Can the Euro survive?

Lionel Barber, the FT’s editor, speaks at the John F Kennedy School, Harvard University, on the future for the European Union’s currency - October 26, 2010

Thank you, Nick, for that kind introduction. I am delighted to be back here at the Kennedy School, and even more flattered to be invited to talk about Europe and the euro. After all, euro-pessimism is infectious these days. We are all familiar with sentiment in Britain, the home of euro-pessimism but I was struck by how the disease has spread to India, where I have just been on assignment. The Indian elite is almost as dismissive about Europe – and almost as China-centric – as the chattering classes here in the US.

The charge sheet against Europe runs something like this: The EU is institutionally blocked, insular, and incapable of effective crisis management. Low growth Europe is in decline in relation to the rising powers of China, India, Brazil and other emerging market economies. To borrow Bob Rubin’s image, Europe is like a museum with splendid antique relics – to the left, the French room devoted to social solidarity; to the right; the German room devoted to metal bashing and mass manufacturing, and out in front, the Swedish room devoted to social democracy. In short, Europe looks politically and structurally incapable of adapting to the challenges of today, let alone tomorrow.

This year’s euro crisis has made Euro-pessimism still more prevalent. A recent three part series in the Financial Times highlighted the prolonged stand-off over a rescue plan for Greece and the corresponding risk of a sovereign default spreading to Portugal, Spain and Ireland. This in turn exposed profound weaknesses in the governance of the eurozone and sharp divisions between the linchpin powers of France and Germany. More significant still, the crisis was averted only after timely interventions from outside, principally from the US and the International Monetary Fund.

But before I explore in more depth the origins of the crisis and the eurozone’s faltering response, I would like you to conduct a small thought experiment. Let’s go back to 1994, two years after the signing of the Maastricht treaty which set out the conditions and timetable for monetary union. The newly-named European Union had suffered two bouts of severe currency turbulence. The first led to the ejection of the UK and Italy from the exchange rate mechanism, and one year later to the creation of wider bands for currency fluctuation within the ERM, so wide in fact that they were dubbed not bands but boulevards.

I remember this period vividly because I was the FT’s chief European

correspondent based in Brussels. I spent many a night and more than a few early mornings watching and reporting on efforts to restore confidence in the shattered Emu project. It looked a forlorn task: at one point, Kohl, Mitterrand, Aznar and others could not even agree on a name for the new currency. Crown, ducat, ecu, euromark, and florint all fell by the wayside before leaders finally settled on the distinctly prosaic euro. Yet within four years the EU had designated 11 founding members of the single currency and executed a seamless transition to notes and coins by 2002. No mean technical and political achievement,

All this is by way of prelude to this year’s drama. The financial crisis has laid bare three basic flaws in Europe’s single currency project: the weakness in the enforcement mechanisms for fiscal discipline among eurozone members; second, the conceit that there could be no bail-out mechanism for fiscal delinquents; third, the lack of effectiveness of the much-vaunted peer review process and collective surveillance by the European Commission.

Let me deal with these in turn. Under the German-inspired Stability and Growth pact agreed ahead of the launch of the euro, member states were obliged to keep their budget deficits below three per cent of GDP in all but exceptional circumstances or face sanctions, including fines. But in 2003, France and Germany, themselves transgressors, agreed that the pact’s strictures need not apply to them, Jean-Claude Trichet, the president of the European Central Bank, is not the only one to argue that the Franco-German circumvention was disastrous in terms of fiscal credibility and eurozone governance. It spelt out an uncomfortable truth: a two-tier Europe with one law applying to the big countries and another for the small.

As for the fate of the no bail-out clause in the Maastricht treaty, inserted at Germany’s insistence as the price for surrendering its treasured deutschemark, well to paraphrase Harold Macmillan’s words, that fate was sealed by “events, dear boy, events”. Once Greece teetered on the brink of default, a collective rescue had to be mounted or else the entire project was at risk, Only the terms had to be agreed and though the bargaining was ferocious in April and May it ended in a new EU borrowing facility - the European financial stabilisation facility as well as bilateral financial aid to complement the IMF package.

