Anton La Guardia

The ailing euro

Does the eurozone face a long and unnecessarily painful road to recovery or a long and painful death?

Soon after taking up my post in Brussels for The Economist, I visited Estonia in December 2010. I was curious about this small and relatively poor country, with a tortured history, that was bucking the economic trend of the rest of the European Union.

While almost all of its peers were officially in excessive deficit, breaching the limit of 3% of GDP, Estonia had the lowest deficit in the EU - even though it had just undergone a brutal recession. While EU countries strained under an average debt burden of about 80% of GDP, Estonia's debt seemed absurdly low, at 8% of GDP. And while many of us in Brussels were busy speculating about whether and how the euro would break up, Estonia was enthusiastically preparing to join the single currency on the upcoming New Year's Day.

The Bank of Estonia's small basement museum, displaying the bewildering succession of currencies that have circulated in Estonia, encapsulates the country's tumultuous history. There were roubles (tsarist and Soviet), marks (imperial and Nazi) and, among these, a cherished era of Estonian money, from 1919 to 1940. After the break-up of the Soviet Union, the kroon was restored in 1992, a symbol of independence regained. The new kroon survived only a bit longer than the old one. The difference this time was that it was being surrendered voluntarily. For all the mixed feelings about losing the coins with the three lions, and adopting the bland euro banknotes with their fictitious bridges, the currency change was seen not as a loss of sovereignty but as an enhancement of national security: a step closer to 'Europe' in the west and further away from Russia in the east.

Economists argued that adopting the euro would also strengthen Estonia economically. Pegged from the outset to the D-mark and then the euro, the kroon was hardly independent. Abandoning it would end speculation about devaluation, reduce transaction costs, lower interest rates and boost investment.

But there was also a sense of irritation. Though poorer than the most troubled euro-zone states, Estonia would have to contribute to the rescue of richer (and more profligate) partners. Estonia's leaders could not understand the hesitation of other European governments to get a grip of their public finances. Anti-austerity protesters may have been flying the red flag in southern Europe, but there were none to be seen in Estonia when it underwent its adjustment. Estonians would joke that having endured the Nazis, the Soviets and hyper-inflation, they could take a few years of belt-tightening.

The correct response to the euro crisis is much debated by economists. But the course of the debt crisis, and ultimately the fate of the euro, will be determined as much by politics as by the precise nature of macro-economic adjustment. Will the debtor states rebel against austerity? Will the creditor states get fed up with supporting others? Or will governments find the political will, and secure the democratic legitimacy, to embark on a process of much deeper fiscal, economic integration that is needed to stabilise the single currency?

The problem with the euro

The eurozone bound diverse economies in a single exchange rate and a single interest rate. Plainly, it is far from being an optimal currency area. That said, most currency unions are not optimal. The difference between the euro and other currency areas is that it lacks the flexibility to make it work (labour mobility in Europe is lower than in the US or Canada) as well as the tools to absorb asymmetric shocks. It took a British prime minister, David Cameron, a self-declared Eurosceptic, to sum up the problem. Successful currency unions, he said, had some vital features in common: a lender of last resort for the state, economic integration and flexibility to deal with shocks, fiscal transfers and collective debt. "Currently it's not that the eurozone doesn't have all of these; it's that it doesn't have any of these," Cameron said. The most passionate Euro idealist could not have put it better.

The result has been perverse. If the European Union and its single market were once a great 'convergence machine' for the economies of its members, as a recent World Bank report put it, the single currency has become an infernal engine pulling them apart. Spain and Greece are suffering from mass unemployment, yet joblessness in Germany is at a record low. The bond yields of peripheral European states may have blown out; but Germany enjoys remarkably low borrowing costs.

Southern Europe, in particular, has suffered a triple blow: the Mediterranean countries were hit hard by globalisation and the loss of low-tech industries such as textiles; they faced competition from cheaper labour in ex-communist member states when the EU was enlarged eastward; and the adoption of the euro made it hard for southern countries with a tradition of high inflation to adjust through the time-tested method of devaluation.

Without a lender of last resort in the European Central Bank, which is prevented from lending directly to governments, members of the eurozone are akin to developing countries using a foreign currency: they are more easily pushed into insolvency when the markets panic. Britain and Spain have similar levels of debt and deficit, yet Britain's borrowing costs are low while Spain's are close to being unsustainable.

