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.