Euro Malaise: From Remission to Cure


barry eichengreen is the George and Helen Pardee professor of economics and political science at the University of California (Berkeley). He is the co-author (with Arnaud Mehl and Livia Chitu) of How Global Currencies Work: Past, Present and Future.

Illustrations by Alexei Vella/Salzmanart

Published January 22, 2018


The euro has long been seen by its critics as a cancer on the European body politic. If so, that cancer now seems to have gone into remission. Newspapers no longer blare headlines about how one or more countries are about to be booted out of the currency area. The risk of Greece defaulting on its euro bonds and reintroducing the drachma is no longer as immediate as it was in the spring of 2017.

It’s no surprise, then, that polling confirms confidence in the euro is rising across the member-states. According to a recent Eurobarometer survey conducted on behalf of the European Commission, 73 percent of euro-area residents support the currency — the highest share since 2004. Currency market assessments, too, are favorable, with the euro rising against the dollar. None of this, in other words, looks like a patient in terminal decline.

But, as with any cancer, remission is only temporary if the underlying pathology remains. And the auguries are not all favorable. Greece still labors under debts that cannot be sustained indefinitely. Italy is still burdened by undercapitalized banks, heavy government debts and a stagnant economy. Whatever the fundamental causes of these maladies, there is a tendency to blame the euro. And the worse the malady, the more the blame. In an exception to the broad support evident in recent polling, only 52 percent of Italians favor the single currency, suggesting questions about the country’s continued participation in the euro area — particularly in the shadow of parliamentary elections in 2018.

Imbalances within the monetary union, moreover, remain pronounced. The euro area’s northern members led by Germany run chronic trade and current account surpluses with their less productive southern partners. French unemployment, at 9.5 percent, is more than double that of Germany, and Greek unemployment exceeds 20 percent.

Normally a country with high unemployment or a weak balance of payments would devalue its currency (or allow market forces to depreciate it) in order to correct these imbalances. But in a common currency area, this avenue is foreclosed. Something will eventually have to give — and that something, it is widely surmised, will be the euro.

Realism Versus Idealism

No one denies that the rules governing the common currency need to be reformed. Unfortunately, there is no agreement on what reforms should be. Broadly speaking, reformers fall into two camps: the realists and the idealists. The idealists insist that monetary union without fiscal union and political union will not work, and that Europe should therefore push ahead to far-greater integration.

Fiscal union means pooling the taxes and public spending decisions of euro-area governments. Such pooling, the idealists insist, is needed to organize transfers from booming to depressed members, in the same manner that such interregional transfers take place in the United States. Impoverished regions would then receive cash infusions from their more prosperous counterparts, much as they do in federal states like the United States, Canada and — dare one say — Germany.

But officials making these tax and spending decisions, perhaps with direction from a newly created European finance minister,

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would have to be accountable for their actions and would need to reflect the will of the people. It follows that fiscal union would require endowing the European Parliament with additional powers to keep a rein on the decision makers. The Parliament would have to be empowered to vote on bills tendered by the European finance minister. It would need the ultimate sanction of a no-confidence vote in that minister and his cabinet colleagues. Fiscal union, put simply, requires political union. You can’t have one without the other.

Realists acknowledge the logic of this argument, but object that Europe is not ready for fiscal union, much less political union. The trend in public opinion is quite the opposite, away from pooling sovereign prerogatives and toward re-assertive nationalism.

Brexit is only the most visible manifestation of this broader tendency, which infects the eurozone as well. A Eurobarometer survey in the spring of 2015 showed that fully 52 percent of Europeans still define themselves primarily by nationality. Only 6 percent see themselves first as European and second as citizens of individual member-states; just 2 percent define themselves as exclusively European. The remaining 40 percent self-identify solely by nationality.

This nationalism has implications for fiscal and political union, since few questions are more sensitive than who to tax, and how much to spend on whom — and above all, who decides. Germans who think of themselves as Germans are reluctant to pool their tax revenues with Greeks, whom they see as fundamentally different from themselves and not always in positive ways.

Realists argue that it is necessary to acknowledge these immutable facts.

Reform, from this perspective, means reform at the national level to make economies more flexible and competitive so that they can live more comfortably within the confines of a single currency. And executing those reforms is ultimately the responsibility of national governments, not some mythical European super-state.

We might as well give the realists and idealists names. Call them Angela Merkel and Emmanuel Macron, respectively.

