Investors now recognize that they did not really understand what these bonds represented – that is, the institutional construct behind the European currency. And if the global financial crisis has taught us anything, it is this: when you do not understand a financial product, you should not buy it. But if investors actually take that lesson to heart, the European crisis will be far from over.

So, should Europe embrace fiscal federalism in order to strengthen the eurozone and restore investor confidence? The problem is that fiscal federalism means different things to different people.

Americans think they know what it is: a central government with a large budget (about 20% of GDP), whose macroeconomic role is to carry out counter-cyclical spending and taxation, as most US states are constitutionally committed to some sort of balanced budget. This was clearly true in the case of the stimulus program launched in 2009, which included federal transfers to the states to sustain state-level fiscal spending. Similarly, when a state such as Michigan is hit by recession in its key economic sector (the auto industry), Washington collects less federal tax but maintains – if not increases – local spending, which partially offsets the shock to state income.

Economically, therefore, the federal budget cushions regional shocks automatically through discretionary action and stabilizing transfers to the states. Politically, it embodies solidarity and thus helps cement the union.

If this is what is meant by federalism, it is better for the European Union to forget about it. The EU budget amounts to about 1% of GDP, just one-fortieth of total public expenditure. No one, not even die-hard European integrationists, imagines that it can reach 5% of GDP (it is more likely to decrease). But even a 5%-of-GDP budget would be insufficient to play a meaningful macroeconomic role.

A second solution is what can be called “distributive federalism.” The goal is not to absorb shocks but to reduce income gaps across regions. In Germany, tax revenues are redistributed between the Länder. This is another form of solidarity, which also exists in the EU, where regional development funds are allocated to poorer regions to foster catch-up growth. These transfers are significant for poor countries: about €300 per person for Greece and Portugal every year from 2000 to 2006. Europe, in this respect, is not qualitatively different from the US.

These transfers have accelerated convergence when put to good use (for example, in several Spanish provinces), but have been ineffective when wasted (as in Greece). This feeds doubts about solidarity’s usefulness. Germans, who since reunification in 1990 know what they are talking about when it comes to such transfers, do not want to hear about a Europe where rich regions would permanently finance pockets of under-development. They are not alone in this.

What, then? Conceptually, the eurozone must include solidarity with countries facing hardship, because this is what unites and gives strength to the whole – but without the heavy machinery of a federal budget or a permanent increase in transfers. It needs some sort of mutual insurance, or what could be termed “insurance-based federalism.”

This is what inspired the decision taken in May to create the European Financial Stability Facility (EFSF), by which assistance can be provided, jointly with the International Monetary Fund, to partner countries in times of crisis. It is also what inspired the European Central Bank to launch an asset-purchase program, which has been used to buy Greek and Portuguese government bonds.

But the uproar caused by these decisions reinforces, rather than dispels, doubts. In Germany, many consider the EFSF a breach of the fundamental principle that EU governments cannot be bailed-out by their partners. And the transformation of the central bank into a quasi-fiscal agent (because if Greek debt is restructured, the ECB will record losses) is regarded with horror, as it violates the separation between money and public finances.

Instead, it is claimed, eurozone members should have been allowed to default. No matter that the public debt of the average US state is less than 0.5% of total US GDP, compared to 5% in the eurozone, which implies that the financial impact of a eurozone sovereign default would be much stronger. And no matter that there is no prohibition on the purchase of government bonds on the secondary market: the Rubicon has been crossed, and the Germans are nervous.

So there is no agreement yet to make the EFSF permanent, and it has been designed to be as un-federal as possible. When it comes to ECB purchases of government bonds, no one understands exactly for how long and for what purpose the new weapon is to be used – which reduces its effectiveness. Meanwhile, proposals for pre-adoption assessment of national budgets by the EU have attracted criticism in France and elsewhere, which serves as a reminder of the distance there is between calls for coordination and actual acceptance of its implications.

The Europeans have begun to assemble the bricks for a new building, but without having agreed on its size and design. For the time being, they rather give the impression to have thrown sandbags in disorder in an attempt to stop a wave. This may make skeptics the very people European policymakers wanted to convince. It is time to accept that those who finance EU governments through purchasing their bonds are entitled to ask inconvenient questions, and to expect clear answers.

Copyright Project Syndicate

How jolly, it just makes you wonder what will replace common sense once those first few decades have passed. I’d hate to think its reign would be so much shorter than that of ideology.

I’d be tempted to mock this grandiose declaration even further if it did not appear to be the harbinger of something more sinister. Yes, Orbán is of course right that some of the issues that shaped the ideological conflicts of the last century are less salient today than they used to be, while plenty of new issues have arisen that are often difficult to integrate into the traditional ideological moulds (e.g. environment and globalisation).

This has led to an increasing and ongoing flux in the democratic party systems and it partly explains why I don’t think social democracy’s current crisis is only a failure of its policies, as I noted a few weeks ago.

Some aspects of the Orbán’s remarks were particularly troubling for Hungary, but they may also offer a few cautioning glimpses into the future of – particularly Eastern – European politics in general.

Orbán picked up on his recurring theme of a national centre that crowds out traditional categories of left and right. A government that does whatever is best for its people, enacting policies that freely borrow left- and right-wing ideas alike, whatever works best if you apply “common sense.”

There is of course room for centrist politics that is not dogmatic about ideology and reaches for whatever means best serve the values it holds and the interests it represents.

In reality, however, the purported non-ideologists often pursue crass populism repackaged as “common sense”, “national interest”, “the public good”, whatever. (By populism I mean policies or communication that overly simplify complex policy matters, incite popular anger against particular groups in society (elites, minorities) with their simplistic explanations of societal problems, and build their agenda around whatever promises to resonate most vibrantly on an emotional level rather than based on their commitment to values).

