Hugo Dixon. Foreign Affairs. Volume 90, Issue 6. November/December 2011.
Conventional wisdom has it that the eurozone cannot have a monetary union without also having a fiscal union. Euro-enthusiasts see the single currency as the first steppingstone toward a broader economic union, which is their dream. Euroskeptics do, too, but they see that endgame as hell-and would prefer the single currency to be dismantled. The euro crisis has, for many observers, validated these notions. Both camps argue that the eurozone countries’ lopsided efforts to construct a monetary union without a fiscal counterpart explain why the union has become such a mess. Many of the enthusiasts say that the way forward is for the 17 eurozone countries to issue euro bonds, which they would all guarantee (one of several variations on the fiscal-union theme). Even the German government, which is reluctant to bail out economies weaker than its own, thinks that some sort of pooling of budgets may be needed once the current debt problems have been solved.
A fiscal union would not come anytime soon, and certainly not soon enough to solve the current crisis. It would require a new treaty, and that would require unanimous approval. It is difficult to imagine how such an agreement could be reached quickly given the fierce opposition from politicians and the public in the eurozone’s relatively healthy economies (led by Finland, Germany, and the Netherlands) to repeated bailouts of their weaker brethren (Greece, Ireland, Italy, Portugal, and Spain). Moreover, once the crisis is solved, the enthusiasm for a fiscal union may wane. Even if Germany is still prepared to pool some budgetary functions, it will insist on imposing strict discipline on what other countries can spend and borrow. The weaker countries, meanwhile, may not wish to submit to a Teutonic straitjacket once the immediate fear of going bust has passed.
But there are more than just two ways forward: fiscal union or a breakup of the euro. There is a third and preferable option: a kind of market discipline combined with tough love. Under this approach, individual states would take as much responsibility as possible for their own finances, but they would also embrace the free market more vigorously. Governments that borrowed too much money would have to be free to default. Limited bailouts for governments and banks in lesser trouble would also be required, albeit in return for economic reforms and belt-tightening. The result would be fitter economies and a Europe that has the strength to play a bigger role on the world stage.
As this article went to press, the eurozone crisis was in a particularly acute phase. Markets were in a high state of anxiety, Greece’s latest rescue package was in difficulty, and much of the region was teetering on the brink of recession. Spain was in the midst of a general election campaign, and Silvio Berlusconi’s government in Italy was losing authority. Nevertheless, amid the turmoil, there were signs that the eurozone might be clumsily muddling along toward something like the market-discipline-plus-tough-love option for dealing with the immediate crisis. It should also adopt it as a long-term model.
In theory, a common currency has many advantages for the European Union’s single market, which also includes countries, such as the United Kingdom, that decided to stay out of the eurozone. When people do not have to worry about fluctuating currencies, they can more easily do business across borders, make long-term investments anywhere in the market, and build transnational enterprises. The ability to harness economies of scale and the opportunity to compete across an entire continent are worthwhile prizes.
But there is also a big disadvantage: individual countries lose the ability to tailor their monetary policies to their particular needs by setting their own interest rates. Instead, interest rates are set by the European Central Bank, which is a problem because different economies move at different speeds. For example, low rates throughout the whole eurozone in the years running up to 2007 amplified Spain’s subsequent housing bubble.
Whether the benefits of having a common currency outweigh the costs depends largely on three factors: the similarity among the economies covered by the single monetary policy, their flexibility, and the existence of a large central budget that can be used to transfer money from flourishing regions to struggling ones. Economies with similar structures and cycles find it easier to live with a one-size-fits all monetary policy. Even economies that are different can cope with a single currency so long as they are adaptable-in particular, so long as their businesses can easily hire and fire employees and people are willing to cross borders in search of work.
The eurozone does not come out well by any of these measures, especially in comparison with the United States. Europe’s economies are diverse, its labor markets are hemmed in by elaborate restrictions, and it has only a small central budget with which to help troubled regions. This is why Euro-enthusiasts and Euroskeptics alike-from Jacques Delors, a former president of the European Commission and one of the principal architects of the single currency, to Boris Johnson, the mayor of London-argue that a fiscal union is needed to oil the wheels of monetary union.
Racking Up Debt
But there is another way of living within the constraints of a one-size-fits-all monetary policy: strengthen Europe’s weaker members, particularly by making their economies more flexible. Before the single currency was launched in 1999, governments did not have an incentive to undertake the hard reforms needed to make that happen. Whenever the likes of Greece or Italy found themselves becoming uncompetitive, their governments devalued their currencies. After the monetary union came about, the eurozone’s unfit economies found another escape route: they borrowed money. This allowed those governments to finance high expenditures without raising taxes. But as these economies became weaker, their competitiveness suffered.
