Giving a speech in Berlin, I
feel obliged to speak about the euro because the euro is in crisis and Germany
is the main protagonist. Unfortunately I didn’t get the timing right because
the crisis has both a fiscal component and a banking component and the situation
of the banks is just now approaching a climax. A comprehensive analysis will
have to await the publication of stress test results. The best I can do at this
moment is to put matters into a historical perspective.
I believe that misconceptions play
a large role in shaping history and the euro crisis is a case in point.
Let me start my analysis with the
previous crisis, the bankruptcy of Lehman Brothers. In the week following
September 15 2008 global financial markets actually broke down and by the end
of the week they had to be put on artificial life support. The life support consisted of substituting
sovereign credit for the credit of financial institutions which ceased to be
acceptable to counterparties.
As Mervyn King of the Bank of
England explained, the authorities had to do in the short-term the exact
opposite of what was needed in the long-term: they had to pump in a lot of credit, to
replace the credit that had disappeared, and thereby reinforce the excess
credit and leverage that had caused the crisis in the first place. Only in the longer term, when the crisis had subsided,
could they drain the credit and reestablish macro-economic balance.
This required a delicate two phase maneuver – just as when a car is skidding,
first you have to turn the car into the direction of the skid and only when you
have regained control can you correct course.
The first phase of the maneuver
has been successfully accomplished – a collapse has been averted. But the underlying causes have not been removed
and they have surfaced again when the financial markets started questioning the
credibility of sovereign debt. That is when the euro took center stage because
of a structural weakness in its constitution. But we are dealing with a
worldwide phenomenon, so the current situation is the direct consequence of the
crash of 2008.
The situation is eerily
reminiscent of the 1930s. Doubts about
sovereign credit are forcing reductions in budget deficits at a time when the
banking system and the economy may not be strong enough to do without fiscal
and monetary stimulus. Keynes taught us
that budget deficits are essential for counter-cyclical policies, yet
governments everywhere feel compelled to reduce them under pressure from the financial
markets. Coming at a time when the
Chinese authorities have also put on the brakes, this is liable to push the
global economy into a slowdown or possibly a double dip. Europe, which
weathered the first phase of the financial crisis relatively well, is now at
the forefront of the downward pressure because of the problems connected with
the common currency.
The euro was an incomplete
currency to start with. The Maastricht
Treaty established a monetary union without a political union. The euro boasted a common central bank but it
lacked a common treasury. It is exactly
that sovereign backing that financial markets started questioning that was
missing from the design. That is why the euro has become the focal point of the
Member countries share a common
currency, but when it comes to sovereign credit they are on their own. This fact was obscured until recently by the
willingness of the European Central Bank to accept the sovereign debt of all
member countries on equal terms at its discount window. This allowed the member countries to borrow
at practically the same interest rate as Germany and the banks were happy to
earn a few extra pennies on supposedly risk-free assets by loading up their balance
sheets with the government debt of the weaker countries. These positions now endanger the
creditworthiness of the European banking system. For instance, European banks
hold nearly a trillion euros of Spanish debt of which half is held by German
and French banks. It can be seen that the euro crisis is intricately
interconnected with the situation of the banks.
How did this connection arise?
The introduction of the euro
brought about a radical narrowing of interest rate differentials. This in turn generated
real estate bubbles in countries like Spain, Greece, and Ireland. Instead of
the convergence prescribed by the Maastricht Treaty, these countries grew
faster and developed trade deficits within the eurozone, while Germany reigned
in its labor costs, became more competitive and developed a chronic trade surplus.
To make matters worse some of these countries, most notably Greece, ran budget
deficits that exceeded the limits set by the Maastricht Treaty. But the
discount facility of the ECB allowed them to continue borrowing at practically
the same rates as Germany, relieving them of any pressure to correct their
The first clear reminder that
the euro does not have a common treasury came after the bankruptcy of Lehman. The
finance ministers of the European Union promised that no other financial institution
whose failure could endanger the system would be allowed to default. But Angela Merkel opposed a joint Europe-wide
guarantee; each country had to take care of its own banks.