Orbán is illustrative of this brand. With a strongly nationalistic rhetoric, his government – and even more its intellectual coterie – has for instance railed against the IMF and its requirements vis-à-vis Hungarian financial consolidation, leading to a breakdown in the talks between Hungary and the IMF and the European Commission.¹ In doing so, it has managed to draw some applause from the far-left in Hungary and, apparently, abroad, too.

Unless one is dogmatically dead set against fiscal consolidation or committed to tax cuts (Orbán: “the greater the crisis, the greater the necessary tax cuts”, cf.: http://simple.wikipedia.org/wiki/Voodoo_economics), the question arises: is the centrepiece of “national centre” government’s policy, a flat tax resulting in a huge tax cut for the highest income brackets, moderate cuts for middle earners, the abolition of the inheritance tax, as well as most likely massive tax hikes for the working poor, really worth more than fiscal consolidation? Common sense would suggest that it is not.

In the larger context of European policy, the issue is whether Orbán’s national centre is something that should be catching on: is a Robin Hood tax on banks (originally planned to exempt the governing party’s own finance oligarchy) and a tough anti-IMF rhetorical stance really enough to capture all that’s common sense about progressive ideology? Especially if the government’s understanding of Robin Hood is taking money from the rich and the poor and to give it to the wealthy?

In any event, Orbán’s particular brand of populism, which paints itself as above petty political ideologies and the sole representative of “national interest”, is fairly widespread in the region.

Some of the most successful Eastern European politicians, including Robert Fico, Lech Kaczynsky and Boyko Borisov have treaded similar rhetorical paths to power. And so has, of course, Vladimir Putin in Russia, albeit in very different political context.

In Orbán’s own words, his desire for Hungary is that there be “a grand ruling party, a central political force that is capable of formulating [by itself] the national issues – and to do so not in the context of permanent debates, but rather stemming from its very nature.” These words, together with similar comments (and also policies) by the PM, suggest that opposition, checks and balances, criticism, etc., are merely nuisances when one party alone has all the answers.

Apart from the damage it potentially does to democratic institutions – as it does now in Hungary, where the “central political force” has translated its vast, 52,7% voter support into a constitutional supermajority of 68% in Parliament and is in the process of bringing all independent institutions under the control of the ruling party –, this understanding is especially harmful because it negates the fundamental democratic notion that public interest is, by definition, a compromise between a multitude of interests and opinions.

“So what?”, you might say, especially in Western Europe, where such populism may have made headway but is rarely as successful as it is in this region. For starters, this means that the gap in the quality of democracy within the EU is far greater still than the economic development gap, and unlike the latter, which tends towards convergence, there are some alarming signs that the democracy gap is widening.

Second, if you do not find this particularly disturbing in and of itself, consider what it means for European politics: a substantial portion of the people shaping the Union will have no fixed political commitments but rather unpredictable, self-serving stances. Coordination and compromise – already an immense burden with 27 members – will be a nightmare with such idiosyncratic and autocratically inclined leaders.

Furthermore, building a coherent and strong progressive political force in Europe will be difficult if social democratic parties in the region will be sidelined to the degree they are now, or worse, morph into populist political organisations themselves. The spread and sustained success of such populist politics will require the rethinking of integration strategies and of progressive politics, too.

These actions are an attempt to manipulate the market; hoarding a huge amount of cocoa now to push up the price and profit later. Earlier this month 16 European traders said they were “shocked with what is happening on the London cocoa market”, claiming it was causing havoc for producers and consumers. The Association of the German Confectionery Industry told The Guardian: “What we are experiencing today is clearly a manipulation of the contract which is bringing the London market into disrepute, and which, we believe, should not be allowed.”

But the manipulation of cocoa prices does not only affect chocolate companies and chocolate eaters. The wild fluctuations in prices which have beset food markets in recent years cause real problems for farmers, making it more difficult to know what to invest in and produce. The danger is speculation has caused artificially high food prices now, which will collapse in coming months causing real problems for cocoa farmers.

Volatility of prices is a huge problem for developing countries, whether importing or exporting commodities. Pedro Paez, former Economy Minister in Ecuador, says both high and low prices are a bad thing: “the oil price because of speculation on futures went as high as $150 per barrel, and then due to short-selling dropped in four weeks to less than $40. How as an importer or exporter can you plan a sustainable economy under those conditions?”.

Speculation does not only affect cocoa and oil. In 2007 and 2008, banks put huge amounts of money into food derivative contracts, particularly for wheat and maize. This pushed up prices, contributing to the global food price crisis. Over 100 million more people were pushed into chronic hunger and the number of people living in poverty increased by between 100 and 200 million.

In developing countries, poor households tend to spend between 50 and 90 per cent of their income on food. Higher food prices not only increase hunger, they cause people to reduce their spending on nutritious foods such as fruit and vegetables, or services such as healthcare, education and family planning.

Whilst speculation is damaging for farmers and consumers, it is big business for banks. Based on figures in its annual report, the World Development Movement has estimated that Goldman Sachs made $1 billion from speculating in food during 2009.

European Commissioner for the internal market Michel Barnier said in January 2010 “Speculation in basic foodstuffs is a scandal when there are a billion starving people in the world. We must ensure markets contribute to sustainable growth. I am fighting for a fairer world and I want Europe to take the lead on that.”

However, it is actually the US which has so far taken the lead. The recent Financial Reform Act passed by Congress increases the transparency of markets whilst also creating new powers for regulators to limit speculation.

