Tag Archives: Eurozone

The Euro does not need a federal superstate to prosper

The Euro crisis is in one of its quiet phases. But few are foolish enough to think that its future is now secure. It is often said that the currency is destined to fail because of a fundamental economic law which means that you cannot operate a successful currency without the full authority and resources of a state behind it. The Euro needs to the apparatus of a federal superstate to survive, it is said. One Tory MP even suggested that the Euro’s promoters were committing fraud to suggest otherwise. But, for all that many in Brussels want it, establishing such a superstate is not politically feasible. And yet it is possible to see emerging the institutional architecture that will allow the Euro to survive and prosper without it. It’s a hard road, but there are enough benefits for the currency’s members to persist with it.

There are four key elements to the architecture. The first is an obvious one: a powerful European Central Bank (ECB), able to do what it takes to ride out the various crises that financial markets will throw at the system. The current ECB has proved up to the task, albeit by pushing at the boundaries of its formal powers, for example by buying the debt of member governments on the secondary market. Confidence that it can handle future crises is growing, adding to the overall stability of the system. And yet this power has its limits; it cannot transfer taxpayer funds from one country to another (referred to as “fiscal transfers” by economists), in the way a federal government could. The Euro has to find a way of existing without the sort of massive fiscal transfers that you see in the United States, for example.

In its place is the second element: provisions for states to default on their debts. This has been resisted tooth and nail by Euro federalists, but at long last it has been implemented for Greece. Alongside this, a crisis infrastructure is emerging, including crisis funds to support governments that are in the process of restructuring their obligations. This whole process needs to go further: publicly held government debt, e.g. that bought by the ECB, needs to be included, for example. Greece will surely need another restructure. But we are seeing the different nations’ bond prices reflecting the risk of default, and this imposes a discipline on government finances. And no government will want to follow the humiliating path of Greece into default, if they can help it.

There remains the problem of managing the banking system, which is very much run along national lines. While Greece got into trouble because of a profligate government, Ireland, Spain and Cyprus were brought down by banking crises. At first the response to a banking crisis was for governments to underwrite all banks’ creditors in order to restore confidence. Many applauded the Irish government when they did this early in the crisis; but it is a terrible idea, transferring liabilities from various people who should have known better to taxpayers who could ill afford it. Therefore the third element of the new architecture is to force bank creditors to pay, or at least contribute to, bailing out bust banks, referred to as “bailing in”. This solution was put in place for Cyprus, and hopefully will be the pattern in future. Of course it remains possible for financially strong governments, like Germany’s, to stand behind their own banks – but this should be discouraged. It is essential for discipline to be brought back into banking, and the system whereby bankers keep the profits and pass losses on to taxpayers has to be terminated.

But this approach is undeniably destabilising; it adds to the risk of bank runs. The obvious solution to this is to establish a Europe wide deposit insurance scheme, just as America has its federal scheme. Initially European governments seemed to favour this, but as they grew to understand its full implications, possible taxpayer transfers between states and increased central regulation, they have backed off. This has left us with the fourth and final element of the new architecture: emergency capital controls. This has been implemented for Cyprus, where depositors at Cyprus banks are suffering severe limits to their ability to move money out. It is an ugly process, and represents a big step bank from the integrated ideal of the Euro. The third and fourth elements in particular mean that a Euro held in a German bank is worth more than one held in a Portuguese one, say. But this is better than the alternatives, which attempt to wish financial risks away into an anonymous federal centre.

I believe that these four elements can evolve into a system that will give the Euro long lasting stability, and a better distribution of risk than a federal system would. We must remember that systems of human relations are only in a small part dependent of formal laws and powers, and much more based on expectations of how people should and will behave. This is how the management of the Euro is evolving. In the early days those expectations were wholly unrealistic, and ultimately required some kind of federal system to underwrite them. Now that we know this cannot be, new expectations are evolving. This is a bit like the way the British constitution and Common Law develops.

But is it worth it? Is it a loveless marriage between southern economies locked into permanent austerity, and more dynamic northern ones which are constantly being dragged down by their neighbours? (And France which manages to be on both sides of this equation at once!) If so the enterprise will lose political support and die anyway.

This question deserves a post all to itself, but I believe that all this pain has benefits to both sides. For the southern economies, joining the Euro was all about converging with their rich northern neighbours and their higher standard of living. Unfortunately they at first thought this would be easy. Lower interest rates and hot money from the north created a short term boom, but could not do the trick. Endless tax transfers (like between north and south Italy), are not on offer, and probably wouldn’t work either. In order to raise living standards the southern economies will have to undertake a painful series of reforms, rather in the way Britain did in the 1980s, Sweden in the 1990s, and, to a lesser extent, Germany in the 2000s. The process is starting, and the new disciplines of the Euro zone help this.

And for the northern economies of Germany, the Netherlands and Finland? Being in the Euro gives them a more stable economic environment, at a time when the global economy has been destabilised by the rising of China and other emerging markets. With a lower exchange rate than otherwise they have been able to preserves their exporting industries and maintain a degree of social stability. You only have to look at Britain to see what might have happened otherwise. There a short-term boom and appreciating exchange rate led to a flooding in of cheap imports and a hollowing out of export industries. Living standards grew for a while, but it could not last. The country is still struggling to escape the bust of 2008/09, with exports remaining weak.

