Deep Dive

Where There’s a Will…

If the founding members of the eurozone don't get their acts together, the euro will collapse.

Many journalists and economists are exasperated with European leaders and pessimistic about the fate of the eurozone. They are frustrated at the slow pace of European decision-making and the fact that the obvious solution -- purchases of sovereign debt by the European Central Bank (ECB) -- is stymied. The results of the most recent Euro summit in Brussels did little to placate the critics. The New York Times, for instance, considers the amount available for bailouts still too small to persuade debt markets, and frets that the eurozone is still left without a lender of last resort. Italy, meanwhile, may again be tested by speculative attacks in the bond market. The International Monetary Fund (IMF) and central banks have indicated their willingness to provide loans, and eurozone members have increased resources available to the European Financial Stability Facility (EFSF), but no one knows if this will be enough to avert a liquidity crisis.  

So, what is the solution? Economists believe that the basic problem of the eurozone is economic. National economic imbalances, they argue, can no longer be restored through the traditional method of currency devaluation. Conventional wisdom insists that either Germany acquiesce to some sort of bailout, or the eurozone is finished. Germany must consent to either a) the issuance of joint and severally liable Eurobonds, or b) a policy of monetary easing by the ECB. The problem is being treated as a technocratic economic matter. Hence, technocrats have come to power in Greece and Italy.   

But the problems of the eurozone are fundamentally political: a) it expanded too fast as wider won out over deeper; b) there is no commitment to common budgetary policies; and c) there is no mechanism to enforce agreements. The crisis turns on central problems of international relations theory like anarchy, sovereignty, and power. 

The Brussels summit on Dec. 8 and Dec. 9 produced a renewed commitment to budgetary discipline, but only to the original guidelines agreed to some 20 years ago in the Maastricht Treaty. There was some talk of sanctions to be imposed on member states that violate these guidelines, but such sanctions are at best problematic and can be obviated by the vote of a qualified majority. Further, "automatic mechanisms" to correct deviations from debt limits are to be designed by member nations themselves.

European leaders have done the minimum possible, and then only at the last possible moment.  Although praised as a breakthrough, the agreement by eurozone members on a "haircut" of 50 percent  on the face value of Greek debt is insufficient. Serious discipline would involve European banks, including the ECB, marking their holdings of sovereign debt to market rates, currently a 60 percent discount to face value. If banks are not made to pay for their mistakes, they have little incentive to avoid them again.

Capital requirements are another area of ambiguity. European banks are required to increase their capital, but only to an inadequate 9 percent of assets. Given the perilous risk environment, a healthy bank should probably have something like twice that amount of capital. But the definition of "capital" is already being watered down by regulators, and banks are restructuring debt to improve capital levels without raising additional money.

The referendum on Greece's EU debt deal proposed by former Prime Minister George Papandreou would have cleared the air. It would have restored a stark reality that European leaders would not be able to evade. If Greeks had voted "no" on the referendum, Greece would have had little choice but to return to the drachma. That would have been a lesson to others that they have only two choices: a) coordinate fiscal and monetary policies or b) press the "eject" button. The problem now is that European leaders may still think they can muddle through by patching up a country here and there. That will destroy the clarity exposed by a Greek default.  

As things stand today, the debate is centered around two poles: pessimists predicting the breakup of the eurozone versus optimists forecasting closer integration. The solution would seem to include both.  

On the one hand, wide economic disparity among members of the eurozone will force weaker members to leave. Greece, as well as those countries that use the euro but cannot afford it (the "PIGS"), will be cast off from the eurozone by centrifugal market forces. A Greek departure from the eurozone will be messy, and the threat of massive capital flight will prompt Greek authorities to announce the country's departure suddenly and without warning. But the risk of contagion and the accompanying collapse of the European project is too great if Greece stays in the eurozone. The recent spread of market contagion to Italy and Spain bears this out.