The European Union needs to do the same. This autumn, the European Commission will be proposing a set of directives on regulating banks. They need to increase the transparency of commodity markets, whilst limiting the excessive speculation which is so destabilising to so many people. You can join the World Development Movement’s campaign to make this happen at http://www.wdm.org.uk/food-speculation

Mario I Blejer

The turmoil in Europe is not abating. True, some calm has returned to the markets after the initial storm, but tenacious misgivings about the euro project in general are growing, driven by disenchantment with the policy responses and a realisation of the magnitude of the problem. Something that was unthinkable six months ago is happening today. There are, still few indeed, but undeniable mounting calls for euro exit – and not only from euro sceptics across the Atlantic (see Feldstein 2010, Financial Times 2010, and Baldwin 2010 for a summary of the debate on Vox.)

While faint exit pleads could be heard in Germany, as a way to avoid bearing the cost of the bailout, the louder calls are coming from the economies under pressure and looking to regain competitiveness, with Greece in front of a potentially larger number of countries willing or forced to give up the single-currency project.

Switching from a strong to a weak currency

But the process of launching a new, weaker, national currency to substitute a stronger one as legal tender is, to be sure, a very complex one. What do we know about this process? Eichengreen (2007) provides an analysis of this event but when it comes to hard facts the answer is simple. We know virtually nothing.

Indeed, it is unclear whether those toying with this type of solution have analysed the preconditions and consequences of such a move since there is not much precedent for an episode of this kind in recent economic history. Abandoning a battered currency in favour of a stronger one (“dollarisation” in the jargon) has been more frequent, and is probably easier in comparison (see for example Levy Yeyati and Sturzenegger 2002). Creating or reintroducing a national currency with the deliberate intention to weaken it relative to the existing one (and to all other world currencies, for that matter) is an altogether different and much more complicated endeavour, particularly if this has to be done in times of distress and mistrust of domestic policies.

Argentina 2002

Eduardo Levy-Yeyati

The closest, although certainly not identical, precedent to this course of action is Argentine’s exit from a currency board arrangement to float a weakening peso in 2002, an event that has important common aspects with the case in point. While still far, in many respects, from a “new drachma” or a “new peseta”, the episode nonetheless offers some interesting pointers as to what the whole affair involves.

At the risk of generalising and omitting, the Argentine lessons can be summarised under four categories. If a country is willing to seriously entertain the idea of introducing a new, weaker, currency (which for simplicity we could call the peso), it needs to be willing to deal with: the “peso-ification” of contracts, the imposition of heavy restrictions to commercial bank operations, an external debt restructuring, and the use of capital and exchange controls – at least temporarily.

Crucially, all of these four types of tribulations, which come on top of the potential inflationary consequences that follow any normal devaluation, need to be tackled jointly and up front, as they are likely to be anticipated by agents and markets. Exit costs can only grow larger if the decision process is protracted and marred by improvisation and half-baked patches. Below we briefly discuss why these four issues are an almost inescapable consequence of leaving the strong currency: Peso-ification or redenomination of contracts. The new currency needs to create its own transactional demand and requires a legal framework that makes it the sole legal tender and unit of account. This requires the forced redenomination of all contracts in the economy. Regarding prices and wages – as well as other flows of funds – the redenomination may not create very serious disruptions.

The redenomination of accumulated stocks, however, particularly those arising from domestic financial contracts, becomes an extremely thorny issue. On the one hand, if the new currency succeeds in achieving a real devaluation (i.e., this if the pass-through of the nominal devaluation to inflation is reasonably low), the forced peso-ification of financial contracts results in heavy and asymmetrical balance sheet effects.
In particular, the losses experienced by domestic euro debtors would more than offset the gains from a more competitive economy and make the whole euro exit strategy self defeating (see Frankel 2005).

On the other hand, the peso-ification of bank deposits and credits could have a massive redistributive impact (benefiting net bank debtors and hurting net deposit holders) and could bring up violent social and political reactions. It would also immediately trigger a bank run, as depositors run to protect their savings by switching them back into hard currency. Indeed a bank run may be unavoidable and precede the exit, as the Argentine case illustrates. The Argentinean bank run started in early 2001, nine months before the abandonment of the currency board arrangement. This is because the mere expectation of an exit is enough to fuel a deposit run, as well as a credit crunch, in anticipation of the inevitable peso-ification (see Levy Yeyati et al. 2010).

A deposit freeze

To counter the deposit run and to avoid massive bank failures until the economy is out of the woods, a temporary deposit freeze would be needed. Crucially, to minimise the damage, the freeze needs to be selective, excluding sight and savings deposits needed for everyday transactions. Argentina, again, is a good example – albeit negative. The gate dropping on all deposit withdrawals in November 2001 (the so-called “corralito”) was a misguided choice that caused a liquidity crunch that only contributed to the downward spiral in economic activity and market sentiment.

This misguided policy was the immediate cause of the government collapse. By contrast, the deposit restructuring in January 2002, that peso-ified and froze only term deposits, slowed down the run thereby preserving the payments system. Needless to say, these options were (as they always are) desperate measures to cope with a terminal crisis, and suffered from many shortcomings that are inevitable when policy is made in a crisis. But even the most careful preparations may not prevent the financial panic surrounding an anticipated conversion.

An external debt restructuring

This is the flipside of the peso-ification of domestic financial contracts. External debt under international law cannot be redenominated by the government but, following the peso-ification of state revenues and expenditures, it becomes very difficult to service on its original terms. Therefore international debt relief could come through a negotiated debt exchange.

