Next Friday, European leaders will attend their 16th summit since the euro crisis began. At stake is the continued existence of the single currency. Can they rise to the challenge, asks DAN O'BRIEN, Economics Editor
THE 350 MILLION inhabitants of the euro zone face the risk of the money in their pockets ceasing to be legal tender. A collapse of the world’s second most important currency, in a continent that still accounts for more of the planet’s economic activity than any other, would amount to the biggest shock to the global economy in living memory.
It is hard to believe that this point has been reached – perhaps because, after existing for a decade, the euro came to be taken for granted. Even those who opposed it fell silent as the single currency worked well over its first 10 years. However, their prelaunch warnings have turned out to be more prescient than even they would have claimed two years ago.
As momentum behind the euro built in the 1990s, the debate about the benefits, costs and risks of embarking on such an ambitious undertaking became more focused. A project that had been largely politically driven, despite its huge economic implications, began to attract much more attention from economists.
Many were unimpressed. The economic fundamentals in the prospective member countries were too diverse, according to one argument. Another was that the design of the currency’s institutions was flawed. Many Irish economists said the risks of joining outweighed the possible gains for this country.
Working in the European Commission in the mid-1990s, I debated the matter frequently with my Italian boss, a career eurocrat who had been born in the dark days of 1930s fascism. An integrationist to his marrow, he dismissed my ponderings about whether the euro would ever come into existence, saying that I was too influenced by scepticism in the English-speaking world. Neither the British nor the Americans understood the continent’s commitment to integration, he said.
Those who had opposed taking part in European integration had been proved wrong after each step forward, and they joined in belatedly. At that juncture it was hard to disagree, given all that had happened in the previous 40 years. But this time it looks very different.
THE WORST-CASE SCENARIO
Two years after the extent of Greece’s debt problems was revealed, the seemingly endless cycle of cross-contamination between euro-area banks and governments has spiralled to a point that mass sovereign default and the break-up of the euro are real possiblities. How bad could it get?
This week Joe Durkan of the Economic and Social Research Institute spoke of a repeat of the Great Depression of the 1930s if the currency falls apart. It is easy to see how he arrived at that conclusion. A break-up of the euro would force countries to create new currencies almost overnight. This would present enormous logistical challenges.
At the very least, there would be a period of disruption to everyday transactions, from buying groceries to paying electricity bills. A disruption of that kind, and the effect it would have on the payments system, would have very serious consequences for economic activity.
Far more troubling is the potential effect on wealth. In rich countries, savings have been accumulated over decades. The stock of wealth in rich countries is typically many times greater than gross domestic product, or the amount of wealth an economy generates each year. This wealth is stored mostly in financial assets: bank accounts, company shares, corporate and government bonds and the like.
The collapse of Lehman Brothers, three years ago, has shown just how interconnected and fragile the financial system is. Default on that scale had huge knock-on effects elsewhere. So had the de-facto sovereign default in Greece. A default by, say, Italy would be likely to trigger a domino effect of default, with Italian banks being the first to go, followed by other banks exposed to Italy, followed by other sovereign bonds, and so on. In such circumstances it is difficult to see the euro surving.
If sovereign default would almost certainly end the euro, a break-up of the euro without default would certainly precipitate it. Consider Italy again. The reintroduction of the lira would see the Italian currency plunging in value, making Italy’s huge debts to stronger currency countries, such as France and Germany, immediately unsustainable. Default would be almost immediate, and decades of accumulated wealth could evaporate.
Earlier this week Minister of State for European Affairs Lucinda Creighton spoke of living standards being driven back to levels of the 1950s in a worst-case scenario. Nothing can be ruled out if the financial system and monetary union collapse.
WHAT TO DO?
Given the world-changing implications of allowing such a scenario to unfold, reason dictates that Europe’s leaders will, eventually, do whatever is necessary to avoid cataclysm. Ultimately, propping up the system will require two pillars: emergency intervention by the European Central Bank and the creation of economic governance structures in the euro zone more akin to those of sovereign states.
The choices facing the ECB are a central banker’s worst nightmare. Every course of action is fraught with risk: economic, financial and legal. Nobody should believe that alchemy can be performed in Frankfurt, but the ECB is the last line of defence in this crisis. It does not have any good options, but it must decide which option is the least bad.
That option will involve, at the very least, an explicit commitment to buy as much government debt as is required to ensure interest rates come down to sustainable levels in order to prevent more sovereign defaults. It is also likely to have to commit its resources to recapitalising banks, most probably via the European Financial Stabilisation Fund, which is the bailout fund that finances Ireland’s needs. Given that the worst-case scenario outlined above appears likely to come to pass if the ECB does not act, sooner or later this will almost certainly happen.
But such radical action by the ECB will merely give governments the breathing space to put in place longer-term solutions and allow economies more time to grow their way out of trouble.
