The debt crisis is overwhelming the twin ideals of a single market and a common currency. What then is the future for the Old Continent, and how did it arrive at this critical moment?
Why Europe's beautiful project is in peril
"It is no longer only about saving the euro, now it's about saving the European Community as a whole." This stark prognosis, made by the German daily Die Welt, would have been decried as alarmist even a month ago. Today there is almost nobody who doesn't see Europe's spiralling currency and debt crises as existential to the fate of the European Union, at least in anything resembling its present form.
Indeed, Europe's prestigious confederation has already been transformed: The bloc's power centre has shifted irreversibly (to Germany), newly created institutions and regulations further centralise policymaking (opposed by most Europeans), and loud anti-EU voices in its own ranks (some belonging to ugly populists) have been immeasurably bolstered. A dark irony, the historic experiment in supranational cooperation seems to have triggered not greater harmony and European loyalty, as intended, but rather it has amplified their antitheses, namely dissidence and strident nationalism.
There is no end in sight to this Wagnerian drama, no matter how many billions more Nicolas Sarkozy and Angela Merkel throw in the direction of Greece or Ireland, or now even Italy. In fact, their austerity prescriptions for these reeling nations may well even exacerbate the crisis. This is the conclusion of two new books, David Marsh's revised edition of his classic The Euro: The Battle for the New Global Currency and Johan Van Overtveldt's The End of the Euro: The Uneasy Future of the European Union. The authors blame the euro's fall not on speculators, who they may let off the hook a bit too easily, but on fundamental structural flaws in the monetary union itself, deficiencies that must be addressed at their source if the currency is to make a comeback.
Europe's beautiful project, the quintessentially civilised mission of uniting a peaceful and prosperous continent, is on the rocks, a debacle ultimately brought on by its most ardent enthusiasts. Neither the unambiguous warnings of whole teams of top-flight international economists nor the elementary laws of macroeconomics deterred them from forging a monetary union and common currency among 17 extremely disparate economies, from the Levantine island of Cyprus to oil-rich Norway. The ancient Greeks called it hubris, and thus perhaps it is fitting that the tragedy of the euro opened in Greece, even if it isn't the culprit for bringing the Old Continent's grandest success story to the brink - and maybe even to ruin.
Of course, it's always easier in hindsight to detect the inherent flaws and acquired deformities of a policy when its consequences are wreaking havoc on the global economy. Many observers were party to the initial euphoria around the launch of the single currency in 1999 - and it is instructive to examine the advantages that its advocates, which included highly respected economists, saw in the project at the time, many of which remain valid.
Indeed, there are a host of undeniable benefits that currency union brings like-minded states that regularly do business with one another. In the case of the European Union, for example, advocates underscored that the euro would break down the last barriers to the free movement of people, goods and capital among its cohorts, facilitating even further business within the common market, the world's largest trading bloc. The elimination of costly and time-consuming currency conversion boosts economic efficiency and makes prices readily transparent, which lowers prices and thus ameliorates inflation.
Critically, replacing national currencies with one money eradicates fluctuating exchange rates, which had in the past proved easy pickings for currency speculators. Thus exchange rate risks and national currency crises would be banished forever. Moreover, the creation of a single, autonomous central bank, the European Central Bank (ECB), promised to eliminate competition between states and reduce uncertainty. No longer would sound economic policy be subject to political whims.
Moreover, since its earliest days in postwar Europe, integration has always been about more than money. Many figures, like the europhile heavyweights German Chancellor Helmut Kohl and French presidents Francois Mitterand and Jacques Chirac, saw the euro as the final brick in the postwar edifice that had brought unprecedented peace to its members. The single currency was to be the pinnacle of Franco-German reconciliation and pave the way to a political union. Among other bonuses, this would fetter mighty Germany once and for all. Europe also envisaged the euro as a rival force to the dollar, lending the eurozone states more gravitas on the world stage.
The three-stage creation of the European Monetary Union (EMU) was agreed upon in 1992 at Maastricht, a Dutch city in the border regions of the Netherlands, Germany and Belgium. The treaty set budgetary, debt, inflation, interest rate, and other convergence criteria as goals to narrow differences between the future eurozone members. According to the treaty, only countries that met these criteria could be part of the euro. In order to encourage budgetary discipline - an essential safeguard, everyone agreed - countries would be fined for annual deficits larger than three per cent of GDP. These essential conditions would fall by the wayside en route to the present quagmire.
