How to Save the Euro

My new book, Financial Turmoil in Europe and the United States,¹ tries to explain and, to the extent possible, predict the outcome of the euro crisis. It follows the same pattern as my other books: it contains an updated version of my conceptual approach and the application of that approach to a particular situation, and it presents a real-time experiment to test the validity of my interpretation. Its account is not complete because the crisis is still ongoing.

We remain in the acute phase of the crisis; the prospect of a meltdown of the global financial system has not been removed. In my book, I proposed a plan that would bring immediate relief to global financial markets but it has not been adopted.

My proposal is to use the European Financial Stability Facility (EFSF), and its successor the European Stability Mechanism (ESM), to insure the European Central Bank (ECB) against the solvency risk on any newly issued Italian or Spanish treasury bills they may buy from commercial banks.² Banks could then hold those bills as the equivalent of cash, enabling Italy and Spain to refinance their debt at close to 1 percent. Italy, for instance, would see its average cost of borrowing decline rather than increase from the current 4.3 percent. This would put their debt on a sustainable course and protect them against the threat of an impending Greek default. I call this the Padoa-Schioppa plan, in memory of my friend who helped stabilize Italy’s finances in the 1990s and who inspired the proposal. The plan is rather complicated, but it is both legally and technically sound. I describe it in detail in my book.

The European financial authorities rejected this plan in favor of the Long-Term Refinancing Operation (LTRO) of the European Central Bank, which provides unlimited amounts of liquidity to European banks—not to states themselves—for up to three years. That allows Italian and Spanish banks to buy the bonds of their own country and engage in a very profitable “carry trade”—in which one borrows at low interest to buy something that will pay higher interest—in those bonds at practically no risk because if the country defaulted the banks would be insolvent anyhow.

The difference between the two schemes is that mine would provide an instant reduction in interest costs to governments while the one actually adopted has kept the countries and their banks hovering on the edge of a potential insolvency. I am not sure whether the authorities have deliberately prolonged the crisis atmosphere in order to maintain pressure on heavily indebted countries or whether they were driven to their course of action by divergent views that they could not reconcile in any other way. As a disciple of Karl Popper, I ought to opt for the second alternative. Which interpretation is correct is not inconsequential, because the Padoa-Schioppa plan is still available and could be implemented at any time as long as the remaining funds of the EFSF are not otherwise committed.

Either way, it is Germany that dictates European policy because at times of crisis the creditors are in the driver’s seat. The trouble is that the cuts in government expenditures that Germany wants to impose on other countries will push Europe into a deflationary debt trap. Reducing budget deficits will put both wages and profits under downward pressure, the economies will contract, and tax revenues will fall. So the debt burden, which is a ratio of the accumulated debt to the GDP, will actually rise, requiring further budget cuts, setting in motion a vicious circle.

To be sure, I am not accusing Germany of acting in bad faith. It genuinely believes in the policies it is advocating. Germany is the most successful economy in Europe. Why should not the rest of Europe be like it? But it is pursuing an impossibility. In a closed system like the euro clearing system, everybody cannot be a creditor at the same time. The fact that a counterproductive policy is being imposed by Germany creates a very dangerous political dynamic. Instead of bringing the member countries closer together it will drive them to mutual recriminations. There is a real danger that the euro will undermine the political cohesion of the European Union.

The evolution of the European Union is following a course that greatly resembles a sequence of boom and bust or a financial bubble. That is no accident. Both processes are “reflexive,” that is, as I have argued elsewhere, they are largely driven by mistakes and misconceptions.

In the boom phase the European Union was what the British psychologist David Tuckett calls a “fantastic object”—an unreal but attractive object of desire. To my mind, it represented the embodiment of an open society—another fantastic object. It was an association of nations founded on the principles of democracy, human rights, and the rule of law that is not dominated by any nation or nationality. Its creation was a feat of piecemeal social engineering led by a group of far-sighted statesmen who understood that the fantastic object itself was not within their reach. They set limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they accomplished it, its inadequacy would become apparent and require a further step.

That is how the European Coal and Steel Community was gradually transformed into the European Union, step by step. During the boom period Germany was the main driving force. When the Soviet empire started to fall apart, Germany’s leaders realized that reunification of their country was possible only in a more united Europe. They needed the political support of other European powers, and they were willing to make considerable sacrifices to obtain it. When it came to bargaining they were willing to contribute a little more and take a little less than the others, thereby facilitating agreement. At that time, German statesmen used to assert that Germany had no independent foreign policy, only a European policy. The process—the boom, if you will—culminated with the Maastricht Treaty in 1992 and the introduction of the euro in 2002. It was followed by a period of stagnation that turned into a process of disintegration after the crash of 2008.

The euro was an incomplete currency and its architects knew it. The Maastricht Treaty established a monetary union without a political union. The euro boasted a common central bank to provide liquidity, but it lacked a common treasury that would be able to deal with solvency risk in times of crisis. The architects had good reason to believe, however, that when the time came further steps would be taken toward a political union. But the euro also had some other defects of which the architects were unaware and that are not fully understood even today. These defects contributed to setting in motion a process of disintegration.

The fathers of the euro relied on an interpretation of financial markets that proved its inadequacy in the crash of 2008. They believed, in particular, that only the public sector is capable of producing unacceptable economic imbalances; the invisible hand of the market would correct the imbalances produced by markets. In addition, they believed that the safeguards they introduced against public sector imbalances were adequate. Consequently, they treated government bonds as riskless assets that banks could buy and hold without allocating any capital reserves against them.

