There is a similarity between marital relations and currency. Whatever system prevails, the alternative is more attractive. The EU is a wonderful example of a boom-bust process in politics. It is initially self-reinforcing, but can return and become self-defeating. It is also very involved in the concept of open society because during the period of integration, during its positive development it had a remarkable similarity and relevance to the ideal of an open society because it was led by some far-sighted leaders who realized that all human constructs are imperfect. Karl Popper called it piecemeal social engineering. Probably the most successful example of piecemeal social engineering in human history. Starting with limited goal, setting an agenda, poltical will and a deadline, knowing that that step will not be sufficient. The EC became the EU in a span of 20 years or so. It was led by an ideal of democracy, open society and human rights, a very inspiring idea. It was a self-reinforcing process and the leaders were leading the process of integration. It reached its maximum extent after the collapse of the Soviet Union with German reunification, where Germany recognized reunification can only be done in the context of a strong European union. Germany was the mortar that drove the process and it culminated in the reunification of Germany, the Maastricht Treaty and the introduction of the euro. Then there was a period of digestion and stagnation and it then entered a period of disintegration. That came a few years after the crash of 2008 and that’s where the financial boom-bust process interacted with the political and reinforced it on the downside.
A Single Currency Without the Political Union
The designers of the euro were conscious that it was an incomplete structure. A currency needs a common central bank and a common fiscal policy or a treasury. This was only a monetary union, not a fiscal, not a political union so it lacked those. They knew it was incomplete but they had the expectation that when the time comes you will be able to generate the politicall will to take the next step. The euro had this incomplete structure, the lack of a common treasury. It had other shortfalls of which they were not aware, which have now surfaced. When the time came to take the next step, the political will could not be mustered.
They were mixed up with the market fundamentalist beliefs that dominated the economic theory at the time. There was a belief that markets tend toward equilibrium, that the imbalances only arise in the public sector, that the private sector can be left to correct its own mistakes. This turned out to be a fundamental false belief that was at the root of the crash of 2008 and it also affected the situation in Europe. In the crash of 2008 the financial system actually collapsed. It was saved by the authorities by a very delicate maneuver. Credit collapsed and they substituted the credit of the state to make up for private credit. It started in Europe at the end of the IMF meeting in November 2008 the finance ministers left a day early, went to Paris and declared there would be no other systemically important financial institutions allowed to fail, effectively guaranteeing the financial system. The U.S. followed. Angela Merkel, correctly reading political opinion at the time, said we will only guarantee it separately. Each country will have to take care of its own system and guarantee it. That was the first step in the process of disintegration.
The Weakness in the Euro Structure
The markets are not always right, in fact they are often wrong. The first reaction was great relief, and a year later when Greece suddenly revealed their deficit was much bigger –with a new government that wanted to reform and revealed that the previous government had had a bigger deficit —that is when the markets realized the weakness in the euro structure. They were a bit late. Because of this flaw in the construction of the euro, the euro was supposed to bring about convergence of the economies. The ECB accepted the government debt of all the countries equally at the discount window, Spanish, Greek and German bonds could be deposited and considered riskless so you could borrow 100% of the face value from the central bank. At that time Italian bonds, Spanish bonds which paid a few more percent than German, German and French banks rushed in and bought Spanish bonds instead, and that’s the beginning of the euro crisis because they used the interest rate differential. The convergence in interest rates created a divergence in economic performance. Germany had to carry the burden of reunification, which came with a big increase in public debt because it had to spend so much on East German debt and subsidies and therefore German industry tightened and cooperated so Germany greatly increased its efficiency and competitiveness. At the same time, the reduction in the ability to borrow cheaply created a housing boom in Spain, Italy and other countries like Ireland. They continued to operate their fiscal policies soundly but there was a tremendous expansion in borrowing on real estate. We had a boom and those countries as a result became less competitive. The convergence of interest rates created a divergence in competitiveness.
The Crisis and The Political Union
This is primarily a banking crisis and a government debt crisis but the two are interconnected and reinforce each other. There is a third crisis which is a political one because there is a process of disintegration. The euro crisis has the potential to destroy the cohesion of the EU. It is a real threat to the political union. This negative dynamic came into play because the leadership, once the process of disintegration started, stopped moving forward and wanted to preserve the status quo because any step would accelerate disintegration. They stuck to it as if it were immutable yet it was constructed knowing it would need change. The status quo as untenable or intolerable was pushed into an anti-European Union posture.
The authorities saw no solution for the euro and the Greek crisis came because they could not go to a fiscal union. The political will was not there in the heyday of the EU. It was impossible to advocate any thing like a common treasury. They wanted to buy time. When There is a financial crisis, buying time very often works. The markets calm down and the resources used help to create a profit and values that are depressed come back to normal. This time however, time worked against the authorities because of the political dynamic. By buying time reluctantly the authorities always acted doing too little, too late. It made the crisis grow. It was a relatively small Greek problem. Had they done earlier what they are willing to do now, the Greek crisis could have been easily contained. But at first they offered support at penal interest rates and Greek debt became unsustainable. There has to be a reorganization of the debt. They were kicking the can down the road but they came to the end of the road. Then came the EFSF. An embryo of a common treasury. It was then declared by the German constitutional court that it is okay but no further steps of delegating powers can be accepted. Every delegation of powers has to be approved by the Bundestag. So far, but no further. Germany is clearly in the driver’s seat. Germany is now dictating the economic policy for Europe and doing it reluctantly. It is something it wanted to avoid because of its history. Being the most efficient, largest and most successful economy with the best credit, it was pushed into this role. They are unfortunately advocating the wrong policy. They say Germany is successful so every other country should be like Germany. Germany is a chronic creditor but not every country can be that, there must be chronic debtors.
