Comment on “The Tragedy of the European Union” by George Soros

Misdiagnosing the causes of any crisis is costly. To give the right medicine, it is critically important to distinguish between the symptoms and the root causes of the crisis. Following the argument of George Soros, the transfer of monetary policy competencies to the ECB without establishing a true fiscal union lies at the heart of the crisis in Europe. Thus, sovereign credit of the (weaker) member states that are lacking an implicit guarantee from their central banks that cash will always be available to pay out the creditors is exposed to the risk of liquidity runs, contagion and self-fulfilling default. Many other design flaws add to the complexity of the current situation.

The rationale of the European monetary unification process was not only based on an economic cost-benefit analysis. Economic grounds were to be seen together with the strong political will for integration on the part of policy-makers, which is deeply rooted in the traumatic history of Europe. Monetary unification was seen as a vehicle to strengthen integration and coordination in other fields. And the established governance structures of the economic policy coordination procedures were not designed on the basis of theoretically optimal economic policy considerations. They were the outcome of a political compromise. The crisis has laid bare its fundamental and deep flaws, errors that were well articulated by some economists even in the very beginning of the planning period of EMU.

The institutional flaws have now been identified and in the last few years there was growing consensus on the necessity to fix them.

Effective crisis resolution can be boiled down to two elements. First, a mechanism for provision of liquidity is key, above all, to correct the dysfunctions of interbank and capital markets. Several steps have been taken, including the creation of the European Financial Stability Facility (EFSF), the European Stabilisation Mechanism (ESM) and the set-up of the OMT (Outright Market Transactions), the new program of the ECB to purchase government bonds in the secondary market without announcing any limits in advance.

Second, liquidity provision requires strict conditionality to avoid moral hazard, for instance by establishing elements of a fiscal union, such as the fiscal compact. Unconditional funding of some member states and banks, though in some urgent cases reasonable on economic grounds, would lack political support and democratic legitimacy. The integrated supervision for European banks can also be seen as part of conditionality. Further, a banking union, comprising a centralized banking supervision mechanism, as well as a resolution regime to ensure that unsecured creditors rather than taxpayers bear the cost of future bank failures, serves the purpose of breaking the diabolical negative feedback loops between national sovereign and banking crisis.

The measures taken so far undoubtedly fall short of optimal crisis resolution mechanisms that are designed by economists on a drawing board. And they were not set timely and decisively enough. But they do reflect the maximum possible given the numerous constitutional and political constraints economic policy-makers are facing today in Europe. Given these constraints, progress has been remarkable. Building and reforming institutions as well as transferring sovereignty to the center requires an inclusionary democratic process. It takes time to win the minds of European citizens. But time is in precariously short supply given the risks of liquidity runs and contagion. Striking the right balance between effective and timely crisis management and striving for political acceptability of the measures taken is an extraordinary challenge economic policy-makers are faced with in the upcoming months.

The analytical part of George Soros’ considerations is quite appreciable, as well as his visible empathy for the European project. Crisis resolution requires joint responsibility of all member states while each has to deliver its maximum for the benefit of the whole. But there is doubt whether his recommendation of Germany leaving the euro (in case it rejects to fully back the euro, to act as a benevolent hegemon) may be part of a reasonable and viable solution at all. Any exit from the euro incurs huge and uncontrollable risks and involves balance sheet adjustments in the course of the redenomination of assets and liabilities, irrespective of the origin of the country leaving. And it might find imitators, which puts the whole European project at risk. Given the severe hardships this option would create for Germany, the recommendation can be viewed as a wake-up call rather than a proposal to be taken seriously. But addressing just Germany with this call is probably too narrow a perspective.

Restructuring long-established economic imbalances and governance arrangements takes time. Buying time is a reasonable way to go.

Ewald Nowotny is Governor of the Austrian National Bank

George Soros
The Tragedy of the European Union

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Tr@nsit online, 2012
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