Importantly, however, such a restructuring is not restricted to the sovereign. Corporate euro debtors would suffer the same balance-sheet shock and, with the government unable to fund a bailout, would be forced to renegotiate their liabilities. In Argentina that was a painful and protracted but essentially successful process. Firms restructured their debts under the umbrella provided by the combination of sovereign default and capital controls that inhibited debt servicing abroad. In this way, bankruptcies were avoided but the access to international markets by the corporate sector remained impaired for many years. Besides this distinction, however, the main lesson from the Argentine experience is that it is unrealistic to conceive a euro exit without a debt default.

Capital and exchange-rate controls

Euros (and other reserve currencies) will be precious in the event of a euro exit. Financial uncertainty fuels capital flight just at the time when the country needs to fund a narrowing but still sizeable current-account deficit. This scarcity of euros will probably be exacerbated by a loss of access to international capital markets.

As a result, traditional restrictive measures such as the obligation to surrender export proceeds to the central bank, often coupled with capital outflow and exchange-rate controls, are necessary. All of these measures were launched in Argentina in early 2002 and contributed to stabilise the transition.

In fact, it may not be possible to enforce the redenomination of contracts nor the deposit freeze without capital controls; without them all settlements would immediately move abroad. Again, the lesson here is that conceiving a euro exit while maintaining full convertibility is probably wishful thinking.

The euro difference: Harder than a currency board arrangement Argentina’s abandonment of its hard peg has some similarities but also marked differences with the current situation regarding euro exit. Leaving the currency board arrangement was actually simpler than the introduction of a new currency in that the currency board arrangement never eliminated the use of the local currency for transaction purposes, the basis of the demand for money.

In Argentina, the devaluation caught people with pesos in their wallets, and the need for liquidity supported a steady demand for pesos all through the first quarter of 2002 when it depreciated by 300% (see De la Torre et al. 2003). By contrast, a “new drachma” or a “new peseta” would need to create from scratch a demand for a currency born weaker by design. Could it work? Everything is possible but, as noted, there are no real precedents and, just judging from the costs involved in redistributing wealth through the redenomination of contracts, imposing bank restrictions, restructuring external debt, and limiting capital mobility, it is certainly not the easiest way out.

References

Baldwin, Richard (2010), “A re-cap of Vox columns on the Eurozone crisis”, VoxEU.org, 10 May.
De la Torre, Augusto, Eduardo Levy Yeyati, and Sergio Schmukler (2003), “Living and Dying with Hard Pegs”, Economia, 43-107.
Eichengreen, Barry (2007), “Eurozone breakup would trigger the mother of all financial crises”, VoxEU.org, 17 November.
Feldstein, Martin (2010), “Let Greece Take a Holiday from the Eurozone”, Financial Times, 17 February.
Financial Times, “Dis-membering the euro”, 14 July, Lex.
Frankel, Jeffrey (2005), “Contractionary Currency Crashes in Developing Countries”, IMF Staff Papers, 52(2).
Levy Yeyati, Eduardo, Maria Soledad Martinez Peria, and Sergio Schmukler (2010), “Market Discipline under Macroeconomic Risk”, Journal of Money, Credit, and Banking.
Levy Yeyati, Eduardo, and Federico Sturzenegger (2002) (eds.), Dollarization: Debates and Policy Alternatives, MIT Press.

This column was first published by voxeu.org

Americans think they know quite a lot about Europe, yet most of it is based on stereotypes. Americans like to be numero uno, and they are fed a steady diet of stories by a corps of patriotic Euroskeptics, as well as a sensationalist media (which shares the public’s biases), about Europe’s allegedly weak, socialist economy, about its being overrun by Islamic jihadi immigrants, and being plagued by an aging, dying-out population.

These trans-Atlantic perceptions were exacerbated greatly by the rupture at the United Nations over the invasion of Iraq. Suddenly America’s erstwhile Cold War allies transmogrified overnight into double crossers, an “axis of weasels” and “cheese-eating surrender monkeys,” to quote that erudite American political analyst, Bart Simpson. Each of these fronts has allowed Europe to be used as a convenient punching bag to score ideological points by rabid anti-regulation, anti-government free marketeers, as well as by pro-military and anti-immigration conservatives.

Unfortunately there hasn’t been much of a counter-narrative within American shores to balance all these misperceptions. Remarkably, Europe today is lower on the U.S. public relations totem pole than China, the most over-hyped, overrated, “not-yet-a-superpower” superpower in history. Given authoritarian China’s obvious warts, that takes some doing. Professors of European studies in American universities have lamented to me that most of the undergraduate and graduate students want to study China and learn Chinese; Europe has become a mere afterthought.

Which of course is delusional, in the sense that these perceptions are not based in reality. Europe has the largest economy in the world, producing nearly a third of the world’s economy, almost as large as the United States and China combined. Europeans are enjoying the highest of living standards, but no one is breaking down the door to get into authoritarian, poverty-racked China. People are trying to break OUT of China, not in, and that tells you most of what you need to know.

Europe is suffering from, as they say in the advertising biz, poor branding and low product appeal. So that got me to thinking: if Europe were to launch a public relations campaign in the United States, what would it look like? How could Europe advertise its strengths and selling points?

I can envision TV ads running in heartland America that go something like this. Voiceover: “Jobs. Americans want them and European companies can supply them.” Show visuals of American workers on the job, building autos, working in grocery stores and hospitals. Re-cue the voiceover: “Did you know that in Dick Cheney’s Wyoming and Sarah Palin’s Alaska, as well as in Utah, Oklahoma, New Mexico, Kansas, Idaho and Alabama, European companies supply over 65 percent of all foreign investment? In George Bush’s Texas, European companies have invested over $50 billion, more than American investments in all of Asia? About 2 million American workers are employed by German and British companies, providing jobs that pay better than average wages and provide health care benefits. Across the great USA, Europeans accounted for nearly three-quarters of all foreign investment, being the top foreign investors in 45 states with over $1.4 trillion in investments.