There has been a substantial change in the attitudes of the German leadership. They realized they have made a mess of it. They are determined to save the euro. They are right to do so. They have no choice. The euro exists. It is imperfect. But you cannot unscramble the omelet. The assets and liabalities of the financial system and economy are so intermingled based on the common currency that we cannot undo it. We would not know who is broke and who is not. We would have a financial meltdown.
To Save the Euro
There has been a change, there is a desire to do the right thing and unfortunately, they are not doing the right thing. I have to be rather blunt about it, even though it is not a good thing to paint a dark picture. They have to face reality and then they can remedy it. The fact they are still doing the wrong thing does not mean gloom and doom. They can still get it right. The longer they wait and the further they go the bigger the cost. Right now we are at a crisis point and what they are doing is again too little, too late.
I have to explain that there is a right way. I must express my frustration because I have both privately and publicly outlined the right way and I believe it would have been adequate. It can still be adequate tomorrow. There is a way to solve the problem but it may be very costly. First, they have to calm the markets. For that they need two things, leadership – the authorities must be united –and have adequate resources to carry out the plan behind which they are uniting. As it is, they are not united and the resources cannot be stretched because they want to recapitalize the banks and provide a guarantee for the sovereign bonds that will bring down interest rates and those are the wrong things to do. The way they should do it is not to recapitalize the banks now, when the shares are at a discount to asset values and the asset values are low because the bonds they hold are below cost. What they should have done is to use the EFSF to guarantee the banking system against failure and in exchange get the banks to follow their instruction which would be not to reduce their balance sheet which is what they are doing now, maintain their loan portfolio and credit lines, put in inspectors that ensure they do not take risks for their own account that would endanger them. Then the second step would be to encourage Italy and Spain to issue treasury bills, reduce the interest rate to at least half a percent by the ECB, encourage Italy to borrow short-term only and encourage the banks to hold their liquidity by holding treasury bills which is as good as cash and yields more than assets they maintain at the central bank. That would enable them to borrow and suddenly everything would be very different. That would have worked.
Greece and The Euro Zone
The Greek debt has to be reduced and there is pressure to have a voluntary reduction, a haircut of 50%. This only applies to private sector, so it only reduces the debt of Greece by 20% and that is not enough. The ECB is dead set against this because they bought a lot of Greek bonds and own them and they would suffer a loss. They did it pushing the envelope, trying to save the financial system. The constitution of the central bank only allows them to maintain the stability of the currency but it is the normal role of a central bank to try to preserve the financial system. The solvency risk they took should have been taken by a treasury but it did not exist. The EFSF should have taken over Greek bonds from the IMF and also reduced the debt burden on Greece . They would have given Greece a chance to work its way out of the debt crisis. That was the other opportunity that was missed. There is a real danger of a disorderly default. It is a real danger. A scheme like this could still be the solution. There has to be a voluntary or involuntary reorganization but it has to be done in an orderly way and particularly the greek banks have to be kept alive and the depositors have to be protected because if you do not there is liable to be a run on the banks in other countries as well. This is a danger of a meltdown and it is real but it can be avoided. That leads me to the other unsolved problem. If all countries are indulging in austerity and you have a number of countries that have to go into internal devaluation within the euro system by reducing wages and prices, that sets up a deflationary pressure and the debt burden is a ratio between accumulated debt and GNP and if by austerity you reduce expenditures but you also reduce GDP your debt burden actually grows. This is a trap that is the opposite of a bubble. It is a black hole. If one country does it, they can readjust but if every country does it you get a depression. That is what is facing the European Union even if you contain the financial crisis. The next job is to find a way to stimulate the European economy as a whole. Given the legal constraints that apply to Germany, this can only be done on a European level. That would be the next step after the Greek crisis is under control.
The Need To Recreate Political Will for a Common Europe
There is a need to reinvent the European project. For better or worse the euro is here to stay. You cannot do without it. But that leads to forcing people to live together, a short-term marriage that does not lead to domestic harmony. There has to be something positive. There was something positive about Europe and there still is, it has to be rekindled on the political level. A common project like green growth is a positive goal for getting that process going.
Occupy Wall Street movements?
I am on record as expressing sympathy with the feelings of the people occupying Wall Street because they are victims of mistaken policy and a misfunctioning financial system. It is an expression of frustration, a legitimate expression. The trouble is, reality is very complicated. People look for simple answers and especially in moments of stress and fear, everybody is trying to advocate his own self-interest and yet the European project requires cooperation. Cooperation is something you can achieve in times when there is hope and a functioning leadership and at the moment you do not have that. Particularly the role of misconceptions and lack of understanding has been shaping history.