The Euro, Europe’s adolescent single currency, is in rough waters.
This week European finance chiefs signed off on a 78 billion Euro bail-out for Portugal, while calling for Greece to accept stringent austerity measures.
For more than a year, Euro area member countries such as Greece, Ireland, Portugal and most recently Spain have come into the focus of financial markets increasingly unwilling to finance the government debts of these countries.
Sharply increasing interest rates for re-financing public debt and deficits are the consequence.
Some countries have even getting close to the inability to re-finance.
There is a considerable debate whether Europe is merely witnessing sovereign debt crises of some members of the Euro area or whether it is facing a crisis of the Euro.
European leaders and the European Central Bank (ECB) are negating a Euro crisis by pointing to the external value of the currency and a ten year record of low inflation.
Is it then primarily the fault of profligate member states which did not stick to the rules of prudent economic policy making?
Then financial assistance to the sinners may be sufficient to prevent unjustified contagion to other countries and to link this support with strict conditions to force the profligate back to a more prudent policy.
Unfortunately this finance-cum-austerity receipt has not succeeded yet.
To the contrary, interest rates for Greece, Ireland and Portugal have been reaching new peaks even after the new European Stabilisation Mechanism (ESM) has been created in late March (to go into effect in 2013).
I argue that we are neither facing simple debt crises nor a Euro crisis, but a European governance crisis that calls for a renewed and sustainable European governance structure.
The trilemma of the single currency
Many economists have warned that introducing a common currency without a fiscal union – or at least efficient fiscal policy coordination – can be dangerous.
However, as long as the economic environment is largely stable a common currency may work – at a cost though, but other benefits could make the endeavour worthwhile.
The trouble has started in the aftermath of the global financial crises that dramatically weakened the European banking system and eroded the tax bases in the problem countries, revealing underlying structural problems: Greece’s profligate debt policy, Ireland’s rescue of parts of an increasingly integrated European banking system and excessive private debt accumulations in Spain and Portugal.
Why has Europe created a Euro without installing the necessary complementary institutions to make it work in difficult times too?
The simple answer is that Europe was and is still not ready for such a deep level of political integration. But why then embarking on the ambitious Euro experiment?
On the one hand, there has always been the hope that the Euro will lead the way to more economic and eventually political integration that will finally make EMU functioning under all conditions.
On the other hand, there were strong push factors, too.
They came from contradictions within the European Monetary System (EMS) of fixed exchange rates that Europe has adopted in 1979 in order to insulate intra-European trade from exchange rate volatility which was considered as a threat to deeper integration.
When Europe embarked on the ambitious Single Market project, opening up markets and finally abolishing national borders, the freely flowing capital forced interest rates to converge to German rates as the German mark has de facto, not by design become the anchor currency in the EMS.
Thus, interest rates were de-facto set in Frankfurt. In a system of fixed exchange rates and perfect capital mobility there is no room for a national autonomous monetary policy.
This so-called trilemma led finally to a speculative attack on several EMS countries in 1992 and 1993 when German interest rates were increased sharply by the Deutsche Bundesbank after unification.
Financial markets made a bet that EMS countries suffering from high unemployment would prefer a devaluation of its currency over suffering from German-imposed high interest rates.
The lesson learned was that in a Europe of free capital movements exchange rate pegs can be attacked anytime.
By irrevocably fixing the peg, a common currency was supposed to solve the problem of speculative attacks forever. Moreover, as the monetary policy was now handed over to the ECB, at least partial sovereignty over monetary policy could be regained.
The trilemma strikes back
What we see today is a sad and in a way ironic comment on these hopes. Speculative attacks are back more forcefully than ever, as countries lost the ability to solve their problems by devaluing their currencies.
Thus the countries under attack have to undergo austerity programs under which they lose additionally and almost completely the sovereignty over their fiscal policy.
Decisions about pension, government salaries, spending on school and roads, taxes and so forth are heavily controlled by the austerity policy demands from the stable EMU countries, notably Germany. How far can this go?
