Europe has been in a financial crisis ever since 2007. When the bankruptcy of Lehman Brothers endangered the credit of financial institutions, financial markets had to be put on artificial life support. That meant substituting the credit of the state for the financial credit that was no longer accepted by the markets. The emphasis on sovereign credit revealed a flaw in the construction of the euro that had remained unrecognized either by the markets or the European authorities until then. By transferring their right to print money to the European Central Bank, the member states exposed their sovereign credit to the risk of default. This put some of them into the position of third world countries that had become heavily indebted in a foreign currency. It has also rendered the commercial banks whose balance sheets were loaded with the bonds of the weaker countries potentially insolvent. So the euro crisis is a direct consequence of the global financial crisis of 2007-8.
There is a close parallel between the euro crisis and the international banking crisis of 1982. Then the IMF and the international banking authorities saved the international banking system by lending just enough money to the heavily indebted countries to enable them to avoid default but at the cost of pushing them into a lasting depression. Latin America suffered a lost decade.
Today Germany is playing the same role as the IMF did then. The setting differs, but the effect is the same. The creditors are in effect shifting the whole burden of adjustment on to the debtor countries and avoiding their own responsibility for the imbalances. Yet they were largely responsible not only for the faulty design of the euro but also for continuing to enforce rules that aggravated the situation.
The euro crisis was a composite of banking and sovereign debt problems which were tied together like Siamese twins as well as divergences in economic performance which gave rise to balance of payments problems within the Eurozone. The authorities did not understand the complexity of the crisis, let alone see a solution. So they tried to buy time.
Usually that works. Financial panics subside and the authorities realize a profit on their intervention. But not this time, because the financial problems were combined with a process of political disintegration. When the European Union was created, it was the embodiment of an open society – a voluntary association of equal states that surrendered part of their sovereignty for the common good. The euro crisis is now turning the European Union into something fundamentally different.
The member countries are divided into two classes – creditors and debtors –, with the creditors in charge. As the strongest creditor country, Germany is emerging as the hegemon. Under current policies, debtor countries pay substantial risk premiums for financing their government debt and this is reflected in their cost of financing in general. To make matters worse, the Bundesbank remains committed to an outmoded monetary doctrine that is deeply rooted in Germany’s traumatic experience with inflation. The Bundesbank recognizes only inflation as a threat to stability and ignores deflation, which is the real threat today. Germany insists on imposing austerity on debtor countries. This can easily become counterproductive because a reduction in GDP causes an increase in the debt ratio.
There is a real danger that a two-tier Europe will become permanent. 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 is seething with discontent.
This is not the result of some evil plot but of a lack of coherent policies. German politicians, however, have started to figure out the advantages it has conferred on Germany and this has begun to influence their policy decisions. As time passes, there are increasing grounds for blaming Germany for the policies it is imposing on Europe, while the German public is feeling unjustly blamed. This is truly a tragedy of historic significance. As in ancient Greek tragedies, misconceptions and the sheer lack of understanding have unintended but fateful consequences.
Germany, as the largest creditor country, is in charge but refuses to take on any additional liabilities; as a result every opportunity to resolve the crisis has been missed. The crisis spread from Greece to other deficit countries and eventually the very survival of the euro has come into question. Since a breakup of the euro would cause immense damage, Germany is doing and will continue to do the minimum necessary to hold the euro together.
Most recently, Chancellor Merkel has backed Mario Draghi and left Bundesbank President Jens Weidmann isolated on the Board of the European Central Bank. This will enable the ECB to put a lid on the borrowing costs of countries that submit to an austerity program under the supervision of the Troika. That will save the euro but it is also a step towards the permanent division of Europe into debtors and creditors. The debtors are bound to reject a two-tier Europe sooner or later. If the euro eventually breaks up in disarray, it will destroy the common market and the European Union. Europe will be worse off than it was when the effort to unite it began, because of a legacy of mutual mistrust and hostility. The later it happens, the worse the ultimate outcome. That is such a dismal prospect that it is time to consider alternatives that would have been inconceivable until recently.
In my judgment, the best course of action is to persuade Germany to choose between either leading the creation of a political union with genuine burden sharing or leaving the euro.
Since all the accumulated debt is denominated in euros it makes all the difference who remains in charge of the euro. If Germany left, the euro would depreciate. The debtor countries would regain their competitiveness; their debt would diminish in real terms and, with the ECB in their control, the threat of default would disappear and their cost of borrowing would fall to a level comparable with that of the UK. The creditor countries, by contrast, would encounter stiff competition in their home markets from the euro area and incur losses on their claims and investments denominated in euro. The extent of their losses would depend on the extent of the depreciation; therefore creditor countries would have an interest in keeping the depreciation within bounds. After initial dislocations, the eventual outcome would fulfill John Maynard Keynes’ dream of an international currency system in which both creditors and debtors share responsibility for maintaining stability. And Europe would escape from the looming depression.
The same result could be achieved, with less cost to Germany, if Germany chose to behave as a benevolent hegemon. That would mean 1) implementing the proposed European banking union; 2) establishing a more or less level playing field between debtor and creditor countries by first establishing a Debt Reduction Fund and eventually converting all debt into eurobonds; and 3) aiming at nominal growth of up to 5%, which would allow Europe to grow its way out of excessive indebtedness. However, this would entail a greater degree of inflation than the Bundesbank is likely to approve.
Whether Germany decides to lead or leave, either alternative would be better than creating a two-tier Europe.
1. Debt issued under domestic law can be
re-denominated into the domestic currency, debt issued under foreign law cannot.
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