When the euro was introduced, the ECB treated the government bonds of all member states as equal. This gave banks an incentive to gorge themselves on the bonds of the weaker countries in order to earn a few extra basis points, since the yields on those bonds were slightly higher. It also caused interest rates to converge. That, in turn, caused economic performance to diverge. Germany, struggling with the burdens of reunification, undertook structural reforms, principally in its labor markets, and became more competitive. Other countries, benefiting from lower interest rates, enjoyed a housing boom that made them less competitive. That is how the introduction of the euro caused the divergence in competitiveness that is now so difficult to correct. The banks were weighed down with the government bonds of less competitive countries that turned from riskless assets into the riskiest ones.

The tipping point was reached when a newly elected Greek government revealed that the previous government had cheated and the national deficit was much bigger than had been announced. The Greek crisis revealed the gravest defect in the Maastricht Treaty: it has no provisions for correcting errors in the euro’s design. There is neither a mechanism for enforcing payment by member states of the European debt nor an exit mechanism from the euro; and member countries cannot resort to printing money. The statutes of the ECB strictly prohibit it from lending to member states, although it lends to banks. So it was left to the other member states to come to Greece’s rescue.

Unfortunately the European authorities had little understanding of how financial markets really work. Far from combining all the available knowledge in the market’s movements, as economic theory claims, financial markets are ruled by impressions and emotions and they abhor uncertainty. To bring a financial crisis under control requires firm leadership and ample financial resources. But Germany did not want to become the deep pocket for bad debtors. Consequently Europe always did too little too late and the Greek crisis snowballed. The bonds of other heavily indebted countries such as Italy and Spain were hit by contagion—i.e., in view of the failure in Greece they had to pay higher yields. The European banks suffered losses that were not recognized on their balance sheets.

Germany aggravated the situation by imposing draconian conditions and insisting that Greece should pay penalty rates on the loans in the rescue package that Germany and other states provided. The Greek economy collapsed, capital fled, and Greece repeatedly failed to meet the conditions of the rescue package. Eventually Greece became patently insolvent. Germany then further destabilized the situation by insisting on private sector participation in the rescue. This pushed the risk premiums on Italian and Spanish bonds through the roof and endangered the solvency of the banking system. The authorities then ordered the European banking system to be recapitalized. This was the coup de grâce. It created a powerful incentive for the banks to shrink their balance sheets by calling in loans and getting rid of risky government bonds, rather than selling shares at a discount.

That is where we are today. The credit crunch started to make its effect felt on the real economy in the last quarter of 2011. The ECB then started to reduce interest rates and aggressively expand its balance sheet by buying government bonds in the open market. The ECB’s LTRO facility provided relief to the banking system but left Italian and Spanish bonds precariously balanced between the sustainable and the unsustainable.

What lies ahead? Economic deterioration and political and social disintegration will mutually reinforce each other. During the boom phase the political leadership was in the forefront of further integration; now the European leaders are trying to protect a status quo that is clearly untenable. Treaties and laws that were meant to be stepping stones have turned into immovable rocks. I have in mind Article 123 of the Lisbon Treaty, which prohibits the ECB from lending money directly to member states. The German authorities, notably the Constitutional Court and the Bundesbank, are dead set on enforcing rules that have proved to be unworkable. For instance, the Bundesbank’s narrow interpretation of Article 123 prevented Germany from contributing its Special Drawing Rights to a rescue effort by the G20. This is the path to disintegration. Those who find the status quo intolerable and are actively looking for change are driven to anti-European and xenophobic extremism. What is happening today in Hungary—where a far-right party is demanding that Hungary leave the EU—is a precursor of what is in store.

The outlook is truly dismal but there must be a way to avoid it. After all, history is not predetermined. I can see an alternative. It is to rediscover the European Union as the “fantastic object” that used to be so alluring when it was only an idea. That fantastic object was almost within reach until we lost our way. The authorities forgot that they are fallible and started to cling to the status quo as if it were sacrosanct. The European Union as a reality bears little resemblance to the fantastic object that used to be so alluring. It is undemocratic to the point where the electorate is disaffected and it is ungovernable to the point where it cannot deal with the crisis that it has created.

These are the defects that need to be fixed. That should not be impossible. All we need to do is to reassert the principles of open society and recognize that the prevailing order is not cast in stone and rules are in need of improvement. We need to find a European solution for the euro crisis because national solutions would lead to the dissolution of the European Union, and that would be catastrophic; but we must also change the status quo. That is the kind of program that could inspire the silent majority that is disaffected and disoriented but at heart still pro-European.

When I look around the world I see people aspiring to open society. I see it in the Arab Spring, in various African countries; I see stirrings in Russia, and as far away as Burma and Malaysia. Why not in Europe?

To be a little more specific, let me suggest the outlines of a European solution to the euro crisis. It involves a delicate two-phase maneuver, similar to the one that got us out of the crash of 2008. When a car is skidding, you first have to turn the steering wheel in the direction of the skid, and only after you have regained control can you correct your direction. In this case, you must first impose strict fiscal discipline on the deficit countries and encourage structural reforms; but then you must find some stimulus to get you out of the deflationary vicious circle—because structural reforms alone will not do it. The stimulus will have to come from the European Union and it will have to be guaranteed jointly and severally. It is likely to involve eurobonds in one guise or another. It is important, however, to spell out the solution in advance. Without a clear game plan Europe will remain mired in a larger vicious circle in which economic decline and political disintegration mutually reinforce each other.

—January 20, 2012