On the other hand, the remaining members will converge on tighter economic policy along the German model. As a corollary to more restricted membership, those countries remaining in the eurozone will harmonize their policies regarding budget deficits, pension reform, privatization, unemployment insurance, and revenue sharing. This will have the effect of bringing Europe -- or at least those countries that can achieve convergence -- closer together. It may also create a more politically coherent Europe, with those remaining in the eurozone leading the European Union both economically and politically.

The divide, as usual, is between France and Germany over monetary policy. The French, along with their southern European allies in Greece, Italy, Spain, and Portugal, favor easy money, while the Germans, along with northern Europeans in the Netherlands, Austria, and Finland, insist on a tight money policy. Any hint of German capitulation to French demands of easier money will be the end of the euro. The first sign of wavering, the first inkling that a compromise is afoot, will signal to the markets that the floodgates for a river of euros are open, that fiscal and monetary discipline are history, that inflation will be rampant, and that the euro will be worthless. That is why German Chancellor Angela Merkel will remain firm.

Germans will not pay for the profligacy of their neighbors. Otherwise, where would it stop? Any concession towards easy money will only reinforce the "moral hazard" of further risk-accepting behavior. It is a story as old as Aesop's tale, The Ant and the Grasshopper. Germany entered into the euro under assurances that all members would conduct their economic affairs responsibly. If this is no longer the case, then Germany will reserve the right to withdraw. A former British chancellor of the exchequer agrees, insisting that Germany would sooner withdraw from the euro than see its integrity compromised. Another not insignificant factor is the survival of Angela Merkel as chancellor. Any suggestion of Merkel wavering at the prospect of easy money is tantamount to political suicide. So all the speculation that the ECB or the EFSF will "stabilize" (rescue) the euro is so much folderol.

The power calculus, then, favors Germany. France will be dragged along kicking and screaming, but two points suggest eventual French capitulation. One is that Germany may otherwise threaten to secede from the euro, which would put France in a nasty competitive economic position. And the second is that, without the unity embodied in a common currency, French hopes of ever again exerting influence on the world scene will have evaporated. Europeans understand that they cannot meet global challenges as individual nations because they are no longer great powers. As President Nicolas Sarkozy conceded, "If Europe does not change quickly enough, global history will be written without Europe."

The original path to the common currency was through a convergence of economic policies. Nations would have budget deficits of no more than 3 percent of gross domestic product (GDP), and total debt of no more than 60 percent of GDP. If euro members had stuck to these criteria, they would be in dandy shape now. So a return to that mechanism, with additional penalties for non-compliance, might work. The challenge is to create binding agreements.

On the question of enforcement, some have raised the possibility of an automatic increase in taxes to offset a budget deficit beyond acceptable limits. Other devices to ensure compliance with EU oversight of national budgets are available for the same purpose. These sanctions would be imposed by a central authority that can override national budget decisions. The European Court of Justice and the European Commission have been suggested as ultimate arbiters, but such supranational enforcement has its limits in a union of sovereign states.

Sovereign governments, moreover, may oppose such measures for domestic political reasons. As long as sovereignty remains, national governments may negate previous agreements. Even within national governments, as in the U.S. Congress, existing legislatures may negate the agreements of previous legislatures. Therefore, a more severe penalty is required. 

The ultimate penalty for non-compliance is, of course, expulsion. The eurozone could expel any country that fails -- after a suitable time period -- to adhere to budgetary guidelines set forth in a new agreement. The ultima ratio of economic union is expulsion, just as the ultima ratio of politics is war. It lurks behind every decision as the final alternative.

The demise of the euro, as a proxy for the European Union itself, is not underway. Neither is a consolidation on the German federal model. A big push for more Europe is not in the cards now, either. The loss of that much national sovereignty is unrealistic, given the immature development of a European identity. That is why convergence of fiscal and economic policies is the most likely outcome, not complete structural reform.

But convergence will not save the euro if member states refuse to comply with agreed guidelines. Both France and Germany violated the guidelines in 2003, blowing through the barriers of 3 percent budget deficits and 60 percent debt for more than a year. If the founding members of the eurozone fail to comply or to remedy violations within prescribed time periods, then the euro will well and truly collapse. In a union of sovereign powers, political will is the ultimate arbiter.


