Between Voluntarism, Vision and Revision
The decision that was taken on January 11, 1999 to introduce the euro as a common currency, initially for eleven members of the European Union, is certainly the most unusual among the steps taken towards European union, and at the same time the most consequential. After it had been the subject of intensive conceptual work in countless commissions for decades, a political consensus developed in Germany towards the end of the 1980s that a common currency could only result from a political union. As we know, this is not what happened. Given that the vision of a political union on which France and Germany were after all negotiating never took on clear contours in the political debate, it was relatively uncomplicated to withdraw from it after it had only briefly been the subject of a heated discourse. Even the resignation of a highly respected President of the Bundesbank was not able to halt the wheels of history. Helmut Kohl’s mantra of German unity as the driving force for the unity of Europe became the probably most powerful political narrative of its time. It also caused us to forget that contemporaries considered the transaction costs, which a common currency might help to save as a numerable economic advantage according to its defenders, as small change in comparison to the fateful step towards the renunciation of autonomous monetary policy. This story has been told many times over. Why does it still remain relevant? Because monetary union has not been completed, and its everyday presence in the lives of citizens in Europe has only in a superficial sense become a matter of course to the same degree as have the internal market and freedom of movement in the Schengen area.
The Ambivalence of Success and Failure
The builders of the euro need to be defended here against cheap criticism. They can be presumed to have made the best out of what could be done between political constraints and the various concepts aimed at creating a better structure in the European Community’s currency area. Contrary to the highly critical Anglo-Saxon academic mainstream, The Economist was respectful in comments which it made in a 1998 special edition on the launch of monetary union:
Europe has barely got round to discussing the international effect of the euro; yet this will be huge, and may cause some concern in America. Once again, there is no past experience to go on. The international financial system is bracing itself for something entirely new on January 1st next year: the arrival in one bound of a major international currency, and one that was created by not just one sovereign government but by many.[1]
The common currency became a success on the capital market as soon as it was introduced. Apart from some teething troubles that were encountered in the first months in which it was traded, the currency changeover was noiseless. It was with justified satisfaction that Jean-Claude Trichet commented on its success with the following words in a speech that he held in Osnabrück on the occasion of the 10th anniversary: “The promise that ‘the Euro will be as strong as the Mark’ has been kept.”[2]
The common currency advanced in quite a short time to become the second most important means of payment in the world, accounting for roughly 35% of international payment transactions, coming in behind the dollar, with roughly 45%. Given that it is a European Community institution, the member states’ representatives in the European Central Bank were obliged to strictly adhere to responsibility for the currency area, and were not beholden to their countries of origin. Designed to be the most independent among the principal central banks, it has brought a variety of criticisms down on itself at different junctures, and continues to do so. This however also previously applied to the Bundesbank, and it still applies to the Federal Reserve and to other central banks to the present day.
There are two fundamental reasons why the common currency nonetheless receives a consistently ambivalent verdict after roughly twenty years of its existence: It is a common currency of democratic member states who, defend their sovereign budgetary rights, and whose lack of economic convergence has not diminished, but in fact increased, over time.
It would admittedly be naive to believe that everything would have been better without the euro: recall the political infighting between Germany and France over the revaluation of the deutschemark against the franc or the pressure regularly applied to German Federal Chancellors to show European responsibility as a sort of “lender of last resort” for Italy: It was unmistakeable long before the start of the precursor to European economic and monetary union that Germany would not be able to simply cast off its role as the country exercising economic leadership at the center of Europe. Anyone who believed that the divergences in Europe would resolve themselves when the euro came along was equally naive. There was little foundation for Georges Pompidou’s optimism that a kind of “European gold standard” would not only spare France the ignominy of recurrent devaluations of the franc against the deutschemark, but also eliminate the reasons causing them in the first place. The same was true of the promise that was made to German taxpayers that they would never be asked to pay up for the Community area, and that this was adequately shored up by rules on debt and deficits.
Free convergence for the South, free stability for the North: This unity of illusions that dominated the first decades has resulted in the explosive potential to which the currency area is exposed today. The first of these cannot be remedied by calling for joint liability in the shape of eurobonds, while the other cannot be obtained by appealing to the Federal Constitutional Court.