The eurozone's response to the crisis so far has been slow, hesitating and erratic. That said, countries in danger of collapse have been rescued with hundreds of billions' worth of loans. Greek debt has been belatedly restructured. Financial firewalls have been built and expanded. Brussels has been given greater powers to monitor national economies, and demand changes of policy backed with the threat of 'semi-automatic' sanctions. A fiscal compact, enshrining balanced-budget rules, has been negotiated and signed. The European Central Bank has intervened sporadically and controversially, buying up government bonds in secondary markets and spraying banks with €1 trillion worth of cheap three-year liquidity.

It is possible that, had all this been done sooner and more decisively, the euro crisis might have been arrested. If Greece's debt had been recognised immediately as unsustainable and restructured rapidly, if its first loans had been granted on concessionary rather than punitive terms, if it had been told to concentrate on structural reforms rather than drastic budget-cutting, if the ECB had been willing to wield the big bazooka more convincingly, if...if...then perhaps financial contagion might not have spread so far.

As matters stand, the crisis goes on. Indeed, in some ways it is getting worse. Spain is a far larger problem than Greece, Ireland or Portugal, and it could drag down Italy and perhaps even France. The firewalls, though enhanced, are inadequate to deal with this scale of problem. The relief from the central bank's liquidity was short-lived, and loaded banks with even more dodgy sovereign bonds. Above all, the patient has not responded to the austerity medicine.

The treatment has been inadequate on two fronts: it has focused, for the most part, only on individual symptoms rather than the underlying disease. And it is unlikely to be sustainable politically. The simplistic diagnosis, offered mainly by Germany, is that the problem is due to profligacy in public spending. There is an angry self-righteousness about German officials these days: it is a mixture of boastfulness about the merits of the German model, and resentment about being forced to stake hundreds of billions of euros to help others. The German word for debt, Schulden, is derived from Schuld, which also means guilt. Urged by Americans to do more to stabilise the euro, German officials reply that you cannot fight debt with more debt: the answer is fiscal consolidation to restore public finances and structural reforms to regain competitiveness.

Some of this therapy is needed. But the problem is more complex. The eurozone is afflicted by three interconnected ills: a sovereign-debt crisis, a banking crisis and a growth crisis. Dealing with one often makes the others worse. Weak banks weaken sovereigns that are called upon to bail them out; weak sovereigns impair banks that hold their bonds. Poor growth enfeebles both the sovereigns and the banks. In turn, cutting deficits reduces growth, as does reduced lending by banks trying to restore their balance-sheets.

The underlying cause is not so much high budget deficits (though Greece certainly lied about its free-spending ways) but the current-account deficit, i.e., the net foreign borrowing by all actors, public and private (say to finance a trade deficit). Spain and Ireland were running budget surpluses before the crisis, yet were crippled by the puncturing of housing bubbles inflated by high private borrowing. Without the ability to devalue the currency or adapt monetary policy, redressing the imbalances must come through 'internal devaluation': bringing down real wages and prices relative to those of competitors. This was easier before 1991, when inflation around the world was higher, but has rarely been achieved since then. With the ECB determined to keep inflation at around 2%, internal devaluation brings severe recession, even deflation.

A return to growth would relieve many of the strains. But for all the excited talk of a new 'growth compact' in the wake of the expected election of Francois Hollande, the Socialist candidate in the French presidential election, there is little agreement on how it might be achieved.

Forget the idea of an expansionary fiscal contraction. Time and again, deficit-cutting targets have been missed because recession has turned out to be unexpectedly deep. Indeed, the latest evidence is that, in a downturn, the multiplier effect of fiscal belt-tightening is more acute, leading to even deeper recession. That said, fiscal stimulus is out of the question for most, particularly countries under pressure in the bond markets. Debt in many advanced economies has reached levels exceeded only during the second world war, and all the evidence is that high debt stifles long-term growth. Sooner or later, most European countries will have to start working off their debt. So the trick will be to relax the pace of deficit-cutting in the short term, while reassuring markets with a credible programme of debt reduction in the medium and long term.

Structural reforms are vital to boosting growth, but these are unlikely to produce big results in the short term. Deepening the single market, particular in services, would help too, but any change will be slow. Even now, a new European patent system is being held up by a dispute between France, Britain and Germany over the location of a new patent court. Maybe Estonia should put up its hand to host it.

Solutions, in theory

So what should be done? Economists are full of ideas, particularly when the problem is addressed Europe-wide and rather than simply in terms of adjustment in the most troubled economies.

In macro-economic policy, deficit countries could cut payroll taxes to reduce labour costs and raise VAT to discourage imports; the effect would be magnified if surplus states did the opposite. Germany could help by stimulating its economy through spending or tax cuts, or at least by slowing down its own budget consolidation. The ECB could loosen monetary policy further and let inflation run higher, especially in Germany, to give more space for southern countries to regain competitiveness without being pushed into self-defeating deflation.

