The euro: Reaching the endgame?

by Simon Tilford

Eurozone policy-makers, especially German and Dutch ones, have been unable to rise above hubris and moral posturing, leaving the eurozone with very little ammunition to confront the coming financial storm. They have stubbornly dug in their feet, preferring to deepen the crisis than to admit their mistakes. This makes a fracturing of the eurozone almost inevitable. And it will not simply be Greece (and possibly Portugal) leaving, as some German and Dutch policy-makers appear to think. This is wilfully naive. This threat goes right up to and includes France. A ‘core’ could be very small indeed, comprising just Germany, the Netherlands, Austria, Finland and Luxembourg. France and Germany would no longer share a currency.

The eurozone has opted to deny itself the policy tools to deal with the crisis: there will be no debt mutualisation, even one accompanied by tight fiscal rules; the European Central Bank (ECB) will not be permitted to exercise the full range of lender of last resort functions (for example, to buy unlimited volumes of sovereign debt or other financial assets); there will be no co-ordinated recapitalisation of eurozone banks; and economic policy will be driven by faith, not reason (leading eurozone policy-makers believe that unco-ordinated, simultaneous cuts in public spending allied to tax increases, will boost household and business confidence). This is the kind of thinking that caused economic slump in the 1930s, and with it the rise of political extremism.

Debt mutualisation: September’s ruling by Germany’s Constitutional Court has thrown a further obstacle in the way of the issuance of eurobonds, but the political obstacles to such a move were already formidable. A move to fiscal union cannot be pushed through under the radar (in time-honoured EU tradition) but has to be sanctioned democratically. Because of the way various eurozone governments (especially the German and Dutch ones) have characterised the eurozone crisis – as a battle between the virtuous and the venal, between those countries that keep to the rules and those that break them – it will be nigh-impossible to win democratic consent for a debt union in these countries.

Lender of last resort: The ECB is highly unlikely to be permitted to carry out the full range of lender of last resort functions to eurozone sovereigns and banks. It will not, for example, be free to step in and buy unlimited amounts of government debt in order to demonstrate to investors that their fears over insolvency are unfounded. The resignations of both Juergen Stark and Axel Weber (the German chief economist at the ECB and the head of Bundesbank respectively) in protest at the ECB’s buying of the government debt of hard-hit member-states, demonstrates that much of the German policy establishment would prefer the crisis to run its course rather than compromise on their philosophical positions. Had the ECB not stepped in to purchase Spanish and Italian bonds over the summer of 2011, both countries’ borrowing costs would have continued to balloon, almost certainly causing interrelated sovereign and banking sector crises, calling into question the future of the single currency.

Far from laying the way open for a more activist ECB strategy aimed at reassuring investors that the central banks stand behind the sovereign debt of eurozone economies, the departure of Mr Stark confirms the breach with Germany and threatens to paralyse the ECB. In extremis, the European Financial Stability Fund (EFSF) and its successor, the European Stability Mechanism (ESM), will be able to buy some sovereign debt and inject some funds into the banks, but nowhere near enough to cope with an interrelated sovereign and banking sector crisis. Any attempt at a properly activist strategy will prompt a stand-off with Germany. The outcome of such a stand-off cannot be predicted, but it is unlikely to involve Germany backing-down (at least, not far enough) and the ECB could not risk pushing ahead in the teeth of German opposition.

Bank recapitalisation: The dual failure to agree debt mutualisation or allow the ECB to act in the interests of the whole eurozone rather than just its creditor economies would be less critical if eurozone governments were moving to recapitalise their banks, so that they were better placed to cope with the coming debt defaults. Eurozone policy-makers had hoped that a rebound in economic growth and moves to postpone defaults would give eurozone banks time to strengthen their balance sheets. But with the eurozone economy having almost certainly fallen back into recession, this strategy is untenable. Despite an unfolding banking crisis – some bank shares have already fallen by more than in the 2008 financial crisis – there is no plan to make Europe’s banks bullet proof. August’s call by Christine Lagarde (the former French finance minister and now head of the IMF) for the forced recapitalisation of eurozone banks was airily dismissed across the eurozone. But it would be much cheaper to address the problem now than try to pick up the pieces later.

Growth-orientated economic policy: Finally, eurozone macroeconomic policy is being driven by a belief in the confidence fairy. Eurozone policy-makers, from German finance minister, Wolfgang Schaeuble, to ECB president, Jean-Claude Trichet, queue up to argue that fiscal austerity, even if pursued by all member-states simultaneously, will not be contractionary, let alone risk destroying the euro. According to this belief, fiscal austerity will boost household and business confidence by reassuring households and businesses that government finances are sustainable, leading to a recovery in consumption and investment. But they are unable to cite any historical precedent in support of this belief, which appears to boil down to little more than faith. There are, of course, examples of fiscal austerity preceding economic growth, but they all include currency devaluation and/or big cuts in interest rates. Neither option is open to eurozone economies. Unsurprisingly, household and business confidence is crumbling rapidly across the currency union, depressing economic activity, and with it the likelihood of governments meeting their fiscal targets.

On current policy trends, a series of sovereign and banking defaults are unavoidable. Does this mean that dissolution of the eurozone is inevitable? Almost certainly, yes. On current policy trends, much of the eurozone faces depression and deflation. The ECB and EFSF will not be able to keep a lid on bond yields, with the result that countries will face unsustainably high borrowing costs and default. This, in turn, will cripple these countries’ banking sectors, but they will be unable to raise the funds needed to recapitalise them. Stuck in a vicious deflationary circle, unable to borrow on affordable terms, and subject to quixotic and counter-productive fiscal and other rules for what support they do get from the EFSF and ECB, political support for continued membership will drain away. Faced with a choice between permanent slump and rising debt burdens (as falling GDP and deflation leads to inexorable increases in debt), countries will elect to quit the currency union. At least this way they will be able to print money, recapitalise their banks and escape deflation. Once Spain or Italy opt for this, the dissolution of the eurozone will be unstoppable. Investors will not wear French participation in a core euro: the country has weak public finances and a sizeable external deficit. Participation in the core would imply a potentially huge real currency appreciation and a corresponding collapse in economic activity. Investors will calculate that the wage cuts (to restore competitiveness) and cuts in public spending (to rein in the fiscal deficit) would be politically unsustainable. In short, France will effectively be in the same position as Italy and Spain are at present.

Such contentions are met with derision and incredulity across much of the eurozone. Otherwise rational people talk about something ‘coming up’ or express confidence that policy-makers ‘will never let that happen’. The political investment in the project is just too great for this to happen, they argue, usually accompanying this assertion with accusations that Anglo-Saxons are hopelessly wedded to the world of the nation-state and just do not understand that Europe has moved beyond such primitive attachments. Such assertions sit very uneasily with events over the last two years. The euro crisis has spun out of control because eurozone governments are unwilling to acknowledge that their policies have an impact on other member-states, and that this requires a measure of solidarity. Indeed, if there is one thing this crisis has shown, it is that the nation-state is alive and kicking in the eurozone.

Simon Tilford is chief economist at the CER.