THE euro crisis is a direct consequence of the crash of
2008. When Lehman Brothers failed, the entire financial system started to
collapse and had to be put on artificial life support. This took the form of
substituting the sovereign credit of governments for the bank and other credit
that had collapsed.
At a memorable meeting of European finance ministers in
November 2008, they guaranteed that no other financial institutions that are
important to the workings of the financial system would be allowed to fail, and
their example was followed by the United States.
Angela Merkel then declared that the guarantee should be
exercised by each European state individually, not by the European Union or the
eurozone acting as a whole. This sowed the seeds of the euro crisis because it
revealed and activated a hidden weakness in the construction of the euro: the
lack of a common treasury. The crisis itself erupted more than a year later, in
2010.
There is some similarity between the euro crisis and the
subprime crisis that caused the crash of 2008. In each case a supposedly
riskless asset - collateralised debt obligations (CDOs), based largely on
mortgages, in 2008 and European government bonds now - lost some or all of
their value.
Unfortunately the euro crisis is more intractable. In 2008
the US financial authorities that were needed to respond to the crisis were in
place; at present in the eurozone one of these authorities, the common
treasury, has yet to be brought into existence. This requires a political
process involving a number of sovereign states. That is what has made the
problem so severe.
The political will to create a common European treasury was absent in the first place; and since the time when the euro was created the political cohesion of the European Union has greatly deteriorated. As a result there is no clearly visible solution to the euro crisis. In its absence the authorities have been trying to buy time.
In an ordinary financial crisis this tactic works: with the
passage of time the panic subsides and confidence returns. But in this case
time has been working against the authorities. Since the political will is
missing, the problems continue to grow larger while the politics are also
becoming more poisonous.
It takes a crisis to make the politically impossible
possible. Under the pressure of a financial crisis the authorities take
whatever steps are necessary to hold the system together, but they only do the
minimum and that is soon perceived by the financial markets as inadequate.
That is how one crisis leads to another. So Europe is
condemned to a seemingly unending series of crises. Measures that would have
worked if they had they been adopted earlier turn out to be inadequate by the
time they become politically possible. This is the key to understanding the
euro crisis.
Where are we now in this process? The outlines of the
missing ingredient, namely a common treasury, are beginning to emerge. They are
to be found in the European Financial Stability Facility (EFSF) - agreed on by
27 member states of the EU in May 2010 - and its successor, after 2013, the
European Stability Mechanism (ESM).
But the EFSF is not adequately capitalised and its functions
are not adequately defined. It is supposed to provide a safety net for the
eurozone as a whole, but in practice it has been tailored to finance the rescue
packages for three small countries: Greece, Portugal, and Ireland; it is not
large enough to support bigger countries like Spain or Italy.
Nor was it originally meant to deal with the problems of the
banking system, although its scope has subsequently been extended to include
banks as well as sovereign states. Its biggest shortcoming is that it is purely
a fund-raising mechanism; the authority to spend the money is left with the
governments of the member countries. This renders the EFSF useless in
responding to a crisis; it has to await instructions from the member countries.
The situation has been further aggravated by the recent
decision of the German Constitutional Court. While the court found that the
EFSF is constitutional, it prohibited any future guarantees benefiting
additional states without the prior approval of the budget committee of the
Bundestag. This will greatly constrain the discretionary powers of the German
government in confronting future crises.
The seeds of the next crisis have already been sown by the way the authorities responded to the last crisis. They accepted the principle that countries receiving assistance should not have to pay punitive interest rates and they set up the EFSF as a fund-raising mechanism for this purpose. Had this principle been accepted in the first place, the Greek crisis would not have grown so severe.
Contagion spreading
As it is, the contagion - in the form of increasing
inability to pay sovereign and other debt - has spread to Spain and Italy, but
those countries are not allowed to borrow at the lower, concessional rates
extended to Greece. This has set them on a course that will eventually land
them in the same predicament as Greece.
In the case of Greece, the debt burden has clearly become
unsustainable. Bondholders have been offered a "voluntary"
restructuring by which they would accept lower interest rates and delayed or
decreased repayments, but no other arrangements have been made for a possible
default or for defection from the eurozone.
These two deficiencies - no concessional rates for Italy or
Spain and no preparation for a possible default and defection from the eurozone
by Greece - have cast a heavy shadow of doubt both on the government bonds of
other deficit countries and on the banking system of the eurozone, which is
loaded with those bonds. As a stopgap measure the European Central Bank (ECB)
stepped into the breach by buying Spanish and Italian bonds in the market.
But that is not a viable solution. The ECB had done the same
thing for Greece, but that did not stop the Greek debt from becoming
unsustainable. If Italy, with its debt at 108% of gross domestic product (GDP)
and growth of less than 1%, had to pay risk premiums of 3% or more to borrow
money, its debt would also become unsustainable.
The ECB's earlier decision to buy Greek bonds had been
highly controversial; Axel Weber, the ECB's German board member, resigned from
the board in protest. The intervention did blur the line between monetary and
fiscal policy, but a central bank is supposed to do whatever is necessary to
preserve the financial system. That is particularly true in the absence of a
fiscal authority.
Subsequently, the controversy led the ECB to adamantly
oppose a restructuring of Greek debt - by which, among other measures, the time
for repayment would be extended - turning the ECB from a saviour of the system
into an obstructionist force. The ECB has prevailed: the EFSF took over the
risk of possible insolvency of the Greek bonds from the ECB.
