“Perhaps future historians will consider Maastricht a decisive step towards the emergence of a stable, European-wide power. Yet there is another, darker possibility …The effort to bind states together may lead, instead, to a huge increase in frictions among them. If so, the event would meet the classical definition of tragedy: hubris (arrogance), ate (folly); nemesis (destruction).”
I wrote the above in the Financial Times almost 20 years ago. My fears are coming true. This crisis has done more than demonstrate that the initial design of the eurozone was defective, as most intelligent analysts then knew; it has also revealed – and, in the process, exacerbated – a fundamental lack of trust, let alone sense of shared identity, among the peoples locked together in what has become a marriage of inconvenience.
The extent of the breakdown was not brought home to me by the resignation of Germany’s Jürgen Stark from the board of the European Central Bank, nor by the looming Greek default, nor by new constraints imposed by the German constitutional court. What brought it home to me was a visit to Rome.
This is what I heard from an Italian policymaker: “We gave up the old safety valves of inflation and devaluation in return for lower interest rates, but now we do not even have the low interest rates.” Then: “Some people seem to think we have joined a currency board, but Italy is not Latvia.” And, not least: “It would be better to leave than endure 30 years of pain.” These remarks speak of a loss of faith in both the project and the partners.
In his latest press conference, Jean-Claude Trichet, outgoing president of the European Central Bank, pointed to the bank’s stellar counter-inflationary record, far better than the Bundesbank’s. But the low inflation masked the emergence of profound imbalances within the zone and the lack of means – or will – to resolve them. As a result, a default by a major government, a break-up of the eurozone or both are now conceivable. The consequent flight to safety, which must include attempts to hedge cross-border exposures in a supposedly integrated currency area, threatens a meltdown. We are witnessing a lethal interplay between fears of sovereign insolvency, emerging sovereign illiquidity and financial stress (see chart).
As designed the eurozone lacked essential institutions, the most important being a central bank able and willing to act as lender of last resort in all important markets, a rescue fund large enough to ensure liquidity in sovereign bond markets and effective ways of managing an interconnected web of sovereign insolvencies and banking crises.
In the absence of strong institutions, the attitudes and policies of the core country have become crucial. Along with everybody else, I admire the political and economic reconstruction of Germany after the second world war and again after unification, the commitment to economic stability and its first-class manufactured exports. Unfortunately, these are insufficient. German policymakers persist in viewing the world through the lens of a relatively small, open and highly competitive economy. But the eurozone is not a small open economy; it is a large and relatively closed one. The core country of such a union must either provide a buoyant market for less creditworthy countries when the latter can no longer finance their deficits, or it has to finance them. If the private sector will not provide the needed finance, the public sector must do so. If the latter fails to act, a wave of private and public sector defaults will occur. These are sure to damage the financial sector and exports of the core country itself, as well.
The failure of Germany’s leaders to explain these facts at home makes it impossible to solve the current crisis. Instead, they indulge in the fantasy that everybody can be a lender, simultaneously. For small open economies such as Latvia and Ireland, regaining competitiveness and growth through deflation might work. For a big country such as Italy, it is too painful to be credible. Wolfgang Schäuble, Germany’s finance minister, may call for such austerity. It will not happen.
Today, raging fire must be put out. Only then can attempts at building a more fireproof eurozone begin. The least bad option would be for the ECB to ensure liquidity for solvent governments and financial institutions, without limit. It should not, in fact, be intellectually difficult to argue that buying bonds is compatible with continued monetary stability, since broad money has been growing at a mere 2 per cent a year. It is sure to be politically hard, however, particularly for Mario Draghi, the incoming Italian ECB president. Yet it is what has to be done given the inadequate size of the European financial stability facility if called on to help larger beleaguered euro-member countries. Politicians must then dare to support such action.
What should happen if the German government decided that it could not support such a bold step? The ECB should go ahead anyway rather than let a cascading collapse unfold. It would then be up to Germany to decide whether to leave, perhaps with Austria, the Netherlands and Finland. The German people should be made aware that the results would include a soaring exchange rate, a massive decline in the profitability of Germany’s exports, a huge financial shock and a sharp fall in gross domestic product. All this would be apart from the failure of two generations of efforts to build a strong European framework around Germany itself.
Germany possesses a binding veto over efforts to expand official fiscal support. But it is losing control over its central bank. In a crisis so menacing to Europe and the world, the one European institution with the capacity to act on the requisite scale should dare to do so, since the costs of not doing so are bound to prove devastating. That will surely create a political crisis, but this would be better than the financial crisis unleashed by a failure to try.
In the end Germany must choose between a eurozone disturbingly different from the larger Germany it expected or no eurozone at all. I recognise how much its leaders and people must hate having been forced into a position in which they have to make this choice. But it is the one they confront. Chancellor Angela Merkel must now dare to make that choice, clearly and openly.
Get alerts on Eurozone economy when a new story is published