Those who have already given up on the euro area for this reason are perhaps not naive, but they are certainly short-sighted. New institutions such as the European Stability Mechanism ESM, as controversial as they may be, and new structures like the Banking Union, as little as they may be regarded as completed, document the willingness of the euro countries not to permit their fates to be taken out of their hands, to learn from mistakes, and to remedy shortcomings. There are good reasons why this widespread willingness to effect repairs is favorably approved of in qualifying the European Union as a “learning system in a state of flux.”[3]
A less complementary, but nonetheless realistic categorization of the governance of the eurozone was carried out by a clever British observer, who referred to it as “fuzzy, but stable.” In light of the level of debt, which has now increased dramatically, and of the sobering economic verdict on the eurozone, as presented warts and all by Le Monde,[4] today’s realist must amend this dictum in a vital aspect, despite the considerable reform efforts that have been undertaken in recent years: “Fuzzy, AND fragile” would probably be a more accurate description today. Monetary union is “fuzzy” because European budgetary rules have tended to develop a life of their own rather than coming together, and because it remains unresolved, should the next crisis of solvency occur, according to which rules the euro system would be governed when it came to dividing up the burdens caused by such a crisis. And it is “fragile” because confidence on the capital markets today rests on the presumption that infinite resources of the European Central Bank would be brought into play, as well as that interest rates will remain permanently low, and that the economically successful countries in monetary union will provide unwavering support.
The Right Reasons, but the Wrong Paths
A “learning system” can naturally also stray onto the wrong path for the right reasons. The current debate on the euro is a derivative of two developments. The first of these rests in the new geostrategic confrontation between the United States and China, in which in the words of President Macron the Union is seeking to lend substance to the ambition of “strategic autonomy.” The second lies in the economic implications of the pandemic, to which the European Union has responded with the “NextGenerationEU.”
To regard the euro as a major factor for the geo-economic survival of the EU is, as obvious as it is, correct. In addition to European trade policy, the euro is currently the only lever with which the European Union is able to operate globally as a player aiming to be taken seriously. It lends it weight in the global monetary system, and it is a strong indication that the EU is also a force to be reckoned with in political terms, as the largest economic area in the world. What is more, the world of currencies is in a state of flux.
The prediction that the “decline of the dollar” is imminent does not become more accurate if it is repeated more frequently. It is, however, right that the global financial system is more dependent than ever on the U.S. government, together with the Federal Reserve Bank, pursuing a rational, far-sighted, successful financial policy. And it is also comprehensible that the strategy of U.S. administrations since George W. Bush, namely to instrumentalize the dollar in geostrategic conflicts by way of “weaponization of the currency,” has far-reaching consequences. It kindles China’s aspirations towards expanding the reach of that country’s own currency; it led the Russian Central Bank to divest itself of dollar reserves on a massive scale, and it enlivens a European debate from the ECB via the ESM through to the “Greens” in the German Bundestag all regarding an enhanced international role of the euro as the silver bullet for escaping Europe’s self-inflicted lack of maturity. Having said that, this geo-economic optimism overlooks the fact that such an ambition is contingent on the very thing which the euro area does not yet have, namely a common idea of the nature and extent of the political integration that is to be aspired towards.
This shortcoming is also revealed in the European response to the COVID crisis. It pursues both the right motive, namely the need for “European solidarity,” as well as the right analysis, according to which the COVID crisis is threatening to increase the economic asymmetries within Europe up to a level that is no longer viable. It started off, however, with a demand emanating from the South of Europe to forgive what were referred to as “COVID debts,” as if it were only possible to combat a health crisis and its economic consequences by taking a leap towards financial policy integration. This would entail throwing all the principles to the wind by which the European Union, and with it the euro currency area, functions. In comparison to previous standards, the “Recovery Plan” deployed in its place is both a great leap and the smallest common denominator: a transfer mechanism for substantial structural funds, and one which also provides for subsidies and which is financed via joint debt, but which is planned as a one-off measure and is therefore not intended to entail any long-term institutional reforms of the European financial architecture. Nonetheless, the political narratives come thick and fast: German Minister of Finance Olaf Scholz was conjuring up a “Hamilton Moment,” recalling the creation of the monetary union in the United States. The ESM welcomes the enlargement of the pool of “safe assets” in the shape of the new Commission bonds, which are indeed desirable in terms of the functioning of European financial markets, and some economists are evoking the breakthrough to European “fiscal capacity.” This is accompanied in both of these cases by the expectation that this tool will become permanent. There is no question that the very announcement of the Fund helped to shore up confidence in the European economic area, and it can also certainly make a contribution towards economic recovery and to the modernisation of the economies of the EU. It is, however, not an institutional reform, and nor does it leave behind well-trodden paths of European structural aid with which national projects are financed but no genuine “European common goods” are created. Instead of this, it levels the path towards a transfer union which has particularly good prospects for becoming permanent in a vertical form.
