A quarter of a century after the euro’s conception, the flaws in its design have become apparent. EU leaders have fixed some of them but the euro needs better policies in order to be a successful currency.
It is almost 25 years since European finance ministers, meeting in Rome in December 1990, launched an ‘inter-governmental conference’ on Economic and Monetary Union (EMU). Their work emerged a year later as the Treaty of Maastricht, which set out a roadmap for creating what became the euro.
At that time I was a journalist in Brussels, interviewing many of those involved in the conception of the euro. Most of them assumed that the euro would encourage trade and investment across frontiers, thereby deepening the single market and boosting competition. They thought that an independent European Central Bank (ECB) would keep inflation and interest rates low, encouraging investment and job creation. They were also convinced that the euro would strengthen the political bonds between the European nations.
The euro has in fact delivered real benefits to some of its members, particularly in northern Europe. But since 2010, the euro’s difficulties have forced its supporters to challenge some of their assumptions: the eurozone has under-performed compared with other advanced economies (its output is still below pre-crisis levels); high unemployment in southern Europe has contributed to the rise of populist parties; and countless acrimonious emergency summits have pitted north against south, or more recently, against just Greece. Even in Britain, which has no plans to join the euro, its problems have tarnished the EU’s reputation.
A quarter of a century on, it is worth taking stock of what went wrong with EMU and what its future holds. Were its architects driven by political priorities, at the expense of economic fundamentals? What were the biggest flaws in their plans? And are today’s EU leaders doing enough to save the project?
Nowadays, many people view the euro as the child of a Franco-German bargain over German unification that had little to do with economics. However, EMU was initially an economic project, spurred by the success of the single market programme that Jacques Delors, the president of the European Commission, had launched in 1985.
In 1987 a seminal report by Tommaso Padoa-Schioppa, an Italian economist, had a profound effect on Delors. Padoa-Schioppa predicted that the imminent liberalisation of capital controls, a key part of the single market programme, would destabilise the Exchange Rate Mechanism (ERM) that then linked most EU currencies. He argued that of the three objectives of a stable ERM, free movement of capital and national autonomy on monetary policy, only two were possible at the same time.
Delors feared that if the ERM fell apart – as it very nearly did in 1993 – the single market would be threatened: gyrating currencies could provoke the return of protectionist barriers. He concluded that national monetary policies would have to go and persuaded Chancellor Helmut Kohl of the case for monetary union. In June 1988 the European Council asked Delors to chair a committee of central bank governors that would draw up a plan for EMU. A year later EU leaders endorsed the Delors report – before anyone thought the Berlin Wall might fall.
At the end of that year, when the two halves of Germany were starting to move together, Franҫois Mitterrand, France’s president, made EMU unstoppable: he told Kohl that he would not support reunification unless Germany gave up the Deutschmark (which was very popular with most Germans). The Delors report, amended to reflect German concerns, became the basis of the Maastricht treaty’s provisions on EMU.
Monetary union was driven by the politics not only of reunification but also of the ERM, which had evolved into a German-led system of semi-fixed exchange rates. Realignments of currencies were rare, and whenever the Bundesbank shifted interest rates, for the sake of the German economy, the other central banks in the ERM had to follow suit immediately. France and the other countries, finding this German hegemony unacceptable, saw EMU as a means of curbing it. Yet ironically the euro has now become, to a considerable extent, a means for Germany to cajole the rest of the eurozone to adopt its preferred economic policies.
With hindsight, the plans for EMU had at least five serious design flaws. First, the eurozone has lacked a system for making fiscal policy counter-cyclical. When growing, economies need fiscal discipline, but in recession they need freedom to borrow. Lack of discipline has proved to be a particular problem in Greece. During the Maastricht negotiations, German finance minister Theo Waigel insisted on binding rules on budget deficits, with the prospect of fines for governments that borrowed more than 3 per cent of GDP. A strange alliance of Delors and Norman Lamont, the British finance minister, argued that binding rules would in practice be unenforceable. Lamont trusted financial markets to discipline a country that over-borrowed, by demanding a higher rate of interest. Delors said that a country in difficulties would need credits from the EU, which would then impose conditions, including budget cuts. But they lost the argument.
Waigel was right that the markets were fallible: not believing in the Maastricht treaty’s no-bail-out rule, they went on lending to Greece at almost the same interest rate as they lent to Germany, until 2010. But Delors and Lamont were correct that binding rules were unenforceable; France and Germany first broke the 3 per cent rule in 2003 and many others have done so since.
A second problem is that the plans for monetary union lacked provisions for a ‘banking union
’, which is now recognised as an essential component. EMU’s parents failed to foresee that the euro would engender a cross-border intermingling of bank assets and liabilities, with the result that if a large bank or a sovereign government wobbles, the reverberations may destabilise banking systems across the EU. A bank bail-out may affect creditors in several countries and lead to difficult questions on who should pay. Nor did the parents foresee the danger of ‘doom loops’: if a bank holds a lot of debt of its own government, which then in a crisis has to bail out the bank, a vicious circle may destabilise both. Such problems emerged after the financial crisis of 2008, which spurred the eurozone to create a ‘single supervisory mechanism
’ and a ‘single resolution mechanism’ – including a small recapitalisation fund – for its banks.