“We believe in taking care of our American employees. It’s the European Way.” Cue the closing visuals, two flags, side by side, one the Stars and Stripes, the other the European Union’s royal blue with a circle of twelve gold stars, like a halo. Fade away.

Or how about a full page ad in the New York Times that read: Big Headline: “Who are you calling Weak? Who are you calling Socialist? Text: “Europe today, stretching from Portugal to Norway to the Balkans, is the largest, wealthiest trading bloc in the world. Europe has more Fortune 500 companies than the U.S. and China combined, as well as more small businesses than the U.S. that produce two-thirds of the jobs, compared to fewer than half the jobs in America. Europe has some of the most competitive national economies in the world, according to the World Economic Forum, and is the largest trading partner with both the U.S. and China. In fact, Europe is corporate America’s biggest target for foreign investment, with U.S. companies making twenty times more profit in Europe than in China. The $19.2 billion invested by U.S. companies in tiny Netherlands in 2005 nearly equaled U.S. investment in all of Asia. If Europe is such a basket case, why would American businesses spend so much time and money here?

“Socialism? Forget it, this is capitalism baby. But it’s capitalism with a heart. We call it social capitalism, because we harness our capitalist engine and plow the wealth into things that help families and workers – such as health care, retirement, vacation, child care, paid sick leave, paid parental leave after giving birth, a kiddie stipend to pay for diapers and other baby needs – you know, family values stuff. We don’t just talk about families, we actually spend money to support them. You don’t need roaring economic growth rates if you’re good at sharing what you have. That’s the European Way.

“Europe – it’s not just a nice place to vacation, but also a nice place to live. Now accepting applications for national membership. But strict criteria apply.”

Or how about this ad on prime time TV: Visuals of green hills and sparkling ocean. Children at play, fields of golden grain, with the voiceover coming in: “Europe is the leading innovator in preparing for global warming. Widespread deployment of conservation practices and “green design” in everything from automobiles, buildings, light bulbs and toilets has reduced our ecological footprint.” More visuals, showing windmills, solar panels and trains. “A European uses half the electricity and emits half the carbon of an American. It takes 40 percent more fuel to drive a mile in an American car than in a European one. And Europe’s green industry has created hundreds of thousands of new jobs and is exporting its innovations to the world. That shows that jobs don’t have to be pitted against the environment.

“Europe: doing our fair share to ensure humanity’s future. And looking for partners, wherever we can find them.” Quick flash of President Obama’s face, to the fade away shot.

You get the idea. Part of the solution to Europe’s poor standing with the American public is to use old-fashioned, conventional means: product advertisement. Just as any business knows, advertising is essential to marketing and branding your product. Europe should advertise its accomplishments just like a business does — through TV, radio and newspaper ads. Corporations do it, why shouldn’t governments? Europe should have clear bragging rights over China, for heaven’s sake, but it never does any bragging. It’s time to change that.

Other things Europe could do besides advertisements include organizing opeds and letters to the editor campaigns in newspapers; and speaking tours all across the United States for European leaders, including interviews with local media. When Merkel, Barroso, Sarkozy or Cameron come to Washington DC, a part of their visit should take them outside the Beltway. Local media would rave over a visit by the Chancellor of Germany or the President of the European Commission. It even might be a good idea to launch something like a Radio Free America to help break the information blockade.

This is a public relations challenge that Europe needs to wage because it would be foster a healthier trans-Atlantic partnership. The world is looking for leadership during this crucial time, and a US-EU alliance could be powerful if Americans valued Europe’s contributions more.

Greece has proven one fact: the intergovernmental method of governing the single currency is doomed, because individual member states will always pursue partial interests, and never the collective interests of all citizens. This makes it impossible to implement policies that are optimal for the welfare of European citizens. By definition, national governments represent national constituencies, but the effects of their actions have consequences for citizens all over the Euro Area. Because national governments seek to rally support for a bundle of policies that mixes national and European issues, they cannot speak or decide for all Europeans together; and the decisions made by one government are inevitably an imposition on those who could not vote for them in a different member state. Intergovernmental policy agreements are not agreements between citizens.

Thus, the excessive deficits of the Karamanlis government have weakened the euro for all Europeans, but non-Greek Europeans were not able to democratically control that government. The Greek opposition, which is now striking against the austerity plan, asks why they should suffer to meet conditions imposed by Germany, and in Germany a chauvinist majority refuses to pay for Greek irresponsibility.

The intergovernmental system has two consequences: first, it prevents efficient policy solutions, because member state governments block each other; the system therefore contributes to the deterioration of ‘output legitimacy’ and a general disenchantment with Europe. Second, it prevents European citizens from articulating their preferences for policies that affect them all. There is no debate about what policies should be pursued, because citizens cannot charge a European government with the defence of their European interests, as distinct from national ones. The problem is not that Europe is lacking a public sphere, where issues of common concern could be discussed, but rather that European citizens are lacking the power to make policy choices, which they would need to discuss. As a consequence, a sense of frustration and the perception of Europe’s un-democratic character are becoming increasingly stronger in Europe. Both these tendencies could ultimately destroy the European Union.

Recognising the inefficiency of the Euro Area’s macroeconomic governance, French governments have frequently called for a gouvernement économique, without ever specifying what this meant. German governments used to resist these demands out of fear that it could threaten the independence of the European Central Bank. After the disaster of Germany’s handling of the Greek crisis, Chancellor Angela Merkel has now rallied President Nicolas Sarkozy, although she immediately clarified: ‘The economic government is us, the 27 member states’. One is reminded of Louis XIV: ‘L’Etat, c’est moi!’. Thus, the Merkel-Sarkozy approach to economic government is a pre-democratic, absolutist model. It is unlikely to produce results because intergovernmental cooperation does not work. Nor will a Diktat by the directoire of the big member states make Europe more acceptable to its citizens.

