I sympathize with the Germans. This is not because I agree with their prevailing view of how the crisis occurred or what to do about it. I sympathize because the German elite were the ones who understood what creating the euro implied. They realized that a currency union could not work without a political union. But the French elite wanted, instead, to end their humiliating dependence on the monetary policy set by Germany’s Bundesbank. Now, two decades later, Germany’s partners, including France, have learnt a painful lesson. Far from being liberated from German control, they are now far more firmly under it. In a big crisis, creditors rule.
Consider how much better off Europe would have been if the exchange rate mechanism had continued, instead, with wide bands. Interest rates in the crisis-hit countries would probably have been higher and asset price bubbles and current account deficits smaller. When the turnround in financial flows occurred, currency crises would indeed have erupted. The Greek drachma, the Irish punt, the Portuguese escudo, the Spanish peseta, the Italian lira and, maybe, the French franc would have devalued against the Deutschmark. Price levels of these countries would have shown a temporary jump. But the blame for any fallout would have fallen overwhelmingly at home. I feared that the euro would weaken the sense of mutual trust, in a crisis, not reinforce it. So it has proved already, even though the euro zone has barely started the adjustment.
Why, then, do creditors rule in a crisis? The answer is simple: they can borrow cheaply. As lenders have fled from weaker credits, the interest rate on German Bunds has fallen to 1.3 per cent, against 5.8 per cent in Italy and 6.2 per cent in Spain. With flat nominal gross domestic products, countries with high interest rates are at risk of falling into a debt trap. They need help in controlling their costs of borrowing that only creditors can supply.
As Harold James of Princeton university, Ronald McKinnon of Stanford and many others have noted, Alexander Hamilton, the first U.S. Treasury secretary, confronted a not dissimilar challenge with the debts incurred by the states in the American war of independence. Hamilton used the powers of the (second and centralizing) constitution to assume these debts, issuing new federal debt, instead. In the long run, the modern U.S. federal system emerged, with limits on state borrowing, a central bank (at the third time of asking) and a federal budget able to stabilize the economy.
Since dismantling the euro zone would be very costly, as I argued last week, could such a union deal with the current difficulties? The answer, in theory, is yes. The euro zone already has a central bank. The fiscal compact beloved of Angela Merkel, Germany’s chancellor, could be the equivalent of the balanced budget rule of U.S. states. So what is missing for a life “happy ever after”? The answer seems to be a robust fiscal arrangement, to cushion the impact of crises, help members manage their debts and cut the link between weak sovereigns and banks.
Yet assumption of debts by a central treasury or replacement of national by federal fiscal mechanisms support is out of the question. The budget of the EU is 1 per cent of gross domestic product. There is no will to make it bigger.
In place of such central action, stronger solidarity among members would need to emerge. But I find it hard to believe such measures would endure. The European Stability Mechanism, designed in this crisis to help countries in difficulty, is too small, at just 5 per cent of euro zone GDP. The answer would have to be some kind of euro zone bonds, with joint and several backing. Support will be quite limited. Creditworthy members tend to dislike supporting the “irresponsible”. Voters dislike sharing with non-voters. Crucially, the federal constitution preceded Hamilton’s solution, though the big debts were a reason for ratification.
If dismantling the euro is out of the question, true federal finance is unavailable and mutual solidarity will remain limited, what is left? The answer is faster adjustment, to bring economies back to health. Indeed, that would be essential even if stronger solidarity were available. The euro zone must not turn the weaker economies of today into depressed regions, permanently supported by transfers, a policy that has blighted the south of Italy.
So how is faster adjustment to be achieved? The answer is through a buoyant euro zone economy and higher wage growth and inflation in core economies than in the enfeebled periphery. Moreover, the required growth strategy is definitely not just a matter of policies for supply. According to forecasts from the International Monetary Fund, euro zone nominal gross domestic product will rise by a mere 20 per cent between 2008 and 2017. In the latter year, it will be 16 per cent lower than if it had continued to grow at the rate of 4 per cent achieved between 1999 and 2008 (consistent with 2 per cent real growth and 2 per cent inflation). For the economies under stress, such feeble growth in the euro zone is a disaster: it means that the euro zone as a whole tends to reinforce, rather than offset, their credit contractions and fiscal stringency. They can blame the universal adoption of fiscal stringency and the policies of the European Central Bank, which let the money supply stagnate.
What has this to do with the risk of a Greek exit and the need to manage the fallout, should this occur? Nothing and everything. Nothing, because it will still be necessary to manage panics, almost certainly by unlimited ECB support, as Jacek Rostowski, Poland’s finance minister has argued in the FT. Everything, because with large divergences in competitiveness, weak fiscal solidarity and fragile banks, a plausible prospect of adjustment into growth is vital. If countries face year after weary year of debt deflation and depression, the euro risks becoming a detested symbol of impoverishment. As a strong federal union, the U.S. will bear the strain of such sustained disappointment. The far more fragile euro zone will not.