The resolution of this dispute has in turn made it easier
for the ECB to embark on its current programme to purchase Italian and Spanish
bonds, which, unlike those of Greece, are not about to default. Still, the
decision has encountered the same internal opposition from Germany as the earlier
intervention in Greek bonds.
Jürgen Stark, the chief economist of the ECB, resigned on
September 9. In any case the current intervention has to be limited in scope,
because the capacity of the EFSF to extend help is virtually exhausted by the
rescue operations already in progress in Greece, Portugal, and Ireland.
In the meantime, the Greek government is having increasing
difficulties in meeting the conditions imposed by the assistance programme. The
troika supervising the programme - the EU, the IMF, and the ECB - is not
satisfied; Greek banks did not fully subscribe to the latest treasury bill
auction; and the Greek government is running out of funds.
In these circumstances an orderly default and temporary
withdrawal from the eurozone may be preferable to a drawn-out agony. But no
preparations have been made. A disorderly default could precipitate a meltdown
similar to the one that followed the bankruptcy of Lehman Brothers, but this
time one of the authorities that would be needed to contain it is missing.
No wonder that the financial markets have taken fright. Risk
premiums that must be paid to buy government bonds have increased, stocks have
plummeted, led by bank stocks, and recently even the euro has broken out of its
trading range on the downside. The volatility of markets is reminiscent of the
crash of 2008.
Unfortunately the capacity of the financial authorities to take the measures necessary to contain the crisis has been severely restricted by the recent ruling of the German Constitutional Court. It appears that the authorities have reached the end of the road with their policy of "kicking the can down the road". Even if a catastrophe can be avoided, one thing is certain: the pressure to reduce deficits will push the eurozone into prolonged recession. This will have incalculable political consequences. The euro crisis could endanger the political cohesion of the European Union.
No escape
There is no escape from this gloomy scenario as long as the
authorities persist in their current course. They could, however, change
course. They could recognise that they have reached the end of the road and
take a radically different approach. Instead of acquiescing in the absence of a
solution and trying to buy time, they could look for a solution first and then
find a path leading to it.
The path that leads to a solution has to be found in
Germany, which, as the EU's largest and highest-rated creditor country, has
been thrust into the position of deciding the future of Europe. That is the
approach I propose to explore.
To resolve a crisis in which the impossible becomes possible
it is necessary to think about the unthinkable. To start with, it is imperative
to prepare for the possibility of default and defection from the eurozone in
the case of Greece, Portugal, and perhaps Ireland.
To prevent a financial meltdown, four sets of measures would
have to be taken. First, bank deposits have to be protected. If a euro
deposited in a Greek bank would be lost to the depositor, a euro deposited in
an Italian bank would then be worth less than one in a German or Dutch bank and
there would be a run on the banks of other deficit countries.
Second, some banks in the defaulting countries have to be
kept functioning in order to keep the economy from breaking down. Third, the
European banking system would have to be recapitalised and put under European,
as distinct from national, supervision. Fourth, the government bonds of the
other deficit countries would have to be protected from contagion. The last two
requirements would apply even if no country defaults.
All this would cost money. Under existing arrangements no
more money is to be found and no new arrangements are allowed by the German
Constitutional Court decision without the authorisation of the Bundestag. There
is no alternative but to give birth to the missing ingredient: a European
treasury with the power to tax and therefore to borrow. This would require a
new treaty, transforming the EFSF into a fully-fledged treasury.
That would presuppose a radical change of heart, particularly in Germany. The German public still thinks that it has a choice about whether to support the euro or to abandon it. That is a mistake. The euro exists and the assets and liabilities of the financial system are so intermingled on the basis of a common currency that a breakdown of the euro would cause a meltdown beyond the capacity of the authorities to contain. The longer it takes for the German public to realizse this, the heavier the price they and the rest of the world will have to pay.
Merkel's dilemma
The question is whether the German public can be convinced
of this argument. Angela Merkel may not be able to persuade her own coalition,
but she could rely on the opposition. Having resolved the euro crisis, she
would have less to fear from the next elections.
The fact that arrangements are made for the possible default
or defection of three small countries does not mean that those countries would
be abandoned. On the contrary, the possibility of an orderly default - paid for
by the other eurozone countries and the International Monetary Fund (IMF) -
would offer Greece and Portugal policy choices.
Moreover, it would end the vicious cycle now threatening all
of the eurozone's deficit countries whereby austerity weakens their growth
prospects, leading investors to demand prohibitively high interest rates and
thus forcing their governments to cut spending further.
Leaving the euro would make it easier for them to regain
competitiveness; but if they are willing to make the necessary sacrifices they
could also stay in. In both cases, the EFSF would protect bank deposits and the
IMF would help to recapitalise the banking system. That would help these
countries to escape from the trap in which they currently find themselves. It
would be against the best interests of the EU to allow these countries to
collapse and drag down the global banking system with them.
It is not for me to spell out the details of the new treaty;
that has to be decided by the member countries. But the discussions ought to
start right away because even under extreme pressure they will take a long time
to conclude.
Once the principle of setting up a European Treasury is
agreed upon, the European Council could authorise the ECB to step into the breach,
indemnifying the ECB in advance against risks to its solvency. That is the only
way to forestall a possible financial meltdown and another Great Depression.
* This essay is reprinted with permission from the author, and from the New York Review of Books, where it was originally published.