasted years; it had been 10 years of travel in the wrong direction.

The marriage trap

The vulnerable countries are suffering economic depressions and difficulties with debt likely to last many years. It would be extraordinary if their economies were to be back to their precrisis levels a decade after the crisis. It is still likely that at least one and possibly more than one of them are going to be forced to default on their public debt, with devastating consequences for confidence in the only governments these countries have.

This is all bad. But one must also appreciate the longer-run costs of such disasters. Any able and enterprising young person will contemplate emigrating, and in the worst-hit countries many are already doing so. With depressed investment and an anxious younger generation, these countries may be eating their seedcorn.

At worst they could enter a downward spiral of slumps, fiscal difficulties and a yet more unbalanced demographic profile. If so, what we would be witnessing would be not just a temporary euro-zone crisis, however extended, but the emergence of something like the old Mezzogiorno, Italy’s poor southern region, but across whole countries, not just regions.

Such a prognosis may seem alarmist. But it is conceivable. The Irish and Portuguese economies expanded in 2013. But in neither case was GDP decisively above 2012 levels. Moreover, both economies were still about 7 per cent smaller in late 2013 than at their precrisis peaks. Neither Italy nor Spain showed much recovery in 2013, and Greece languished in a deep depression.

If we are to understand why adjustment is proving so hard, we need to look at what is happening in the euro zone as a whole. The economy has, alas, been allowed to stagnate. Moreover, euro-zone annual headline and core inflation (less food, energy, alcohol and tobacco) were both just 0.8 per cent in the year to January 2014.

This is far below the European Central Bank’s admittedly ambiguous inflation target. It would be far better for the ECB to raise inflation above its medium-term target of 2 per cent rather than let it fall below it. Such a rise in inflation and inflation expectations could lower real interest rates and so encourage spending and growth.

The ECB has failed to do its basic job by allowing inflation to become too low. Worse, the euro zone is now probably just one adverse shock away from deflation. Higher inflation would also make needed adjustments in competitiveness among economies quicker, given resistance to nominal wage declines.

The difficulty is not only that the economic outcomes have been so terrible but also that a complete separation has emerged between the national level of accountability and the euro-zone level of power. Democracy has been nullified, as politicians of foreign countries – more precisely of one foreign country – and their official lackeys dictate to sovereign nations not just temporarily, in a period of crisis, but indefinitely. This structure cannot hold – and, if it can, it should not.

Divorce

If the bad marriage is miserable and in the long run probably unsustainable, only two alternatives remain: divorce or a good marriage. So what might a divorce look like? One can envisage two possibilities: a disorderly exit and an orderly exit.

A cessation of external official funding, perhaps because a country refused to abide by an agreed programme, might trigger a disorderly collapse. The government of the country in question would default. The European Central Bank would argue that the banks of the country in question no longer had acceptable collateral, which would prevent it operating as a lender of last resort. Comprehensive bank runs would occur. The country would impose exchange controls, introduce a new currency, redenominate domestic contracts and default on external contracts denominated in euro. These defaults would be by both the public and the private sectors. Chaos might break out. A coup or civil war would become conceivable. Any new currency would be sure to depreciate sharply. Inflation would soar.

In the medium run, order would be restored in some way, even at enormous cost. In time, after a huge devaluation, the economy would probably thrive, as happened to the east Asian economies after their postcrisis devaluations in 1997 and 1998.

Of course, the government might make a mess of this opportunity. Indeed, after a crisis of this magnitude irresponsible populism is all too likely. The consequences would then look a bit like Argentina 10 years after its default and devaluation.

An agreed, orderly departure would end up in much the same place, but much sooner. In either case a big challenge would be to manage the contagion. An exit, particularly a disorderly one, would surely trigger bank runs and capital flight from other members.

A decisive response from the euro zone would be required to halt the contagion. The ECB would need to act as a lender of last resort on an unlimited scale, replacing money taken out in bank runs. Interest rates on sovereign debt would need to be capped. Above all, the commitment to keep the rest of the euro zone together would have to be reinforced.

