A troubled euro needs a softer Germany

Opinion piece (The World Today: Chatham House)
25 September 2015

For those of us who think that the European Union is a good idea, the euro’s travails in recent years have been very trying. We had long assumed that the euro would encourage trade and investment across frontiers, thereby deepening the single market and boosting competition. We thought an independent European Central Bank would keep inflation and interest rates low, encouraging investment and job creation. We were also sure 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 crisis has challenged many of our 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 retains the pound, the eurozone’s difficulties have tarnished the EU’s reputation. In the forthcoming referendum campaign, those calling for the UK to leave the EU will ask: ‘Do you want to remain in a club whose leaders have made such as mess of the euro?’

It is 25 years since an EU inter-governmental conference on Economic and Monetary Union started work on drafting the Maastricht Treaty. At that time I was a journalist in Brussels, interviewing many of those involved. Were EMU’s architects driven by political priorities at the expense of economic fundamentals? What were the flaws in their plans? And are today’s EU leaders doing enough to save the project?

The case for monetary union
Nowadays, many people assume that the euro is the child of a Franco-German bargain over German unification and that it had little to do with economics. However, EMU was initially an economic project, spurred on by the success of the single market programme that Jacques Delors, the president of the European Commission, had launched in 1985. 

A seminal report drawn up in 1987 by Tommaso Padoa-Schioppa, the brilliant Italian economist, had a profound effect on Delors. Padoa-Schioppa predicted that the imminent liberalization of capital controls, a key part of the single market programme, would destabilize the Exchange Rate Mechanism that then linked most EU currencies. He argued that of the three objectives – 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. In 1988, Delors persuaded Chancellor Helmut Kohl of the case for monetary union. In June of that year the European Council made a committee of central bank governors, chaired by Delors, responsible for drawing up a plan for EMU. In June 1989, the European Council adopted the Delors report’s conclusions – long before anyone thought the Berlin Wall might fall.

By the end of that year, when the two halves of Germany began to move together, François Mitterrand, France’s president, made EMU unstoppable: he told Kohl that he would not support reunification unless Germany gave up the D-mark – which was very popular with most Germans. The Delors report, somewhat amended to reflect German concerns, formed the basis of the provisions on EMU in the Maastricht Treaty, signed in 1992. 

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 others countries, finding this German hegemony unacceptable, saw EMU as a means of reducing 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.

Design flaws
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, Theo Waigel, the German finance minister, 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 chancellor, 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-bailout rule, they went on lending to Greece at almost the same 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 recognized 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 destabilize banking systems across the EU. And that may require bailouts that spill across borders, necessitating cost-sharing mechanisms. 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 destabilize 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 fund for recapitalizations – for its banks.

Third, the EMU’s architects should have created a lender of last resort – one that, in a crisis of confidence, could stabilize financial markets by lending to governments. In 2012, when there was a danger that the markets would tear apart the euro, the European Central Bank plugged the gap by announcing a scheme known as OMT (outright monetary transactions) 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 bailout 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). 

Why were the criteria financial rather than economic? In the early 1990s, the peripheral EU economies were growing faster than those of the core; some of them, including Italy, were adopting painful economic reforms 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 to 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 at the beginning of the 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.

Centralized economic decision-making
Flowing from this fourth problem was a fifth: too many countries joined the club too quickly. Karl Otto Pöhl, the Bundesbank president during the Maastricht negotiations, expressed doubts about letting in the southern Europeans. So did Wolfgang Schäuble, who as a senior parliamentarian co-authored a paper in 1994 that called 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 the 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 centralization of economic decision-making in the eurozone’s institutions can ensure its long-term prosperity. But this cannot 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. Luckily for those of us who hope that the eurozone will prosper, the federalists and Eurosceptics are mistaken. Though the mutualization 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 worsening deflation, shrinking economies and growing debt burdens – needs to be softened (and has already been 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 recapitalization fund will need more resources. And, crucially, Germany needs to rebalance its own economy: with an extraordinary current account surplus of more than 7 per cent of GDP, stemming from very low levels of investment and imports, 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 left Berlin in charge. My biggest worry for the future of the euro is the intellectual isolation of much of Germany’s economic and financial elite. The problem is not so much that German policymakers are wrong on everything – for example they are right that structural reform is essential and that Keynesians can over-prioritize 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.