On January 1, 1999, exchange rates of the original "euro-eleven" were locked in place, kicking off the EMU, and three years later its crown jewel, the euro itself, was introduced as a freely circulating physical currency, namely as euro notes and coins. This grand experiment, British financial journalist and economic consultant David Marsh describes in The Euro as an incredible "bloodless, noiseless, bureaucratic revolution. But it was a revolution all the same: an unprecedented, self-willed abrogation of state prerogative."
And the euro jumped off to a superlative start. In bolstering the internal market for European commerce, the euro fortified European firms' competitiveness worldwide - and exports as well as imports to and from non-euro states soared between 1999 and 2010. The euro expanded the size and liquidity of the continent's financial markets: investors from around the world channelled excess savings into the euro, argues Marsh, which "contributed to a sizeable fall in borrowing costs for the poorer-performing euro states". Those countries that in the past had endured high inflation and instability, like the southern Europeans, enjoyed access to previously unthinkable interest rates, which enabled the likes of Ireland and Spain to bankroll enormous housing booms.
And the euro sheltered its members from wild fluctuations in the dollar, which in the past had sent shock waves through European economies. The eurozone weathered nearly a decade of crises, from the after effects of 9/11 to the financial meltdowns of 2007 and 2008, with flying colours. The euro shielded the smaller countries from global turmoil, something that non-euro countries such as Hungary lacked, and were ravaged as a result. Cyprus, Estonia, Greece, Malta, Slovakia and Slovenia eagerly joined the euro club in the course of the decade.
"It is one of the greatest success stories in the history of the European Community," gushed Germany's finance minister, Peer Steinbrück, in 2008. Just months before the crisis broke in Europe in 2009, the European Commission was unqualified in praise for its precocious creation: The euro "has clearly become the second most important currency in the world; it has brought economic stability; it has promoted economic and financial integration, and generated trade and growth among its members; and its framework for sound and sustainable public finances helps ensure that future generations can continue to benefit from the social systems that Europe is justly famous for."
So good did things look, safeguards such as keeping to yearly budget deficits of less than three per cent of GDP were completely ignored - and broken - by almost every country, not least and early on by Germany and France.
The euro's early smooth sailing whisked away the resounding criticism that an array of experts had previously levied against monetary union. Critically, a single monetary policy conducted by an independent, supranational central bank, like the ECB, takes key levers out of the hands of national policymakers, like the ability to set interest rates and devaluate currency, which had in the past been used in very different ways by the countries joining the monetary union, which had different growth and spending patterns, and dissimilar business cycles.
As much sense as a single monetary policy can make, experts warned, it can only succeed among nations with like-minded monetary and fiscal policies. This was basic economics that was recognised in the (unheeded) Maastricht conditions. Otherwise, a "one-size-fits-all" monetary regime may be just right at one time for one set of countries, while handcuffing and imperilling others at just the wrong time. The ECB set a single monetary policy in an economic area that had diverse economic, budgetary and regulatory policies, which were determined by 17 independent national governments.
In the past, for example, Germany, notorious for its tight money policies and historic fears of inflation, pursued conservative monetary and fiscal policies, which produced low and stable inflation, and higher personal income. The guardian of these policies in Germany was the politically independent Bundesbank, Germany's central bank. On the other hand, the southern Europeans tended to fight economic slowdown by liberal government spending and increasing deficits - and in crises devaluing the currency in order to sink production costs and thus prime exports. Their lower-growth economies lived with high inflation and currency fluctuations, as well as politically managed central banks.
Economists understood from the beginning that imbalances between countries could doom the whole project. The Maastricht treaty indeed set some significant, if minimal criteria. But with bookkeeping slights-of-hand nearly every country had fudged the EMU's convergence criteria, including for deficit levels, assets and expected revenue. In Germany, 155 university professors issued a public letter pleading for the EMU's postponement. They argued vigorously for an even higher bar that included standards for a strong political union with automatic fiscal transfers and flexible, mobile labour markets. Britain opted out of the euro, among other reasons, over concern about these omissions.
