Where Are We Now?
The June Summit seemed to offer the last opportunity to preserve the euro within the existing legal frame. In preparing for it, the European authorities under the leadership of Herman Van Rompuy, president of the European Council—which includes all the heads of state or government of the EU member states—realized that the current course was leading to disaster, and they were determined to explore the alternatives. They also understood that the banking problems and the sovereign debt problems are tied together like Siamese twins and cannot be solved separately. They were trying to develop a comprehensive program but of course they had to consult with Germany at every point along the way. They received positive reinforcement from Germany on developing plans for a banking union because Germany was concerned about the risks that capital flight from the “periphery” countries posed to the Bundesbank. So that part of the program was much better developed than a solution to the sovereign debt problem, in spite of the reflexive feedback loop between the two.
The cost of refinancing the national debt was of critical importance to Italy. At the outset of the June summit, Prime Minister Mario Monti declared that Italy would not agree to anything else unless something was done about it. To avoid a fiasco, Chancellor Merkel promised that Germany would entertain any proposal as long as it was within the existing legal framework. The summit was salvaged. It was decided to finalize the plans for a banking union, allowing the European bailout funds, the ESM and the EFSM, to recapitalize the banks directly and, after an all-night session, the meeting was adjourned.2 Monti declared victory.
But in subsequent negotiations it turned out that no proposal for reducing risk premiums fit into the existing legal framework. The plan to use the ESM to recapitalize the Spanish banks was also weakened beyond recognition when Chancellor Merkel had to assure the Bundestag that Spain would still remain liable for any losses. The financial markets responded by pushing risk premiums on Spanish bonds to record highs, with Italian yields rising in sympathy. The crisis was back in full force. With Germany immobilized by its constitutional court, whose decision on the legality of the ESM will be announced on September 12, it was left to the European Central Bank to step into the breach.
Mario Draghi, the current president of the ECB, announced that it will do whatever it takes to preserve the euro within its mandate. Bundesbank President Jens Weidmann has since been vocal in emphasizing the legal limitations on the ECB ever since, but Jörg Asmussen, the representative of the German government on the ECB’s board, came out in support of unlimited intervention on the grounds that the survival of the euro was at stake. This was a turning point. Chancellor Merkel was backing Mario Draghi, leaving the Bundesbank president isolated on the board of the ECB. President Draghi made the most of this opportunity. Financial markets took heart and rallied in anticipation of the ECB’s decision on September 6. Unfortunately, even unlimited intervention may not be sufficient to prevent the division of the euro area into creditor and debtor countries from becoming permanent. It will not eliminate the risk premiums, only narrow them and the conditionality imposed on the debtor countries by the EFSF is likely to push them into a deflationary trap. As a consequence, they will not be able to regain competitiveness until the pursuit of debt reduction through austerity is abandoned.
The line of least resistance leads not to the immediate breakup of the euro but to the indefinite extension of the crisis. A disorderly breakup would be catastrophic for the euro area and indirectly for the whole world. Germany, having fared better than the other members of the euro area, has further to fall than the others—therefore it will continue to do the minimum that it considers necessary to prevent a breakup.
The European Union that will emerge from this process will be diametrically opposed to the idea of a European Union that is the embodiment of an open society. It will be a hierarchical system built on debt obligations instead of a voluntary association of equals. There will be two classes of states, creditors and debtors, and the creditors will be in charge. As the strongest creditor country, Germany will emerge as the hegemon. The class differentiation will become permanent because the debtor countries will have to pay significant risk premiums for access to capital and it will become impossible for them to catch up with the creditor countries.
The divergence in economic performance, instead of narrowing, will become wider. Both human and financial resources will be attracted to the center and the periphery will become permanently depressed. Germany will even enjoy some relief from its demographic problems by the immigration of well-educated people from the Iberian Peninsula and Italy instead of less qualified Gastarbeiter from Turkey or Ukraine. But the periphery will be seething with resentment.
Imperial power can bring great benefits but it must be earned by looking after those who live under its aegis. The United States emerged as the leader of the free world after the end of World War II. The Bretton Woods system made it the first among equals, but the United States was a benevolent hegemon that earned the lasting gratitude of Europe by engaging in the Marshall Plan. That is the historic opportunity that Germany is missing by holding the heavily indebted countries to their Schuld.
It is worth recalling that the reparations payments demanded of Germany after World War I were among the factors giving rise to National Socialism. And Germany had its own Schuld reduced on three separate occasions: the Dawes Plan in 1924, the Young Plan in 1929—too late to prevent the rise of Hitler—and the London Debt Agreement in 1953.