Recalling that its task is to ensure the proper functioning and development of the common market, the European Commission has proposed tighter surveillance of member states to ensure that they stick to their obligations under the Stability and Growth Pact. National budgets are to be coordinated during a ‘European Semester’; governments that violate the rules are to be punished; and the Commission is to be authorised to ring alarm bells early on. All member states must decide budget rules, similar to Germany’s new constitutional Schuldenbremse. These proposals seek greater consistency between member states’ fiscal policies and the unified monetary policy. However, they do not address the fundamental problem behind the diverging national policies, namely the issue of democratic legitimacy.

Modern democracies are built on the principle: ‘No taxation without representation’. A government is only to act within the scope of what citizens have authorised it to do. Clearly, a European economic government must act in the interest of European citizens, who are the owners of the euro and who are affected by policy decisions that impact inflation, interest rates, the exchange rate, etc. It would be logical that the Commission is charged to administer these common European public goods, but only, if citizens have the right to control it through their elected representatives in the European Parliament. National governments cannot carry this legitimacy because they are not elected by all European citizens, but only by national factions that cannot represent the collective interest of Europeans.

Hence, even if the Commission plans could improve output legitimacy for European institutions by centralising competences, it will widen the democratic deficit and thereby undermine the consensus for the European integration project. Under such a system, it is impossible to implement policies in the interest of all. An unelected European Commission, and even worse, an independent Fiscal Policy Council of unelected experts as proposed by the European Central Bank, cannot command the legitimacy, which is required to govern people’s money. President Chirac famously said about Commission President Prodi, who had requested the reduction of the structural deficit caused by Chirac’s tax reforms: ‘Does he not know that he is only a high-ranking civil servant’.

The conclusion must be to set up a European government, which will design a coherent set of policies and at the same time give citizens the right to decide what this government should do. For Europe’s left, it means to fight the undemocratic reforms proposed by Merkel/Sarkozy and the Barroso Commission. In Europe, we now need to ‘dare more democracy’, to take up the famous sentence by Willy Brandt.

But some economists – not just German economists – argue that although the Greek economy has grown over the past decade, the gains in Greek productivity have been spent either on raising wages or on raising social benefits, or else have been squandered on wholly unproductive government spending. The argument boils down to saying that the Greek trade deficit can be cured in either of two ways: Either Greece must leave the Eurozone and devalue its ‘new’ drachma, or retain the euro and squeeze wages to boost export competitiveness. This argument is then generalised to cover all Club-Med countries.

There are several problems with this type of argument. For one thing, while the argument may be valid in normal circumstances, the current economic climate is far from normal. Severe cuts in Greek public spending are sending the economy into recession, a recession compounded by the ‘deficit hysteria’ currently sweeping Europe like the plague. It seems likely that we shall soon see a double-dip not just in Britain but in much of the Eurozone. Let us imagine Greece wants to increase its tourism (an export industry). It is of no use cutting real wages and public transfers (pensions, social benefits and so on) to make Greece a cheaper holiday destination if all other Europeans are losing their jobs and cancelling their holidays.

More generally, there is a simple, logical reason why cutting wages will not make Greece (or any other Club Med country) a new Germany. At the moment, Germany runs a large trade surplus with the Eurozone – about two-thirds of its exports go to the Eurozone – while Greece and the other Club-Med countries together run a large trade deficit. This in not because Mediterranean citizens work less hard or are less thrifty. It is because one county’s exports by definition must be another country’s imports. Keynes recognised this problem in 1944 at the Bretton Woods conference where he proposed that an international bank or fund should be set up both to help finance those countries running a trade deficit, and also to limit the size of trade surpluses. His proposal was rejected by the Americans who insisted on setting up the IMF on quite different lines, but that’s another story.

Where does that leave Greece and other Club Med countries? Should Greece accept the dramatic budget cuts demanded by the northern Europeans; should it leave the Eurozone and adopt a new devalued drachma; or should it stay in the Eurozone but renegotiate its debt? All these options will be painful. We know that dramatic budget cuts will prolong recession and lead to high unemployment and a lower real wage. On the other hand, defaulting on sovereign debt and leaving the Eurozone would involve a very large devaluation of the ‘new’ drachma, driving up import prices, causing inflation and leaving many with high private euro debts.

My own guess – and I stress the fact that it is a guess – is that Greece will not leave the euro, but nevertheless will be forced sooner or later to renegotiate much of its sovereign debt in order to improve its terms of repayment – as indeed will Spain, Portugal and others. Although Spain’s debt/GDP ratio is well within the Maastricht limit, much of its sovereign debt is relatively short-term. In this case, the loss will be borne by German, French and other banks – to use the jargon, they will take a ‘haircut’. But debt restructuring resolves only part of the problem. The cuts agenda remains!

In truth, in the short term there is no painless way out for ordinary hard-working Greeks or other southern Europeans. In the long term, the Eurozone will need to establish a strong federal budget like the Americans and affect intra-Eurozone transfers if it is to survive. But as Keynes famously remarked, in the long term we shall all be dead.

I believe that these fears are exaggerated, even misplaced. And should things work out that way, this would be due more to a self-fulfilling prophecy on the West’s part than to Turkey’s policies.