Fiscal union, put simply, requires political union.
You can’t have one without the other.
Root of the Problem

A big question, then, is whether there is a middle way. Could more limited reforms make the euro more robust — correcting a condition that Macron has dubbed “half-pregnancy” — while respecting the constraints imposed by sovereign nations?

To answer this question, we need to start with more precise descriptions of the problems to be solved. And here, there is a reasonable degree of agreement.

First, Europe has a financial-stability problem. As a result of bad management, bad supervision and badly designed regulation, euro-area banks became deeply entangled in the global financial crisis. On the cusp of the meltdown, they were undercapitalized, overleveraged and blithely unware of the risks of investing in U.S. securities backed by subprime mortgages. European regulators were then slow to clean up the post-meltdown mess, which goes a long way toward explaining why Europe’s recovery has been so sluggish.

Second, the euro area has a debt problem. Government debt as a share of GDP in the area as a whole is not noticeably higher than in the United States, but it is spread unevenly across countries. It is a problem for Belgium, Cyprus, Italy and Portugal with debt-to-GDP ratios well above 100 percent. And it is a monster problem for Greece, with an eye-watering ratio approaching 180 percent. Servicing these heavy debts is a drain on public finances that will become even more burdensome when interest rates rise from current, historically low levels.

High debts are also a source of financial fragility. Since government bonds are constantly maturing, governments must constantly induce investors to refinance them. And when the government in question is heavily indebted, this is a delicate task. Success is far from assured.

Third (and relatedly), fiscal policy is a problem. The euro area has an elaborate set of fiscal rules that are honored mainly in the breach. When Greece flaunted those rules at the end of the last decade, it was only following in the footsteps of France and Germany, which had broken the rules some five years earlier. Although the rules in question specify sanctions and fines for violators, those fines have never once been levied in the eurozone’s almost two decades of existence.

Fourth, the euro area lacks an adequate financial fire brigade, a regional equivalent of the International Monetary Fund.

In response to the global financial crisis, it created the European Stability Mechanism to provide emergency loans to embattled countries. The ESM is authorized to lend up to €500 billion (about $550 billion at current exchange rates) to troubled governments and banks. While this may sound like a lot, it’s not much firepower for an institution responsible for the stability of a region with a GDP of $12 trillion. Consider, too, that the ESM functions under a unanimity rule, allowing a single recalcitrant member-state to block it from taking action. In some cases, moreover, governments must secure the approval of their national parliaments, which can allow an unhappy political party to prevent the ESM from moving.

Thus, as a practical matter, the burden of responding to a financial crisis in timely fashion falls on the European Central Bank, which is not subject to these same constraints. But this only excites the ECB’s critics, who see its market-stabilizing activities as exceeding its mandate and subordinating its central objective of maintaining price stability.

Fifth, the euro area lacks the flexibility to adjust to what the economist Robert Mundell, the intellectual father of the euro, referred to as “asymmetric disturbances.” There is no mechanism for eliminating the imbalances that arise when some member-states are booming while others are depressed, or when some members increase productivity more rapidly than others. It has no way of eliminating the chronic trade surpluses of some members and chronic deficits of others.

Exchange rate adjustments are ruled out, as already noted. Transfers of budgetary resources through the EU budget are largely limited to some small, inflexible and largely counterproductive transfers to farmers in high-cost countries. Reductions in wages and prices are difficult to impose despite the European Commission harping on their importance. And some such adjustments — sharp budget cuts, reductions in wage, and reducing hiring and firing costs — only compound a country’s problems when it is already in a bad situation.

The nature of the problem, then, is no mystery. But is there a set of limited reforms, one that is consistent with the reality of national identity and the absence of appetite for fiscal and political union, sufficient to solve it?

A Hard Sell

At the top of the reform agenda, everyone agrees, is completion of the banking union. The global financial crisis was a reminder, if one was needed, that banking problems are highly contagious in an integrated monetary and financial zone. Banks borrow and lend to one another through the so-called interbank market, and more so when they are not deterred by exchange risk (the risk that a change in the exchange rate may make it impossible for a borrower to repay). The interbank market is a way for banks to fund their operations. But it is also a powerful conduit for spreading banking problems, especially in Europe.

It follows that inadequate regulation in one country can endanger financial stability abroad, while creating financial vulnerabilities at home. And in an integrated monetary and financial zone made up of sovereign nations, there will be an inherent tendency toward inadequate supervision and regulation. Each national government will be tempted to reduce capital standards and other burdensome regulations to give domestic banks a leg up on the international competition. In the language of economics, financial stability is a collective good that individual national governments, left to their own devices, will tend to undersupply.