Critics charged that a functional monetary union required common trade, finance and budget, and social and wage policies. And this high degree of economic coordination was in effect possible only in a full-scale political union - a tightly knit federation of some sort. But it was no secret that the vast majority of EU Europeans had no appetite for political union, one that bit even further into national sovereignty. Pro-EU politicos knew this very well, but gambled that putting the cart before the horse, namely monetary before political union, would produce a horse.
In his new book, Belgian economic journalist Johan Van Overtveldt piles the blame on the euro's political architects, who either knew well - or should have known - that a single currency under flawed conditions could blow up in their faces, be it sooner or later. The political elite, he claims, "paid elaborate lip service to these warnings, insisting that these conditions were unnecessary. Showing persistence and unity, they claimed, would automatically turn the EMU into a strong monetary union - and furthermore, the political cooperation required to operate the EMU project efficiently would lead to political unification".
As of 1999, the fixed exchange rate was valid for every eurozone country. But this rate - and ECB policy in general - ended up basically that of the Germans, the euro's undisputed anchor. The eurozone's tight, low-inflation monetary policy resembled the Bundesbank's postwar policies closer than the French or anyone else had ever imagined possible. As both Marsh and Van Overtveldt argue, the French in particular saw the euro as a way to undermine the powerful Bundesbank's conservative ways. Thus for the eurozone's peripheral countries, such as Ireland, Portugal, Spain and Greece - and France and Italy, too - the exchange rate was much too high. In effect, the Deutsche mark had replaced the drachma.
This priced many of their goods and services out of business on the international market. Damaging their competitiveness even further was the failure to reform labour markets. Greece and Portugal, for example, thus lost out to the Central Europeans who had lower labour costs and just as much human capital.
But these countries had access to money at virtually the same, for them, rock-bottom prices that the Germans could borrow at, regardless of their financial circumstances. The Europe-wide fall in market interest rates and risk premiums to German levels, argues Marsh, that accompanied the start of the single currency "was used in the more inflation-prone peripheral countries not to build up productive capacity and prepare economies for the challenges of technological change and foreign competition, but to fuel wasteful consumption and speculative purchases of financial assets and real estate whose values subsequently plummeted". Yet, while they were riding high, the eurozone "success stories" of Ireland and Spain made headlines everywhere.
These countries (the so-called Club Med countries) experienced credit booms during the first eight years of the century that enabled unusually high growth rates and higher inflation, which sparked off increasing balance of payments deficits. Since internal transfers in such cases weren't part of the Maastricht blueprint (every nation for itself when it came to budgets), these had to be paid off by foreign borrowing. Domestic spending rapidly outpaced domestic production. In the south, budget deficits soared, financed by foreign banks and other institutions that saw no currency risk.
Meanwhile, the Germans were sitting pretty. They experienced lower growth and inflation rates, which resulted in greater competitiveness and enormous surpluses. Between 1999 and 2010, for example, Germany's exports to Greece, Ireland, Portugal and Spain nearly doubled. Exports to China increased tenfold. The surpluses were channelled back to the poorer states in the form of credit. This argues Marsh effectively poured "oil on a slow-burning monetary fire".
Even as early as 2006 the writing was on the wall: Greece, Portugal and Spain ran up some of the world's largest balance of payments imbalances. As Van Overtveldt puts it: "Excessive credit creation fuelled inflation, which in turn contributed to wages increases that hurt competitiveness. Combined with mounting government deficits, these developments jacked up current account deficits." The fiction that the eurozone was on its way to becoming one big economy was never openly challenged, even though the economic upheaval raging elsewhere was aggravating the underlying imbalances within the euro area.
When the great recession finally reached Europe's shores, the eurozone's dirty laundry was suddenly open to public viewing and the crisis escalated at warp speed. It opened in Greece with Athens's admission that its 2009 budget deficit would at least quadruple the Maastricht stipulations. But "let there be no mistake", argues Van Overtveldt. "If Papandreou hadn't confessed ... something else would have sparked the sovereign debt crisis in Europe. The situation had become untenable, and Greece was just the tip of the iceberg. The discovery of Greece's chicanery drew almost immediate attention to a host of major problems within the euro area, from huge imbalances in current accounts to the fragility of Europe's banking sector."
