While the pronouncement of the “euro crisis” has become a main topic in the newsrooms and while a plethora of pundits hasn’t got tired of predicting the end of the common European currency, the facts tell a different story. By the end of 2011 the euro was quoted higher than its long-term average since its inception and the official inflation rate of the euro zone has been kept under two percent. The average debt burden of the countries that make up the euro-zone is less than that of the United States or Japan. What is, then, the problem with the euro? Why doesn’t a day go by without a headline that says that the euro is doomed and that it would be only a matter of time until the European Monetary Union and the European Union, too, would blow apart?
The Origin of the Mess
When the financial crisis broke out in the United States in 2008 no commentator showed up to blame the US dollar as the cause of the housing and financial market crisis and to state that the use of a common currency for a large and highly diverse economy such as that of the United States was the root of the problem. Besides blaming the regulatory framework as being either too strict or too lose, it was mainly the monetary policy that was identified as the origin of the current financial crisis. A monetary policy of extremely low interest rates and ample liquidity put in place by the US central bank since the late 1980s had produced an inflated financial sector. The appetite of investors and lenders for high yield risky investments had gotten bigger over the decades in as much as the US central bank had acted in a way that hardened the conviction among financial market operators that there would be a reliable bailout guarantee for the financial system as implicitly pledged by the American central bank.
In Europe, moral hazard was on the rise when planning for a common European currency was put in place in the second half of the 1990s. With the introduction of a common European currency came the belief that because a country such as Greece would use the same currency as Germany or the Netherlands its sovereign debt would be of equal standing. Consequently, it did not take long until bond investors would drive down interest rates of countries such as Greece, Portugal, Spain and Italy to the levels of Germany and the Netherlands. As it was the case in the US where financial market operators acted under the delusion of absence of risk during the housing bubble, in Europe it was sovereign debt of the euro-zone members that was held to be risk-free.
In retrospect one can state that the period which some economist identified as the “Great Moderation” was in fact closer to being the time of the “Great Delusion”. Not much different than the politicians in the US who acted as cheerleaders for the mortgage binge in the housing market, governments in Europe were enticed to borrow up to the hilt firstly because interest rates were much lower after they joined the euro-zone and secondly because borrowing was so easy given the willingness of bankers and investors to lend as much as they could in the belief that the investment in bonds of the members of the euro-zone of the Southern periphery would be lucrative and safe (see chart)
The simple fact that a country such as Greece did over-borrow and as a consequence had to face default, something which is not new at all in financial history, was profoundly misinterpreted by the major groups that were the main decision-makers in the unfolding of the Greek tragedy. When it became evident that Greece encountered difficulties at rolling over its debt, the prospect that Greece would default was vehemently negated right away as a rational option. Of course, Greece wanted to avoid default and in this aim it was joined by its lenders who obviously also did not want Greece to default and obviously so preferred a bailout as well. These two self-interested groups got prompt support by members of the highest echelons of the European Union. By this party of three the stage was set to turn the Greek drama first into a farce and then into Greek tragedy.
The proper way to resolve the Greek debt problem would have been to let Greece and its bankers make their deal and have them work out a rescheduling agreement without a direct European involvement. Yet things took their turn to disaster when politicians of the euro-zone announced that Greece must get a bailout because no euro member state should ever default. This was an absurd allegation and it did not take long until financial market operators sensed that the day had come to speculate against this false and pretentious claim.
When the sell-off of Greek bonds began and interest rates for the country began its steep rise, it became manifest that Greece would be unable to refinance its debt load that was about to fall due in 2011 and thereafter. Contagion spread to Portugal and Spain and towards the end of the year, Italian interest rates began to skyrocket as well. Severe shock waves were sent across Europe and beyond when in late 2011 even Germany and France had to struggle to refinance their public debt. The main credit rating agencies announced that the standing of the core European economies would be under review for a downgrade as it was already done for a series of smaller countries of the euro-zone.
A major factor for the crisis to spin out of control was the disorder that ruled when the crisis began. Serious doubts arose about who would effectively be in charge if a member of the euro-zone should encounter severe payment problems with the prospect of default. The straightforward rule, which was laid down in the Maastricht treaty for the European Monetary Union, namely that each country was responsible for its own debt and that there would be no bailout guarantee by the Union, was discarded without necessity and carelessly replaced by a declaration of solidarity.
Members of the executive branch of the European Union, the European Commission, pushed ahead with the demand of assisting Greece with funds from the European Union which in essence meant that it was up to the solvent countries of the euro-zone to come up with the money. Germany, which would be the main paymaster for Greece and the other countries in need for financial aid, was not amused. The divergence among the major European decision makers provoked a loss of confidence among financial market operators concerning not only the payment ability of individual countries but also regarding the euro itself and finally the European Union as institution.
