When things get really difficult ... suddenly solutions which seemed impossible become possible….Because of this, the crisis represents an opportunity. I'm not saying that I enjoy being in a crisis, but I'm not worried. Europe always moved forward in times of crisis. Sometimes you need a little pressure for certain decisions to be taken.—Wolfgang Schäuble1
Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.—Jean Monnet
Doom and gloom about the euro are abundant. An increasing number of commentators and economists have started to question whether the common currency can survive.
The economic and financial problems in the Eurozone are clearly serious and plentiful. The area is in the midst of multiple, frequently overlapping and mutually reinforcing crises.
- A fiscal crisis is centred in Greece but visible across the southern Eurozone and Ireland.
- A competitiveness crisis is manifest in large and persistent pre-crisis current-account deficits in the Eurozone periphery and even larger intra-Eurozone current-account imbalances.
- A banking crisis was first evident in Ireland but is now spreading throughout the Eurozone via accelerating concerns over sovereign solvencies.
We, however, think that these fears are overblown. We believe that the European crisis is political, and even largely presentational. This realisation holds the key to understanding how it has developed and to its solution.
Institutional design flaws
The lack of confidence in the euro is first and foremost rooted in a crisis of fundamental institutional design. The economic and monetary union adopted in the 1990s comprised an extensive (though still incomplete) monetary union, with the euro and the European Central Bank. But it included virtually no economic union:
- No fiscal union;
- No credible economic governance institutions; and
- No meaningful coordination of structural economic policies.
It was assumed by the euro’s architects that the single currency would act as a ‘locomotive’ and that ever deeper economic union would inexorably follow monetary union.
However, as financial markets in the years following the euro’s introduction seemingly assumed that a full economic union had nonetheless been achieved (a mistaken belief self-congratulating European officials were often eager to cheerlead), as Greece could for years miraculously borrow at the same rates as Germany, there was no pressure on policymakers to implement required reforms during the boom years prior to the Great Recession.
With access to ‘German interest rates’, many new Eurozone members in fact suddenly enjoyed their own supercharged version of the ‘exorbitant privilege’ originally attributed to the US by Valery Giscard d'Estaing.
Large public- and private-debt overhangs were correspondingly built up in the Eurozone in the first years of the new currency and in the run-up to the global financial crisis in 2008. When the Great Recession finally hit, the economic contraction and loss of mispriced capital inflows into the periphery laid bare the lack of true economic integration in the Eurozone and triggered severe market reactions that continue to this day.
There are today only two alternatives in front of European leaders:
- Europe could jettison the monetary union, and in the process reverse 60 years of gradual political and economic integration; or
- It could adopt a complementary economic union.
We believe that, for all the turmoil, Europe is well on its way to completing the original concept of an economic and monetary union. Indeed, we are convinced that Europe will emerge from the crisis much stronger as a result.
Doing what they cannot say they are doing
The key to understanding the evolution of the euro is to observe and analyse 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 have strengthened the institutions and pushed European integration 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 ultimate political goals of each 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 ‘political moral hazard’.
It would relieve the debtor countries of the pressure necessary to compel them to continue to take tough political decisions and maintain effective adjustment policies and all Eurozone leaders from the equally important political imperative of forging the institutions necessary for a complete economic and monetary union.
This first dilemma has been felt most acutely at the ECB, the overseer of the monetary union and the only Eurozone institution capable of affecting financial markets in real time. In this crisis, this has made it a uniquely powerful central bank. Its institutional independence is enshrined in the EU Treaty and it is not answerable to any individual government. Consequently, the ECB Governing Council has functioned 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, the ECB has in this crisis been able to issue direct political demands to Eurozone 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 Eurozone fiscal entity exists. Moreover, its committing to a major ‘bridging monetary stimulus’, as some have called for, would undermine chances of a permanent political resolution to the Eurozone’s underlying under-institutionalisation problem. Were the ECB to cap governments’ financing costs at no more than 5%, for instance, Eurozone politicians would probably never take the essential but painful decisions.