At first, the financial markets
were so impressed by the guarantee that they hardly noticed the
difference. Capital fled from the
countries which were not in a position to offer similar guarantees, but the
interest differentials within the eurozone remained minimal. That was when the
countries of Eastern Europe, notably Hungary and the Baltic States, got into
difficulties and had to be rescued.
It was only this year that
financial markets started to worry about the accumulation of sovereign debt within
the eurozone. Greece became the center of attention when the newly elected
government revealed that the previous government had lied and the deficit for 2009
was much larger than indicated.
Interest rate differentials
started to widen but the European authorities were slow to react because the
member countries held radically different views. Germany,
which had been traumatized by two episodes of runaway inflation, was allergic
to any buildup of inflationary pressures; France and other countries were more willing
to show their solidarity. Since Germany was heading for elections, it was
unwilling to act. But nothing could be
done without Germany. So the Greek crisis festered and spread. When the authorities finally got their act
together they had to offer a much larger rescue package than would have been
necessary if they had acted earlier.
meantime, the crisis spread to the other deficit countries and, in order to
reassure the markets, the authorities felt obliged to put together a €750
billion European Financial Stabilization Fund, €500 billion from the member
states and €250 billion from the IMF.
markets are not reassured, because the term sheet of the Fund was dictated by
Germany. The Fund is guaranteed not jointly but only severally so that the
weaker countries will in fact be guaranteeing a portion of their own debt. The
Fund will be raised by selling bonds to the market and charging a fee on top. It
is difficult to see how it will merit a triple A rating.
more troubling is the fact that Germany is not only insisting on strict fiscal
discipline for weaker countries but is also reducing its own fiscal deficit.
When all countries are reducing deficits at a time of high unemployment they
set in motion a downward spiral. Reductions in employment, tax receipts, and
exports reinforce each other, ensuring that the targets will not be met and further
reductions will be required. And even if budgetary targets were met, it
is difficult to see how the weaker countries could regain their competitiveness
and start growing again because, in the absence of exchange rate depreciation,
the adjustment process would require reductions in wages and prices, producing
extent a continued decline in the value of the euro may mitigate the deflation
but as long as there is no growth, the relative weight of the debt will
continue to grow. This is true not only
for the national debt but also for the commercial loans held by banks. This will make the banks even more reluctant
to lend, compounding the downward pressures.
euro is a patently flawed construct and its architects knew it at the time of
its creation. They expected its defects to be corrected, if and when they
became acute, by the same process that brought the European Union into
European Union was built by a process of piecemeal social engineering, indeed
it is probably the most successful feat of social engineering in history. The
architects recognized that perfection is unattainable. They set limited objectives and firm
deadlines. They mobilized the political will for a small step forward, knowing
full well that when it was accomplished its inadequacy would become apparent
and require further steps. That is how
the coal and steel community was gradually developed into the European Union,
step by step.
Germany used to be at the heart of the process. German statesmen used to assert
that Germany has no independent foreign policy, only a European policy. After
the fall of the Berlin Wall, Germany’s leaders realized that unification was
possible only in the context of a united Europe and they were willing to make considerable
sacrifices to secure European acceptance.
When it came to bargaining they were willing to contribute a little more
and take a little less than the others, thereby facilitating agreement. But those days are over. Germany doesn’t feel so rich anymore and
doesn’t want to continue serving as the deep pocket for the rest of
Europe. This change in attitudes is
understandable but it did bring the process of integration to a screeching
now wants to treat the Maastricht Treaty as the scripture which has to be
obeyed without any modifications and this is not understandable, because it is
in conflict with the incremental method by which the European Union was built.
