Can the Eurozone be Saved? by Henning Meyer

The Eurozone crisis is becoming ever more complex and cutting through the chase is becoming more and more difficult. My broad analysis of overlapping structural, political and democratic crises seems to hold up reasonably well but it is time to expand on these categories following a series of conversations I had with a variety of economists. The different crisis strands are coming together in a toxic mix and there is still a significant amount of confusion about the causes of the predicament. This needs to be clarified.

The Structural Crisis

The structural crisis we are facing is a mixture of the design flaws of the Eurozone itself, the construction and functioning of the financial sector and the results these design flaws have had in several areas. The Eurozone design flaws mean that one country after the other can be picked out and there can easily be contagion and self-fulfilling prophecies of insolvency across the currency union even though the underlying economic fundamental look sound. These issues have been extensively discussed and are reasonably well understood.

The deep competitiveness problems in some crisis countries are the result of massive inner-Eurozone capital flows that should not have occurred in the first place. There was a failure of macroeconomic oversight and regulation to prevent these capital flows and the incentives for banks were to abuse their too-big-to fail status and engage in risky activities. The buildup and bursting of economic bubbles and the deep trouble some of the Eurozone banks are in are the result of this situation.

These structural flaws of the Eurozone and their consequences converged with a second source of economic distress – the financial sector induced global economic meltdown set off in the United States – which led to governments initially propping up economies by stimulus spending and stabilising the financial sector with bank bailouts. So in many important ways it is still the structure and incentive system of the financial sector that are in urgent need of reform.

Related to this are sovereign debt issues. Current sovereign debt levels are composed of three elements: First, the pre-existing debt levels before the crisis, which in most countries were unproblematic. Second, new debt accumulated as a result of necessary economic stabilisation measures in the first crisis phase after the London G20 and the loss of tax revenues as well as higher social costs as economic activity deteriorated. And third the rather widespread socialisation (beyond the initial bailout measures) of private risks (which affects yields) and debts. The fact that it is financial players currently exploiting the structural flaws and putting excessive pressure on countries caught in debt traps – with no regard to their own crucial role in driving them into this situation – is again an indication that deep structural reform and proper regulation of the sector is long overdue.

The Political Crisis

The political crisis has made the overall situation worse still. Apart from the fact that we still don’t have a full blueprint for a sustainable Eurozone architecture, only individual measures that don’t seem to add up to a coherent strategy, political leaders have also failed in stabilising the crisis. They have also been reacting to events rather than shaping developments. This is to a large extent driven by the mistaken analysis that the sovereign debt problems were the cause of the crisis rather than the result of the deeper structural issues described above. The resulting policy of austerity has driven European nations apart and pushed crisis countries into debt traps making the necessary reforms and a sustainable reduction of debt to GDP ratios impossible to achieve.

It is true that the economic bubbles in the South should not be re-inflated and that the restoration of competitiveness also means pursuing a difficult process of adjustment. But this adjustment process needs to be symmetrical by having higher wages and also higher inflation in the core countries. An asymmetrical adjustment achieved only by deflation in the South is economically and politically unviable. It is also an often-heard argument that pushing up wages in the core would make the Eurozone uncompetitive vis-à-vis the rest of the world. But this tendency could be addressed by devaluing the Euro so external competiveness does not suffer along the way.

Some people argue that a shock adjustment is the way to go. But I don’t think that such an approach is either politically viable or socially acceptable and it is also incompatible with a symmetric approach as there won’t be high enough wage rises in places like Germany over night. The levers of conditional credit can force measures in crisis countries. Comparable levers for upward adjustment in the core countries are, however, missing. It is therefore utterly important to set a credible path for symmetric adjustment.

What needs to be done? I think four steps are necessary. First, there needs to be growth to make structural adjustment and the medium-term reduction of debt to GDP ratios possible. This requires a move away from austerity and the decoupling – as much as possible – of competitive adjustment from fiscal policy. Competitive adjustment primarily needs to take place in the private sector and governments should support this difficult process by growth-enhancing measures, not austerity.

Second, if there are stagnant or slowly increasing real wage levels in the South, matched by considerably higher wage increases and higher inflation in the core, new growth could not only help to address competitive imbalances but also the huge unemployment issues. This in turn could also help to bring social costs and public deficits under control.

Third, inequality has been identified as one of the key structural drivers behind our broken model of finance-driven capitalism. Inequality is for instance revealed by the ever-decreasing income share of wages in the face of an ever-increasing share of profits. Addressing this issue is an urgent matter for the reform of the economic system as a whole, the fairness of the adjustment process and the regaining of trust in democracy. And it goes without saying that given the arguments above the fundamental reform of the financial sector is another key political priorty.