Deep Dive

The Icarus Zone

Never before has a monetary union been so full of anticipation and hype. Should we have known that the euro would buckle?

It was not supposed to turn out like this. At the core of the euro, the supranational currency at the heart of the Economic and Monetary Union (EMU), is a tale of faltering ambitions and unrequited hopes. Launched in 1999 as one of Europe's brightest success stories, the single currency has become a saga of Wagnerian intensity, full of interweaving subplots in which the grandest designs have been subverted, the most beguiling intentions contorted, the most elaborate political calculations turned to dust. Monetary union threw a veil of comfort and well-being over the fortunes of the continent. In 2009 and 2010, the veil was ripped away.

With a unified monetary and interest rate policy that by 2011 encompassed 17 countries, the EMU and its key institution, the Frankfurt-based European Central Bank (ECB), were conceived as breaking down barriers between people, companies, and markets -- a force for unity and prosperity following the fall of the Berlin Wall, the reunification of Germany, and the ending of the communist-capitalist divide.

Some of the euro's achievements are incontestable. The euro area makes up one-fifth of the global economy and contains a population of 330 million -- in economic size, roughly equivalent to the United States. The ECB, keen to uphold a rigorous monetary reputation, has built up respect and acumen in the councils of monetary power around the world. The euro is the second-most important international currency after the dollar, of major significance in financial market transactions and in the holdings of central banks, pension funds, insurance companies, and government agencies around the world. In cash terms, there are 15 to 20 percent more euros in worldwide circulation than dollars.

Yet, a dozen years after its birth, the EMU has become Europe's melancholy union. The roots of its travails, or at least some of them, lie outside Europe: the buildup of massive, footloose investment capital by fast-growing developing nations like China; tightened conditions for international borrowing and lending after the U.S. home loans crash in 2007 and the downfall of New York investment bank Lehman Brothers in 2008; and then, in 2009, the worst world recession since the 1930s. But the central reasons for the dashing of European dreams have been relentlessly homemade. They lie in the EMU's inherent encouragement, through the "one-size-fits-all" interest rate policy, of vulnerable member states to live beyond their means, and in the extraordinary failure of Europe's governments and financial authorities to heed the warning signs and take corrective action until it was far too late.

The euro's advantages were meant to be self-fulfilling; success would feed on itself. Yet as a result of the defects revealed in 2009-2010, European countries have had to embark, within a period of just two years, on a massive program of financial overhaul for which they were almost completely unprepared and which dwarfs, in real terms, the sums of money mobilized to repair Europe after the end of the first and second world wars. The single currency bloc stands revealed as a zone of semipermanent economic divergence, corrosive political polarization, and built-in financial imbalances, beset by a perpetual penumbra of hope and pain. For the broad mass of the European electorate, "Europe" has become a byword for unpopular and painful economic restructuring. In allocating funds to prevent payments and debt disparities from destroying the euro, EMU governments have decided to commit colossal sums of taxpayers' money they cannot afford to heal internal disparities they cannot conceal to shore up an edifice many believe cannot stand -- at least, not in its current form.

To correct the malignant effects of years of economic recklessness, Europe, backed up by the International Monetary Fund, is imposing austerity and belt-tightening on the problem-ridden peripheral states led by Greece, Ireland, and Portugal, in exchange for emergency financing to help them pay their massive debts. These countries, three of the smaller economies in the euro, ran into serious problems in 2009-2011 as a result of a large increase in debts built up due to low interest rates and faulty supervision after the monetary union started, with the Greek imbroglio considerably worsened by government manipulation of key statistics that camouflaged the true extent of the country's economic deterioration. As part of crisis measures, the creditor nations -- with Germany in the vanguard -- are being asked to join in the sacrifices by taking a soft line over repayment of the problem states' existing debts, as well as by guaranteeing new ones.

European banks, severely weakened in many cases by the collapse of the pre-2007 global credit boom, have been drawn into the fray through their involvement as owners of hundreds of billions of dollars of government bond issues of the hard-hit peripheral states. European governments, powerfully backed by the ECB, have been reluctant to see the banks suffer outright losses through restructuring of the deficit nations' debts. The result is that responsibility for bailing out the errant eurozone members has been inexorably shifting away from the banking sector to taxpayers in the better-off countries.