The appropriate response in such circumstances is to centralize regulation, which is what euro-area members did in 2014 when they created their Single Supervisory Mechanism. This proved possible, despite the absence of political union, because bank supervision was a technical task already delegated to specialists, and because its impact on people’s finances is less visible than that of, say, income taxation.

Agreement was thus reached to designate the ECB as the single supervisor responsible for overseeing the members’ 130 largest banks and for cooperating with national supervisors in monitoring the others, so as to ensure that the banks complied with European rules. Questions remain about whether the Single Supervisory Mechanism can successfully work with national supervisors, or whether those national authorities will be inclined to withhold sensitive information about the condition of their banks. Still, early experience has been positive.

But the other two legs of banking union remain incomplete. The first of these, the single resolution mechanism, is meant to allow the authorities to intervene in failed banks, recapitalizing or liquidating them so they don’t threaten the stability of the financial system and the real economy, while doing so at minimum possible cost to European taxpayers. The idea is to contain the cost by requiring that shareholders and bondholders be “bailed in” — a play on words that means their stakes will be wiped out before public money is injected.

The rationale for this approach is that taxpayer-financed bailouts are unfair, that they encourage excessive risk-taking by bank management and that taxpayers in countries that prudently manage their banks may end up on the hook. To put it bluntly, Germans fear they will have to pay to salvage Italian banks.

But this bail-in rule creates further problems. First, equity- and bondholders will flee at the first sign of trouble if there is a high likelihood of their being bailed in, precipitating the very crisis of confidence that regulators are so anxious to avoid. Indeed, it is possible that fears founded purely on rumor could ignite a run on even a sound financial intermediary under such circumstances.

Second, most European bank bonds are held in personal portfolios because investment advisors (often bankers) sell their clients on the idea that the banks are rock solid. Governments (read: Italy’s government) remain reluctant to bail in bondholders because they know that the latter would vent their anger at the polls. This, in turn, renders regulators reluctant to promptly liquidate or recapitalize failing banks. And so the banking problem lingers.

This latter problem, it can be argued, is only transitional. As bank bonds mature, their successors will be purchased by hedge funds and other institutional investors cognizant of the risks. Resolving the first problem, on the other hand, may require more work at refining the resolution rules. This aspect of banking union is still a work in progress, in other words.

The third and final leg of banking union, a European deposit insurance scheme, is dead in the water. Not that there is any question about the need for common deposit insurance. When the global financial crisis hit, several euro-area countries unilaterally raised their deposit insurance ceilings to attract deposits from abroad — and in so doing transferred their home-grown liquidity problems to their neighbors. Moreover, it became evident with time that their deposit insurance funds were inadequate to make good on the guarantees. The solution to both problems, it is widely understood, is integrated deposit insurance with a backstop fully funded by banks across the euro area and overseen by European officials.

But German leaders again fear that their virtue will be punished. Fees contributed to the deposit insurance scheme by German banks, they worry, will be used to pay off depositors in still-weak Italian banks. They also worry that more generous deposit insurance will weaken market discipline because depositors will grow complacent and fail to penalize excessive risk-taking by bank management.

These problems will presumably recede as the Single Supervisory Mechanism proves its mettle in keeping banks out of trouble in the first place. The question is how long publics and policymakers are prepared to wait.

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Crisis Management

In 2012, when doubts developed about the survival of the euro, it took both a forceful statement by ECB president Mario Draghi of his readiness to “do whatever it takes to preserve the euro” to put those existential questions to rest, and an agreement by his colleagues to buy large quantities of government bonds to stabilize the market. The ECB was praised for its initiative. But it was also criticized, particularly in Germany, for exceeding its mandate.

It would have been better, the critics in Berlin argued, if such statements and actions came from officials explicitly tasked with emergency lending to governments, subject to pre-agreed rules. And when Berlin scolds, European finance ministers are inclined to listen.

Hence the decision in 2014 to create the ESM, and now the argument for transforming the ESM into a full-fledged European Monetary Fund. The name change would be partly cosmetic, but it would also signal that the reconstituted fund was assuming the ad hoc rescue functions of the ECB. To make this work, the ESM would have to be restructured. Its resources would need to be augmented by increasing the capital subscriptions of governments and by expanding its ability to borrow. Decision making would need to be streamlined by moving from the current unanimity rule to qualified majority voting.