Moreover, the euro's design flaws need to be repaired through greater fiscal federalism. A 'banking union', with a European system to wind down or recapitalise troubled banks and a Europe-wide bank-deposit insurance scheme, would help break the feedback loop between weak banks and weak sovereigns. A 'fiscal union' in which all or part of the national debts are mutualised as joint Eurobonds would stop markets pushing sovereigns into insolvency, and would create a European asset that banks could hold. Moreover, if these were financed through federal taxes Eurobonds would be even more of a safe asset. Instead of providing liquidity indirectly to banks, the ECB could declare that it stands fully behind solvent sovereigns, just as the Fed stands behind the America government.

All this makes economic sense. America has worst deficit and debt levels than the euro-zone in aggregate terms, yet the dollar is a refuge for investors fleeing the euro. If the American system has been fired into financial granite; the euro is still crumbly chalk.

The question is: is such transformation feasible politically, or even desirable?

What about the politics?

The crisis has pushed European governments further and faster down the road of economic integration than many would have expected. But it is also raising profound questions about sovereignty and national identity.

When the newly-elected Belgian government was told by the Commission it had to do more to balance its public finances or face the threat of EU sanctions, one minister lashed out: "Who knows Olli Rehn? Who has ever seen Olli Rehn's face? Who knows where he comes from and what he has done? Nobody. Yet he tells us how we should conduct economic policy. Europe has no democratic legitimacy to do this."

Olli Rehn, in case anyone does not know, is the Finnish commissioner for economic and monetary affairs. He speaks softly, but carries a big stick: the power to scrutinise national budgets, demand changes to economic policies and to recommend sanctions, which must be approved by ministers 'semi-automatically', i.e., they can only be blocked if there is a weighted majority against them. This month his economic forecasts will set the stage for 'country-specific recommendations'. The big test will come if France is deemed to be missing its target to bring the deficit below 3% of GDP next year. Will Mr Rehn really tell a newly elected French president how he can and cannot spend French taxpayers' money?

The political problem runs deeper still. To judge from the first round of the French presidential election, the fall of the Dutch government, and opinion polls in Greece, resistance against austerity is rising. And a big chunk of the electorate is supporting anti-immigrant, anti-EU parties. It is often the low-skilled and poorly educated - the supposed losers from globalisation - who are most openly in revolt. For them, the EU is not the solution but the problem. It has brought either austerity, or migrants, or unwanted economic competition, or all three.

Wittingly or unwittingly, the EU erodes national democracies in several ways. It eviscerates national governments, who are seen to be increasingly powerless as competences are shifted to Brussels. The EU, moreover, imposes itself to an unprecedented degree on the policies of member-states, especially in economic policy. And the Brussels institutions are too remote and Byzantine for citizens to feel they have a direct say in the decisions they take.

Legislation is proposed by the European Commission, the EU's civil service (drawn up behind closed doors by an appointed college). Laws must then be approved by the Council of Ministers (where governments also strike bargains behind closed doors) and the European Parliament (where alliances shift from issue to issue). Differences must then be resolved by haggling among all three bodies. The system is accountable to lots of people, but not directly to voters.

Much of the time citizens do not much notice or care. The EU's business is often too technocratic and complex to evince strong political emotions. But the development of 'economic governance' is a different matter. If voters cannot choose how wealth is created, spent and distributed, what is the point of national democracy? A voter can throw out a government that drives the economy to the wall. But he or she cannot throw out the bums in Brussels if Mr Rehn and his colleagues screw up. The IMF, for instance, quite openly thinks the eurozone is getting its policy horribly wrong.

Increasingly, the talk in Brussels is of increasing the powers of the European Parliament, having pan-European parties run for election, holding direct elections for the president of the European Commission and, perhaps, merging the post with that of the president of the European Council (who represents leaders and chairs their summits). European governments and citizens may have other ideas.

Hamilton and all that

The problem of fragility of the eurozone, and of the EU's democratic deficit, comes down to the same question: the hybrid nature of European economic and political integration, and the ambiguity about the ultimate aim of the European project. Is the EU it a collection of sovereign states, like the United Nations? Or is it the start of the United States of Europe?

If it is an international organisation, then most power must remain with sovereign governments and Brussels must be subservient to them. The European Commission must be a mere arbiter between members, messy as this may be. But if the EU, or maybe just the eurozone, is a proto-federation, then the problems are more easily resolved. More fiscal federalism will stabilise the euro, and more political federalism will grant a greater democratic mandate to European institutions.

