Sticking to the rules will not rescue the eurozone

Most events have an official – or at any rate widely accepted – narrative. In much of Europe, the narrative of the eurozone crisis goes something like this: this is not a crisis of the eurozone, which has been a success. The European Central Bank (ECB) has delivered price stability, and the euro has become an established and stable international currency. If some member-states currently face difficulties, it is because they lost ‘competitiveness’ and violated the fiscal rules. It follows that the way to restore confidence in the eurozone is for the sinners to consolidate their public finances and to reform their economies. The road to redemption passes through the rediscovery of discipline, thrift and hard work. 

The narrative has an unmistakable North European imprint: “We, the creditor countries, are free of sin. Other countries would be fine if only they behaved like us. Our behaviour must therefore be universalised. The eurozone as currently designed is a workable arrangement, provided all its member-states learn to observe the rules of the club (as North Europeans do). Countries that break the rules must be punished, while serial offenders may have to be shown the exit door.” This narrative passes for received wisdom in Finland, Germany and the Netherlands. But it is self-righteous, complacent and wrong-headed. And its underlying message is probably incompatible with the survival of the eurozone. 

The Northerners are obviously right that excesses have occurred in the eurozone’s periphery and that South European countries need to reform. But the North European narrative is illogical because it is impossible for every country to ‘live within its means’ (creditor countries can only exist if there are debtors). It is wrong-headed because compliance with the fiscal rules had little bearing on whether countries subsequently found themselves shut out of the bond markets. And it is self-serving because it skates over sin in the core. It is a little unedifying to watch Germany call for ever greater levels of pain in Southern Europe while it does so little to tackle its weakly-capitalised banking system. 

The obsession with discipline and rules continues to spawn perverse attitudes and policies. Greece is being berated for missing its fiscal targets – even though a sharper than projected contraction in GDP is to blame. All eurozone countries are trying to prove their virtue by slashing public spending at the same time – the collective outcome will be a brutally contractionary policy for the region as a whole. (This is not policy co-ordination, but the opposite.) As for the ECB, it has come in for fierce criticism in Germany for buying Spanish and Italian government bonds – a move that was necessary to avert the collapse of the eurozone, but which prompted the resignation of the ECB’s chief economist, Jürgen Stark. 

Countries in the eurozone’s core increasingly give the impression that rules should be obeyed at almost any price. Why? The answer is that rules are a substitute for fiscal union. Rules exist because the appetite for fiscal union does not. The fussing over rules and discipline looks like displacement activity. The crux of the matter is that the eurozone as currently constituted is institutionally incomplete – and governments have no democratic mandate to rectify the design flaw. 

This lack of political will is disastrous given that the euro – a shared currency outside a fiscal union – has turned out to be less stable than even longstanding sceptics had imagined. The reason is that a currency shared by fiscally independent member-states can generate vicious negative feed-back loops between sovereigns and banks. The legacy of the global financial crisis in 2008 was a sovereign debt crisis in parts of the eurozone, and a banking crisis across the region as a whole. The two crises have fed on each other ever since, with weak sovereigns undermining confidence in banks and vice versa. The greatest threat to the eurozone is that this vicious feedback loop spins out of control. The polarisation of government bond yields within the eurozone since early July, allied to the growing funding difficulties of banks across the region, suggest that this point is perilously close to hand. 

What might help to arrest the negative feed-back loop? The short answer is: mutualisation. Since yields on peripheral bonds are unsustainably high and yields on core bonds are abnormally low (because of high levels of risk aversion), pooling debt would reduce the polarisation of borrowing costs. Likewise, the adoption of a pan-European deposit protection scheme would stabilise banks domiciled in countries with weakened sovereigns, because it would reduce their vulnerability to runs on deposits. But describing what may be necessary to stabilise the euro is to emphasise how far European leaders are from doing so: mutualisation is anathema to many governments and voters in creditor countries. 

Rules, however strictly or inflexibly applied, will not restore faith in the eurozone. Fiscal consolidation in Greece, labour reforms in Spain, and pension reforms in Italy are all necessary. However, they will not turn the eurozone into a more stable arrangement, as creditor countries appear to have convinced themselves. That cannot happen without a further institutional step forward, the nature of which exceeds current political appetites. In the absence of such a step, the eurozone is condemned to be a currency area marked (in the most benign scenario) by periodic confidence crises and sovereign defaults, but which is more likely to break up in an uncontrolled and potentially catastrophic manner. 

Since the 1950s, monetary stability and European integration have been two leading (and largely complementary) German policy priorities. This is no longer the case. German appetite for European integration is waning. Voters do not want to be part of a ‘transfer union’, and some influential policy-makers now seem to believe that European integration poses a threat to monetary stability. From Southern Europe, the view looks different: it is of a Germany obsessed with the lessons of the 1920s condemning them to the disastrous policies of the 1930s.