The euro: not the end yet, but the beginning of the end perhaps …

(This article was updated on 22/04/2014)

As currencies go, the European single currency is not in great shape. The problems of the two-speed Eurozone are well known but the consequences of the failure of repeated waves of measures to fix it are not yet fully understood. We struggle on in hope of some new measure, probably from Frankfurt, to get it through the current storm and into less turbulent waters.

But what if the single currency itself is the problem? Again we are not having a full debate. Much of the discussion about the European Union and the single currency is dominated by xenophobic nationalist voices. The danger for us is that in filtering them out, we also divorce ourselves from an important discussion about the future of the euro and the possibility of it failing.

Those who think that the euro is doomed are not yet mainstream voices, but they are gaining in numbers, strength and confidence. Their arguments need to be considered. And although it is happening piecemeal, the process of examining if the single currency can be saved or is worth saving has already begun.

A good starting point is a new book from a veteran EU watcher. David Marsh is unimpressed by the political responses to the current plight of the euro. He is dismayed by the continuation of the current deadlock and discord as countries at different stages of the economic cycle try to manage their finances within the euro straitjacket, where the interests of the dominant country – Germany – always hold sway.
Amazingly, even after five years of muddle there is still no agreed understanding of what happened. Marsh provides a perspective that is becoming more widely understood, placing the euro centrally as a key driver of what went wrong. “Europe’s united money has not alleviated the European crisis: it has in fact been one of its principal causes” he argues.
The problem with the euro is this: no one has direct control over it; no one is solely responsible for it; it is “a currency in search of a state”; no one feels under enough pressure, or has enough power, to take the problems by the scruff of the neck and force a solution. In fact the opposite is the case. The simple human reaction to these vacuums of power and responsibility is that all interested parties are chiefly occupied in squabbling, protecting their own interests, and shifting the blame on to someone else. No responsibility, no accountability, no solution.
Marsh then shows how five mutually reinforcing miscalculations at the heart of the new currency contributed to the build-up of the crisis.
Firstly, the European Central Bank’s focus on achieving its 2% inflation target diverted its attention from problems building up elsewhere, particularly in European banks. The creation of the euro generated an enormous expansion in the finance sector, the implications of which were never properly evaluated. When the crisis broke the EU’s banks were three times as large and twice as leveraged (borrowed) as the US banking system. Therefore the banking system in the Eurozone, particularly German banks, generated huge credit and investment flows which helped create the massive credit and other bubbles that eventually brought the house down. The ECB did nothing to restrain this credit surge.
Secondly, the belief that the “one size fits all” monetary policy would lead to a symmetrical distribution of pain and gain, cancelling each other out, was misplaced optimism. In essence the willingness to undergo painful reform or restructuring when required by economic developments, was greater in some countries than in others, leading to the costs exceeding the rewards, and giving Europe a net deflationary bias, with all that entails, which is now emerging into the clear light of day.
Thirdly, the more competitive economies, the northern sector, if you like, opened up a competiveness gap over the less developed southern economies. This was not supposed to happen. In theory more competitive countries would then spend more, reducing competiveness to meet debtor states halfway, while they trade out of their problems by significant restructuring, and a reduction in wages and benefits. In practice Germany refuses to undergo a programme of price increases. In effect this goes back to Marsh’s first point: low inflation is not the Holy Grail, but the German electorate thinks it is, and has the scars to prove it.
Fourthly, the belief that low-cost financing could be available in perpetuity for countries with a mixture of current account surpluses and deficits overlooked the fact that such a system would be prone to credit crises. When these happened, with interest increasing significantly for the deficit countries, those with current account surpluses continued as usual, with – if anything – reductions in interest rates. The subsequent burden of adjustment was therefore excessively skewed towards the deficit countries, generating growing resentment and continuing economic distress.
Finally, finance ministers and central banks geared policies to limiting public debt and budget deficits, but neglected the extraordinary growth in private sector debt (in banks, corporates, and individuals) in a number of countries. This private sector debt proved to be the Achilles heel of the single currency.
These miscalculations, overlooked when the single currency was introduced, helped generate the current Eurozone crisis; the way those weaknesses played out generated significant rifts between member states, thereby inhibiting solutions to the crisis, and increasing resentment against external forces like Germany and the European Union. But national politicians took the hit too, providing fertile ground for the growth of radical parties with isolationist tendencies.
Rational solutions became politically unfeasible in domestic terms and the situation became crystallised around three difficult choices.
• Leave the single currency and suffer the extraordinarily high political and financial costs that go with that.
• Move rapidly towards complete political union which most of Europe’s citizens don’t want.
• Soldier on and hope that things will get better, without having any good reason to think that they will.
This is the ultimate Catch-22. Exit the euro with all the pain and chaos entailed; go for total political union, generating an almost total “democracy deficit” with all its possible implications; or hope to muddle through, while the citizens of Europe despair over their politicians, lose faith in democracy and abandon the possibility of providing sustainable jobs for their children, all in a continent facing a huge demographic crisis.