And fourth, the refinancing costs of countries also need to be brought down. Here, the issues of debt mutualisation, ECB reform and a joint banking system, which are required for the long-term institutional sustainability of the Euro, are at the core of current discussions. There are, however, important democratic issues attached to this, which leads me to the third crisis.

The Crisis of Democracy

The democratic crisis is also worsening and might well be the fighting ground that eventually decides the fate of the Eurozone. There is first of all the situation – resulting from the Euro’s structural design flaws – that 17 sovereign fiscal decision-making procedures create policy externalities for all Euro countries because of the joint currency. Second, there are national democratic crises as the burdens of economic adjustment are currently not only unfairly distributed amongst countries but also within countries, partially because of credit conditionality and partially because of deep-seated democratic problems in some member states. Across the Eurozone, people increasingly seem to lose faith in politics and the ability of the political class to master the huge problems and at the same time maintain democratic principles. And last but not least the move towards a political union, necessary to overcome the Euro’s structural flaws in the long-run, faces several serious challenges.

It is often argued that a mutualisation of debt would create a moral hazard as it reduces the pressure to pursue necessary adjustment and break the link between decision and responsibility – similar to the same broken link in the financial sector. There are basically two options to address this issue. The first one does not involve a full political union. One basically keeps 17 national decision-making procedures in place and constrains them by generally binding rules. This is what is currently pursued. Even if the rules were right – and the fiscal compact rules are not right in my view – there is a big issue of enforcement. The only sanction for rule breaking would be penalties but could one realistically fine countries already in a financial crisis for breaking rules? This hasn’t worked in the past and is unlikely to work in the future. Seen in this light the common rules approach – even if there was a way to establish the right rules – seems unworkable.

Moral hazard has to be contained by a governance mechanism with teeth that intervenes before a spending decision is finalised (ex ante not ex post). This would mean supranationalising a large part of fiscal policy decision-making, which effectively breaches current national sovereignty rules and would be unconstitutional in Germany  and I suspect also in most, if not all, other Eurozone countries. So this kind of political union would require extensive constitutional change on the European as well as the national level.

At this point the sheer scale of the task becomes clear: There are no easy solutions and there are no quick fixes. Is such a supranationalisation possible? Would citizens across the Eurozone back such a move, maybe even by referendum? If these hurdles cannot be overcome, could there be minimal integration, for instance a banking union, without a full fiscal integration? Could this work or will the Euro with such a construction inevitably fail at some point with all the huge and unpredictable political, economic and social consequences? Can such a large reform be achieved in the short-term, effectively with a gun to your head? Or can we at least set a process in motion that would transform the Eurozone in this way, maybe over the next decade or so?

Where do we go from here?

The fusion of structural, political and democratic crisis aspects is becoming more and more complex. Against this backdrop, it might well be the issue of democracy that finally decides the fate of the Eurozone in one way or the other. The European integration process driven by elites seems to have reached its limits. In the long run the Eurozone crisis can only be solved by a democratically legitimised leap forward; or by disintegration which could be a political, economic and social disaster (nobody knows!). So after all, at its core the Eurozone crisis is still a political crisis.

This column is part of the Eurozone Scenarios Project of the Friedrich-Ebert-Stiftung and Social Europe JournalThe long version of the scenarios paper can be downloaded hereStatistical Annex is also available.

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  • http://Borba Eusebio Manuel Vestias Pecurto

    A crise da Zona do Euro deve-se ás politicas dos antigos governos do Eurogrupo ainda há pouco tempo tivemos uma cimeira em que os lideres Europeus assinaram tratados com mais medidas de austeridade para baixar o défice dos paises com dividas soberanas temos um presidente da França que criava o eurobonds no eurogrupo ainda não vimos esta medida As familias Europeias é só apertar o cinto e chegam ao fim do mês sem combustivel A incompetência na gestão desta crise tem sido multiplicado pelo excesso de confiaça no mito da competência Alemã

  • Siegfried Loeffler

    I think you can safely add a fifth point that needs to be addressed, as answer to the issue you raise being one of the root causes… (“So in many important ways it is still the structure and incentive system of the financial sector that are in urgent need of reform.”)

    • Henning Meyer

      I brought that in at the end of point three. But you are right, in terms of importance it certainly warrants an own number…

  • Anthony Sperryn

    As one of the previous comment-makers has done, I would like to highlight one key sentence in this paper.

    “…..it is still the structure and incentive system of the financial sector that is in urgent need of reform.”

    I suppose that, in a hard-nosed global financial system, it is too much to expect a banker arranging a loan to believe that he has a duty of care towards the borrower. But that is at the root of the present eurozone crisis.

    When bankers were bankers, rather than cowboys with MBAs or degrees in computing, they had experience of lending their own money and were correspondingly cautious. Now, with investment bankers having made the running in the last few years, it is different.