In fact, Turkey’s foreign policy, which seeks to resolve existing conflicts with and within neighboring states, and active Turkish involvement there, is anything but in conflict with Western interests. Quite the contrary. But the West (and Europe in particular) will finally have to take Turkey seriously as a partner – and stop viewing it as a Western client state.

Turkey is and should be a member of the G-20, because, with its young, rapidly growing population it will become a very strong state economically in the twenty-first century. Even today, the image of Turkey as the “sick man of Europe” is no longer accurate.

When, after the UN decision, United States Secretary of Defense Robert Gates harshly criticized Europeans for having contributed to this estrangement by their behavior towards Turkey, his undiplomatic frankness caused quite a stir in Paris and Berlin. But Gates had hit the nail on the head.

Ever since the change in government from Jacques Chirac to Nicolas Sarkozy in France and from Gerhard Schröder to Angela Merkel in Germany, Turkey has been strung along and put off by the European Union. Indeed, in the case of Cyprus, the EU wasn’t even above breaking previous commitments vis-à-vis Turkey and unilaterally changing jointly-agreed rules. And, while the Europeans have formally kept to their decision to begin accession negotiations with Turkey, they have done little to advance the cause.

Only now, when the disaster in Turkish-European relations is becoming apparent, is the EU suddenly willing to open a new chapter in the negotiations (which, incidentally, clearly proves that the deadlock was politically motivated).

It can’t be said often enough: Turkey is situated in a highly sensitive geopolitical location, particularly where Europe’s security is concerned. The eastern Mediterranean, the Aegean, the western Balkans, the Caspian region and the southern Caucasus, Central Asia, and the Middle East are all areas where the West will achieve nothing or very little without Turkey’s support. And this is true in terms not only of security policy, but also of energy policy if you’re looking for alternatives to Europe’s growing reliance on Russian energy supplies.

The West, and Europe in particular, really can’t afford to alienate Turkey, considering their interests, but objectively it is exactly this kind of estrangement that follows from European policy towards Turkey in the last few years.

Europe’s security in the twenty-first century will be determined to a significant degree in its neighborhood in the southeast – exactly where Turkey is crucial for Europe’s security interests now and, increasingly, in the future. But, rather than binding Turkey as closely as possible to Europe and the West, European policy is driving Turkey into the arms of Russia and Iran.

This kind of policy is ironic, absurd, and shortsighted all at once. For centuries, Russia, Iran, and Turkey have been regional rivals, never allies. Europe’s political blindness, however, seems to override this fact.

Of course, Turkey, too, is greatly dependent on integration with the West. Should it lose this, it would drastically weaken its own position vis-à-vis its potential regional partners (and rivals), despite its ideal geopolitical location. Turkey’s “no” to new sanctions against Iran in all likelihood will prove to be a significant error, unless Prime Minister Recep Tayyip Erdo?an can deliver a real turnaround in Iran’s nuclear policy. This, however, is highly unlikely.

Moreover, with the confrontation between Israel and Turkey strengthening radical forces in the Middle East, what is European diplomacy (both in Brussels and in European capitals) waiting for? The West, as well as Israel and Turkey themselves, most certainly cannot afford a permanent rupture between the two states, unless the desired outcome is for the region to continue on its path to lasting destabilization. It is more than time for Europe to act.

Worse still, while Europe’s listlessness is visible first and foremost in the case of Turkey and the Middle East, this lamentable state of affairs is not limited to that region. The same applies to the southern Caucasus and Central Asia, where Europe, with the approval of the smaller supplier countries there, should firmly pursue its energy interests and assert itself vis-à-vis Russia, as well as to Ukraine, where Europe should also become seriously involved. Many new developments have been set in motion in that entire region by the global economic crisis, and a new player, China (a long-term planner), has entered the geopolitical stage.

Europe risks running out of time, even in its own neighborhood, because active European foreign policy and a strong commitment on the part of the EU are sorely missed in all these countries. Or, as Mikhail Gorbachev, that great Russian statesman of the last decades of the twentieth century, put it: “Life has a way of punishing those who come too late.”

Naturally, defence is a very sensitive political area lying at the heart of concerns about national sovereignty and security. No politician wants to be accused of leaving his/her country defenceless. The reality, though, is that a lot of defence spending is money poured down the drain. We spend money on the wrong things. We have 10,000 battle tanks, at a time when modern warfare has made them largely obsolete. On the other hand, we have a serious lack of support helicopters and good quality communication equipment. Many EU countries spend around 60% of their budgets on personnel and only about 20% on equipment. Yet, as the British have found in Afghanistan, good quality and appropriate equipment is key to success in modern warfare. This is why the Americans spend a third of their budget on personnel and a third on equipment. Our spending on personnel is particularly bizarre when you realise that 70% of European land forces simply cannot operate outside their national territory at a time when the threat is not that of invasion of our borders. That is a lot of money tied up in something of little value.

Defence spending is also bedevilled by duplication, fragmentation and overcapacity. For example, Europe has 7.2 naval systems for each US naval system. We have 7 different types of diesel submarines, 11 different frigates and 25 naval prime contractors. Not only is this expensive, it also means when member states combine in NATO and EU operations, their equipment is simply not interoperable. In the Kosovo war, British troops waiting to go into Kosovo had to keep their air defence equipment locked up for fear it would bring down NATO’s own aircraft. Even where platforms are shared, we still do not have interoperability. The UK and Germany have long operated Tornado aircraft side by side, but they have only been able to share logistics in fuel and oxygen.

In the fields of health and education, such waste and inefficiency would be condemned as scandalous. Yet we seem prepared to accept it when it comes to defence. Surely, though, in these times of exceptional financial constraint, we ought to find a better way of ensuring our defence and security.