Maastricht 3.0, Not “Next Generation Hamilton”
It is nothing new to see the European debate oscillating between blackmail, vision, goodwill and pragmatic crisis management. The eurozone, however, is not the single market, for which the fact of the United Kingdom leaving is a major loss, but does not constitute a threat. It is, as the late economist Henrik Enderlein said in 2016, “inherently unstable.”[5]
We note with astonishment that the eurozone’s structural problems, as exacerbated once more by the COVID crisis, do unleash all sorts of political energies, but they do not trigger any convincing initiative for a fresh set of reforms. In the interest of financial stability, tax money was used to save a medium-sized German bank in 2007, and only a few years later Greece was protected from state insolvency by pumping in hundreds of billions of euros. The markets, at currently historically low interest rates, appear to define a new level of tolerance for how high state debt can go. There is also much to suggest that the current swings in the inflation rate will be short lived. That said, there is no reason to believe that the present state will last, nor that it could be shielded by the central banks with concepts such as yield curve control against what might come as a sudden increase in long-term interest rates. In its response to last April’s downgrade of Italy by the Fitch rating agency to one notch above “Sub-Investment Grade,” the then Italian Finance Minister expressed his disappointment that the rating agency had not adequately accounted for the support received by the European Central Bank.[6] Anyone reading Fitch’s report of July 2020 must wonder what the rating would have been if the ECB’s PEPP programme, which has now been extended, had never existed.[7]
There are no shortcuts on the path towards an economically more successful, shock-resistant monetary union. The debate on potentially forgiving debt is currently being continued in market and academic circles. A more detailed analysis, however, shows two things: Forgiving of obligations within the euro system would also have to be paid for by the latter, and it would tear a major hole in the ECB’s balance sheet. There is no such thing as a “free lunch” here, as attractive as supposedly painfree easing measures deployed via “financial engineering” may appear to be. Central banks operating with negative equity is not without its precedents, but the debate on this for the eurozone tends to be a major distraction that may one day actually turn into an uncovered cheque instead of reinforcing much needed confidence in the euro.
The veil of the alleged “Hamilton Moment” also conceals the fact that the euro reform debate has suffered for quite some time from the deceptive deployment of false precedents. It would have been possible to prevent, or at least hedge, the 2011 and 2012 crisis, had there been European banking supervision and better risk diversification in the eurozone. A federal budget of the euro countries could not, however, have achieved this. The assertion which is always raised that the eurozone needed a “fiscal capacity,” and that this would require it to expand to form a fiscal union in order to be able to work in a stable manner, can be traced back to a conventional view and to an inadequate understanding of the manner in which monetary union operates in the United States. In his 2017 analysis for the European Parliament’s Economic and Financial Committee, American political scientist Jonathan Rodden demonstrates in detail that the much-quoted automatic “fiscal stabilizers” of the U.S. system only serve to compensate for mechanisms at the level of the individual states, which must reduce spending in order to meet their obligation to operate balanced budgets in an absolutely uncompromising manner in a crisis. This is inconceivable in a federal system made up of democratic states, which regard their budgetary rights as sacrosanct. Doubts might moreover arise as to whether a European fiscal union could in any way serve as an effective counter-cyclical stabiliser in the member states, given the high level of correlation of cyclical economic factors.
The path to sustained governance in the eurozone must start from two fundamental conditions: Neither the eurozone, nor indeed the European Union, is going to become a federal state any time soon. Nor would reverting to a confederation be an adequate foundation for a well-functioning monetary union. In fact, there is a need for a new understanding of the fact that the complex system that makes up European monetary union requires both more integration and greater subsidiarity.
“More” integration enhances the resistance and competitiveness of the Union by deepening the internal markets, as well as via more effective diversification of financial risks. The concept of the capital market union is a good start for this. If capital markets are better interlinked and investment risks are spread over the currency area, “shock absorbers” develop, which according to estimates are able to cushion up to 50% of the risks in an integrated currency and financial area such as the United States. A real single market for financial services enabled by completing the Banking Union, greater mobility on the labour market, a larger share of cross-border direct investment, as well as capital-based old-age pensions, and everything that makes the eurozone more eco[1]nomically productive, form part and parcel of this.