Crisis Without a Cause
The simple fact that a relatively small country such as Greece had payment difficulties and would be in need of rescheduling its debt transmogrified into the so-called “euro crisis”. It would not take long and the financial press and its favorite pundits would pronounce that not only the common European currency would be close to its end but the European Union as well.
If the European authorities had declared -- in true concordance with the Maastricht Treaty -- that Greek debt is a Greek problem, no “euro crisis” would have occurred. There would have been a Greek debt crisis and bankers would have had to pay their so-called “hair cut” and the interest rates for Greece would have been considerable higher than before. Greek debt payments would have been extended to the future in a rescheduling agreement, the International Monetary Fund (IMF) would have provided an emergency loan, and some other countries, such as Germany and France would have provided extra funding. Like in so many instances before, when economies had debt problems, the IMF would have taken over the supervision of the restructuring and the implementation of an adaptation program. In other words: all that we currently have with the European bailout would also have happened without the European bailout albeit with the major difference that no-one would speak today of the euro crises and only about a Greek debt crisis.
The interventionist hyperactivity of politicians, particularly at the top of the executive branch of the European Union who, so it appears, were following the rule of all power grabbers never to let a crisis go by without using it as an opportunity for extending dominance was surely a major factor in turning a relatively minor problem into one that threatens the stability of the global financial system and has been prone to cause mind-boggling havoc for the people of Europe if indeed the euro zone were to fall apart.
Transformation of the Eurozone
All the while when politicians and governments were arguing and disagreeing in dispute, an avalanche of self-declared experts on European matters showed up to offer one dark scenario after the other. A dedicated consumer of financial news soon would have gained the conviction that the Maya prediction of the end of the world in 2012 was nothing compared to the end of the euro and the European Union. Yet while sinister ink was spilled, the exchange rate of the euro held up well and economic growth did not falter in the main economies of the euro-zone. Germany, which represents the largest European economy, experienced the year 2011 as one with steady growth, low interest rates, and a declining unemployment rate. While the pundits were struggling to outcompete each other putting forth one worst case after the next, reality took a different path.
Different from the scenario in which Greece would have settled its debt problem without a deep involvement of the European Union, the actual path that was taken has transformed the euro-zone into a genuine fiscal union. Did the authorities get what they wanted? That is it, after all, how bailouts work. Can one truly exclude the hypothesis that maybe it was the intention of some decision-makers at the top echelon of the European Union to take the Greek debt troubles as an opportunity to push the Eurozone towards a fiscal union? Anyway, as a consequence of the Greek debt debacle, chief additional European financial institutions were established which for the time to come will band the members of the Eurozone closer together at the cost of leaving some other members of the European Union, like the United Kingdom, in isolation.
On May 9, 2010, the 27 members of the European Union set up the “European Financial Stability Facility” (EFSF) as a vehicle to provide financial assistance to member states. The EFSF is allowed to borrow up to 440 billion while the “European Financial Stabilisation Mechanism” (EFSM) as an emergency program may raise up to 60 billion euros which are guaranteed by the budget of the European Union. A veritable fiscal union was practically created on December 9, 2011, when the member states of the European Union, with the exception of the United Kingdom, agreed upon strict limits for government spending and borrowing including mechanisms of sanction in the case on non-compliance. On December 20, 2011, the European Central Bank (ECB) took its dubious prognosis of an imminent liquidity crisis as the pretext to assume the role as a genuine Lender-of-the-Last-Resort for the euro-zone when it offered 489.2 billion euros for the banking sector of the euro-zone as the first of a two part operation to augment liquidity and to animate banks to buy bonds of the troubled euro-zone countries.
With the new institutions and the action of the ECB a profound transformation of the European Union has taken place. With the EFSF and the EFSM financial stability has moved from being a national concern into the authority of the European Union. With the fiscal pact, member countries of the European Union (other than the UK) have given up their sovereignty over their national budgets. Finally, making the round complete, the ECB has taken over comprehensive authority to act as the eurozone’s Lender-of-the-Last-Resort.
The crisis has not weakened the position of the common European currency but fortified its institutional framework.
As much as the euro crisis became more severe, it also became clear that there is no reasonable alternative to a common currency in Europe. A return to national currencies would not resolve the basic problem that modern economies face. The root of the trouble is not the currency per se but a financial system based on fractional reserve banking, which, in combination with the modern warfare-welfare state drives towards an unremitting expansion of state activity and debt burdens.
Yet the true nature of the current crisis is not that of a currency, be it the euro or the dollar, but the symptom of fundamental problems of the structure of modern democracy and its monetary system. The fiscal pact is an attempt to stand against the tide of debt expansion. It is hard to see how the goal could be reached. As long as we continue to maintain a monetary system of fractional reserve banking in combination with state money and a welfare-warfare state, the pattern of perilous booms and busts will not vanish.