When Papandreou let the cat out of the bag, the prices of its government bonds, the chief means to cover deficits, soared. The markets, by isolating and attacking Greece, quickly pushed its debt costs beyond Athens's reach. This is exactly what happened to the other Club Med countries and what's happening to Italy today - the bond spread increases made their financing costs unbearable. The single currency didn't abolish national credit risk, as everybody thought it would, but shifted it to another venue: from currencies to national debt. The financial markets saw these countries' solvency in jeopardy and the days of easy credit skidded to an end. One bailout followed another: Greece, then Ireland, then Portugal, and then Greece again.
The peripheral countries, argues Van Overtveldt, were trapped by policies that "focused solely on lending money against promises of austerity and structural reforms. The contradictions inherent in this approach turned this precarious situation into a highly destructive cycle."
Both Van Overtveldt and Marsh bring the euro saga up to summer 2011, and even though much has happened since then - such as the trillion-euro bailout package, debt relief, and new fiscal coordination and crisis resolution mechanisms - their dire conclusions remain valid.
Marsh is the more pessimistic of the two, although not by much. He believes that economic policies need nation states, especially when things go awry. "The battle to maintain the euro as it was originally conceived has been lost," he argues. "The repercussions of the financial crisis on Europe - even though it started elsewhere - will prove longer-lasting and more pernicious than on America."
The euro's structural flaws made the present crisis inevitable and the nature of the EMU makes them irresoluble, Marsh concludes. The major creditor nations and those who have profited most from the strong-currency policies - Germany, above all, as well as the Netherlands, Finland, Austria and Belgium - are unlikely either to relinquish the one-size monetary policies that fit their economies. And although they might dig deeper into their pockets to bail out the peripheral countries, these loans simply sink them further into debt and render them unable to restart their economies. The hundreds of billions provided by the European Financial Stability Facility heaps debt upon debt and traps them "in a vicious circle of economic decline and growing financial market suspicion that loans will not be repaid, generating self-fulfilling consequences".
The other possibility, namely to buckle down and create a political union capable of transferring taxpayers' money between the zone's have and have-nots, is simply not on the cards. Perhaps a bit too hastily, he writes off real economic governance as a mirage.
Rather, the upshot will be a Germany-led Europe in which the area's most muscular economy sets policy for the rest of the eurozone - or those who opt to remain in it. This is the exact opposite of what the French and others envisioned when they originally pushed the idea of monetary union.
Van Overtveldt agrees that the present course of loading debt on the fringe countries will bury them for many years to come. The harder they try to meet the demands imposed upon them, the more debt will escalate and the deeper into recession they will fall. Thus the odds increase that these countries will sink into chaos and the EU with them.
But Van Overtveldt outlines a way forward that he calls "back to square one". He believes that completing the EMU - fulfilling those criteria that many experts deemed essential 10 years ago, and a few additional ones as well - can lay the foundations for a sound monetary union. These conditions include political union, fiscal integration, labour mobility, and price and wage flexibility.
He sees the initiatives taken in this direction in spring and summer 2011 as encouraging, even if too meek. And the monumental task of pushing through tighter political and fiscal union lies ahead of them in an atmosphere of ever greater national acrimony. Above all he's worried about Germany, where a change in popular support for the European project as a whole could derail the entire enterprise.
That would seem unlikely, particularly in light of Merkel's new-found resolve since The End of the Euro was published. Germany probably won't withdraw from the eurozone, as Van Overtveldt suggests possible, but rather its bullheadedness could drive other countries out. Many experts today are suggesting this would be best for Greece for this very reason; it desperately needs back the monetary levers it lost to the EMU to address its crisis. Merkel's recent initiatives, such as forcing banks and other creditors to slash the Greek debt in half, indicate a commitment to the European Union that both authors appear to underestimate.
But Merkel has been at least one step behind the careening crisis from the beginning, and has displayed little aptitude for the kind of innovative thinking or tough-minded decision-making required. Merkel and her European peers have done next to nothing about providing the over-indebted euro countries with a road map to get their economies back on their feet and address the skewed monetary policies that landed everybody in this mess. This means coming up with a convincing strategic vision for the future and not just half-measures to patch up the blunders of the past.
Paul Hockenos is a writer living in Berlin. His most recent book is Joschka Fischer and the Making of the Berlin Republic.