“Greater” subsidiarity is first and foremost an institutional safeguard of what is at the core of the Maastricht idea: In accordance with the “no bail-out” clause, the member states are responsible for their own financial actions. The so-called “Fiscal Compact” constitutes an attempt to minimize the “moral hazard” problem that is inherent to any monetary union by means of rules as well as of checks and balances. But the system is at risk of falling foul of misincentives in the absence of structures or credible mechanisms allowing it to actually enforce rules. Well thought-out proposals have been put forward for such mechanisms for years. These would enable the ESM to be expanded from a stabilization fund to form a European monetary fund which makes provision for un[1]ambiguous rules in case of crises of liquidity and solvency of member states, borrowing from those of the IMF. A direct consequence would be that these could also break up the previously unresolved “bank/sovereign nexus,” that is the high degree of vulnerability of the financial system that results from the mutual risks entailed by the large share that banks in Europe account for in the state bonds of their respective home countries. The dissolution of this interrelationship is a measure inconvenient for state funding in Europe, but a necessary one if the eurozone is serious with its aspirations of financial stability and crisis resilience.
As a result of the hesitant, contradictory manner of proceeding in the Greek crisis, the German government managed at that time to ensure that state bonds in the eurozone were provided with so called “collective action clauses,” which regulate the mechanisms that investors can use to defend themselves against the restructuring of state bonds, and which conversely define the degrees of freedom available to countries negotiating with investors on loss participation when restructuring state debt. These rules have led a very lonely existence so far in the governance of the euro as tender offshoots of a new thinking. With the proposals for an effective European monetary fund, prominently put forward for the first time in the Financial Times in 2010 by the then German Federal Minister of Finance Wolfgang Schäuble, it became part of a logic of reform which at that time made a both vital and courageous start with the “bail-in” rules for unsecured bank bonds. According to these rules, it is not only investors participating in the equity capital who may have to bear the banks’ losses, but also the owners of unsecured, repayable debt titles. Given the extent to which the financial system is vulnerable to banking crises, both unsecured bank bonds as well as state bonds were for a long time a sacrosanct building block of the financial system for which taxpayers regularly became liable. Today’s financial market has completely dealt with the regime change, which originally appeared as revolutionary, and which was set in motion by the G20 in 2008. Deadlines which are transparent and sufficiently long for their introduction, as well as a favorable capital market environment, were major factors for success that could be replicated today in the Euro area state bond markets. The bail-in rules are not yet perfect for banks, nor are they consistently implemented in Europe. But it’s a start. Applied to euro governance, this would mean that investors, as well as policymakers in the countries in question, must anticipate the concrete possibility for the capital market to contribute towards the cost of crises. As such nothing other than fleshing out the Maastricht “no bail-out” principle, its institutionalization would help focus the debate in the member states: on the primary competence and responsibility for the trust capital among voters, partners and economic actors resulting from forward-looking and reliable public governance.
There is a tendency towards pointing the proponents of more market-orientated governance towards Argentina, where debt restructuring has failed many times, as a deterrent example. But to what degree is Argentina similar to the member states of the eurozone? The concept of a state bond from a currency area which aspires to assume a reliable leadership role in political and economic terms naturally includes that investors are repaid what they invested in such state bonds. However, the European Union is both: leading and reliable, but politically un[1]finished. We therefore need to address the question of the possibility of restructurings of state bonds. Even in the United States, the need may arise to use such tools. Anyone interested in exploring this further could, for instance, study the continued debates on the finances of the state of Illinois. The euro countries are integrated members of the European Union and recipients of substantial structural aid. They are protected against market risks by a central bank, which in the view of many oversteps its role in this regard. In crises they can fall back on stabilizing resources if they are willing to respect the basic rules of conditionality. A European monetary fund would not establish the capital market, and with it the so-called “bond vigilantes” (investors who are active and through their dealings make the risks of state bonds transparent), as the new lords of their members’ financial fates. In fact, it would help to strike a balance for which central political institutions within the European monetary union are out of their depth for the time being.[8]
The energy for reform needed to embark on such a path should, finally, provide for three further steps in order to set up the “learning system” of the European Union for the decades to come in the sense of a “Maastricht 3.0.” First, enhancing decentralized governance as part of the regional “fiscal boards” that support the work of the Fiscal Compact, as well as simplifying budgetary supervision with a straightforward debt rule.[9] Second, this would entail orientating the EU’s finances towards genuine “public goods” such as border protection, security and defense, research and European infrastructure. And third, completion of the Banking Union.