    The consequence has been that the (investment, mostly) bankers arranging a loan have pocketed their front-end fees, syndicated the loan so that others are on risk and then moved on. They didn’t care what mess they would leave behind. An additional aspect of this practice has been that a high volume of loans has been created, with irresponsibility getting entrenched in the system, money too easy to come by and private and public sector overspending arising.

    Although it may be expecting a bit much for investment bankers to care about the borrowers, the least that a reform can do is to ensure that any front-end fee is shared pro-rata to the amount that is put up.

    Furthermore, the matter of trading in loans after issue needs to be addressed, because it detracts from the duty of care a lender, in best practice, should have towards a borrower. In recent years, the practice of hedging with derivatives has allowed the volume of loans to increase, with disastrous effect. Assignment of loans, in general, breaks the trust that ought to exist between borrower and lender.

    This practice of hedging, I believe, arises from the American business philosophy of “there’s always a sucker” – a philosophy which is abhorrent to European culture and values, though Britain still has its “caveat emptor”, which, however, is not absolute. It means that institutions which trust are taken advantage of, to their detriment initially, but ultimately to the detriment of society as a whole. The investment bankers have a lot to answer for, for their sweet-talk and, now, as the Barclays scandal shows, for their dishonesty.

    It may be that eurozone institutions ought not to borrow from non-eurozone sources. The world-wide financial dealing industry has ended up being like a giant vacuum cleaner, funnelling money into tax havens (not to mention laundering money in vast quantities).

    It is to be regretted that, when the global financial crisis was first recognised as such, the euro-leaders did not recognise that default is no big deal, if handled properly (Iceland shows the way). It is a pity that Germany’s reluctance to accept its own vulnerability has inhibited this course of action. Circumstances can change and force majeure clauses should have been included in all loan documentation. Sovereign borrowers are not like commercial entities and sheer decency requires that they are not sent to the knacker’s yard, as people want to do to Greece. They should not have to submit to the default clauses in loan agreements they would if they were private companies.

    The key feature of this argument is that international markets can only operate in a socially acceptable manner when transactions take place continuously and within a narrow price bracket. Anything else amounts to market failure, for which different rules need to apply.

    A particular aspect of this is that interest rates of 6-7 per cent for Spain, Italy and so on are absurd , because they are destructive. Bail-out loans on that basis never really work. We’ve left it late, but, probably, a collective refusal to pay, coupled with a strong bout of xenophobia towards those outside the eurozone (think Malaysia), might be a controversial, if effective, remedy.

  • Hugo Radice

    Dear Henning,

    Just read your analysis. I have no major disagreements, but I am increasingly concerned about why and how the option of worker solidarity across the EU has been so successfully closed out. As the lead article in this month’s Le Monde Diplomatique documents, a majority of German citizens, evidently including many workers, have been persuaded to support the “lazy Greeks” line, and have no understanding at all of the point you yourself make that there was reckless lending by German (and other northern-EU) banks to the Euro-periphery – and of course the other points based on elementary macroeconomics.

    But we hear nothing about any alternative position that must, surely, be vigorously asserted by at least the left wing of the German labour movement, the ETUC, and indeed unions right across the EU. Is this because of the unions’ decades-long complicity in the erosion of workers’ wages and conditions, especially the two-tier labour market that the Harz reforms have created? Without a strong voice for solidarity, it’s hard to have any hope for democratic governance. This, incidentally, is not just needed for the first time at the EU level, but desperately needs rebuilding in each and every member state, after 20 years in which policy-making has increasingly become the preserve of business and financial lobbyists masquerading as “experts”. The political crisis here is not just the rise of the far right parties, but the widespread decline in political party membership and electoral turnout.

    It is also important to note that those same Eurobanks that lent recklessly to the Europeriphery were deeply implicated as well in the US sub-prime mortgage crisis: in this regard, they were themselves the “suckers”, as Anthony Sperryn puts it, conned by US money-market funds who lent them the $$ with which they purchased the dodgy derivatives that nearly destroyed them in 2008. And in the second half of 2010, it was the refusal of the US funds to roll over their term deposits in the Eurobanks that led to the liquidity crisis that Draghi had to deal with in his December and February LTROs.

    Why did the Eurobanks, especially the German Landesbanken (and Commerzbank too), fall for this? Because the Anglo-Saxon banks were making much higher returns on equity, and the ever-increasing numbers of US/UK-based shareholders demanded higher returns too. Indeed, it was precisely the prospect of “unlocking value” languishing in the deposit-rich Eurobanks that attracted them as shareholders. But of course, liberalising and encouraging inward FDI was a key part of the post-Maastricht mantra as the business lobbies grew in power!

