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Farewell, Fair-Weather Euro

The eurozone needs a fundamental redesign, with Germany at the drafting table

1 February 2011
by François Godement & Thomas Klau, in: IP-GE March/April 2011

Although the eurozone is in better shape than the United States following the global financial crisis, it is the euro that markets are nervous about. As an untested prototype, the European Union must propose alternatives in order to create a more stable future for eurozone economies and to increase cohesion among its member states.

Sebastian Zwez

The European Union has been in crisis before. But in the past, Europe’s leaders seized crises as opportunities to deepen political and economic integration. This time, while the European Central Bank (ECB) took the lead in stabilizing the situation, Europe’s national leaders have dithered, acting mostly when overwhelming market pressure left no alternative. With Germany newly reluctant to move into deeper European engagement, European leaders publicly quarrelled about the way forward, strengthening fears about a break-up of the euro.1 As doubts grew over the eurozone’s ability to weather the financial storm, influential voices around the world started singing a requiem for Europe’s global ambitions. “Even before it began, Europe’s moment as a major world power in the 21st century looks to be over,” wrote Richard N. Haass, president of the New York-based Council on Foreign Relations, in the Financial Times in May.

The Origins of the Crisis

The eurozone sovereign debt crisis was a direct consequence of the rescue of Europe’s financial sector and economy after the collapse of Lehman Brothers in September 2008. “The first phase of the maneuver has been successfully accomplished—a collapse has been averted,” said George Soros in June last year. “But the underlying causes have not been removed and they have surfaced again when the financial markets started questioning the credibility of sovereign debt. That is when the euro took center stage because of a structural weakness in its constitution.”2 The unique character of the crisis arises from several failures. The first, shared across the West, is the catastrophic lack of legal control and regulatory oversight of the financial sector. Second, the governance derived from the Maastricht Treaty was deeply inadequate. It failed to prevent both the widening of disparities between the economies of its members and the dangerous cross-border bets that an increasingly interdependent European banking sector placed on continuing growth and stability in countries across the eurozone.

For example, both Ireland and Spain, each saddled with massive financial sector debt after a speculation-driven construction boom, ranked among the best performers according to the Maastricht rule book. “We have been talking about imbalances at least since 2005 but nothing was done,” says French economist Jean Pisani-Ferry.3 Lower interest rates resulting from the creation of the single currency facilitated reckless spending and lending. “We underestimated the negative windfall effect of the euro,” says Pascal Lamy. “The creation of the eurozone has failed to enforce fiscal discipline,” says Giuseppe Scognamiglio of the UniCredit Bank Group. The system built on the foundations of the Maastricht Treaty was too weak to resist a severe financial market storm: “There was no crisis management provision in the treaty,” says Pisani-Ferry. “There was this strange belief that crisis prevention through the stability pact would make crisis management unnecessary and even counterproductive, as it would create the wrong incentives.” In the words of Financial Times economic columnist Wolfgang Münchau, “Germany, in particular, had reduced monetary union to its fiscal and monetary core, and thought it could achieve a stable and sustainable budgetary and economic situation through a system of rules. Somewhat naively, it believed in the ‘no bailout’ rule for countries facing the threat of default. But, logically, if you have no bailout, no default, and no provision for exiting the eurozone, by definition you have a fair-weather construction—and this was not even part of the debate or national consciousness, even among intelligent Germans.”

Many of these weaknesses resulted from the conflictual search for a way to achieve budgetary discipline and economic convergence while letting member states determine their own policies—leading to the Maastricht Treaty in 1991 and the Stability and Growth Pact signed in 1996. Doubts about the system’s viability were there from the start. “Everybody who follows this could predict that that would happen,” says Jean-Luc Dehaene, Belgian politician and European Parliament member. “From the start, Jacques Delors warned that next to a central bank you need also a form of economic governance. But Germany always said this would compromise the autonomy of the [European Central] Bank.” The struggle continued after the introduction of the euro; the most telling and damaging clash was the Franco-German rebellion of 2003 and 2004 against a European Commission move to initiate sanctions procedures against Paris and Berlin for having failed to bring their respective budget deficits back under the Maastricht limit of three percent of GDP. The subsequent decision in 2005 to introduce a number of modifications to the rule book for economic governance—a move from ‘Maastricht I’ to ‘Maastricht II’—was hailed by some as a victory of common sense over bureaucratic rigidity. But to many smaller member states, it seemed that the rules no longer operated when two big countries were targeted. “The French and the Germans killed the Stability Pact in 2004,” says Lamy. “This is one of the reasons for the Greek shock.”

It is instructive to note that when it comes to overall public and private debt levels and current accounts, the eurozone is in better shape than the United States. Yet the markets have made the eurozone the focus of their anxiety. The reason is simple. Whereas the United States is an established state complete with a large budget and flexible fiscal transfers from richer to poorer regions, the eurozone remains an untested prototype. The markets expect that the United States will always ensure the cohesion and survival of the whole. The European Union has no such historical capital, nor has it a recognizable model of governance. In the current crisis, it is paying a steep price for being sui generis. Former Italian Economics and Finance Minister Tommaso Padoa-Schioppa explained that the markets attack the eurozone “because it is a post-Westphalian (post-nation-state) experiment, and people don’t believe in that.”