Saddled with administering a common currency, and endowed with governing institutions flawed by early political compromises, it is hardly surprising that the ECB’s dominant concern as it manages this crisis has been to prevent ‘political moral hazard’ and not let Eurozone leaders off the hook. Precisely because Silvio Berlusconi would still be prime minister of Italy if the ECB had purchased unlimited amounts of Italian government bonds at an earlier time, the central bank is highly unlikely to provide the necessary assistance to Eurozone elected leaders to end the crisis – including the Italian successors of Silvio Berlusconi – unless and until they offer and implement a suitable quid pro quo.
It is therefore imperative to understand that the ECB as a political actor is not primarily interested in ending market anxieties and thus the Eurozone crisis as soon as possible. It is instead focused on achieving its priority goals of getting government leaders to fundamentally reform the Eurozone institutions and structurally overhaul many Eurozone economies.
- Second, the main actors cannot declare their intentions openly because each of the four creditors – Germany and the other northern European governments, the ECB, private-sector lenders, and the IMF (including 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.
As the Greek government (with the rest of the Eurozone and the IMF looking over their shoulders) haggles with private creditors, and non-Eurozone members of the G20 consider whether to provide more resources to the IMF, the key actors in the crisis are still positioning themselves to force others to pick up as much of the crisis costs as possible. In the meantime, the crisis continues and may superficially appear to be insoluble. Yet, there are in fact several possible solutions to stave off a near-term meltdown when Italy and Spain begin their large bond rollovers in early 2012:
- Germany (and the other economically stronger Eurozone members) can write a cheque and agree to expand the European Financial Stability Facility/European Stability Mechanism and/or give it a banking licence;
- The IMF can write a cheque using new resources from the Eurozone and rest of the world to put together a sizeable new support programme for Italy and/or Spain; or
- The ECB can write a cheque and begin to purchase much larger amounts of the relevant sovereign bonds.
It remains to be seen which solution will be chosen. It is possible, indeed likely, that the ultimate package will combine parts of each of the above.
Crisis resolution cheaper than euro collapse
But it is obvious that none of these solutions are even remotely as costly for any of the main actors involved, inside or outside the Eurozone, as a sovereign default in Italy and/or collapse of the euro. That is why, once the political pre-positioning is over and the alternatives are exhausted, the games of chicken will end and the political decision on how to split the bill for securing the euro’s survival will be taken.
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 – it is a matter of establishing the political will to pay rather than the economic ability to pay.
Europe’s key political actors in Berlin, Frankfurt, Paris, 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. But the process relies on that financial-market volatility to incentivise solutions that will ultimately resolve the crisis and 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.
Stabilisation and resolution on the way: What next?
We therefore believe the Eurozone crisis – despite the superficial appearance of the opposite – is well on the way towards stabilisation and resolution. The final major political challenge on the Eurozone agenda for 2012 goes beyond measures to address the immediate crisis and will instead focus on the longer-term continuation and direction of Eurozone institutional reform.
During 2012, the Eurozone is likely to adopt a new and considerably more credible set of fiscal rules and budget-oversight regulation. This has been a clear demand from both the ECB and Germany. But while the new fiscal compact will undoubtedly help stabilise the Eurozone in the future, it must be thought of as merely a beginning of the institutional reforms needed in the region.
Fiscal consolidation is not everything and the movement toward further and symmetrical deepening of Eurozone fiscal integration must be maintained. Following the ‘fiscal rules first’ down payment, Eurozone leaders must consequently take further concrete steps in 2012 on a reasonable timetable toward the introduction of Eurobonds or the expansion of the ESM firewall (+ potential IMF involvement) to magnitudes which will help assuage financial markets and facilitate an expeditious reduction in the interest rates of especially Spain and Italy.
It has taken ten years since the introduction of the euro for the first serious economic and political crisis to arrive. 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 US. It will require further substantial Treaty and institutional revisions in the future.
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.