The EMF could then take the place of the ECB in negotiating assistance programs with governments. Program negotiations with Greece have been conducted with the ECB, the European Commission and the International Monetary Fund (collectively the “Troika”) on one side of the table, and the Greek government on the other — which was an odd position for Greece’s own monetary authority, and one best not repeated. Moreover, as the EMF gains experience in program design and negotiation, it would no longer be necessary to outsource these responsibilities to the IMF, an arrangement that has worked to no one’s satisfaction.

The final decision of whether to extend an emergency loan would then no longer fall to heads of state in all-night negotiations. Rather, it would be taken by an EMF board made up of national finance ministers and other euro-area representatives, including perhaps independent experts nominated by the European Council and confirmed by the European Parliament. The rescue process would thereby gain a political legitimacy that it currently lacks.

Debt restructuring, even when it’s called for, is still not feasible if restructuring threatens the stability of the broader banking system.

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Bulletproofing Debt

Germany will agree to such steps only if it is part of a package designed to bring national government debts and deficits under control — and thus obviate the need for future multibillion-euro rescue operations. That brings us to the vexed question of fiscal policy.

The current strategy for working down kilometer-high inherited debt is for governments to run budget surpluses as far as the eye can see. Greece’s bailout effectively requires the government to run primary surpluses (budgets excluding interest outlays) from here to 2060. Investors making decisions today not unreasonably question whether they can count on the commitments of governments that will not exist for another 30 years. And they worry that the program is not robust, since “stuff happens.” Sooner or later, in other words, a shock will come along that derails the debt-retirement process, requiring intervention by the yet-to-be-established EMF. The situation in other highly indebted eurozone countries is quantitatively less extreme, but qualitatively similar.

The alternative to bailouts, which are appropriate when debt repayment is unsustainable, is for those debts to be restructured — the term of art for writing off some debt and repackaging the remainder in a more manageable form. European officials have already agreed that all new government bonds should include “collective action” clauses that require only a qualified majority of bondholders to agree to the terms of a restructuring. The goal is to prevent so-called vulture funds from buying up heavily discounted bonds and playing hard to get. They have also agreed to legal reforms that clarify contract terms and further strengthen the hand of the majority of creditors.

The next step would be to add to debt contracts provisions that automatically extend the maturity of bonds in the event of a crisis, giving participants time to initiate and conclude workout negotiations. Were this done, EMF lending could be limited to instances of unwarranted panic when turning over maturing debt becomes impossible — that is, cases in which a solvent government on a sustainable fiscal path experiences a liquidity crisis.

But debt restructuring, even when it’s called for, is still not feasible if restructuring threatens the stability of the broader banking system. Hence, these proposals require bullet-proofing the banks through regulations that prevent them from holding concentrations of government bonds. Doing so is logically the responsibility of the single supervisor — which is a reminder that the mix of reforms needed in order to strengthen the euro area are complementary to one another.

What, risk-loathing Germans will ask, would prevent governments from again running chronic budget deficits and incurring unsustainable debts? The solution, argue officials (most notably, former German Finance Minister Wolfgang Schauble), lies in reinforcing Europe’s fiscal rules. There should be no exceptions to the 3 percent ceiling on annual deficits specified by the EU-28’s Stability and Growth Pact.

There should be no leeway for deviating from the budget plans pre-cleared by the fiscal overseers in Brussels. There should be no hesitation about fining violators. And if my granny had wings, she could fly…

This kind of strict fiscal discipline resonates with northern European governments, but it is rather less appealing to their southern counterparts. The idea of strengthening European Commission oversight of national fiscal decisions runs up against the value attached to national identity and sovereignty, as described above. Moreover, promises that the rules will be enforced and fines will be imposed are subject to what economists refer to as a “time consistency” problem — namely, that commitments made today can always be reneged on tomorrow, and that reneging may prove the most convenient course of action in that hypothetical future.

The alternative is to return control of fiscal policy to national governments, abandoning the fiction that policy can be strictly regimented by the EU’s fiscal rules. Governments could then make their own decisions and bear the consequences when those decisions are bad. In the event they incur unsustainable obligations, they would have to restructure their debts. And if they did so, they would face higher borrowing costs.

The adverse consequences of national financial crises would thus no longer infect their neighbors, since the big banks subject to oversight by the Single Supervisory Mechanism would no longer be allowed concentrated holdings of government bonds. Intervention would no longer bankrupt the EMF, since the latter would lend only in cases of illiquidity, as opposed to insolvency.