Many states also accumulated mountains of debt, sowing the seeds of the current crisis. Under the Maastricht Treaty, which began the process of forming the monetary union, governments are not supposed to run up debts that equal more than 60 percent of GDP, but every major economy of the eurozone exceeded that level significantly. After the world economy slowed down early in the century, supposedly virtuous states, such as France and Germany, started flouting rules meant to limit budget deficits. There was then no chance of disciplining the others. Last year, the debt-to-GDP ratios of France and Germany exceeded 80 percent; Italy’s hit 119 percent, and Greece’s 143 percent.
Debt grew not only because governments were breaking the rules; it also grew because governments managed to persuade investors, in particular banks and insurance companies, to lend them money. Beginning in early 2010, investors finally stopped funding Greece; then they stopped funding Ireland and Portugal. But this bond strike took an awfully long time to emerge. The market’s failure to discipline governments any sooner was largely the result of the governments themselves. They took advantage of the widespread view that European nations could not default. This was reinforced by the way that banks were (and still are) regulated. The so-called Basel rules, recommendations on banking regulations devised by central bankers of the g-2o countries and others, say that government bonds are risk-free assets and so banks do not have to hold any capital when they invest in them. Not surprisingly, banks piled in, with the consequence that sovereign debt problems infected them, too. Both before and after Lehman Brothers went bust in September 2008, moreover, central banks on both sides of the Atlantic flooded the world with cheap money, distorting money markets and making it easy for governments to rack up debt. It was deliberate rule breaking by governments and their rigging of the market in favor of government bonds, not the lack of a fiscal union, that led to the current crisis.
This, however, has not stopped Europe’s weak economies from calling for a fiscal union. Quite the opposite: they are looking for yet another way to continue living beyond their means. George Papandreou, the Greek prime minister, and Giulio Tremonti, the Italian finance minister, want their countries to be able to issue euro bonds. One can see the appeal: euro bonds would insulate weak states from the discipline of the market by signaling to investors that Germany and other fit countries would ultimately pay the bill if Greece or Italy defaulted. But from the strong countries’ perspective, allowing the issuance of euro bonds would give weak economies the license to be profligate, unless it was done in an extremely controlled manner. Moreover, the need to carry the entire eurozone’s debt could ultimately break the strong countries’ backs, too.
Some supposedly more palatable versions of this idea have been proposed. A paper published last year by Bruegel, a Brussels-based think tank, suggests limiting euro bonds to 60 percent of each nation’s gdp. The snag is that the troubled countries already carry debt well above that level, which raises the question of how they would fund themselves. This is the reason that George Soros and other market gurus have argued for a much higher figure.
Germany, the eurozone’s main paymaster, has been willing to countenance the idea of a fiscal union, but only after a long process of integration once the crisis has been resolved. It is also insisting on strong new rules limiting the amount of money that individual countries can borrow and inflicting penalties on those that break those rules. Meanwhile, Mark Rutte, the Dutch prime minister, has suggested creating the position of European Commission budget czar to police the rules. If countries continued to flout the rules, the czar would have the right to tell them how to run their economies, for example, by telling them to raise taxes. If they did not do what they were told, they would have to quit the single currency.
But all of this lies far in the future-if at all. So far, managing the current crisis has consisted of case-by-case bailouts. In return for lowinterest loans from various different European war chests and the International Monetary Fund, troubled countries have had to reform their economies and cut back on their borrowing. These bailouts do involve aid from fiscally strong countries to weaker ones, but not as much as would occur in a full fiscal union.
As market conditions have deteriorated and more countries have been sucked into the vortex of economic collapse, there have been several different versions of these bailouts. The 17 eurozone countries have found it hard to agree on what to do, leading to zigzagging policymaking, which has undermined investor confidence and created unnecessary economic hardship.
For all its warts, however, the policy has had some successes. The weaker European governments have been forced to embrace reforms that they had shirked for decades. They are liberalizing their labor markets, rooting out tax evasion, pushing up excessively low retirement ages, slashing bureaucracies, privatizing industries, and opening up cartel-like industries, such as pharmacies and taxi services. This is happening not only in Greece, Ireland, and Portugal, the three countries that have taken bailouts. Italy and Spain have also adopted their own fitness regimes, albeit falteringly. Had these states just been able to issue euro bonds, they would not have had the incentive to shape up.
The Freedom to Fail
Still, the current crisis management has been deficient in one important respect. At least by the time this article went to press, no insolvent country had been allowed to go bust. Greece’s debts were spiraling out of control at the time, but the bailout plan that was devised for the country at a European summit in July encouraged banks that had lent it money to roll over their debts or extend their repayment terms. That is a long way from a proper debt restructuring, which would leave Athens with a lower level of debt, one it could realistically support.
Companies and individuals all around the world restructure their debts. Governments outside Europe default. Why should the eurozone countries be exempt from bankruptcy? Defaulting is not nice, of course. Lenders lose money; borrowers can be boycotted for years or have to pay higher interest rates. But this is how things ought to be. Like investors who make unwise loans, governments that borrow too much should not get off scot-free. If they do not feel any pain, they will repeat the same mistakes. Indeed, the fear of being forced into bankruptcy might prevent governments from running up excess debts in the first place. The option of defaulting in a controlled manner ought to be part of the current crisis-management approach for those governments that really cannot support their debts: certainly Greece and possibly Ireland and Portugal, too.