This is exemplified most dramatically by the significant risks for national exchequers built up through the lending policies of the ECB, the capital of which is backed above all by Germany and France. The chief characteristic of this new European interdependence -- neither expected nor, for the most part, properly explained by political or monetary leaders -- is not freely exchanged solidarity, but growing resentment and recrimination. In a spiral of mutual discontent in some ways reminiscent of the atmosphere engendered by demands for reparations from defeated Germany after the First World War, both creditors and debtors look likely to revolt: the former, against the prospect that they will not be repaid; the latter, against the onerous conditions attached to loans made in the spirit of an economic union that has become increasingly discredited.

Whatever the setbacks it has faced and the strains it will continue to suffer, the euro is most unlikely to collapse and disappear. Too great has been the expenditure of political and economic capital, too arduous the efforts of many governments from many nations over many years, for the product of their labors simply to wither and die. Nonetheless, the system clearly faces the danger of fragmentation, with either strong or weak countries separating from the system and reintroducing -- despite all the costs and upheaval -- some form of national currency management more suited to their economic requirements.

One development holding the bloc together is that preserving the euro has become a strategic priority for China, the world's second-largest economy, No. 1 reserve currency owner, and main creditor nation, holding one-third of all foreign exchange reserves. The People's Bank of China, the Chinese central bank, and the State Administration of Foreign Exchange (SAFE), the country's premier sovereign wealth fund, have emerged as strong buyers of the euro in a bid to diversify their reserves away from the dollar. (To a more moderate extent, Japan has been following the same policy.) China does not want to be exposed to a chronically weak European currency when its own exports are being hit by rising inflation at home and by the threat of protectionism in some of its main markets, led by the United States. And neither China nor Japan wishes the Americans to benefit indefinitely from the unchallenged monopoly power of the dollar.

Additionally, both China and Japan have strong political reasons for winning favors from the Europeans at a time of economic upheavals. China would like to use the leverage of aid for the euro as a way of gaining relaxation of controls on technology flows from Europe in sensitive militarily relevant areas, and also to advance ways of purchasing industrial and service companies and logistics and transport facilities throughout the continent. The single currency has thus been caught up in China and the United States' battle over the future of the world economy.

In their involvement in these skirmishes, however, European policymakers have been reduced to the role of bystanders. Europe's objective in creating the euro had been to become an essential part of a new trilateral currency system in which America, Europe, and China parleyed over power; the monetary future of the globe would be in the hands of a triumvirate of central banks, the Federal Reserve in Washington, the ECB in Frankfurt, and the People's Bank in Beijing. In fact, for all the ECB's undoubted accomplishments, grave flaws in the political governance of the euro have placed the Europeans in positions of weakness rather than strength. In the eyes of its supporters as well as its detractors, the euro has been signally downgraded. The single currency that is emerging from the economic wreckage left by the European sovereign debt upheavals will be significantly different from that planned by its protagonists. The eurozone will be divided rather than united by diversity, fragmented into opposing blocs of creditor and debtor states, and condemned to years of costly and complex financial underpinning through the monetary equivalent of medical life-support machinery. A two-speed Europe has become reality, made up of a northern group of relatively integrated, homogeneous, and cohesive creditor states around Germany and the Netherlands, and a more diverse collection of hard-hit debtors on the periphery -- Italy, Spain, Portugal, Greece, and Ireland. France, which is politically and economically close to Germany yet prone to long-lasting tensions with the Germans over running the monetary union, is sandwiched uneasily between the two groups.