“The crisis has brutally laid bare the weaknesses of the European model and of the euro,” says Joschka Fischer. “Either we seize the chance to move forward or the euro will break apart.” The agreement last year to establish a permanent European Stability Mechanism (ESM) by 2013 represents a big step. But it does not address key issues such as economic imbalances. EU leaders have acknowledged this and called for a broad overhaul of eurozone governance by the summer of 2011. But they have chosen to give the Maastricht-derived framework a third chance rather than go for a more fundamental re-design. “The budgetary surveillance framework currently in place, defined in the Stability and Growth Pact, remains broadly valid,” wrote the Van Rompuy Task Force in its final report.4 The precise shape of the reform will now be thrashed out in a process in which the European Parliament plays an essential role as co-legislator.

Member states have already agreed to step up coordination and mutual monitoring of economic and fiscal trends through the introduction of a so-called European semester. Other elements of the current reform proposal would require member states to set up a national framework to make budgetary planning more compatible with EU requirements. It would target excessive national debt, as well as deficits, with a variation of the Stability and Growth Pact sanctions. This stricter procedure would make it easier and faster for finance ministers to adopt sanctions, introduce new surveillance, and possibly a new sanctions procedure to control imbalances in eurozone economies, based on a scoreboard of economic indicators.

Maastricht’s Structural Flaws

There are still deep disagreements between governments over crucial details of this third attempt to make Maastricht-based governance work. Germany and France have proposed a “competitiveness pact,” the final shape of which is to be settled in March. Already, though, the proposal has run into stiff resistance from eurozone partners. Yet however the differences are resolved, it already seems clear that ‘Maastricht III’ will share three essential structural flaws with its two predecessors.

First, Maastricht governance ignores the impact that the electoral cycle and other democratic political considerations have over the timing of economic and budgetary decisions. In other words, political timing and political context often trump economic timing. For instance, as former Irish prime minister John Bruton says, “the political reality is that you can only make serious expenditure cuts in economic hard times, because you can only get political consensus to make cuts in hard times. Making deep cuts in the middle of the boom may be theoretically the right thing to do, but it’s politically impossible.”

Second, EU member states’ own rules and constitutional practices regarding the conduct of economic and budgetary policy differ in fundamental respects. In some states, it is mostly the finance minister who determines budgetary policy; in others, it is the head of government or the cabinet as a whole. In some states, the parliamentary majority exercises a high degree of control over the make-up of the budget; in others, the government simply puts the budget to a vote. In the past, the finance ministers assembled in the eurogroup—the eurozone’s main steering committee—have often acted and spoken as if they possess the power to make decisions effectively binding all eurozone governments. But in reality they do not. They can woo, bully, and, as their ultimate weapon, launch unwieldy sanctions procedures. But their collective power is very limited, no matter what the Maastricht rule book suggests.

Third, it is inevitable that mistakes will be made. Over time, the European Commission, the European Council, and the eurogroup will inevitably give some erroneous guidance and sometimes base sanctions on incorrect economic assumptions. In fact, Maastricht III will make this more likely: with more options for sanctions built in, the odds increase that mistakes will occur. Inevitably, such errors will gradually weaken the system’s legitimacy and facilitate organized rebellion from unwilling recipients of guidance or punishment. The Franco-German uprising against Maastricht I was criticized as being “un-European.” But both countries at the time defended their fiscal stance as appropriate; and, in purely economic and budgetary terms, later developments have tended to vindicate the German position.

The Maastricht framework takes next to no account of these three fundamental realities. Unless they are addressed, Maastricht III might easily fail like its predecessors. Making the Stability and Growth Pact work would, at a minimum, require a significant harmonization of national habits of governance and, in some cases, even of national constitutions to make them compatible with the European coordination and surveillance framework. “There is no way one can organize an effective European coordination without major changes in national practices and, in some cases, structures,” says Hans Eichel. But, as Padoa-Schioppa has pointed out, this throws up a paradox. “Many people say that a federal budgetary system is a dream of an EU that is a much stronger EU than they would like to see,” he said. “But these same people see it as the European Union’s job to coordinate national budgetary policies, which is of course much more intrusive. There is no federation I know where the federal power coordinates the local powers. We are in the paradoxical situation that those who have little ambition to integrate the EU further have big ambitions about the role of the EU as a powerful, intrusive coordinator.”

Bonds, TARPS, or Big Budgets

Some eurozone governments have now opened the debate about other means—in particular, eurobonds—to strengthen the eurozone’s cohesion.