Yet most European policymakers have so far viewed default as anathema because they have been scared of contagion. If Greece defaulted, the banks that lent it money might also go bust. The market might conclude that other weak governments will default, too, making it hard for them to raise money. Some policymakers are frightened that the mayhem unleashed would be like, or even worse than, the chaos that followed Lehman Brothers’ bankruptcy. As this article went to press, there were indeed signs that the crisis was spreading to Italy: its government was finding it increasingly expensive to borrow money on the bond market.
But the lesson of Lehman’s collapse is not that banks or governments should never be allowed to go bust. It is that defaults should be controlled and that those that are exposed to possible contamination should prepare for it. But the eurozone seems not to have learned this yet. Banks stuffed with government bonds have merely been nudged to shore up their balance sheets. Whereas the United States and the United Kingdom conducted rigorous stress tests on their banks in early 2009, Europe has done three fairly limp reviews in the past two years. Even the most recent one, in July, failed to model for a possible Greek default. Meanwhile, governments that are exposed to contagion have been slow to reduce their budget debts and liberalize their economies. Berlusconi, for example, has acted like a latter-day Nero, fiddling while Rome burns. Even French President Nicolas Sarkozy behaved until recently as if France lived in a charmed world where borrowing was its privilege.
But it is not too late to put the controlled-default option back on the table. Given the policy errors for which France and Germany are responsible-from flouting the original deficit rules to standing in the way of a sensible restructuring of Greece’s debt-they should pay some penance. And they will, in the form of low interest rates on the money they have already lent struggling economies and in the form of the extra capital they may need to pump into their own banks to cover the cost of their bad loans to Greece and possibly others. This will cost a lot, but less than throwing more good money after bad to avoid defaults. And it will certainly be cheaper than a full-fledged fiscal union.
Lenders of Last Resort
Part of the art of managing a financial crisis is distinguishing insolvent institutions from merely illiquid ones. The debts of insolvent institutions should be restructured, whereas illiquid institutions should get funding. Like a country with its own currency, the eurozone needs a lender of last resort. The key, however, will be to ensure that it does not become a lender of first resort, as that would remove the incentive for states and banks to manage their own affairs responsibly.
Having entered the 2007 credit crunch without a properly thoughtout plan for how a lender of last resort would operate, the eurozone has had to make up policy on the fly. The European Central Bank has been showering banks with liquidity since the crisis hit, but this really should have been done hand in glove with integrated banking supervision across the eurozone. Instead, regulation was fragmented and, to some extent, continues to be. The European Central Bank has also helped fund troubled governments-first, Greece, Ireland, and Portugal; then, Italy and Spain-by buying their bonds. It hoped that this would push up the value of the bonds and make it easier for the governments to issue new ones. (As bonds are bought on the market, this is not quite the same as giving the governments cash.)
The European Central Bank was uncomfortable with this role, however, because it does not believe that governments should print money to reduce their deficits. So the eurozone countries decided at a summit in July that this task should be transferred to the European Financial Stability Facility (EFSF), a new slush fund set up to help manage the crisis. At the same time, they agreed to expand the size of the facility, give it the authority to provide money to cash-strapped banks, and grant it the power to provide emergency credit lines to governments that are not in full bailout programs.
But this has not ended the debate over which policy is best. Willem Buiter, Citigroup’s chief economist, among others, has argued that despite its expanded 440 billion euros, the EFSF is still too small to handle full bailouts of Italy and Spain. Although this is true, a lender of last resort should not be used as a permanent prop anyway. Italy and Spain could solve their own problems if they had the political will to tighten their belts. Full bailouts will become necessary only if they shirk that responsibility.
The EFSF will be replaced in mid-2013 by a new bailout fund called the European Stability Mechanism, a permanent facility. In one important respect, the ESM will be better than the EFSF: it will be required to distinguish insolvent from illiquid governments when it makes loans. In the case of insolvent governments, the debt held by private sector creditors will have to be restructured so as to make the governments’ debts sustainable. Too bad this mechanism will not kick in for almost two more years.
The Third Way
Given these complexities, many Euroskeptics think it would be better to abandon the euro project altogether. But this is a bad idea. The monetary union may have developed prematurely, but nobody has come up with a way of putting the toothpaste back in the tube. If Athens ever decided to reintroduce the drachma, for example, people would promptly pull their euros out of Greek banks, causing the country’s financial system to collapse even before the new currency was minted. Depositors in other weak countries would then pull their money from those countries’ banks, triggering a chain of collapses and a deep depression. There is another option: market discipline plus tough love. This medicine will be difficult to swallow, but in the end, it will lead to a healthier Europe.