Politicians have long avoided the question. Indeed, the European project has only been able to move forward by retaining a large dose of ambiguity about the finalite politique: the political end-point. The method devised by Jean Monnet, the EU's forefather, was to move in half-steps, justified on technocratic merit. This allowed euro-enthusiasts to claim they were making another step towards federal Europe and euro-sceptics to insist that national interests were being preserved. When problems cropped up, another half-step might be called for. Or if a proposal for integration ran into resistance, the European bureaucracy would wait for a more propitious political alignment.

For decades time was deemed to be on the side of the European project, slowly eroding national frontiers and building up a sense of European common purpose. Legitimacy for Europe, though imperfect, would be secured through concrete achievements: prosperity and freedom of movement.

But the crisis has inverted this equation. Time is running against the euro. Markets demand answers: is the euro a coherent economic zone that will survive, or merely a collection of national units that can and will break up? As long as they suspect weaker members will fall out of the euro, they will dump their bonds. And the more the crisis drags on, the more citizens become disenchanted with the European project.

At such moments, Eurocrats reach for American history books for inspiration. The Federalist papers of 1787-88 argue that trying to coerce a group of sovereign states to follow common rules is ultimately doomed. Leagues and confederacies are like feudal baronies: sooner or later somebody breaks the rules. And attempts to bring them into line lead to anarchy, tyranny and war. Europe is not at the point where, as the Federalist papers argue, it is about to revert to "bloody wars in which one half of the confederacy has displayed its banners against the other half." But many a citizen feels an economic conflict is well underway.

For Alexander Hamilton, the leading author of the Federalist papers, the solution to the problem was to create a strong American federal government, acting directly on the citizen rather than through the constituent states. With the adoption of America's federal constitution, Hamilton became treasury secretary. The federal government assumed the war debts of the ex-colonies, issued new national bonds backed by direct taxes and minted its own currency. Hamilton's new financial system helped transform the young republic from a basket-case into an economic powerhouse.

So will Europe have its Hamiltonian moment? Probably not. America in Hamilton's time was a young, post-revolutionary republic. Its founding fathers had the prestige to refashion the nation to confront military and economic threats. Hamilton's assumption of state debt was contentious: virtuous states did not think they should pay for lax ones. Yet for Hamilton, assuming the debt was a necessary price of liberty. Europe, by contrast, is an older and more diverse place, with each country boasting of a national identity often forged from conflict with others. There is no European demos.

America resolved the question of national identity first, by fighting a war of independence and creating a political union. From there it was easier to create a fiscal union. But Europe is doing things backwards. It created the euro partly in the hope of fostering political union. Fiscal integration is being pushed not to preserve freedom and a new nation, but to save a failing currency and a political project supported mainly by the elite.

In any case, the embers of Europeanism are dying. The memory of the second world war is fading, and the old Soviet foe has collapsed. And who, among today's mediocrities could pretend to be a new Hamilton? The crisis has confirmed countries in their prejudices. Germans see Greeks as indolent and corrupt; do they really want to commit the German chequebook to Greece fully and indefinitely? And having portrayed Angela Merkel and Wolfgang Schauble as the embodiment of the old Nazi invader, are Greeks ready to be forever bound to German strictures?

If the eurozone cannot, or will not commit to deeper integration, then it would be wise to consider how disintegration might take place, and how best to manage it. Would it be better for strong states like Germany to leave? Or would it be best to cut off the weakest members? This is an uncomfortable discussion. Merely being heard to talk about such things may exacerbate the crisis.

As is apparent from the submissions to the Wolfson prize in Britain, to be conferred on the authors of the best plan for monetary divorce, a break-up would be acutely painful for all. That helps

explain why, for all the disenchantment, leaders are straining to keep the euro going. Nicolas Sarkozy may have been ready to wreck the Schengen free-travel zone in his call for the restoration of national borders, but he knew better than to talk of a restoration of national currencies. But someone, somewhere needs to be thinking about an orderly break-up, because the most agonising way to go would be a chaotic collapse that would wreck the other benefits of European integration, such as the single market.

The most hopeful scenario for the eurozone is that it faces a long and unnecessarily painful road to recovery, with the adjustment placed almost entirely on deficit countries. But the euro could just as well face a long and painful death.

Where would that leave Estonia? It would have a strong claim to join a successor currency union, perhaps a 'northern' euro with Germany and others that believe in solid fiscal discipline. Still, the Bank of Estonia should make sure it knows where it has left the printing plates for the old kroon banknotes. In a few years' time, perhaps, those coins with the three lions will be resurrected yet again. And the bank's museum will have a new display of a funny old currency called the euro, depicting fictitious bridges that go from nowhere to nowhere.

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