Finally, the crisis has exposed flaws in the peer review process which put disproportionate emphasis on fiscal discipline at the expense of equally relevant criteria such as current account deficits. So the likes of Greece and Spain were awarded the equivalent of gold stars for bringing their deficits (temporarily) under the three per cent target. Greece admitted later that it had only met the criteria falsifying the data (!) – a novel approach to economic management.

Equally seriously, no one was paying attention to excessive consumption and the attendant current account deficits. The reason, of course, lay in the false convergence between bond yields post Emu launch which left Greece and other Club Med countries borrowing at rates little higher than Germany and investors chasing yield, leading to large speculative inflows, higher wages and a loss of competitiveness. More broadly, the problems were compounded by exploding private sector debt and property bubbles in Ireland and Spain. In this respect, it is surely legitimate to ask whether the low interest rates set primarily for Germany’s benefit in the early years of the euro merely exacerbated the problems of the “peripheral” member states and highlighted how the eurozone is less than an optimal currency area.

The global financial crisis has spared no one, from Wall Street investment bankers, to the Dubai sheiks, Russian oligarchs, the City of London, even the maestro himself, Alan Greenspan himself. But it has struck Europe especially hard because it has coincided with a period of weak political leadership which has made crisis management even harder. Chancellor Angela Merkel of Germany and President Nicolas Sarkozy are losing popularity and are frequently at odds. This goes beyond a well-documented mutual distrust bordering on antipathy. As one senior German official said in Berlin recently: the Chancellor receives five policy ideas from the Elysee before breakfast and they all end up in the waste paper basket by lunchtime.”

As George Soros has written in an excellent recent article in the New York Review of Books, the euro crisis has led to a crise de conscience - or perhaps that should be Gewissensbisse - in Germany. The Maastricht treaty specifically banned bailouts and that ban has been upheld by the German constitutional court, but that is precisely what has happened. Pardon my French (again) but the German public feels duped by a bunch of feckless Greeks.

Elsewhere, weak political leadership is tangible in Italy, where Silvio Berlusconi is still preoccupied with preserving his parliamentary immunity against corruption charges; in the Netherlands, where a new coalition supported externally by the far right anti-Muslim, anti-immigration populist Geert Wilders looks unstable at best. The nationalist right has also gained ground in Belgium, Sweden and enjoys substantial support in the former communist countries of central Europe. Meanwhile, in Spain and Portugal, Mssers Zapatero and Socrates look to be in deep political trouble. Paradoxically, Britain looks to be a relative haven of stability despite having embarked on the first full-scale coalition government in more than 70 years, though the big test on public spending cuts is still to come.

I am conscious at this point that I am sounding a little euro-sceptic myself so let me offer some positive counterpoints: While the survival of the euro is not a given, there are a number of reasons for optimism in the short to medium term, by that I mean an unscientific five to seven years. As for the long term, I am inclined to agree with Keynes: in the long run we are all dead anyway.

The primary cause for guarded optimism is that the eurozone did pull through the heat of the sovereign debt crisis. Of course, that crisis is far from over. But the 750bn euro war chest or rescue fund has given countries a breathing space, even if the disputes over how it will precisely work in practice are still unresolved. Moreover there is some cause to agree with the verdict of the ECB board governor Lorenzo Bini Smaghi who opined that financial markets overshot in their enthusiasm for “convergence” in the eurozone in the early part of the decade and have since overshot in their scepticism regarding the lack of convergence between the German core in eurozone and the Club Med countries in the periphery.

Second, all member states are taking extraordinary measures to tackle not just their fiscal deficits but also deeper, long-term issues such as pension deficits arising from an ageing population and low birth rates. While it is tempting to focus on President Sarkozy’s travails with street protestors as he seeks to raise the pension age to a modest 62, it is worth taking a hard look at the crisis measures being pushed through in Greece and Spain, among others. In Greece, for example, tens of thousands of tax evaders are being brought back into the net. In Spain, the government is finally tackling labour market rigidity characterized by excessively generous severance pay; finally in Ireland, individual public sector pay has been slashed by up to 20 per cent.

Third, a semblance of agreement is taking shape on the new rules governing the eurozone. Yes, there is still plenty of wrangling, particularly over German demands for enforcing fiscal discipline. But as my colleague Martin Wolf has noted: Berlin’s insistence on automatic fines is and will remain politically unrealistic in a hybrid political structure like the European Union where power is shared between semi supranational institutions such as the European Commission and national governments.