The obvious solution is for there to be greater ‘Europeanisation’ of national capabilities and procurement. We already have all the structures necessary. The European Security and Defence Identity is recognised in the treaties, as is the European Defence Agency, which is intended to rationalise procurement. Further, the European Commission has driven through a ‘defence package’ of EU legislation, which has brought much of the defence field under Single Market rules. Collaboration between member countries, including (whisper it!) the UK and France, is growing. Yet, progress has been so slow and rhetoric has rarely been matched by action. We once had a commitment to a 60,000 strong Rapid Reaction Force, which has now been diluted to 1,500 man battle groups. The European Defence Agency is kept on a very tight rein by national governments and indeed, the British Conservatives are committed to withdrawing from it. National defence establishments still want to do their own thing and have their own toys to play with and so resist moves towards rationalisation.

The economic crisis surely gives us a huge opportunity to transform European defence spending. Money needs to be spent more efficiently and effectively and that will only happen through much greater cooperation between member states. Now is the time for governments to take on their defence establishments and tell them it is either collaboration or nothing. If we do not do that, either we will seriously weaken our defence capability or there will be major social tensions caused by social services such as education and health bearing the brunt of cuts while defence gets off lightly.

Naturally, we will never get 27 member states to agree to major defence cooperation (especially the UK), but we don’t have to. The Lisbon Treaty has the provision for ‘permanent structured cooperation’. It is time member states started to use it.

Those days are over. The euro is in crisis, and Germany is the main protagonist. Germans don’t feel so rich anymore, so they don’t want to continue serving as the deep pocket for the rest of Europe. This change in attitude is understandable, but it has brought the European integration process to a halt.

By design, the euro was an incomplete currency at its launch. The Maastricht Treaty established a monetary union without a political union – a central bank, but no central treasury. When it came to sovereign credit, euro zone members were on their own.

This fact was obscured until recently by the European Central Bank’s willingness to accept the sovereign debt of all eurozone members on equal terms at its discount window. As a result, they all could borrow at practically the same interest rate as Germany. The banks were happy to earn a few extra pennies on supposedly risk-free assets and loaded up their balance sheets with the weaker countries’ government debt.

The first sign of trouble came after the collapse of Lehman Brothers in September 2008, when the European Union’s finance ministers decided, at an emergency meeting in Paris that October, to provide a virtual guarantee that no other systemically important financial institution would be allowed to default. But German Chancellor Angela Merkel opposed a joint EU-wide guarantee; each country had to take care of its own banks.

At first, financial markets were so impressed by the guarantee that they hardly noticed the difference. Capital fled from the countries that were not in a position to offer similar guarantees, but interest-rate differentials within the eurozone remained minimal. That was when countries in Eastern Europe, notably Hungary and the Baltic States, got into trouble and had to be rescued.

It was only this year, when financial markets started to worry about the accumulation of sovereign debt, that interest-rate differentials began to widen. Greece became the center of attention when its new government revealed that its predecessors had lied about the size of the 2009 budget deficit.

European authorities were slow to react, because eurozone members held radically different views. France and other countries were willing to show solidarity, but Germany, traumatized twice in the twentieth century by runaway prices, was allergic to any buildup of inflationary pressures. (Indeed, when Germany agreed to adopt the euro, it insisted on strong safeguards to maintain the new currency’s value, and its Constitutional Court has reaffirmed the Maastricht Treaty’s prohibition of bailouts.)

Moreover, German politicians, facing a general election in September 2009, procrastinated. The Greek crisis festered and spread to other deficit countries. When European leaders finally acted, they had to provide a much larger rescue package than would have been necessary had they moved earlier. Moreover, in order to reassure the markets, the authorities felt obliged to create the €750 billion European Financial Stabilization Fund, with €500 billion from the member states and €250 billion from the IMF.

But the markets have not been reassured, because Germany dictated the Fund’s terms and made them somewhat punitive. Moreover, investors correctly recognize that cutting deficits at a time of high unemployment will merely increase unemployment, making fiscal consolidation that much harder. Even if the budget targets could be met, it is difficult to see how these countries could regain competitiveness and revive growth. In the absence of exchange-rate depreciation, the adjustment process will depress wages and prices, raising the specter of deflation.

The policies currently being imposed on the eurozone directly contradict the lessons learned from the Great Depression of the 1930’s, and risk pushing Europe into a period of prolonged stagnation or worse. That, in turn, would generate discontent and social unrest. In a worst case scenario, the EU could be paralyzed or destroyed by the rise of xenophobic and nationalist extremism.

If that were to happen, Germany would bear a major share of the responsibility. Germany cannot be blamed for wanting a strong currency and a balanced budget, but as the strongest and most creditworthy country, it is unwittingly imposing its deflationary policies on the rest of the eurozone. The German public is unlikely to recognize the harm German policies are doing to the rest of Europe because, the way the euro works, deflation will serve to make Germany more competitive on world markets, while pushing the weaker countries further into depression and increasing the burden of their debt.

Germans should consider the following thought experiment: withdrawal from the euro. The restored Deutsche Mark would soar, the euro would plummet. The rest of Europe would become competitive and could grow its way out of its difficulties but Germany would find out how painful it can be to have an overvalued currency. Its trade balance would turn negative, and there would be widespread unemployment. Banks would suffer severe losses on exchange rates and require large injections of public funds. But the government would find it politically more acceptable to rescue German banks than Greece or Spain. And there would be other compensations; German pensioners could retire to Spain and live like kings, helping Spanish real estate to recover.

Of course, this is purely hypothetical because if Germany were to leave the euro the political consequences would be unthinkable. But the thought experiment may be useful in preventing the unthinkable from actually happening.

Copyright Project Syndicate