As a result of persistent Franco-German differences and a general ebbing of European desires for more integrated political structures, any new framework for the single currency will fall a long way short of the full-blown political union envisioned by the EMU's founders. Helmut Kohl, the German chancellor who pushed through reunification, worked tirelessly to replace the previous German national currency, the D-Mark, with the euro as a sign of reunited Germany's strong pro-European credentials, but his parallel objective of political union has long ceased to be realistic. As many skeptics had earlier predicted, events in Europe since 2009 have produced a textbook display of the drawbacks of establishing a "one-size-fits-all" monetary policy without thoroughgoing political interlinkages -- above all especially fiscal solidarity offering automatic redistribution of tax income among stronger and weaker countries. The fiscal rules of the so-called Stability and Growth Pact, established in 1997 as a means of maintaining EMU members' macroeconomic and budgetary probity, have proven woefully inadequate. The "no-bail-out clause" at the heart of the EMU's statutes agreed in Maastricht, laying down that member states had no liability for each other's debts, has been insufficient to prevent financial contagion, via which individual states' payments difficulties upset other members' fiscal health.

At the heart of the eurozone's gradual transition to a state of misery was a gross misreading of the laws of economics. The architects of the monetary union believed that individual euro countries' disparities in balance of payments performances -- caused by diverse rates of economic growth and inflation -- would have a negligible impact on the resilience of the eurozone as a whole. According to this notion, individual countries' current account deficits -- especially vis-à-vis other member countries -- would be largely self-financing. This ultimately proved to be pure fiction. But, since it appeared to be true in the early years of the EMU, the thesis attracted a great deal of support from within and beyond Europe -- and ended up promoting a self-perpetuating process in which spendthrift governments, companies, and consumers were rewarded rather than penalized by the financial markets. During negotiations on the Maastricht Treaty, the old European Community provision for mutual balance of payments assistance was removed. This reflected both the German-led view that monetary union should embody optimal discipline for member states and the belief that, once the new currency was created, financing current account deficits within the eurozone would no longer present difficulties.

But because within a single currency area devaluations are no longer possible, states on Europe's southern and western fringes such as Greece, Ireland, Portugal, and Spain with higher inflation effectively had exchange rates that were far too high, pricing their goods and services out of business in international trade. The Europe-wide fall in interest rates to German levels was used in the more inflation-prone peripheral countries not to build up productive capacity and prepare economies for the challenges of technological change and foreign competition, but to fuel wasteful consumption and speculative purchases of financial assets and real estate whose values subsequently plummeted. Since interest rates in the first eight years of the euro were plainly too low in peripheral states, these countries experienced credit booms, leading to above-average growth rates and also higher inflation and thus a loss of competitiveness -- setting off increasing balance of payments deficits that had to be financed by foreign borrowing. Countries such as Germany had the opposite experience: lower growth rates and inflation, resulting in higher competitiveness and large current account surpluses that were subsequently channeled back as loans to the deficit states, effectively pouring oil on a slow-burning monetary fire.

In August 2007 -- the month when the transatlantic credit crisis erupted internationally with the bursting of the bubble in the U.S. subprime mortgage sector -- the ECB published a 12-page article devoted to global imbalances in current account surpluses and deficits, saying, "The issue is important, as a potentially disorderly unwinding could pose a risk for the global economy and the stability of the international financial system." The article focused on the rise in the U.S. current account deficit "to unprecedented levels" and on the surplus countries of China, Japan, Russia, and Saudi Arabia. But it failed to mention the imbalances within the eurozone on the grounds that the current account position of the EMU countries had been "broadly balanced" and had even contributed to international adjustment by moving to a small deficit in 2006.

This was a telling sign of how the ECB in its myriad statements and publications habitually gave prominence to financial and economic statistics on the eurozone as a whole, virtually ignoring national data from individual members.

In an unwitting prophecy of the Greek unrest just two years later, the ECB wrote in August 2007, "[I]t is hard to define which countries are systemically important: some past financial crises have been triggered by relatively small economies." However, the bank failed completely to spot how the seeds of turbulence were being sown by developments within the eurozone itself. Unregistered by the ECB's statistical coverage, euro members in 2006 recorded some of the world's largest balance of payments disequilibria. Greece, Portugal, and Spain respectively ran up deficits of 11, 10, and 9 percent of GDP, while Germany and the Netherlands earned surpluses of 6.5 and 9 percent. In all cases, these imbalances were even larger than that displayed by the United States, with its current account deficit of 6 percent of GDP that year.

