The common market would survive but the relative position of Germany and other creditor countries that may leave the euro would swing from the winning to the losing side. They would encounter stiff competition in their home markets from the euro area and while they may not lose their export markets, these would become less lucrative. They would also suffer financial losses on their ownership of assets denominated in the euro as well as on their claims within the TARGET2 clearing system. The extent of the losses would depend on the extent of the euro’s depreciation.4
Thus they would have a vital interest in keeping the depreciation within bounds. Of course there would be many transitional difficulties, but the eventual result would be the fulfillment of Keynes’s aspiration for a currency system in which the creditors and debtors would both have a vital interest in maintaining stability.
After the initial shock, Europe would escape from the deflationary debt trap in which it is currently caught; the global economy in general and Europe in particular would recover and Germany, after it has adjusted to its losses, could resume its position as a leading producer and exporter of high-value-added products. Germany would benefit from the overall improvement. Nevertheless the immediate financial losses and the reversal of its relative position within the common market would be so large that it would be unrealistic to expect Germany to leave the euro voluntarily. The push would have to come from the outside.
By contrast, Germany would fare much better if it chooses to behave as a benevolent hegemon and Europe would be spared the upheaval the German withdrawal from the euro would cause. But the path to achieving the dual objectives of a more-or-less level playing field and an effective growth policy would be much more tortuous. I will sketch it out here.
The first step would be to establish a European Fiscal Authority (EFA) that would be authorized to make important economic decisions on behalf of member states. This is the missing ingredient that is needed to make the euro a full-fledged currency with a genuine lender of last resort. The fiscal authority acting in partnership with the central bank could do what the ECB cannot do on its own. The mandate of the ECB is to maintain the stability of the currency; it is expressly prohibited from financing government deficits. But there is nothing prohibiting the member states from establishing a fiscal authority. It is Germany’s fear of becoming the deep pocket for Europe that stands in the way.
Given the magnitude of Europe’s problems, this is understandable; but it does not justify a permanent division of the euro area into debtors and creditors. The creditors’ interests could and should be protected by giving them veto power over decisions that would affect them disproportionately. That is already recognized in the voting system of the ESM, which requires an 85 percent majority to make important decisions. This feature ought to be incorporated into a new EFA. But when member states contribute proportionately, for instance by providing a certain percentage of their VAT, a simple majority should be sufficient.
The EFA would automatically take charge of the EFSF and the ESM. The great advantage of having an EFA is that it would be able to make decisions on a day-to-day basis, like the ECB. Another advantage of the EFA is that it would reestablish the proper distinction between fiscal and monetary responsibilities. For instance, the EFA ought to take the solvency risk on all government bonds purchased by the ECB. There would then be no grounds for objecting to unlimited open-market operations by the ECB. (The ECB may decide to do this on its own on September 6, but only after strenuous objections by the Bundesbank.) Importantly, the EFA would find it much easier than it would be for the ECB to offer public-sector participation in reorganizing the Greek debt. The EFA could express willingness to convert all Greek bonds held by the public sector into zero-coupon bonds starting to mature ten years out, provided Greece reached a primary surplus of, say, 2 percent. This would create a light at the end of the tunnel that could be helpful to Greece even at this late stage.
The second step would be to use the EFA to establish a more level playing field than the ECB will be able to offer on its own on September 6. I have proposed that the EFA should establish a Debt Reduction Fund—a modified form of the European Debt Redemption Pact proposed by Chancellor Merkel’s own Council of Economic Advisers and endorsed by the Social Democrats and Greens. The Debt Reduction Fund would acquire national debts in excess of 60 percent of GDP on condition that the countries concerned undertook structural reforms approved by the EFA. The debt would not be canceled but held by the fund. If a debtor country fails to abide by the conditions to which it has agreed the fund would impose an appropriate penalty. As required by the Fiscal Compact, the debtor country would be required to reduce its excess debt by 5 percent a year after a moratorium of five years. That is why Europe must aim at nominal growth of up to 5 percent.
The Debt Reduction Fund would finance its bond purchases either through the ECB or by issuing Debt Reduction Bills—a joint obligation of the member countries—and passing on the benefit of cheap financing to the countries concerned. Either way the cost to the debtor country would be reduced to 1 percent or less. The bills would be assigned a zero-risk weighting by the authorities and treated as the highest-quality collateral for repurchase agreements (repos) used in operations at the ECB. The banking system has an urgent need for such a risk-free liquid asset. Banks were holding more than €700 billion of surplus liquidity at the ECB, earning 0.25 percent interest at the time that I proposed this scheme. Since then the ECB reduced the interest rate paid on deposits further, to zero. This assures a large and ready market for the bills at less than 1 percent. By contrast, the plan announced by the ECB on September 6 is unlikely to reduce the cost of financing much below 3 percent.