Something has gone fundamentally wrong in Germany’s attitude towards the
first analyze the structural defects of the euro and then examine Germany’s
attitude. The biggest deficiency in the euro, the absence of a common fiscal
policy, is well known. But there is another defect that has received less
recognition: a false belief in the stability of financial markets. As I tried to explain in my writings, the
Crash of 2008 has demonstrated that financial markets do not necessarily tend
towards equilibrium; they are just as likely to produce bubbles. I don’t want to repeat my arguments here
because you can find them in my lectures which have just been published in
German. All I need to do is remind you that the introduction of the euro created
its own bubble in the countries whose borrowing costs were greatly
reduced. Greece abused the privilege by
cheating, but Spain didn’t. It followed
sound macro-economic policies, maintained its sovereign debt level below the
European average, and exercised exemplary supervision over its banking
system. Yet it enjoyed a tremendous real
estate boom which has turned into a bust resulting in 20% unemployment. Now it has to rescue the savings banks called
cajas and the municipalities. And the entire European banking system is weighed
down by bad debts and needs to be recapitalized. The design of the euro did not
take this possibility into account.
structural flaw in the euro is that it guards only against the danger of
inflation and ignores the possibility of deflation. In this respect the task
assigned to the ECB is asymmetric. This is due to Germany’s fear of
inflation. When Germany agreed to
substitute the euro for Deutschmark it insisted on strong safeguards to
maintain the value of the currency. The Maastricht Treaty contained a clause
that expressly prohibited bailouts and the ban has been reaffirmed by the
German Constitutional Court. It is this clause that has made the current
situation so difficult to deal with.
this brings me to the gravest defect in the euro’s design; it does not allow
for error. It expects member states to
abide by the Maastricht criteria without establishing an adequate enforcement
mechanism. And now that several countries are far away from the Maastricht
criteria, there is neither an adjustment mechanism nor an exit mechanism. Now
these countries are expected to return to the Maastricht criteria even if such
a move sets in motion a deflationary spiral. This is in direct conflict with
the lessons learnt from the Great Depression of the 1930s and is liable to push
Europe into a period of prolonged stagnation or worse. That will, in turn,
generate discontent and social unrest. It
is difficult to predict how the anger and frustration will express itself.
wide range of possibilities will weigh heavily on the financial markets. They will have to discount the prospects of
deflation and inflation, default and disintegration. Financial markets dislike
were to happen, Germany would have to bear a major share of the responsibility
because as the strongest and most creditworthy country it calls the shots. By insisting on pro-cyclical policies, Germany
is endangering the European Union. I realize
that this is a grave accusation but I am afraid it is justified.
sure, Germany cannot be blamed for wanting a strong currency and a balanced
budget but it can be blamed for imposing its predilection on other
countries that have different needs and preferences – like Procrustes, who forced
other people to lie in his bed and stretched them or cut off their legs to make
them fit. The Procrustes bed inflicted on the eurozone is called deflation.
Germany does not realize what it is doing. It has no desire to impose its will on Europe;
all it wants to do is to maintain its competitiveness and avoid becoming the
deep pocket to the rest of Europe. But as the strongest and most creditworthy
country it is in the driver’s seat. As a result Germany objectively determines
the financial and macroeconomic policies of the eurozone without being
subjectively aware of it. When all the member countries try to be like
Germany they are bound to send the eurozone into a deflationary spiral. That is the effect of the policy pursued by
Germany and – since Germany is in the driver’s seat – these are the policies
imposed on the eurozone.
German public does not understand why it should be blamed for the troubles of
eurozone. After all, it is the most successful economy in Europe, fully capable
of competing in world markets. The troubles of the eurozone feel like a burden
weighing Germany down. It is difficult to see what would change this perception
because the troubles of the eurozone are depressing the euro and being the most
competitive Germany benefits the most. As a result Germany is likely to feel
the least pain of all the member states.
error in the German attitude can best be brought home by engaging in a thought
experiment. The most ardent instigators of that attitude would prefer that
Germany leave the euro rather than modify its position. Let us consider where
that would lead.