The least destabilising exit would be by a creditor country, notably Germany, as George Soros has argued. But even this would be highly destabilising. German manufacturing would be hit. The credibility of Germany's commitment to the European project – the core of its postwar political identity – would be shattered and its relations with important partners, notably France, put into limbo.

Or suppose the euro-zone members agreed to break the whole structure. In principle it would be possible to divide every euro and redenominate every euro contract in the component currencies, weighted as they were when they joined the euro. But this would mean telling the citizens of, say, Germany that their euro accounts and euro claims suddenly contained a substantial proportion of French francs, Italian lire, Spanish pesetas and all the rest. This would be very unpopular.

In fact, governments would want to redenominate domestic money and contracts in their restored national currencies. Individual countries’ experiences would vary, depending on their exposure to foreign trade and financial interlinkages. But inflation would soar in the devaluing debtor countries; in creditor nations deflation would be likely to set in. It would be painful for all.

The sad truth is that an orderly break-up is a contradiction in terms. The EU would be cast into legal and political limbo. It is impossible to guess at the result of such a profound change in the European order.

These perils are not of concern to the euro zone alone. Taken as a whole, it is the world’s second-largest economy, with the largest banking system. The risk that a bigger euro-zone upheaval would cause a global crisis is real. Moreover, beyond that, a stable Europe is among the greatest achievements of the post-second World War order and surely the finest triumph of American statecraft. It cannot be thrown away. However bad an idea the euro zone might have been, break-up would be worse.

A good marriage

So, if the marriage is bad and divorce terrifying, the challenge is to turn the bad marriage into a good, or at least a tolerable, one.

One must start by recalling what critics knew in the early 1990s: this is not a natural economic union. The economic forces driving these economies apart are far greater than in other federal monetary unions, because of their economic diversity, while the institutional and political underpinnings of the union are far weaker, because of their political diversity.

The immediate challenge confronting the euro zone is adjustment. The vulnerable countries need to achieve internal and external balance once again: sustainable external accounts, sustainable fiscal positions and full employment.

The reason why the process of adjustment has been so painful is partly because the exchange rate has been removed as an instrument but even more because it is so asymmetrical. Indeed, it is not clear that the vulnerable countries can live with creditor countries that run such huge persistent current-account surpluses.

If Germany and other surplus countries were to earn those surpluses in trade with economies outside the euro zone, the result would probably be an appreciation of the euro. That would once again undermine the competitiveness of the vulnerable economies.

In effect the current-account surpluses of creditor countries are sucking demand out of vulnerable countries. It makes little sense to insist that the latter become more competitive if overall demand does not expand. This is a zero-sum game.

The ECB must do more to promote demand in the euro zone. It should be willing to use unconventional policies. It should also target a higher rate of inflation, to facilitate needed adjustments in relative prices. Aggregate inflation of 3-4 per cent a year would not be a disaster. A nominal GDP target for the euro zone would also make a great deal of sense. Another implication is that the euro zone’s new imbalances procedure must bite. The most important contributor to the euro zone’s internal imbalances is Germany. It needs to find a way to reduce its current-account surplus. If it does not wish to use fiscal policy, let it try something else.

Financing adjustment

In the euro zone the role of financier of last resort falls to the ECB. Yes, the creation of the European Stability Mechanism, together with funding (and intellectual input) from the

International Monetary Fund

, provides a backstop.

But what members of the euro zone, particularly Italy and Spain, needed most during the worst of the market panic was insurance against illiquidity in their markets for government and bank funding. They lacked what the UK and the US possess: a supportive central bank. Euro-zone members have no such central bank. In effect they borrow in a quasi-foreign currency.

Note that if the ECB succeeded in stabilising government bond markets it would automatically stabilise banks as well, as fears of sovereign defaults drove worries about insolvency of banks. The capital needed to protect the European banking system from defaults by important sovereigns does not exist. It is ridiculous to suppose that sovereigns can provide insurance against their own default. Yet as there is no good reason for a well-managed euro zone to suffer illiquidity-driven defaults, the answer is to stop them at source.