Governments would regain the power to decide who to tax, how much to tax and on what to spend the revenue, in line with the preferences of their constituents. They would have more room to use fiscal policy to lean against the vicissitudes of the business cycle because they would no longer be bound by arbitrarily defined deficit ceilings.

These ideas horrify dedicated Euro-federalists, who champion the euro precisely because it creates pressure for fiscal union and, therefore, political union. This is a problem, since building a consensus for euro-area reform requires the federalists’ support as well.

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An Immodest Proposal

One way of reassuring them is to create a eurozone unemployment insurance fund, analogous to arrangements in the United States under which Washington provides partial funding for state-administered unemployment insurance. Each member-state could contribute, say, 1 percent of its GDP to a fund that would make payments to those same governments, on an actuarially sound basis, when the national unemployment rate rose relative to its historic baseline. The details of such a scheme have been fleshed out by researchers at the European University Institute in Florence. Even better, existing contributions to the EU budget to finance payments to farmers could be diverted to this purpose, thereby meeting German objections to a larger EU budget.

If this modest pilot program were shown to work, it could be expanded. Jean-Claude Trichet, who was involved in the negotiations to create the euro and then served as president of the ECB, had a name for this approach: “federalism by exception.” Maybe the exception should be the rule.

But even if the size of this European unemployment fund were strictly limited, there would still be resistance to creating it. German voters are well aware that unemployment is two-and-a-half times in France what it is in their own country, and they worry that transfers would all go one way. Such proposals are contingent, therefore, on structural reforms that reduce unemployment where it is high and enhance the flexibility of labor and product markets. This would limit the likelihood that large and persistent unemployment differentials would remain a fact of European life.

This is essentially the bargain Emmanuel Macron has offered Angela Merkel. To paraphrase: “I will undertake deep structural reforms if you agree to steps in the direction of fiscal federalism to complete the banking union and to establish a European Monetary Fund.”

The advantage of structural reform is thus that it could make the other steps needed to remedy the worst defects of the eurozone’s structure both politically and economically feasible. It would also address the issue created by the tendency of less competitive member-states to run chronic deficits in trade and investment flows, while more competitive members run chronic surpluses, by making it easier for the former to cut costs and raise productivity.

Structural reform (in particular, labor market reform) is devilishly difficult in practice. Still, Macron is off to a good start. Last September, he bypassed the legislature, signing five executive decrees overhauling French labor rules. These change the unemployment-benefit system to require the unemployed to accept “reasonable” employment offers, meaning in practice jobs with salaries within 25 percent of what they received before their layoffs. They simplify the process of terminating workers and cap the compensation individuals can receive for wrongful termination. And they increase the flexibility afforded individual employers by allowing contracts to be negotiated between individual firms and their workers rather than with national trade unions.

While this ambitious reform agenda has aroused opposition in left-wing labor circles, it nonetheless shows every sign of sticking. This should reassure German leaders, especially insofar as Macron’s measures resemble Germany’s successful labor reforms implemented more than a decade ago.

The advantage of structural reform is thus that it could make the other steps needed to remedy the worst defects of the eurozone’s structure both politically and economically feasible.
The Ball is in Her Court

Now it’s Merkel’s turn. Her task has been complicated by Germany’s recent elections. The staunchly euro-federalist center-left Social Democratic Party performed poorly, while the Alternativ für Deutschland — the hard-right party that opposes everything European — made huge gains. But the impact of the election on the euro’s prognosis should not be oversold. The burgeoning support for the AfD was first, second and third about opposition to immigration. And in any event, the AfD will not be invited to join any conceivable coalition government in the future.

To be sure, coalition partners will have to execute a delicate balancing act. They will have to agree to deposit insurance to complete the banking union, while at the same time insisting on strengthened bank supervision to assuage the critics of deposit insurance. They will have to agree to increase the resources of the ESM, while at the same time strictly limiting the circumstances in which it could lend. They will have to agree to more control by national governments over their fiscal policies, but also to a European debt-restructuring regime (as the Free Democrats have proposed) to ensure that those governments are responsible for their debts in bad times as well as good. They will have to agree to redeploy funds now going to support French and German farmers to a common unemployment insurance fund — something to which Macron has already hinted he is prepared to agree.

Marine Le Pen, the hard-right French politician who opposed Macron in the second round of the French election, called the euro “the corpse that still moves.” Merkel and Macron now have a narrow window in time to breathe new life into its body.