The first decade and a half of the Euro has not been a happy experience, taken as a whole. But these are difficult times for developed world economies. In these circumstances the Euro remains a good idea, and indeed eastern European countries are still queuing to join. In the rough, interconnected world that is the modern economy, living with a freely floating currency is much harder than many would have you believe.


The Euro crisis: structural failure or learning curve?

Coverage of the crisis in the Eurozone is astonishingly poor.  Commentators scarcely try to analyse the situation properly; instead they revert to one of two unsatisfactory critiques.  First, the Eurosceptic one, is that the Eurozone was always an unworkable idea and the best thing to do is abandon the whole thing.  The alternative, the Europhile critique, is that a currency union without political integration was a major mistake, and the best thing to do is move further towards the political integration of the union.

These positions are both unhelpful.  The Eurosceptics fail to see the benefits of the currency union, the awful logistics involved in unpicking it, or the unsatisfactory nature of floating currencies for most countries.  The Europhiles want to drag European peoples down a road they do not want to go.  There is a third way: that Eurozone governments change their countries’ economic arrangements so that they can live within the currency zone, more or less as it is currently configured.  This crisis is a learning experience.

The more far-sighted of the Eurozone’s designers did not want full political integration.  It was never to be a currency zone like the USA, with a federal government able to make massive fiscal transfers across the union to help balance out asymmetric crises.  Instead the single currency, alongside the single market, was meant to act as a discipline on national governments.  This would address the widespread failure of floating currencies, which allowed governments to buy time through currency depreciation rather than addressing economic inefficiency.  This was a process leading inexorably to hyperinflation and economic collapse – which was very clearly beckoning for Portugal in particular before the Euro project was taken on board.

Discipline was required in two particular areas: government finances and labour markets.  In the former case discipline is to be provided by the threat of default; in the zone it was impossible to evade default by debauching the currency.  The consquences of a sovereign default are very severe, and European leaders sought to prevent it through the muddled Growth & Stability Pact, which sought to restrict deficits and levels of government debt.  For labour markets the discipline was that without flexible labour markets, economies would become uncompetitive, creating unemployment.

But things went badly wrong almost immediately.  Bond markets did not seem to believe the default story, as spreads between the more creditworthy governments (like Germany) and the less so (Italy and Greece) were impossibly narrow.  Governments in the shakier countries (especially Italy, Portugal and Greece) found it much too easy to borrow cheaply and used this as an excuse for not proceeding with reform.

Labour markets were largely untouched by reform, as were other economic inflexibilities.  This caused major problems in Spain, Portugal, Italy and Greece whose economies became increasingly uncompetitive.  Only one country (apart from Ireland perhaps) really grasped the implications of living inside the Euro, and that was Germany.  After unification the German economy lost competitiveness and unemployment became a real problem.  But through its system of corporate deal-making between employers and unions, pay was restrained and other reforms instituted.  Competitiveness was duly restored, as was employment.  Unfortunately that made things worse for the laggards.

While the Eurozone had proved a failure in these two areas it proved a bit too successful in another: capital flows.  There was a lot of reckless lending, with quasi-public banks in Germany in prominence.  Capital flowed freely to countries, like Spain and Ireland, that didn’t really deserve it, allowing problems to be hidden in a property bubble.  And then Pop!  The Eurozone has lurched from one crisis to the next.

But the basic idea remains intact.  Markets now fully appreciate the risks of default and are pricing debt accordingly.  This is applying pressure on governments like Italy’s that the Growth & Stability Pact simply could not.  And the pressure to make market reforms is likewise proving unbearable.  It’s been a horrible experience for many, but this is not a structural failure: it’s a learning curve.

So what next?  The Greek government must default, and default properly (i.e. the principal must be cut rather than repayment simply deferred).  Maybe it will be forced out of the Euro.  If so, it will be a terrible example.  Some eurosceptics make it all sound rather easy (“decouple, default, devalue”), but it involves the utter collapse of the Greek economy with private savings being wiped out.  The hope would be that it would be easier to rebuild from the ashes than interminable limping along inside the zone.  Portugal and Ireland (whose crime was not to manage its banking system properly) may also go through some form of de-facto default.  But they will stay in the zone.  Portugal must go through a painful period of reforms, but at least for them this path is clearly better than being outside the Euro.

Meanwhile the Euro governments need to keep “kicking the can down the road”.  This is not as short-sighted as it sounds, since with each kick the various parties invovled understand the situation better and what needs to be done.  The default word is now openly talked of.  German bluster over not bailing out the profligate is gradually having to come to terms with the role German banks played in the disaster.  There is learning for the Germans too.  Bold decisive action can be disastrous – it didn’t help the Irish.  This way things are properly thought through.

Reforms?  Fiscal reforms are unnecessary.  But the banking system does need serious attention.  The regulatory system is badly coordinated.  There are too many cosy quasi-public banks who have been allowed to make silly investments.  Banks remain largely national affairs, with only a limited number of transnationals.  There is strong case for a centralised banking regulator.  And cross-border banking mergers need to be encouraged.

But the Eurozone is not dead; and neither are we on the verge of a more centralised European government.