The ECB had the firepower to do this – and finally it did it in the summer of 2012, enormously easing the pressure on Italy and Spain. It is a tragedy that it did not do this earlier.

Debt restructuring

Adjustment, financing and growth are the start of what is needed to put the euro-zone economy back on track. Together they would handle the “flow” problems: those concerning flows of incomes and spending, including the balance of payments. But there is also a stock problem: the overhang of private and public debt from past mistakes. The lower the interest rates paid, the easier debt is to handle. Nevertheless, the vulnerable countries are all going to end up with very high public debt, which it will take a very long time to reduce to manageable levels.

A credibly one-off debt restructuring might be necessary in a number of cases, notably Greece. This would create problems, notably for the banks: it might be necessary to restructure bank debt as well, as has happened in Iceland and Cyprus. But the long- established practice of protecting bank creditors at the expense of taxpayers must be ended in any case. It is unconscionable.

An alternative to the nuclear option of debt restructuring would be agreement on lower interest rates and much longer maturities, supported by the creditor countries directly, via ECB involvement, or both. As the creditor countries bear a full share in the responsibility for the mess they should expect to bear a full share in its resolution as well.

There is another alternative: rapid economic recovery. But that will depend on the speed of adjustment.

Let us assume that the euro zone does manage the adjustment, financing and restructuring needed to put the economies on a sounder footing. What else is needed if it is to be a minimally viable currency union?

First, the euro zone must have a proper banking union. It is now clear that vulnerable countries are unable to provide the backstop for their banks that has, hitherto, seemed normal. A banking union, similar to that already achieved by the US, is vital.

Such a banking union will require strong central regulation and supervision and, in particular, strong macroprudential regulation, to try to prevent the sort of runaway credit booms that led to such disasters.

If a banking union is to work there must exist an adequate supply of unimpeachably safe assets, thereby breaking the doom loop between the sovereigns and their banks. Relying on the debt of just a few countries, principally Germany, is inadequate, particularly as Germany wishes to lower its public debt relative to the economy. For this reason there has to be an adequate supply of eurobonds – bonds for which the euro-zone states are jointly and severally liable.

A eurobond market would give banks a safe asset, and it would give the ECB ideal collateral and so the possibility of operating unconventional monetary policies, such as quantitative easing, quite easily. Turning a substantial portion of existing bonds into eurobonds would sharply reduce current anxieties. It would make restructuring the remaining debt much simpler, as it would not threaten the credibility of a substantial proportion of outstanding debt.

Second, with banks holding eurobonds, it would be far easier to restructure remaining public debt.

Third, the ECB needs to become a true modern central bank determined to underpin stability in the euro-zone economy. Demonstrably, it has failed to do this.

Finally, all of these proposals presuppose a form of fiscal union, not in the form of ongoing fiscal transfers but in the form of collective backstops for the banking union as well as of eurobonds. Over time it will probably be necessary to transfer a part of the fiscal responsibilities of member states to the centre. It will also be necessary to generate some capacity for fiscal-stabilisation policy at the centre.

Can the bad marriage be turned into a good one? The euro zone has definitely not achieved that. Yes, the will to improvise during the crisis was remarkable. But what happened was “just enough, almost too late”.

More fundamental changes will be needed. The obstacles to success are three.

First, making a currency union work well is bound to be difficult, particularly in view of the great differences in the economic structure of these countries, in their economic culture and in their politics.

Second, the divergence in economic ideology remains substantial.

Third, the peoples of the euro zone do not like one another very much at the moment – and, more important, they do not identify with one another very much either. As politics remain national, democratic legitimacy undermines cohesion.

The obstacles to creating a good marriage are indeed high. But perfection is unnecessary. What is needed is rather a “good enough” system.

The question is whether the euro zone can reach a more successful and balanced resolution of its failings before it is too late.

This is an edited extract from The Shifts and the Shocks: What We've Learned – and Have Still to Learn – from the Financial Crisis, by Martin Wolf, associate editor and chief economics commentator at the Financial Times. His column appears in The Irish Times on Wednesdays