It’s the Euro, Stupid: The Roots of the Euro-Zone Crisis

In Brussels, a protester gives vent to his feelings. Ye Pingfan / Xinhua-Corbis

There are two stories of the birth of the euro: an “immaculate” conception and a worldly one. The latter is, as one would expect, rather more exciting. Although the idea of a European monetary union had been floated by Eurocrats in the 1970s and ’80s, in the belief that it would hasten European economic and political integration, the key moment occurred on Dec. 8, 1989. The Berlin Wall had just collapsed. With West Germany pressing for almost immediate German reunification the traditional balance of power inside the European Community was threatened. Keen to avoid what he perceived as an excessively resurgent Germany, the late French president François Mitterrand preconditioned his support of German reunification on the swift adoption of a common currency. Why? Because it would dilute German sovereignty.

In a sense, the euro is still tainted by that original sin. Something that should have been an enthusiastic step toward more unity had become the product of a cold, realpolitik tradeoff. Adopted by the 12 members of the then–European Community at Maastricht in February 1992, the monetary union was put to the democratic test only twice. The Danes rejected it in June of the same year, while the French endorsed it by only the narrowest margin in September, even though every mainstream political party had recklessly campaigned in its favor. The lesson was not lost on other European governments: with very few exceptions, they conspicuously avoided any form of democratic test of the European idea from that moment onward.

There is little doubt that the euro came far too early into the European project. A monetary union implies a high degree of preexisting economic, political, and social integration in order to succeed. Clearly the Europe of 1999 did not qualify, irrespective of the flawed criteria of convergence adopted at Maastricht. Huge gaps in productivity, very different demographics, and a rather low level of internal workforce mobility combined with the absence of a federal budget or tax system could only trigger increasing levels of economic divergence rather than convergence. During the initial decade of the euro, labor costs effectively diverged by nearly 50 percent between the most and least successful countries. As a result, massive intrazone trade deficits built up, with soaring public indebtedness in the weaker countries as a consequence. As devaluations could no longer occur to rebalance these economies, some argue that deflation should have materialized instead. It did not. The weaker countries benefited from the explicit support of the European Central Bank that treated all sovereign bonds of the zone on equal footing in its refinancing operations. As such, interest rates in all peripheral countries fell to levels that could only propel excessive monetary growth in a speculative direction, further increasing competitiveness gaps.

We are now in the euro’s 14th and maybe final year. The main European governments have largely sidelined the mostly unrepresentative European institutions while denying their responsibility and, instead, blaming obscure market forces or supposedly lazy and dishonest Southern Europeans. Driven by the narrowest sense of what they perceive to be their immediate interests, they opted against any form of European solidarity. The public debt of Greece amounted to less than 2 percent of the combined GDP of the European Union. The core countries could have easily absorbed it.

That the European states proved unable to do so illustrates how monetary unions can neither function in the absence of a prior form of deep political integration nor create it among unwilling partners. How the EU may now disintegrate is simple: once combined levels of public debt, interest rates, unemployment, external account deficits, and absence of internal solidarity make clear to everyone that several sovereign entities are heading toward default and potential exit from the euro zone, anyone with any common sense must open bank accounts in Germany and wire money outside of the threatened countries’ banking system. The peripheral central banks have then to borrow from the European Central Bank, which in turn obtains the excess liquidity accumulated by the German banking system. It is then in Germany’s interest to leave the system sooner rather than later before the size of its credit position becomes too high, while the Greek elections illustrate a desperate call toward more solidarity rather than a genuine desire to leave the monetary union. If one looks at the precedent set by the disintegrating Ruble currency area that survived the U.S.S.R., the countries that left it first were the Baltic states and not the Central Asian republics.

The other option is more European union. In an ideal situation, a common budget and tax system would ensure the reallocation of internal resources toward the weaker areas, while the adoption of common working laws; retirement, health-care, and unemployment regimes; education-system standards; official language, and governance would progressively increase the internal mobility of the workforce while promoting productivity convergence across the union.

Since the EU cannot become a federal state overnight, the situation calls for an immediate set of bold decisions. A common deposit insurance and banking-recapitalization scheme or the issuance of euro bonds would certainly help alleviate some of the immediate pressure on the European financial system but would not make the least-competitive countries effective again. As such, the long-term issues would remain unsolved, and recent events show how long-term risks increasingly tend to materialize into short-term crises at breakneck speed.

Europeans have to show more creative flexibility if they wish to maintain their union. Critically, they have to accept that a common currency does not necessarily imply exclusive legal-tender status across their entire economic area. There are historical examples of federations or empires that allowed several currencies to coexist on a more or less transitional basis, in order to adapt to local realities. The U.S. adopted its national currency as its sole legal tender only in 1857. Further back the Roman Empire let up to 350 local currencies thrive for three centuries in a status subordinate to the imperial money. Eastern Europe, Central Asia, Latin America, and Africa offer more recent examples of coexistence between a local cheaper currency and the German mark, the U.S. dollar, the euro, or the Russian ruble used as a more or less official anchor of value. Poland, Brazil, Kazakhstan, and Turkey do better today than Greece or Spain.

Then, true solidarity must develop between member states. The way Greek debt was restructured was the exact opposite of what should have been done. Its private holders, mostly European financial institutions, were bullied into a degree of losses that would be unbearable to the European banking system as a whole if applied to Portugal, Spain, and others in due course. Greece was then left under a still-too-heavy burden as European public institutions shielded themselves from sharing the losses. This is the very reason why the recent Spanish bank bailout failed to improve the peripheral countries’ capital markets: investors correctly assessed they had become holders of subordinated debt. Finally, the deflationary measures imposed on Greece now benefit local passive capital holders at the expense of private-sector workers and shareholders while threatening a 1930s Depression-type situation.

Greek future financing needs should have instead been channeled toward a European mechanism with an explicit joint credit guarantee. Existing debt would have been simultaneously purchased in the market and then swapped at a discount to its notional value, achieving a significant reduction of Greek debt, as public and private holders would have been treated on a similar footing. Since Greece now enjoys a primary surplus, Greek debt would have become sustainable, and the level of risk premium bearing on the other peripheral countries would have been mitigated. European states would have collectively accepted the sovereign risk of Greece, a first step toward a federal debt, budget, and government. The core European countries would have easily withstood any resulting losses, as the area’s consolidated external accounts are balanced, while reaping the political benefits of their European engagement. In contrast, the chosen process of selfish procrastination is a sure recipe toward a monetary-union disintegration and long-lasting animosity among European nations. In any case, disintegration would cost far more than voluntarily accepted losses.

Remarkably, it may not be too late. Appropriate decisions could buy much-needed breathing time for the EU, while a firm commitment toward effective political integration would be announced in order to address the fundamental shortcomings of the current monetary union. The overall credibility of the euro would increase, compounding in return the effectiveness of any shorter-term stabilizing measure. Nothing of that sort will occur without the support of the Europeans themselves. If one lesson has to be learned from the current failure, it is that a federal compact between democratic nations cannot afford the degree of democratic deficit that has plagued the European project for so many decades. This may call for a wide renewal of the often entrenched and ineffective European political leadership. In any case, the euro occupies a status by now so central to the preservation or destruction of the European Union that it has certainly surpassed the ambition of its most enthusiastic initial supporters.

Gilles Bransbourg, an economist, historian, and former banker, is a research associate at NYU’s Institute for the Study of the Ancient World and a Roman curator at the American Numismatic Society in New York.