It is now clear that the main cause of the euro crisis is that the member states surrendered their rights to print money to the European Central Bank when the single currency was created by the Maastricht Treaty in 1992. They did not realise what that entails; neither did the European authorities.
When the euro was introduced European regulators allowed banks to buy unlimited amounts of government bonds—the sovereign debt of each country—without setting aside any equity capital to protect them against the risk of default. The European Central Bank discounted all government bonds on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker countries to earn a few extra basis points. That is what caused interest rates to converge, which in turn caused the competitiveness of the eurozone countries to diverge. Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive. Other countries, such as Spain and Ireland, enjoyed housing and consumption booms on the back of cheap credit, making them less competitive.
Then came the crash of 2008 which created conditions far removed from those prescribed by the Maastricht Treaty. Governments had to bail out their banks and some of them found themselves in the position of a third world country which had become heavily indebted in a currency that it did not control. Europe became divided into creditor and debtor countries.
When financial markets discovered that supposedly riskless government bonds might actually be forced into default, they raised risk premiums dramatically. This rendered commercial banks whose balance sheets were loaded with those bonds potentially insolvent. That gave rise to the twin problems of a sovereign debt and a banking crisis.
The eurozone is now replicating how the global financial system dealt with crises such as the Latin American debt crisis of 1982 and the Asian financial crisis that began in 1997. Then, the international authorities inflicted hardship on the periphery of the global economy in order to protect the central economic powers; now Germany is unintentionally playing the same role. The details differ but the idea is the same: the creditors are shifting all the burden of adjustment onto the debtors and the “centre” avoids its own responsibility for the imbalances—as Germany is now doing. It is interesting that the terms “centre” and “periphery” have crept into usage almost unnoticed. Yet in the euro crisis the responsibility of “the centre” is even greater than it was in 1982 or 1997. The countries at the centre of the eurozone, led by Germany and France, and including the Netherlands, Belgium and Luxembourg, were the architects of a flawed currency system and failed to correct its defects. In the 1980s Latin America suffered a lost decade; a similar fate now awaits Europe.
At the onset of the crisis, a breakup of the euro was inconceivable. The assets and liabilities denominated in a common currency were so intermingled that a breakup would have led to an uncontrollable meltdown. But as the crisis progressed the financial system has been progressively reordered along national lines. This trend has gathered momentum in recent months. The long term refinancing operation (LTRO) enabled Spanish and Italian banks to buy the bonds of their own countries and earn a large spread. At the same time, banks are giving preference to shedding assets outside their national borders, and risk managers are trying to match assets and liabilities within national borders rather than within the eurozone as a whole. That is, banks, investors, and those otherwise acutely exposed to the crisis are beginning to readjust their holdings to treat eurozone member countries more as separate entities than as members of a currency bloc.
If this continued for a few years a break-up of the euro would become possible without a meltdown, but it would leave the creditor countries, such as Germany, with large claims against the debtor countries, such as Greece, Ireland, Spain and Portugal, which would be difficult to collect. In addition to intergovernmental transfers and guarantees, the Bundesbank had claims of €644 billion on April 30th against the central banks of periphery countries within the Target2 clearing system, the European network through which payments are reconciled. The amount is growing steeply due to capital flight, as people and companies take money out of periphery countries.
So the crisis keeps growing. Tensions in financial markets have risen to new highs. Most telling is that Britain, which retained control of its currency, enjoys the lowest yields on its sovereign debt in its history, even though the government is wrestling to bring down the deficit. Meanwhile the risk premium on Spanish bonds is at a new high. The real economy of the eurozone is declining while Germany is still booming. This means that the divergence between the central economies and the periphery is getting wider. The political and social dynamics are also working toward disintegration. Public opinion as expressed in recent election results is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed.
The likelihood is that, barring an accident like the Lehman Brothers bankruptcy of 2008, Germany will continue to do enough to hold the euro together. The chances of an accident in the next few months are quite high—but even if it is avoided the European Union will become something very different from the open society that fired people’s imagination. The division between the debtor and creditor countries will become permanent, with Germany dominating and the periphery countries becoming permanently depressed areas with little or no chance of regaining competitiveness because the playing field is tilted against them.
This will inevitably arouse concerns about Germany’s role in Europe. But any comparison with Germany’s past is quite inappropriate because the current situation is due not to a deliberate plan but to its absence: it is the unintended consequence of a sequence of policy errors. Germany is a well-functioning democracy with an overwhelming majority for an open society. When the German people become aware of the consequences they will want to correct the defects in the euro’s design. We must hope that it will not be too late.
The June summit was probably the last chance to reverse course. The summit started to address the banking crisis but neglected to deal with the sovereign debt problem, and it will take time to implement the decisions that were taken.
The Greek crisis is liable to come to a climax in the autumn even though the election produced a coalition that is ready to abide by the current agreement. By that time the rest of the eurozone has to be adequately ring-fenced to withstand the possibility of Greece defaulting on its debt. With both the eurozone and a global economy weakening, it will become progressively more difficult to persuade the European public to accept additional European responsibilities.
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The only way to reverse this seemingly inexorable course of events is to adopt some measures that are convincing enough to persuade both the public and the financial markets that the authorities have both the will and the resources to make the euro work. What is needed is an initiative that conforms with the existing treaties and brings conditions back closer to those prescribed by them. That would calm both the public and the markets. The treaties could then be revised in a calmer atmosphere to correct their defects and ensure that the current excesses will not recur.
It is difficult but not impossible to construct a set of initiatives that will meet these tough requirements. They would have simultaneously to tackle the banking and the sovereign debt problems without neglecting to reduce divergences in competitiveness.