According to Rodrik a country can choose only two out of three elements: national policy determination, integrated markets and democracy. EMU and its current problems can be viewed through that lens: National monetary policy determination has largely been given up and handed over to the ECB.
Today, however, it has become clear that EMU needs more European governance than just a single central bank.
The current solution still favours national policy determination which, however, increasingly runs counter to what the electorate on both sides wants: those who suffer from and oppose the austerity policy in problem countries and those who oppose financing rescue funds in the remaining countries.
Ignoring these demands can only work when the finance-cum-austerity strategy brings fast results. But even its supporter are expecting many years of hardship and adjustment to come.
For financial markets this allows a new bet, very similar to the ones made in the EMS crisis: Will countries chose exiting EMU over suffering from austerity?
Thus, there is a speculation on the failure of the strategy, resulting either into some form of debt restructuring efforts or – in the worst case – a break-up of the Euro area.
Elements for a sustainable Europe
As Barry Eichengreen has argued convincingly, a break-up of the Euro area would eventually trigger “the mother of all financial crises”.
And up to now the European strategy is to avoid even mentioning any debt restructuring for fear of contagion to other countries and the subsequent threat to overexposed European banks.
Thus, Europe continues with an intensified finance-cum-austerity strategy. But this concept will only work, when some light at the end of the tunnel becomes visible.
Two lines of action have to be taken to make the Euro and Europe sustainable: An immediate change in the crisis management to provide the necessary light at the end of the tunnel and – at the same time – institutional reforms for creating a sustainable Europe.
In the short-run markets have to be stabilised. For this to happen it is necessary to devise a strategy that convincingly can bring the debt service and the debt to GDP levels down to bearable levels over time.
The current strategy asks for too much procyclical austerity in return for too little financing.
Instead, national policy reforms should be geared more towards a medium- and long-term improvement of state finances.
From a political point of view, debt and deficit reduction goals should be defined quantitatively, but the details should be left as much as possible to national policy makers, eventually “approved” by an independent expert body, rather than being (felt) imposed from the outside.
Moreover, the current practice of charging relative high interest rates in order to reduce potential moral hazard incentives makes it more difficult for countries to grow out of their debts and should be abandoned.
Finally, in some cases debt restructuring and “haircuts” are unavoidable, notably Greece and Ireland. Of course, the devil lies in the detail: it has to be made sure that an effective and sufficient debt relief is provided and contagion to other countries and to an overexposed European banking system can be contained.
While default and debt restructuring should in principle be ruled out for advanced European countries, it is also clear that in exceptional cases where banks and bond holders who went into risks with open eyes and have been rescued and rewarded handsomely with high returns have to burden their share, too.
Ultimately, the Euro needs a new governance structure. The creation of the ESM is a first and welcomed step, but as much as its design is visible by now, its conditionality could be too procyclical and the interest charges too high.
This can act as an invitation to speculative attacks, especially as ESM requires private holders of newly issued government bonds to participate in debt restructuring.
Thus, ESM could increase the vulnerability of the Euro area. This problem should be addressed.
Secondly, as it has become clear that the crisis is deeply connected to the still vulnerable European banking industry the creation of a truly European banking supervision and regulation is urgently needed.
Thirdly, issuing joint Eurobonds for investing in pan-European infrastructure could bring at least three benefits: an immediate budget relief for all and not just problem countries, a much needed growth stimulus, and a kick start for Eurobonds and pan-European fiscal co-operation.
Fourth, and in connection to the last point, effective economic policy co-ordination with a view on maintaining competitiveness across the Euro area is urgently needed.
One could extend this list further, but the overriding issue is that Europe has to address the issues imposed by the political trilemma.
How much national determination in exchange for effective European governance are the member states ready to give up in order to make European integration achievements work in rough times too?
Whatever the decisions will be, Europe’s core value is democracy and “more Europe” will therefore also require a democratic foundation of European governance.