And that could yet happen. The underlying fundamentals of the euro zone as a single economy are solid, and the bloc’s aggregate budgetary position is better than those of Britain, the US and Japan, all of which are able to borrow at low interest rates. If confidence is restored in the euro and in the policymakers at its helm, the situation could calm quickly. Reforms could be introduced and economies might grow more rapidly. That is about the best-case scenario. But there is not much time left. Next Friday’s summit may well be the last chance.
CRISIS SUMMIT
Oceans of ink have been used to analyse the 15 EU leaders’ summits that have taken place since the crisis began. Few observers and commentators have applauded the response, and almost all believe the action taken to date has been inadequate. A breakdown in trust has also been a significant factor in delaying action. A north/south divide has opened up in Europe that, even if the euro crisis can be resolved, is unlikely to close again in the foreseeable future. But the scale of it all sometimes appears to have overcome leaders. With the stakes so high and uncertainty so great, the fear of overstepping or mis-stepping has, perhaps understandably, led to half-measures rather than decisive action.
Speeches by some of the main players this week – including by the German chancellor, the French president and the head of the ECB – show that the jockeying for position continues as next Friday’s EU leaders’ summit approaches.
But fears and suspicions will have to be overcome if radical and necessary changes to the design of the euro edifice are to be agreed next week. There are endless details and options, but they all boil down to overcoming the problem of the entire project being only as strong as its weakest national economy. To end the weakest-link problem for good, fiscal union involving commonly issued bonds and something akin to a de-facto euro-area finance minister appears the only way to go.
Although it is by no means certain that we will live in a euro-area fiscal union in a week’s time, if agreed it would overcome the problem of the weakest link. But would it be enough? Kevin O’Rourke, professor of economic history at the University of Oxford, recently called the ideas being mooted now a “pseudo fiscal union”.
A true fiscal union would involve a large proportion of taxes going directly to a euro-area finance ministry, so that regions or countries afflicted by shocks would not have to make matters worse by imposing austerity in times of crisis. Having cash flowing from the centre to regions afflicted by recession is the sort of fiscal shock absorber that exists in the US, a country as economically diverse as the euro zone.
A true fiscal union of the American kind might evolve in time, but it certainly won’t be agreed next week.
LONG-TERM CHALLENGES
But even in a best-case scenario of radical action next week and a calming of the crisis, the single currency faces huge challenges. Greece and Portugal are in dire straits. Ireland, Italy and Spain are borderline. Prof O’Rourke’s pseudo fiscal union might mean these countries’ austerity goes on longer than their citizens are willing to tolerate.
But even if the politics of austerity do not make the euro unworkable, the economics might. It is possible that the Mediterranean countries could implement all the “structural” economic reforms that they need and that make sense. However, it is also possible that the growth dividend from them is small and, even worse, is offset by the growth-dampening effects of austerity. The truth is that economists do not know what mix of policies and conditions generate economic growth. If that recipe were known, every country would be rich.
Another challenge will be to address the underlying reason for the crisis: the failure of the financial system as it has evolved over decades. Finance grew too large and gambled too much. Making it safe is a challenge for all developed countries.
But agreeing common banking regulations in Europe will be even more difficult than elsewhere, as financiers use their formidable lobbying power to play countries off against each other.
Ultimately, the ability of the member countries to reconcile national and European interests including banking, budgets, fiscal transfers and competitiveness will determine whether the single currency survives. If the record of the past two years of crisis is anything to go by, there must be real concern that Europe’s leaders will not rise to the challenge.
“There are decades where nothing happens and weeks where decades happen,” Lenin said. These weeks feel like those in which a great deal will change.
European monetary union: From gold standard to crisis point
The idea of creating a single European currency emerged in the 1970s, the decade of greatest economic upheaval in the period from 1945 to 2008.
After what the French call les trente glorieuses (the 30 glorious years) of dawning mass prosperity after the second World War, unemployment took hold and inflation soared. The “gold standard” system, which had fixed the value of one currency against another for a century, fell apart.
Then, as now, politicians and policymakers were at sea, making it up as they went along. Many ideas were tried and others, including the creation of a single European currency, were mooted. But the advocates of monetary union as a response to the turmoil of the 1970s were before their time.
In a period when the then European Economic Community was little more than a glorified free-trade area, the notion of abandoning national currencies was a bridge too far.
But in the 1980s, and for reasons still much disputed among historians, the continent that invented the modern sovereign state began to dissolve it. The continent’s thinking classes came to believe, with increasing conviction, that “more Europe” meant a stronger, safer and richer Europe. Closer union ultimately meant monetary union too.
But even for an integrating continent there was a lot of hesitation about making the leap to a shared currency. The push came with the unexpected reunification of Germany after the collapse of communism. France’s deep fear of an overly mighty Germany led its then president, François Mitterrand (left), to the conclusion that creating a shared currency would safeguard his country from its larger and more economically dynamic neighbour.
It is an irony of recent European history that a mechanism designed to contain German power and maintain French influence has done precisely the opposite.