Third, EMU’s architects should have created a lender of last resort
– one that, in a crisis of confidence, could stabilise financial markets by lending to governments. In 2012, when there was a danger that the markets would tear apart the euro, the ECB plugged the gap by announcing a scheme known as OMT for buying sovereign bonds. This calmed the markets without being used. Also in 2012, governments set up the European Stability Mechanism (ESM), a €500 billion bail-out fund, which has provided credits to countries in difficulty. And in 2014 the ECB added ‘quantitative easing
’ to its armoury, a bond-buying scheme for curbing deflation.
A fourth omission was the absence of any means to ensure that eurozone members adopted structural economic reforms, to prevent their economies diverging. The Maastricht treaty set convergence criteria as conditions for joining the single currency, but those covered only public debt, budget deficits, inflation and exchange rate stability (Delors lost the argument for an unemployment criterion).
At the time, the case for adopting economic rather than financial convergence criteria did not appear strong. The peripheral EU economies were growing faster than those of the core; some of them, including Italy, were enacting painful economic reforms in order to show their fitness for the euro; many people assumed that, since the southern countries would no longer be able to restore competiveness by devaluing, they would have no choice but reform; and the Commission’s own analysis suggested that poorer countries would benefit most
from EMU, since their inflation and interest rates would drop rapidly.
And that is what appeared to be happening, at least in the early 2000s, as Greece, Ireland and Spain enjoyed credit-fuelled booms. But these obscured and in some ways worsened the growing divergence of competitiveness between the eurozone’s core and periphery. While the biggest problems have been in the south, France and even the fairly successful Germany have often ignored the Commission’s strictures on reform (Germany still suffers from over-regulated services markets
and France from an inflexible labour market).
Flowing from this fourth problem was a fifth: too many countries joined the club too quickly. Karl Otto Pӧhl, the Bundesbank president during the Maastricht negotiations, expressed doubts about letting in the southern Europeans. So did Wolfgang Schäuble, now Germany’s finance minister, who as a senior parliamentarian in 1994 co-authored a paper calling for a group of core countries (but not Italy) to proceed with a single currency and federalism. They were right that several southern economies were not strong enough to flourish in EMU. But such concerns were cast aside in order to satisfy leaders who did not want their countries excluded from this grand prestige project.
Given these design flaws, the euro’s problems in recent years are hardly surprising. But eurozone leaders have taken important steps to make EMU work better, building the ESM, the banking union and OMT. They have done enough to preserve the euro but not to ensure economic growth across the entire monetary union.
An unholy alliance of federalists and eurosceptics argues that only the radical centralisation of economic decision-making in the eurozone’s institutions can ensure its long-term prosperity. But this will not happen in the foreseeable future. There is not enough trust among governments or agreement on what needs doing, and electorates will not support the transfer of substantial new powers to supranational institutions. But in any case the federalists and eurosceptics are mistaken. Though the mutualisation of eurozone sovereign debts or a mechanism for transferring money from north to south would be desirable, such revolutionary steps are not essential. The eurozone can in fact flourish with better policies
The excessive, German-driven austerity imposed on the peripheral countries – which has led to deflation, shrinking economies and growing debt burdens – needs to be softened (and has already been somewhat softened over the past year). Countries such as Greece, Italy and France need to speed up structural reform. In Greece, public debts are unsustainable and need to be partially written off
. In the long run, both the ESM and the bank recapitalisation fund will need more resources. And, crucially, Germany needs to rebalance its own economy
: with an extraordinary current account surplus of over 7 per cent of GDP, stemming from low levels of investment and weak domestic consumption, it should be doing much more to generate growth at home and elsewhere in Europe.
When EMU was designed, many Germans feared it would turn into a French-led enterprise, pursuing un-Germanic policies. They need not have worried. The economic weakness of France, the diminished stature of the Commission, the introversion of Britain and the strength of the German economy have combined to leave Berlin in charge.
My biggest worry for the future of the euro is the intellectual isolation of much of Germany’s financial elite from the rest of the world. The problem is not so much that German policy-makers are wrong on everything – for example they are right that structural reform is essential and that Keynesians can over-prioritise the short term – but rather that some of them think they have little to learn from others. I have heard senior German figures speak of Southern European, French or Anglo-Saxon economic analysis contemptuously. I have also heard them refuse to consider the eurozone’s overall fiscal stance, while insisting that the German, French and Italian economies be treated as separate entities.
What the eurozone needs are not federal institutions – desirable though they might be – so much as a Germany that is more sensitive to its partners’ needs, less arrogant in dealing with them, more open to others’ economic thinking, and more willing to acknowledge that the eurozone economies all affect each other.
Charles Grant is director of the Centre for European Reform. An earlier version of this article appeared in Chatham House’s The World Today, October-November 2015.