The scheme I proposed was rejected out of hand by the Germans on the grounds that it did not conform to the requirements of the German constitutional court. In my opinion their objection was groundless because the constitutional court ruled against commitments that are unlimited in time and size, while the Debt Reduction Bills would be limited in both directions. If Germany wanted to behave as a benign hegemon it could easily approve such a plan. It could be introduced without any treaty change. Eventually the Debt Reduction Bills could provide a bridge to the introduction of eurobonds. That would make the level playing field permanent.
That leaves the second objective: an effective growth policy aiming at nominal growth of up to 5 percent. That is needed to enable the heavily indebted countries to meet the requirements of the Fiscal Compact without falling into a deflationary debt trap. There is no way this objective can be achieved as long as Germany abides by the Bundesbank’s asymmetric interpretation of monetary stability. Germany would have to accept inflation in excess of 2 percent for a limited period of time if it wants to stay in the euro without destroying the European Union.
How To Get There
What can bring Germany to decide whether to stay in the euro without destroying the European Union or to allow the debtor countries to solve their problems on their own by leaving the euro?
External pressure could do it. With François Hollande as the new president, France is the obvious candidate to advocate an alternative policy for Europe. By forming a common front with Italy and Spain, France could present an economically credible and politically appealing program that would save the common market and recapture the European Union as the idealistic vision that fired people’s imagination. The common front could then present Germany with the choice: lead or leave. The objective would not be to exclude Germany, but to radically change its policy stance.
Unfortunately, France is not in a strong position to form a united front with Italy and Spain in the face of determined opposition from Germany. Chancellor Merkel is not only a strong leader but also a skilled politician who knows how to keep adversaries divided. France is particularly vulnerable because it has done less than Italy or Spain to accomplish fiscal consolidation and structural reforms. The relatively low risk premium that French government bonds currently enjoy is due almost entirely to France’s close association with Germany. Asian central banks have been buying French bonds, especially since German Bunds have started selling at negative yields. Should France ally itself too closely with Italy and Spain, it would be judged by the same yardstick and the risk premium on its bonds may rise to similar levels.
Admittedly, the advantages of being in the same boat with Germany are liable to become illusory once a prolonged depression descends upon Europe. As the fault line between Germany and France becomes more apparent, financial markets are liable to reclassify France with Italy and Spain whether or not it remains faithful to Germany. So France’s real choice is, on the one hand, between breaking with Germany to save Europe and restore growth or, on the other, pretending to be in the hard currency boat for a limited time, only to be thrown overboard later. Taking the side of the debtor countries and challenging the policy of austerity would allow France to resume the position of leadership it held during Mitterrand’s presidency. That would be a more dignified position than being a passenger with Germany in the driver’s seat. Still, it would take great courage for France to part ways from Germany in the short run.
Italy and Spain have other weaknesses. Italy has proven itself incapable of maintaining good governance on its own. Its current debt problems were accumulated before it joined the euro; as a member it actually had a better record of primary budget surplus than Germany—even during much of the time when Berlusconi was in power. But Italy seems to need an outside authority to rid itself of bad governance. That is what has made Italians so enthusiastic about the -European Union. Spain is much healthier politically but the current government has become far too subservient to Germany for its own good. Moreover, the reduction in risk premiums as a result of the ECB’s bond purchases will be significant enough to remove the incentive to rebel against German domination.
The campaign to change German attitudes will therefore have to take a very different form from the intergovernmental negotiations that are currently deciding policy. European civil society, the business community, and the general public need to mobilize and become engaged. At present, the public in many eurozone countries is distressed, confused, and angry. This finds expression in xenophobia, anti-European attitudes, and extremist political movements. The latent pro-European sentiments, which currently have no outlet, need to be aroused in order to save the European Union. Such a movement would encounter a sympathetic response in Germany, where the large majority is still pro-European but under the spell of false fiscal and monetary doctrines.
Currently, the German economy is doing relatively well and the political situation is also relatively stable; the crisis is only a distant noise coming from abroad. Only something shocking would shake Germany out of its preconceived ideas and force it to face the consequences of its current policies. That is what a movement offering a workable alternative to German domination could accomplish. In short, the current situation is like a nightmare that can be escaped only by waking up Germany and making it aware of the misconceptions that are currently guiding its policies. We can hope Germany, when put to the choice, will choose to exercise benevolent leadership rather than to suffer the losses connected with leaving the euro.
4 As interbank lending is resumed, Germany may even prefer to remain a member of the TARGET2 clearing system and allow balances to wind down gradually rather than taking an immediate loss. ↩
Germany & the Euro October 25, 2012
As interbank lending is resumed, Germany may even prefer to remain a member of the TARGET2 clearing system and allow balances to wind down gradually rather than taking an immediate loss. ↩