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Binding former enemies together in a common currency was Europe’s historic political achievement. Today those ties are being tested as never before. The euro is not yet on the verge of disintegration. But greater statesmanship is needed to stem the erosion of political support.

Monetary union was always as much a political as an economic project. So it is today. If the euro is under threat, it is not from economic challenges, whether sovereign defaults or a plummeting exchange rate. The euro has successfully buttressed the single market by eliminating currency volatility and competitive devaluations. The risks to its survival are political – and even those risks can be overstated. There are powerful forces holding the eurozone together: there is no way to expel a member; political leaders are still committed to staying in; and even if they wanted to, leaving would be costly.

But the strains on the single currency are severe. If its leaders want the euro to survive, they must forge a new political bargain in place of the one that made its birth possible. Germany gave up the Deutschmark in return for the rest of Europe pursuing more German-style discipline. This understanding was to be safeguarded by three pillars: an independent, inflation-busting European Central Bank; a stability and growth pact mandating fiscal prudence; and a ban on bail-outs. Of these only the first is still standing, and even ECB independence is wobbling.

States, including France and Germany, wriggled out of the pact’s strictures. Governments recoiled from punishing one of their own. The pressure for restraint when times were good was lost. Excessive public borrowing was not the only cause of the debt crisis: Spain is under siege despite its surpluses before the crisis and lower public debt than Germany. But the failure of discipline delayed reforms needed for sustainable growth. Huge capital flows across the continent could have eased such changes; instead they financed consumption binges and wasted investment.

While the boom lasted, the rules could be broken, seemingly with impunity. But now collective support for Europe’s southern rim is increasingly seen as ushering in a “bail-out union” where the virtuous pay for the profligate. The flames are fanned by leaders’ conceit that eurozone defaults are intolerable. The no bail-out clause has now turned into a no-default clause – reinforcing German taxpayers’ feeling of being duped.

A new political bargain must be forged to maintain support for the monetary union. This requires a level of statecraft not yet seen from EU leaders. Their management of the crisis has been faltering; their understanding of its nature inadequate. Visceral opposition to International Monetary Fund involvement hindered decisive action on Greece.

Some EU leaders talk of Greece as if a default would have Lehman-like consequences. The analogy is tempting: overleverage, opacity, funding flight, and potentially devastating contagion are shared by both. But then the correct remedy is also the same: a resolution regime for Greece and other troubled countries. Greece must be made safe to fail, first, by preparing the ground for orderly restructuring if the IMF programme fails, as Germany’s finance minister, Wolfgang Schäuble, has proposed. Second, contagion to other sovereigns must be sealed off as much as possible. If the €750bn liquidity package is automatically available to solvent states in case of market panic, one default need not trigger others. Third, the most damaging contagion to address is to the private financial sector – in particular German and French banks whose governments inexcusably prefer to bail them out on the sly via Greece.

Reaffirming sovereigns’ responsibility for their sovereign mistakes would not weaken the eurozone’s political cohesion. It would strengthen it, by showing that monetary union is not a covert “transfer union” lacking popular legitimacy.

A new growth and stability pact must also be forged. Unlike the original, it must be enforced. Rule-breakers should have European Union funds withheld, and voting rights on eurozone matters suspended. But credible rules must ensure fiscal probity while recognising that fiscal rectitude is not all that matters. Deficits are more sustainable when debt is lower or growth faster, and at the bottom of a cycle. Crucially, growth is a precondition for stability, not something to be traded off against it. Putting countries on the rack of debt deflation will not stabilise their economies, only destabilise their politics.

So surplus states must bring something to the table. Deficit spending can crank a recovery into gear. Fiscal retrenchment must come with measures to expand private demand. In future Europe’s growth rate must be raised through productivity gains. This is something neither fiscal nor monetary policy can do: only the hard structural reforms that Europe has so long ducked will succeed. Despite the angst over the euro, the greatest prize for Europe remains not the stability of its money but the dynamism of its real economy.

If the eurozone cannot strike a grand bargain, countries will act in their self-interest to avoid the lethal cocktail of stagnation and belt-tightening. They will push for inflationary policies, nationally or through the common monetary policy, either way undermining the ECB’s independence. If it gives way, the euro will truly be in jeopardy. To head off such a calamitous failure is the foremost responsibility of eurozone leaders.

Chancellor Merkel has warned: “If the euro fails, then Europe fails.” She should have said: if Europe fails, then the euro fails

Copyright The Financial Times Limited 2017. All rights reserved.
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