Deutschmark would go through the roof and the euro would fall through the
floor. This would indeed help the adjustment process but Germany would find out
how painful it can be to have an overvalued currency. Its trade balance would
turn negative and there would be widespread unemployment. German banks would
suffer severe exchange rate losses and would require large injections of public
funds. But it would be politically more acceptable to rescue German banks than
Greece or Spain. And there would be other compensations: pensioners could
retire to Spain and live like kings, helping Spanish real estate to recover.
emphasized that this scenario is totally hypothetical because it is extremely unlikely
that Germany would be allowed to leave the euro and to do so in a friendly
manner. Germany’s exit would be destabilizing financially, economically and
above all politically. The collapse of
the single market would be difficult to avoid. The purpose of this thought
experiment is to convince Germany to change its ways without going through the
actual experience that its current policies hold in store.
would be the right policy for Germany to pursue? It cannot be expected to
underwrite other countries’ deficits indefinitely. So some tightening of fiscal
policies is inevitable. But some way has to be found to allow the countries in
crisis to grow their way out of their difficulties. The countries concerned
have to do most of the heavy lifting by introducing structural reforms but they
do need some outside help to allow them to stimulate their economies. By cutting
its budget deficit and resisting a rise in wages to compensate for the decline
in the purchasing power of the euro Germany is actually making it more
difficult for the other countries to regain competitiveness.
should Germany do? It needs to recognize three guiding principles.
the current crisis is more a banking crisis than a fiscal one. The continental
European banking system has not been properly cleansed after the crash of 2008.
Bad assets have not been marked-to-market but are being held to maturity. When
markets started to doubt the creditworthiness of sovereign debt it was really
the solvency of the banking system that was brought into question because the
banks were loaded with the bonds of the weaker countries and these are now
selling below par. The banks have difficulties in obtaining short-term
financing. The interbank market and the
commercial paper market have dried up and banks have turned to the ECB both for
short-term financing and for depositing their excess cash. They are in no
position to buy government bonds. That is the main reason why risk premiums on
government bonds have widened, setting up a vicious circle.
crisis has now culminated in forcing the authorities to disclose the results of
their stress tests. We cannot judge how serious the situation is until the
results are published – indeed, we shall not be able to judge even then because
the report will deal only with the twenty five largest banks and the biggest
problems are in the smaller banks, notably the cajas in Spain and the
Landesbanken in Germany. It is clear however that the banks need to be
recapitalized on a compulsory basis. They are way over-leveraged. That ought to
be the first task of the European Financial Stabilization Fund. That will go a
long way to clear the air. It may be seen, for instance, that Spain does not
have a fiscal crisis at all. Recent market moves point in that direction.
Germany’s role may also be seen in a very different light if it becomes a
bigger user than contributor of the Stabilization Fund.
a tightening of fiscal policy must be offset by a loosening of monetary policy.
Specifically, the ECB could buy treasury
bills directly from Spain significantly reducing its financing cost below the punitive
rate charged by the German inspired European Financial Stabilization Fund. But that
is not possible without a change of heart by Germany.
is the time to put idle resources to work by investing in education and
infrastructure. For instance, Europe needs a better gas pipeline system and the
connection between Spain and France is one of the bottlenecks. The European
Investment Bank ought to be able to find other investment opportunities as
impossible to be more concrete at the moment but there are grounds for optimism.
When the solvency situation of the banks
has been clarified and they have been properly recapitalized it should be
possible to devise a growth strategy for Europe. And when the European economy
has regained its balance the time will be ripe to correct the structural
deficiencies of the euro. Make no mistake about it; the fact that the
Maastricht criteria were so massively violated shows that the euro does have
deficiencies that need to be corrected.
needed is a delicate, two-phase maneuver, similar to the one the authorities undertook
after the failure of Lehman Brothers. First help Europe to grow its way out of
its difficulties and then revise and strengthen the structure of the euro. This
cannot be done without German leadership. I hope Germany will once again live
up to the responsibilities that go with its leadership position. After all, it
had done so in the past. Thank you.
In a Financial Times op-ed, George Soros asks us to consider what would happen if Germany left the euro. You can also read Wolfgang Schäuble, Germany’s Finance Minister’s, piece on why Germany is right to cut spending.
The European Council on Foreign Relations does not take collective positions. ECFR publications only represent the views of their individual authors.