Incidentally, I can still remember discussing these same swingeing demands with the former Luxembourg central bank governor Pierre Jahns who described them as the equivalent of a medieval torture chamber. My response was that they might indeed work if they emulated the treatment of Galileo before the Inquisition: the freethinking scientist recanted, but only after being shown the instruments rather than having them applied to various parts of his anatomy.

Moreover, Germany last week made an important concession to France by agreeing that sanctions would be less automatic than foreseen under the Commission’s proposals. This caused the ECB to take the unprecedented step of publicly dissociating itself from the Franco-German deal. And over the past two weeks the ECB has stopped its emergency programme of buying euro area government bonds - which could easily be seen as a warning to governments not to assume that the ECB will be a soft touch in the future. Several governments (such as the Netherlands and Sweden) were just as appalled as the ECB at Germany’s concession to the French.

This to-and-fro suggests that in the short term the eurozone’s response will be to muddle through. Outsiders will find this particularly frustrating because they would prefer far neater solutions such as a fully fledged federal political construct to balance the federal monetary union. But for more than 50 years Europe has defied such categorization. Culture, history and the nation state have proved far too potent. European unity has existed through diversity.

So I would conclude by offering three scenarios for the euro going forward.

Scenario A is that member states, led by France and Germany, agree that the status quo is indeed unsustainable and that the eurozone has to evolve to encompass fiscal transfers. These may be governed by tougher conditions such as temporary suspension of voting rights and/or semi automatic fines on transgressors. This is the logical conclusion of categorical (if not necessarily credible) statements in European capitals that there can be no question of a sovereign default by Greece (which incidentally does not rule out what might euphemistically described as an orderly restructuring of Greek debt, say in two years or so time).

Scenario B is that the euro survives but the present eurozone does not. That is to say, Greece finds it impossible to service its debts, entirely possible given that in the short-term debt is due to rise despite efforts to rein in the budget deficit. A Greek default or disorderly restructuring would then be accompanied by the abandonment of the euro and the introduction of a flexible exchange rate to facilitate adjustment. A smaller, more tightly formed eurozone would however survive and be built around the Franco-German core.

Scenario C might be described as the Armageddon option whereby the eurozone collapses in its entirety. This rests in part on a view of German policy, 20 years after unification. In a nutshell, the Germans simply declare that they have run their economy brilliantly and see no needs to make the kind of adjustments that the majority of the eurozone countries would like to see. The compromises which underpinned European integration prove impossible to sustain.

Earlier in this talk, I invited the audience to conduct a minor thought experiment. Let me call upon your indulgence one more time, in this case a scenario whereby Germany withdrew from the euro to reestablish the old D-mark zone. In this case, the D-mark would go through the roof and Germany’s export-led economy would suffer, with corresponding soaring unemployment. The single market would begin to unravel, as other countries would be tempted into competitive devaluations.

Europe would then resemble the Confederation of the Rhine in the Napoleonic era, a group of self-important but weak principalities caught between the rival powers of France, Austria, Russia and Prussia. In this case, a Europe of nation states would be caught between the US and China, with a brooding Russia on its eastern border. This makes for an uncomfortable prospect at best; and it shows that, however powerful the force of economics, the politics behind the survival of Europe’s single currency are not to be underestimated.

In my view, either Scenario A or B are more likely. Categorical statements that the status quo must prevail have no precedent in history, let alone economics. A Greek default may not be desirable but it is by no means inconceivable. Similarly, the established patterns of bargaining and co-operation within the EU suggest there is scope for further evolution within the eurozone toward French-backed economic government as a counterweight to the independent (German-style) European central bank.

There is however one substantial caveat: the absolute requirement that Europe return to growth. This is the most important missing ingredient, and it depends on addressing the imbalances between Germany and the rest of the eurozone. As Soros has noted, this will depend in turn on all countries tackling the solvency of banks, primarily through recapitalisation but also a loosening of monetary policy to accompany the significant fiscal tightening underway. This again will require an accommodation by Germany and a further adjustment in ECB policy, but the alternatives of a total collapse or spreading sovereign debt crisis are far worse.

In this respect, I remain a cautious optimist about the euro, with the emphasis very much on cautious.

Thank you.