The architects of the euro knew that it was incomplete when they designed it. The currency had a common central bank but no common treasury – unavoidable given that the Maastricht treaty was meant to bring about monetary union without political union. The authorities were confident, however, that if and when the euro ran into a crisis they would be able to overcome it. After all, that is how the European Union was created, taking one step at a time, knowing full well that additional steps would be required.
With hindsight, however, one can identify other deficiencies in the euro of which its architects were unaware. A currency supposed to bring convergence has produced divergences instead. That is because the founders did not realise that imbalances may emerge not only in the public sphere but also in the private sector.
After the euro came into force, commercial banks could refinance their holdings of government bonds at the discount window of the European Central Bank and regulators treated such bonds as riskless. This caused interest rate differentials between various countries to shrink. This in turn generated property booms in the weaker economies, reducing their competitiveness. At the same time Germany, suffering from the after-effects of reunification, had to tighten its belt. Trade unions agreed to make concessions on wages and working conditions in exchange for job security. That is how the divergences emerged. Yet the banks continued to load up on the government bonds of the weaker countries in order to benefit from the minuscule interest rate differentials that still remained.
That lack of a common treasury first became apparent as a problem after the bankruptcy of Lehman Brothers on October 15 2008, when the threat of a systemic collapse forced governments to guarantee that no other systemically important financial institution would be allowed to fail. At that time Angela Merkel, Germany’s chancellor, insisted that each country should guarantee its own institutions, rejecting a Europe-wide approach. Interestingly, interest rate differentials widened only in 2009 when the newly elected Greek government announced that its predecessor had cheated and the deficit was much larger than reported. That was the start of the euro crisis.
The lack of a common treasury is now being remedied: first came the Greek rescue package, then a temporary emergency facility. The financial authorities are a little bit pregnant and it is virtually certain that some permanent institution will be set up. Unfortunately, it is equally certain that the new arrangements will also be flawed. For the euro suffers from other shortcomings. Policymakers are confronted not only by a currency crisis but also by a banking crisis and a crisis in macroeconomic theory.
The authorities are making at least two mistakes. One is that they are determined to avoid defaults or haircuts on currently outstanding sovereign debt for fear of provoking a banking crisis. The bondholders of insolvent banks are being protected at the expense of taxpayers. This is politically unacceptable. A new Irish government to be elected next spring is bound to repudiate the current arrangements. Markets recognise this and that is why the Irish rescue brought no relief. Second, high interest rates charged on rescue packages make it impossible for the weaker countries to improve their competitiveness vis-à-vis the stronger ones. Divergences will continue to widen and weaker countries will continue to weaken. Mutual resentment between creditors and debtors is liable to grow and there is a real danger that the euro may destroy the political and social cohesion of the EU.
Both mistakes can be corrected. With regard to the first, emergency funds ought to be used to recapitalise banking systems as well as to provide loans to sovereign states. The former would be a more efficient use of funds than the latter. It would leave countries with smaller deficits, and they could regain access to the market sooner if the banking system were properly capitalised. It is better to inject equity now rather than later and it is better to do it on a Europe-wide basis than each country acting on its own. That would create a European regulatory regime. Europe-wide regulation of banks interferes with national sovereignty less than European control over fiscal policy. And European control over banks is less amenable to political abuse than national control.
With regard to the second problem, the interest rate on rescue packages should be reduced to the rate at which the EU itself can borrow. This would have the advantage of developing an active Eurobond market.
These two structural changes may not be sufficient to provide the countries in need of rescue with an escape route. Additional measures, such as haircuts on sovereign debt, may be needed. But having been properly recapitalised, banks could absorb this. In any case, two clearly visible mistakes that condemn the EU to a bleak future would be avoided.
The writer is chairman of Soros Fund Management LLC