For a start, the eurozone needs a banking union. It also needs a European deposit insurance scheme in order to stem the capital flight, by reassuring people that they will not lose their deposits in banks. Then, it needs a European source of financing to recapitalise the banks, and eurozone-wide supervision and regulation of them. At the same time, the periphery countries need relief on their financing costs. There are various ways to provide it but they all need the active support of Germany as the largest creditor country.
Angela Merkel, Germany’s chancellor, has recognised the need for a bold new initiative. Her vision of a fiscal union to complement a banking union is the right one for the long term but it is not attainable in the near term. It would require countries to relinquish sovereignty over fiscal policy to a European authority before that body had built up sufficient credibility. France rejected this proposal when the euro was created and is bound to do so now.
I propose to cut through this knot by moving towards both a fiscal and a banking union but more gradually, leaving the political union as a distant goal. The key is in the order of these steps. The first key component that we need is a European Financial Authority. This will serve as the embryo of the fiscal union and also provide fiscal backing for an embryonic banking union. Second, we need a Debt Redemption Fund which will provide immediate relief to the financing problem of the periphery countries. Third, we need a European solution to the immediate problems of the banking system. This could be achieved by putting the European Stability Mechanism, the European bailout facility set up since the start of the crisis, under the control of the new European Financial Authority, and by giving it access to financing from the European Central Bank.
These measures would require an intergovernmental agreement of the kind used to set up the European Stability Mechanism and the fiscal compact, the agreement on how countries receiving emergency help should repair their budgets. This would bring immediate relief to the financial markets and provide the authorities with the time they need for implementation.
This is how it would work. The members of the European Financial Authority would be the finance ministers of eurozone countries. Voting would be according to countries’ shareholdings in the European Central Bank, and decisions would require a majority of 80 per cent when guarantees that disproportionately affect creditor countries were involved, or 50 per cent when members were affected proportionately. The authority would have from the start the control of the European Stability Mechanism and the European Financial Stability Facility, the emergency fund of €440 billion set up in May 2010 to tackle the crisis. Member states would also contribute 0.1 per cent to demonstrate political will. Other financial resources would be mobilised gradually.
Its mission would be to provide fiscal backing for banking union. It would gradually assume the solvency risk on government bonds held by the European Central Bank. It would eventually provide financing for a policy on encouraging growth, to complement the fiscal compact on reducing government budget deficits and debt. After a suitable period of transition, it would allow for annual settlement of Target2 balances.
In setting up the Debt Redemption Fund, the new European Financial Authority would conclude agreements with individual countries that would oblige them to abide by the fiscal compact and to introduce specific structural reforms like labour market liberalisation and pension reforms. In return, the authority would acquire that country’s stock of debt which exceeded 60 per cent of GDP in primary markets, secondary markets and from the ECB and other official bodies.
The authority would finance its purchases by issuing European Treasury Bills and would pass on the benefit of its access to cheap financing to the country concerned. Should that country subsequently fail to live up to its commitments, the authority might impose a fine or other penalty which would be carefully calculated not to turn it into a nuclear option that cannot be exercised. This would provide adequate protection against the moral hazard.
The banking system has an urgent need for risk-free liquid assets. Banks are currently holding roughly €700 billion of surplus liquidity at the European Central Bank. Only after this excess liquidity has been absorbed would the new financial authority consider issuing longer-term bonds, because doing so at the outset might not receive a good reception from the market. The bills and bonds issued by the authority would be assigned zero-risk rating, and would be treated as the highest quality collateral for a the European Central Bank.
The reduction in the average maturity of the beneficiary countries’ debt would make them all the more responsive to any punishment imposed by the authority. For instance, it would be practically impossible for a successor government in Italy to break the commitments undertaken by Mario Monti, the former European technocrat installed as unelected prime minister and finance minister in November 2011 to address the crisis.
The authority could provide the necessary fiscal backing for a European solution to the immediate problems confronting the banking system by taking control of the European Stability Mechanism and the Stability Facility. As a political authority in partnership with the European Central Bank, it could do what the bank as a monetary authority cannot do on its own.
A banking union would have to have three components. The first is a European source of funding for recapitalising the banks. This could be provided by the European Stability Mechanism acting under the control of the new financial authority, using funds borrowed from the European Central Bank. Second, it would need eurozone-wide supervision and regulation of banks. This is best provided by the European Central Bank for the larger institutions and the European Banking Authority for the smaller ones.
Third, it would need a eurozone-wide deposit insurance scheme. This is the thorniest problem. German depositors are reluctant to pay for the extra risk posed by Spanish banks, and German taxpayers are unwilling to make up the difference. Only a makeshift solution is possible in the near-term—by the new financial authority assuming the solvency risk on government bonds held by the European Central Bank. Specifically, the authority could take over the Greek bonds held by the central bank [which are] coming due [for repayment by Greece] on August 20th and thereby avoid a Greek default. The bank could then continue to provide unlimited liquidity to the Greek banks which would have recently been recapitalised. This would not eliminate capital flight but it would remove the most immediate threat confronting the euro-area—a bank run on the banks of other periphery countries. A more lasting solution would take longer to develop. That would lay the institutional groundwork for a well-functioning currency in which the new financial authority would be responsible for solvency risk and the European Central Bank for providing liquidity.
The next steps are for the European Central Bank to start accumulating Italian and Spanish bonds. The European Stability Mechanism should take over the central bank’s holdings of Greek bonds. There will be no demand on a country to implement austerity measures if its GDP is shrinking. Financial ministers will start negotiating structural reforms that will qualify “periphery” countries to benefit from the debt reduction scheme.
Beyond that—ideally, by the end of this year—governments should aim to ratify and implement the agreement to set up these institutions. They should have their eyes firmly on the goals achievable only between three and five years from now: the creation of a fiscal, banking and political union.