Eurobonds: The most prominent and promising proposal concerns the gradual build-up of a massive eurobond market equivalent to 40 percent of the GDP of the European Union and each member state. It was endorsed by Luxembourg’s prime minister Jean-Claude Juncker and the Italian finance minister Giulio Tremonti just before the December 2010 meeting of the European Council. German chancellor Angela Merkel immediately rejected the plan—followed, less categorically, by French President Nicolas Sarkozy. Yet the advantages of a switch of much existing national debt to eurobonds are obvious. The eurobond market would rival the US Treasury market, creating favorable refinancing conditions: the depth of the market and its wide basis are the reason—along with a safe federal system—that US public debt remains as attractive as it does. A eurobond backed by strong European institutions would give investors more clarity and predictability and send a strong signal that eurozone countries see their future together. The scope for speculation against individual countries would be reduced. Eurobonds—with their likely AAA rating—would facilitate much needed investment. Finally, limiting eurobonds to 40 percent of GDP would create an incentive for member states to bring down their debt, since further debt would have to be paid for with higher interest rates.

A Euro-TARP: As the need to bail out the financial sector is the single main cause of the eurozone crisis, one interesting proposal that has emerged is the creation of a European version of the Troubled Asset Relief Program (TARP) through which the US government bought assets from financial institutions.5 Europeanizing the rescue of the banking system in this way would take a major burden off the hardest-hit eurozone members such as Ireland and Spain and diminish investor concerns about national debt. It would likely involve a contribution both from bank bondholders and bank shareholders, possibly going as far as a temporary public takeover of troubled financial establishments. But here the ECB’s preference for a blanket bailout, grounded in its fear of a new global credit freeze, clashes with member states’ reluctance to let taxpayers bear the cost alone. There is also a question as to whether Germany, which opposed a single European rescue operation for the banking sector when the financial crisis erupted in Europe, might now be more open to it.

An expanded budget: This year has demonstrated conclusively that the eurozone needs far more commonality in its budgetary, fiscal, and economic framework to survive. In purely economic terms, one compelling option would be a gradual expansion of the EU budget to make it strong enough to act as an automatic stabilizer for the eurozone economy and flexible enough to take over some redistributive functions within the European Union. This would fit with the general trend of European politics. “The EU budget is very small compared with national budgets. As the EU seems to be required to achieve more and more, its budget should be seriously rethought,” says Vaira Vike-Freiberga. The financing of defense policy, science and innovation, overseas aid, or even some social expenditure such as short-term unemployment assistance could be usefully and sensibly transferred from the national to the European level.

Given the right policies and budgetary practices, the result would be more economic convergence, more political cohesion, better spending, and healthier overall economies. Wolfgang Münchau suggests that moving from one to five percent of GDP—a very modest figure compared with typical national or federal budgets—might be sufficient to achieve the desired economic and political effect. Emma Bonino argues such a “federalism lite” would be the most sensible way forward. But however compelling the economic case may be, the political appetite among EU member states to devolve further budgetary power to the European Union is currently close to nil. The EU’s economic governance has reached an impasse: “People say they prefer close coordination and supervision, meaning an intergovernmental path rather than a federal one, but the truth is that there is no real appetite for that either,” says Emma Bonino.

Storm-Proof Construction

Europe’s Monetary Union has been an extraordinary achievement. But its political governance was designed for fair weather. European leaders must now make it storm-proof. Germany, spiritus rector of the Stability and Growth Pact, needs to accept that the model of rules and sanctions-based governance of the eurozone has failed and do more than insist on a haphazard list of structural reforms. The most subtle defender of Germany’s position, its finance minister Wolfgang Schäuble, points to the return of interest rate spreads within the eurozone as the best way to discipline eurozone member states. But this makes bond investors the arbiters of policy—even though these same investors have demonstrated time and again how unsound their collective judgment can be. Worse, it welcomes the return to a European reality where national policy choices are benchmarked by the markets against the narrow policy preferences of the most powerful country with the best track record—precisely the European reality that the euro was supposed to help overcome.

Europe can continue to stumble through piecemeal reform, hope for the crisis to abate, and count on the financial markets to help impose fiscal discipline. But a far better choice would entail a serious new grand bargain with Germany. Berlin would have to accept that betting on capital markets as permanent enforcers of good policy choices is an unwise gamble and that the third attempt to make the Stability and Growth Pact work might easily fail too. But if Germany underwrote a more fundamental  and coherent redesign of eurozone governance, involving, but not limited to, a stronger and more flexible crisis management mechanism, it would be in a far better position to shape an agreement that would give Europe the economic and political cohe-sion it needs to succeed in a world of rising superpowers. The current Franco-German proposal falls short of what is required. Europe needs forward-looking German leadership anchoring a European Germany in a more German Europe.

*- This article was written with the help of José Ignacio Torreblanca.


1 See, e.g., Gideon Rachman, “How Germany could come to kill the euro,” Financial Times.

2 “The euro crisis could lead to the destruction of the European Union,” Humboldt University lecture, Berlin, June 23, 2010, available at http://ecfr.eu/. November 22, 2010.

3 Unless stated otherwise, quotes are taken from interviews carried out by the authors during 2010.

4 “Strengthening Economic Governance in the EU—Report of the Task Force to the European Council,” October 21, 2001, available at http://www.consilium.europa.eu/.

5 Anatole Kaletsky, “A New Idea to Save the Euro,” GaveKal, December 2, 2010, available at http://gavekal.com/.

FRANÇOIS GODEMENT is a senior policy fellow at the European Council on Foreign Relations.

THOMAS KLAU is head of the Paris office of the European Council on Foreign Relations.

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