The self-delusion about the inviolability of the euro during the EMU's first decade coincided with widespread propagation around the world of three further tenets of central banking lore that also turned out to be false: that producing a low and stable rate of inflation was both necessary and sufficient to develop growth, prosperity and employment; that a combination of price stability and adequate supervision of individual financial institutions would buttress the stability of the financial system as a whole; and that movements of prices on financial markets would turn out to be self-correcting, without the necessity of large-scale intervention by government authorities.

As these delusions persisted, inflows of international capital allowed governments across the eurozone to borrow more or less at the same low interest rates as Germany. The ECB was only too happy to accept the apparently benevolent interpretation of international bond investors. As part of its refinancing operations, the bank accepted government paper from banks at virtually the same price throughout Europe, in line with the fiction that the euro area really had become one single political and economic bloc in which individual governments could borrow on near-identical terms, regardless of their economic circumstances.

As well as buttressing the notion that the monetary union had come of age, the equivalence of borrowing eased the ECB's task of establishing harmonizing economic conditions throughout the eurozone. Financial markets compounded the sense of well-being by setting aside traditional analytical tools (or even common sense) governing the pricing of financial risk, and valuing government debt as though Greece and other less well-off states really did have the same creditworthiness as Germany. This resulted in a self-fueling process in which the sharp reduction in interest rate spreads between different classes of borrowers persuaded the politicians that the monetary union was succeeding far more resoundingly than many had expected. Governments thus had no further incentive to carry out unpopular structural reforms at home to underpin the long-term health of the monetary union; the financial markets seemed to have done their work for them.

Once that complacency was punctured in late 2008, the apparently benevolent European cycle suddenly became vicious, turning out to be as short-lived and as illusory as the asset bubbles on which it was built. As Herman Van Rompuy, the former Belgian prime minister who in 2010 became president of the EU's governmental body, the European Council, put it in June 2010 with rueful pathos, "The euro became a strong currency with very small interest rate spreads [on government bonds]. It was like some kind of sleeping pill, some kind of drug. We weren't aware of the underlying problems." Referring to Europe's complacency about allowing countries like Greece and Portugal to run persistent annual current account deficits of 10 percent of GDP without insisting on corrective action, former West German Chancellor Helmut Schmidt said in late 2010, "The question is: How come that no one took any notice -- in Basel or in Brussels or in some statistical office? No one seems to have understood."

Warnings that monetary union would lead to unsustainable surges in borrowing had in fact been made by authoritative figures such as Hans Tietmeyer, president of the Bundesbank during preparations for EMU in 1993-1999. Tietmeyer spoke frequently in the pre-euro years of the risk that EMU states that generated higher inflation than Germany would suffer losses in competitiveness that could no longer (as in the past) be offset by devaluation but could be withstood only by lowering the internal prices of internationally traded goods and services and, in the last resort, through higher unemployment. Gerhard Schröder, Kohl's successor, who presided over the advent of the single currency in 1999, commented in 1998 that the EMU would increase Germany's industrial domination of Europe because its competitors would be unable to devalue their currencies. Such statements, accompanied by similar warnings from academic economists in many countries, represent strikingly accurate predictions of what actually happened.

As Europe awakens from its narcotic spell, the bitter truth is that very few of the strategic motivations for the formation of the single currency have been fulfilled. The progenitors of the Maastricht Treaty -- led by France and Italy, as well as smaller countries such as Belgium and the Netherlands, but including, too, most of Germany's leading politicians -- foresaw a variety of benefits. The four main arguments for the euro were to promote European growth and prosperity by eliminating exchange risks and boosting trade; to complete France and Germany's postwar political rapprochement by establishing a path toward political union; to create a rival and complementary force to the dollar; and to constrain the perceived dominance of newly reunited Germany. Needless to say, none of these predictions have borne out; Germany, for instance, is more dominant in Europe than ever. Never before had the creation of a new monetary device been so replete with anticipation and hype; it was almost inevitable that, under the weight of these expectations, the euro would buckle.

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