As a doomsayer from the start, who has written several times on the subject, I have recently been reluctant to burden my readers with more jeremiads about the euro.
But fasten your seatbelts. Here I go again. My excuse is that this crisis keeps surprising the unwary. There is so much to say that I will have to have several bites.
Before we can find solutions, which I will discuss at a later date, first the causes. Why is the euro in crisis? Because it was fundamentally flawed at its inception. Only good luck, strong economic growth and enlightened economic management could keep it together. In fact, the eurozone has had to suffer the opposite of all three.
Giving up sovereign currencies is a serious challenge. Exchange rates act as a safety valve. When you remove them, the pressure either has to be reduced or it will find some other way out. In a fixed exchange rate system, such as the ERM, currency speculation could and did break the system. Advocates of the euro project drew comfort from the fact that, by contrast, a full monetary union is immune from such attacks.
It was recognised that economic and financial pressure might still find an outlet as countries which diverged from the core had to face higher bond yields. But this would be a good thing. The prospect of it should serve to restrain them. It wasn’t imagined, though, that strain in the bond markets could threaten the stability of the euro itself.
Four things went wrong. The first two were private sector failures. First, far from reacting to their newly shackled state, Spain and Ireland went on a private sector spending spree. (Meanwhile, in Greece the government led the bonanza.) Second, in all these cases, the bond markets were hopeless at foreseeing possible difficulties and imposed bond yields only marginally higher than on Germany. Accordingly, they provided no restraint at all.
The third and fourth were failures of government. The authorities presided over an extremely shaky banking system, acutely vulnerable to shocks. And their policies over many years resulted in a high government debt to GDP ratio, not only in the peripheral countries, but also in the supposedly solid core. In common with almost everyone else, the European authorities grossly underestimated the possibility of sovereign default as a realistic threat and market worry, and underestimated its capacity to cause a full scale banking crisis.
The fact that the political elite ploughed on with the euro project was the result of profound arrogance. Where possible, electorates would be denied the chance to say whether they approved of the euro and other aspects of integration. Where they had to have their say, they would be compelled to go on voting until they said “yes”. The current crisis has the same roots. The project’s difficult economics would be overcome by the politics. The Brussels establishment would ensure that everything turned out all right.
But it hasn’t. Now the economics threaten to overwhelm the politics. Greece’s sovereign indebtedness is so high that it is impossible to see how it can honour its debts without outside help (ie. gifts). And the economy will go on contracting for years. There will have to be “an event”. The only issues are when this will happen; who will pick up the tab; and what it will be called.
This being the European Union, nomenclature is extremely important. Of course it won’t be called a default – I doubt it will be called anything beginning with “de”. Bad things begin with de – like decline and defeat. It will be called something beginning with “re”. Good things begin with “re”, including rebirth and renewal – and restructuring and reprofiling. But default it will be.
Who picks up the tab is important because the bill could seriously undermine some banks. Remarkably this threat includes the ECB itself because it has taken on a large amount of Greek debt. The rows over the bill are likely to delay any sort of solution and to poison the atmosphere between member states. Meanwhile, the fate of the European banking system will be hanging by a thread.
This is why the “when” issue is so important. The current approach is to try to stave off the event until things get better. You will notice that this bears a striking similarity to the sophisticated strategy adopted by British banks in the face of dud commercial property loans, namely “delay and pray”. Mr Micawber had the same idea but expressed it differently.
So even though the markets cannot cause the euro to break up by exchange rate pressure, they can cause an internal financial crisis worse than any currency panic. The prospect, or the reality, of such a crisis could yet cause some European leaders to precipitate the end of the euro as we know it.
By Roger Bootle who is managing director of Capital Economics and economic adviser to Deloitte.