The German Interest
From a German perspective, it is ostensibly easier to live with the “fuzzy and fragile” status quo than is generally presumed to be the case. The fact that we would have to accept a much higher exchange rate if we did not have the euro has now become a common place. That does not make it incorrect. But Germany equally benefits in financial terms from the fact that the German 10-year bond, the “bund,” has the status of a “safe haven” for the monetary area. Thanks to a complex interplay between this “safe haven” status and the market’s liquidity preferences, since the beginning of the financial crisis in 2008 the conditions for financing in particular have not been as attractive anywhere in Europe as they are in Germany. But what characterises the status quo becomes more accentuated still when crises come to a head in the eurozone. When Italy’s Conte/Salvini government deliberately breached Euro[1]pean budget rules in October 2018, and Matteo Salvini once more declared his intention to do battle with the EU, the risk premium on Italian state bonds tripled. The capital market thus helped to ensure that the Italian government ultimately gave in.
International investors look in such situations not only at the Italian bond itself, but also at what is referred to as its “spread” to the Ger[1]man 10-year bunds, as a relevant crisis indicator. This could also be described as a kind of “euro fever thermometer,” the level of which may rise very rapidly. Very few people are aware that, in most cases where crises bring things to a head, the bund runs counter to Italian bonds, so that the thermometer reading is driven not only by rising Italian interest rates, but also by falling German ones. Were the Germans financial speculators, they could therefore certainly find this fragile state of monetary union appealing. However, it is not advisable. The cost of monetary union falling apart would certainly be higher than the amount of the much-cited “target balances” showing the Bundesbank as the largest creditor of the euro system.
Germany’s economic clout and its political responsibility are those of a leading European power – a task which can be neither rejected nor accepted free of charge. The European Recovery Fund, which was launched with France, is an expression of this. It was unfortunately launched without a connection to a broader idea of a viable institutional reform of European monetary union. This may be the understandable outcome of special circumstances. Time has come, however, to remedy this.
Notes
1. “International Star.” Special Report, The Economist, April 9, 1998.
2. Speech by ECB President Jean-Claude Trichet on February 12, 2009, European Central Bank.
3. Mark Leonard, “One crisis, many responses: Fighting the first wave of the pandemic,” Mark Leonard’s World in 30 Minutes [podcast], March 26, 2021 (https://ecfr.eu/podcasts/episode/one-crisis-many-responses-fighting the-first-wave-of-the-pandemic/, September 2021).
4. P. E. Albert and M. Charrel, “L’Euro, une construction encore inachevée,” Le Monde, December 9, 2020.
5. G. Braunberger, “Der Europäer,” Frankfurter Allgemeine Zeitung, May 31, 2021, p. 20.
6. T. Stubbington and M. Johnson, “Fitch cuts Italy’s credit rating to one notch above junk,” Financial Times, April 29, 2020.
7. Rating Action Commentary, “Fitch affirms Italy at ‘BBB’ - outlook stable,” Fitch ratings, July 10, 2020.
8. For an excellent analysis of drivers for government spreads, see Stéphanie Pamies, Nicolas Carnot and Anda Pătărău, “Do Fundamentals Explain Differences between Euro Area Sovereign Interest Rates?” European Commission Discussion Paper 141, June 2021, https://ec.europa.eu/info/sites/default/files/ economy-finance/dp141_en.pdf.
9. L. Feld, Chr. Schmidt, I. Schnabel and V. Wieland, “Refocusing the European fiscal framework,” Center for Economic Policy Research, VoxEU, September 12, 2018.
Further reading:
Richard Baldwin and Francesco Giavazzi, “How to fix Europe’s monetary union. Views of leading economists.” London: VoxEU, 2016.
Markus K. Bunnermeier, Harold James and Jean-Pierre Landau, Euro: Der Kampf der Wirtschaftskulturen. Munich: C.H. Beck, 2018.
Ashoka Mody, Euro Tragedy: A drama in nine acts. Oxford: Oxford University Press, 2018.
Jonathan A. Rodden, “An evolutionary path for a European Monetary Fund? A comparative perspective,” Economic and Monetary Affairs Committee, European Parliament, 2017.