Marsh is scathing about the culpability of Brussels in getting to such a situation: “All major European actors – the euro group of finance ministers, the ECB and the European Commission – must share responsibility for the much-delayed recognition of problems building up behind the scenes.” He quotes Jacques Delors, one of the euro’s chief architects: “ …I have always considered … that the euro group was morally and politically responsible for the crisis…” By 2012 even the ECB recognised the reality of what had occurred. Vitor Constancio, deputy president of the ECB, stated that the euro’s difficulties were in the area of money and credit, rather than public finances. He identified private, not public sector, imbalances as the main problem, “financed by the banking sectors of the lending and borrowing countries. The inflow of relatively cheap financing turned into a huge credit boom in the countries now under stress.”
Marsh insists that Germany cannot and will not ride to the rescue of the Eurozone. There’s no point in banging on at Germany to use its favourable public debt and borrowing position to undertake large-scale reflation to boost consumption and eventually wages and salaries and other costs in Germany, to “balance” the problems in European stragglers. This will not happen, according to Marsh, and even if it were tried would not succeed in the specific circumstances of Germany.
Firstly, for historic and other reasons, stimulus measures in Germany produce results contrary to experience elsewhere. Tax cuts frequently lead to increase saving, not increased consumption, because the German taxpayer expects the resultant budget deficit to require tax increases subsequently. Attempts at economic stimulus through government-ordered public works often have the same effect.
Secondly, radical German reflation would in essence be a short-term solution, diverting attention from the real economic problems and necessary reform and adjustment in the peripheral states, caused by a combination of the wrong internal European exchange rates and faulty choices by them in industrial and structural policies.
Thirdly, Marsh believes that efforts to boost wage growth in Germany, demanded by many foreign experts, and justified by its dramatic suppression over the last decade, would only temporarily increase consumer demand. As many German companies trade overseas and are exposed to significant global competition, wage increases that go beyond productivity improvement would eventually end up reducing investment, output and jobs. In addition, as Germany’s economic focus is growing increasingly in the direction of countries outside the euro (particularly Poland, Russia and Turkey) as well as towards new markets in Brazil, China, Indonesia, India and South Africa, any subsequent increase in imports would have minimal impact on the peripheral states that need the relief most.
That said, I believe there is more scope for German action in this particular area than Marsh says. Over the last decade returns to capital increased dramatically, while those to labour were almost static in Germany, bringing growing inequality, and a hollowing out of the middle and lower middle class. That suggests that an increase in wages and salaries is overdue, and the consequent reduction in profitability is unlikely to derail German exports. In addition it is increasingly understood that a significant investment in infrastructure is required in Germany which it makes economic sense for the government to finance, and this would also help somewhat in increasing domestic demand. However Marsh is correct that the impact on peripheral states in particular, and on other states such as France, of such changes may not be that massive – there is no magic solution to the Eurozone problems here.
However, an increasing problem is that much of the rest of Europe does not share these German views. The two sides are literally just not on the same wavelength. And reputable opinion poll data shows that citizens of other European countries believe that in EU matters the Germans are playing too big a role.
Many see a banking union, followed by a fiscal union, completed in the usual EU painfully slow, fashion, as the next magic bullet to solve these problems. Not so. “Banking union will remain, like many other European visions, a seductive blend of Utopia and chimera.” Why?
Marsh teases us with part of the answer – noting that Germany plays a key role here, not simply because it is the biggest economy and the biggest creditor, but crucially because half of the Eurozone’s 4,000 plus banks are German.
A significant number of those banks have political connections in Germany. These banks generated a significant amount of the “waves of money” that dramatically helped to inflate the bubbles in US sub-prime mortgages, property and other bubbles in peripheral states, and investment in developing economies, most of which turned in disastrous investment losses. To put it delicately, it is unclear to what extent those banks have accounted for those extraordinarily high losses (as much as €1 trillion of non-performing loans, Eurozone is heading for relapse back into crisis, Satyajit Das, Financial Times, 28 August 2013). Nor do we know how much they have been reformed to stop them making the same mistakes again. In fact as large tranches of funds used in Eurozone rescue packages have effectively been recycled to repay many of those investments, “moral hazard” is as big an issue as ever for many of those banks, The management and boards who got Europe into these problems may still be in place, and likely to repeat the same mistakes again as they bore no cost for the last series of mistakes.
It is no coincidence that European banks are still seen as extraordinarily weak, and likely to produce unpleasant surprises for us all again. Marsh fails to note, as was admitted by Peer Steinbruck, finance minister in a German grand coalition at the time, that his country insisted when the Eurozone crisis broke, that banking problems would be solved locally, rather than at EU level. Thus Germany could maintain “control” of German banks, without outsiders looking at what they were doing. That more than anything else helped create a direct correlation between weakened banks and eventually weakened host countries, a key factor in starting the Eurozone crisis.
Many European politicians, outside Germany, are clearly still hoping against hope that Germany will eventually move, and a reasonable banking union will happen. This simply will not occur.
After all that, it comes as no surprise that Marsh, along with an increasing number of commentators believes that the muddle through option is the only choice available, and Europe will just have to bear the necessary pain for the foreseeable future.
However a respected former French diplomat wants us to take the logical next step and drop the euro itself as the only way to finally exit the crisis and save Europe. François Heisbourg chairs the International Institute for Strategic Studies and the Geneva Centre for Security, and is a special adviser at the Fondation pour la Recherche Strategique in Paris. He is unusual in that he admits that he is not an economist and challenges economists to rebut his arguments. A strategist rather than an academic, he is a strong supporter of Europe and the EMU, but believes that the euro is doomed.