Today Germany does not have imperial ambitions. Paradoxically, the desire to avoid dominating Europe is part of the reason why Germany has failed to rise to the occasion and behave as a benevolent hegemon. The steps taken by the ECB on September 6 constitute the minimum that is necessary to save the euro but they will also take us a step closer to a two-tier Europe. The debtor countries will have to submit to European supervision but the creditor countries will not; and the divergence in economic performance will be reinforced. The prospect of a prolonged depression and a permanent division into debtor and creditor countries is so dismal that it cannot be tolerated. What are the alternatives?
The Way Out
Germany must decide whether to become a benevolent hegemon or leave the euro. The first alternative would be by far the best. What would that entail? Simply put, it would require two new objectives that are at variance with current policies:
1. Establishing a more or less level playing field between debtor and creditor countries, which would mean that they would be able to refinance their government debt on more or less equal terms.
2. Aiming at nominal growth of up to 5 percent so that Europe can grow its way out of its excessive debt burden. This will necessitate a higher level of inflation than the Bundesbank is likely to countenance. It may also require a treaty change and a change in the German constitution.
Both these objectives are attainable, but only after considerable progress toward a political union. The political decisions taken in the next year or so will determine the future of the European Union. The steps taken by the ECB on September 6 could be a prelude to the creation of a two-tier Europe; alternatively they could lead to the formation of a closer political union in which Germany accepts the obligations that its leadership position brings with it.
A two-tier eurozone would eventually destroy the European Union because the disenfranchised would sooner or later withdraw from it. If a political union is not attainable the next best thing would be an orderly separation between creditor and debtor countries. If the members of the euro cannot live together without pushing their union into a lasting depression, they would be better off separating by mutual consent.
In an amicable breakup of the euro it matters a great deal which party leaves, because all the accumulated debts are denominated in a common currency. If a debtor country leaves, its debt increases in value in line with the depreciation of its currency. The country concerned could become competitive; but it would be forced to default on its debt and that would cause incalculable financial disruptions. The common market and the European Union may be able to cope with the default of a small country such as Greece, especially when it is so widely anticipated, but it could not survive the departure of a larger country like Spain or Italy. Even a Greek default may prove fatal. It would encourage capital flight and embolden financial markets to mount bear raids against other countries, so the euro may well break up as the Exchange Rate Mechanism did in 1992.
By contrast, if Germany were to exit and leave the common currency in the hands of the debtor countries, the euro would fall and the accumulated debt would depreciate in line with the currency. Practically all the currently intractable problems would dissolve. The debtor countries would regain competitiveness; their debt would diminish in real terms and, with the ECB in their control, the threat of default would evaporate. Without Germany, the euro area would have no difficulty in carrying out the U-turn for which it would otherwise need Chancellor Merkel’s consent.
To be specific, the shrunken euro area could establish its own fiscal authority and implement its own Debt Reduction Fund along the lines I shall describe below. Indeed, the shrunken euro area could go much further and convert the entire debt of member countires into eurobonds, not only the excess over 60 percent of GDP. When the exchange rate on the shrunken euro stabilized, risk premiums on eurobonds would fall to levels comparable to those attached to bonds issued in other freely floating currencies, such as the British pound or Japanese yen. This may sound unbelievable; but that is only because the misconceptions that have caused the crisis are so widely believed. It may come as a surprise, but the eurozone, even without Germany, would score better on standard indicators of fiscal solvency than Britain, Japan, or the US.3
A German exit would be a disruptive but manageable onetime event, instead of the chaotic and protracted domino effect of one debtor country after another being forced out of the euro by speculation and capital flight. There would be no valid lawsuits from aggrieved bond holders. Even the real estate problems would become more manageable. With a significant exchange rate differential, Germans would be flocking to buy Spanish and Irish real estate. After the initial disruptions the euro area would swing from depression to growth.
2 The European Financial Stability Mechanism, the EFSM, was set up in 2010 as a temporary organization based in Luxembourg to give financial assistance to eurozone member states; it will be replaced by the permanent ESM if Germany ratifies it; fifteen other members of the eurozone have already done so. ↩
3 General government deficit as percent of GDP: eurozone excluding Germany 5.3; UK 8.7; Japan 10.1; US 9.6; eurozone including Germany 4.2. Gross Public Debt as percent of GDP: eurozone excluding Germany 91; UK 82; Japan 230; US 103; eurozone including Germany 88. ↩
The European Financial Stability Mechanism, the EFSM, was set up in 2010 as a temporary organization based in Luxembourg to give financial assistance to eurozone member states; it will be replaced by the permanent ESM if Germany ratifies it; fifteen other members of the eurozone have already done so. ↩
General government deficit as percent of GDP: eurozone excluding Germany 5.3; UK 8.7; Japan 10.1; US 9.6; eurozone including Germany 4.2. Gross Public Debt as percent of GDP: eurozone excluding Germany 91; UK 82; Japan 230; US 103; eurozone including Germany 88. ↩