  • Tom Lynch

    Certain common elements of solutions are emegring:
    1) Each country agrees to split investment banking and regular banking, and then propelry regulate both;
    2) Eurobonds to soak up sovereign debt in troubled economies;
    3) Common age of retiremnt and seniors benefits coordination across Eurozone;
    4) Banking tax on investment capital flows;
    5) Investment in growth and job creation to soak up unemployment and provide youth opportunities;
    6) Moratorium on further EU expansion;
    7) Tax reforms to increrase taxes from top 20%, and tax windfall bonuses accordingly;

  • http://www.Steven-Hill.com Steven Hill

    Hello Henning, nicely done. You have succinctly outlined many of the crucial dilemmas and challenges. The solutions are not easy ones, and sometimes the only thing that appears to be continuing to drive Europe forward is that the consequences of going backward seem so much worse.

    Steven

  • Henning Meyer

    Thanks for all the comments! As I said, before you can work on proper solutions you first of all need a thorough understanding of what went wrong in different areas and a framework to think about it. That’s what I tried to do. The strands fit into the three broad categories which seem fine as a framework. A sustainable solution needs to address all of these issues. An almighty task!

  • George Irvin

    ‘The deep competitiveness problems in some crisis countries are the result of massive inner-Eurozone capital flows that should not have occurred in the first place. There was a failure of macroeconomic oversight and regulation to prevent these capital flows and the incentives for banks were to abuse their too-big-to fail status and engage in risky activities. The buildup and bursting of economic bubbles and the deep trouble some of the Eurozone banks are in are the result of this situation.’

    Doubtless there are ‘deep competiveness problems’, but the K-flows of which you speak are BoP and not simply bank driven. Germany’s surpluses with the rest of the EZ have been recycled to the Club Med countries, not out of greed but of economic necessity (remember that a CA deficit can only be financed by an offsetting capital account surplus). The banks at the centre have made this worse simply because of their profit taking; the banks at the periphery have guided the money towards either unproductive consumption or low productivity investment (overinvestment in housing). The view that it’s all a failure of ‘macro-economic oversight’ is far too simple.

    The resulting policy of austerity has driven European nations apart and pushed crisis countries into debt traps making the necessary reforms and a sustainable reduction of debt to GDP ratios impossible to achieve.

    Yes, I quite agree with this part of the analysis.

    It is true that the economic bubbles in the South should not be re-inflated and that the restoration of competitiveness also means pursuing a difficult process of adjustment.

    The notion that stimulus (essentially deficit spending) will simply re-inflate the southern econ bubbles sounds suspiciously like an argument against reflation. Yet, as you have said above, austerity is killing the EZ—QED, austerity must be quickly reversed, and to do this, a large stimulus package of higher wages and higher investment is needed. The only way to finance this is for the ECB to engage in massive monetisation (or QE if you prefer). This of course is anathema to the Germans who endlessly invoke 1923 (but not 1930-32).

    Second, if there are stagnant or slowly increasing real wage levels in the South, matched by considerably higher wage increases and higher inflation in the core, new growth could not only help to address competitive imbalances but also the huge unemployment issues. This in turn could also help to bring social costs and public deficits under control.

    As I’m sure you realise, there’s a contradiction between reducing intra-EZ inequality and raising real wages faster in the core than in the periphery—although both goals are desirable. A partial solution would be the institution intra-EZ social transfers on the US model—ie, where the federal govt pays unemployment insurance, pensions and the like. As Paul Krugman pointed out recently, intra-EZ differences are not so great as to make such a policy totally unrealistic.

    There are no easy solutions and there are no quick fixes. Is such a supranationalisation possible? Would citizens across the Eurozone back such a move, maybe even by referendum? If these hurdles cannot be overcome, could there be minimal integration, for instance a banking union, without a full fiscal integration? Could this work or will the Euro with such a construction inevitably fail at some point with all the huge and unpredictable political, economic and social consequences?

    That indeed is the heart of the problem. The euro needs a federal government; in short, a country. The sooner we face up to this, the better. And if it can’t be done, we’ll need to face up to that too.

    • Henning Meyer

      Thanks for your comments George! Here a few quick replies.
      - I agree that the capital flows were driven by CA imbalances and offsetting cash flows. That liquidity was however channelled and allocated via the banking system, which in turn had incentives to engage in risky activities. I would include these BoP issues in the need for proper macroeconomic oversight.
      - as you know I have never been a supporter of austerity and the point about not reinflating bubbles is just making the argument that new investment should be used to create more sustainable mixed economies
      - Inequality across the EZ is an issue although I see the issue more in terms of national issues of inequality. It seems to me that the upper echelons in crisis countries are quite happy to almost literally starve their fellow countrymen just to avoid contributing to the (unnecessarily high) crisis costs. This is also what I meant by national democracy eroding. There is much to be criticised about the German approach but one mustn’t overlook these domestic issues, which are very dangerous!
      - again it seems more and more likely to me that democracy will be the final battleground on which the future of the EZ will be decided. This suffers form a lot of misinformation over recent years. It doesn’t look to good!