His recent book La Fin du Reve Européen (The End of the European Dream ) – suggests that the situation has become so intractable that the only way to save Europe now is to abandon the Euro (the “Euro cancer”): “The dream has given way to nightmare. We must face the reality that the EU itself is now threatened by the euro. The current efforts to save it are endangering the Union yet further.” Dismissing the notion of a European federal super state as “pure fantasy”, he sees EU countries drifting further apart; “integration has reached the limit of legitimacy”; and EU intrusions once tolerated as disagreeable have now become “insupportable”.

His view is that the EU structure, with its legal treaties and step-by-step crisis-resolution approach, is not compatible with a proper functioning monetary union. He accuses it of trying to solve the current crisis without the key weapons to successfully do so, debt forgiveness, transfers, and joint liability debt instruments. This has produced a deflationary debt crisis with no end in sight.

“You cannot create a federation to save a currency. Money has to be at the service of the political structure, not the other way around” Heisbourg insists. , He also notes that we are in a vicious circle where electorates blame Europe for the crisis, and are unwilling to transfer more powers to the centre. Without those extra powers the crisis cannot be solved, and on it goes. The current muddle through approach will lead to “serial crises ending in a nervous breakdown and an uncontrolled disintegration of the euro with all its consequences”.

Heisbourg further notes the increasing marginalisation of the UK in the EU, and its possible exit from the union. He places that alongside the current dysfunctionality of the core relationship between France and Germany, and reminds us of the strong defence and strategic relationship between France and the UK. All these trends tend to suggest that France would see itself as isolated and subordinate to Germany, a position totally at loggerheads with its historic mission to jointly lead the EU with Germany. This developing and predictable situation is for very different reasons equally unacceptable to Germany as it is to France.

“Either the euro exists in its entirety, or it does not exist at all ”, he declares. Thus we need to arrange an orderly break up of the single currency and return to using national currencies.

A reversion to national currencies, though it would bring great trauma in its wake, would however give each country significantly more tools to address the problems facing it, and convert the problems facing each country into national ones, rather than, as at present, unacceptable impositions from Europe, the Eurozone or Germany. On balance he believes this would be a positive development. He believes that this strategic change is in the best interest of Europe long term, and should be prepared as a Franco-German joint act in order to “avoid the catastrophe of a situation where Germany is seen as responsible” which would be highly damaging to the idea of Europe itself.

The dismantling of the euro and reversion to national currencies would be prepared in total secrecy by a handful of officials in Berlin and Paris, with everyone else kept in the dark, and would be carried out over a long weekend modelled on the successful Brazilian abolition of the cruzerio in 1994.

As has been pointed out by other commentators, there are significant problems with the reversion to national currencies. Already some suggestions are emerging as to how such a fundamental change to the euro could be effected without terminally damaging consequences. Undoubtedly there will be further debate and consideration of this matter and the tactical approach adopted, should this process ever happen, might be very different from that originally envisaged by Heisbourg.

His core message is that, when looked at carefully, the economic, and therefore the political, position of Europe is now unsustainable. Unless there is a significant upturn in economic conditions, something fundamental will have to change. In the absence of a federal state, which, like Heisbourg and many others, I think is a pipe dream, there are no options available other than a breakup or fundamental restructuring of the euro. The choice at that point would be simply is it going to be an organised or disorganised change?

These are large considerations, and there is much to be done before any EU member state of any significance will contemplate going it alone. However a taboo has now been broken by someone not too far from the Quai d’Orsay, indicating that we may be nearing a political inflection point in the Eurozone crisis.

One way or another, dissolution or fundamental restructuring of the euro is now on the table and the enormous implications arising need to be carefully considered by national governments, corporates and individuals.

Richard Whelan is an Irish chartered accountant and geopolitical analyst. This website is www.richardwhelan.com.

[1] Europe’s Deadlock   How the Euro Crisis Could Be Solved – and Why It Won’t Happen, by David Marsh, Yale University Press, New Haven and London, 2013, 130 pages.

[2] Available only in French language at present.

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