“Monetary union is like marriage between partners of very unequal assets. Prenuptial arrangements are naturally the rule and must be?followed closely. But when the passion is gone, the agreements endure.” — Rudiger Dornbusch, ‘Euro fantasies’, 1996
Keynes described the gold standard as ‘a dangerous and barbarous relic of a bygone era’. Little did he know that Europe would re-create it in the late 1990s, thus replicating the circumstances for another Great Depression in the 2010s.
France President Mitterrand wanted a single currency to avoid dominance by the Deutsche?Mark and Bundesbank. The French were prepared to sacrifice their own sovereignty in order to see the Bundesbank abolished. France’s bargaining position was enhanced by the fall of the Berlin Wall in Nov 1989.
When the idea of a single currency was proposed, all member countries took part but the French and the Germans were the key decision-makers. It was clear that a fiscal union was impossible. The German govt and the public feared that a European fiscal union could expose them to the risk of perennially paying the bills of other European nations. Germany was “the prudent ant” and France the “irresponsible cricket”. Could the ant be expected to put its stored resources at the disposal of the cricket? This was the stance in 1970 when a monetary union was first considered as a serious possibility, and it remained the position throughout 1991.
A clumsy agreement emerged. The draft Maastricht Treaty did say that one member state would not repay another member state’s debts. In principle, the Treaty had a “no bailout rule”. But the fickleness of financial mkts raised a question mark about whether the “no bailout” clause would be enforced if a major crisis occurred.
The exclusive reliance on rules was a triumph of hope over common sense. To be legitimate and enforceable, rules for a monetary union also needed a political union. The muddle was made worse by the weird idea to impose binding upper limits on the budget deficits and debts of member countries. To be reminded at frequent intervals, the?criteria are the essential do’s and don'ts and exude a disdain for loose finances. Sample some.
- Debt to GDP rule: The negotiators initially agreed that each member country would be required to keep its debt-to-GDP below 60% of GDP. But this limit soon became irrelevant. Many countries had significantly higher debt ratios and couldn’t plausibly bring them below 60% of GDP quickly. If the debt ratio rule had been enforced, there would have been no eurozone! Strictly speaking, only 3 out of 11 countries met the debt test. So the negotiators agreed that it was adequate if the debt ratio was clearly coming down toward 60% of GDP. This was a vague and meaningless rule.
- 3% rule: The real drama centred on the rule for budget deficits. The Germans proposed the “golden rule”: a govt should run a deficit only to invest in long-term assets e.g. infra. But the boundary of what constitutes long-term investments is fuzzy. Member countries could easily disguise their regular expenditures as infra investments and amass large deficits. Eventually, the French proposed a simpler limit. Two young civil servants pointed out that a limit of 2% of GDP would be too hard to achieve consistently, while 4% of GDP would give too much leeway. So they proposed a limit of 3% of GDP, which the Mitterrand govt began using for its internal guidance. The French now suggested that the same limit should apply to all members of the monetary union. Why 3%? Mitterrand decided that the French deficits would never again reach the 3% level. The 3% limit would satisfy German insistence on a rule, and France would be safe in a comfy zone where the rule wasn’t binding. (Macron now expects the deficit to hit 5.1% v/s the original 2024 target of 4.4%). There had been no public debate about the rule. Few even at Maastricht understood its implications.
The political attraction of a fixed number required no judgment or analysis, so the thinking went that the possibility of fudging and haggling would be less. The Germans quickly made it their guiding mantra. Although the rule was economic nonsense it would come to exercise a powerful hold on the European psyche.
A fixed budget limit delays recovery from a crisis. When an economy falls into a recession, its budget deficit rises (since revenues fall and expenditures for social support increase). Fiscal austerity to keep the budget deficit within a preset limit turns self-defeating. Austerity—thru lower spending or higher taxes—causes economic growth to decelerate further. The govt’s budget deficit and debt rise, not fall. For this reason, considerable fiscal latitude (obviously exercised with judgement and wisdom) is needed during recessions and crises.
The Euro can be imagined as a club whose rules of entry were meant to be violated and whose functions were designed as mind-boggling paradoxes. For example:
- Italy’s debt-to-GDP ratio (at 120%) was twice that specified by Maastricht as the max allowable level for an entrant, with its inflation languishing in the red zone too. Smart folks, working with the best financial minds Goldman Sachs could provide, resorted to creative accounting that shaved off some of the debt and a bit of the govt’s budget deficit. However, the numbers hardly budged even when Rome applied huge doses of austerity.
- So it was clear that the Maastricht rules had to be bent for Italy to exchange its unloved, depreciating lira for the copper-plated euro. And bent they were! The bleak evaluation of Italy’s prospects changed suddenly and dramatically. If Italy were denied membership and retained the lira, Italian goods would be able to compete with Germany’s.
- Brussels and Frankfurt reinterpreted their rules: as long as countries were moving in the direction of the Maastricht thresholds, Europe's authorities could decide?that they had made the grade.?FT reported with incredulity: “Pinch yourself. It now looks a pretty safe bet that Italy will be a founder member of Europe’s economic and monetary union.” PM Romano Prodi emphasized the “extraordinary” progress achieved. He promised to bring the debt-to-GDP ratio from 120% to the required 60% threshold by 2009. [In 2023, it was 137% with little likelihood of falling to 60% anytime soon]. These promises renewed hopes among investors that Italy was turning over a new leaf, and the lira strengthened.
- Skeptics doubted the numbers and the sudden “renaissance.” Becoz of his tough opposition, Italians accused Dutch FM of “spaghettiphobia.” Critics projected that the debt ratio would remain above the Maastricht threshold until 2030.
- Throwing all caution to the wind, Germany’s Kohl insisted Italians would continue “structural reforms”. Feeling the weight of history, his “not without the Italians, please” decision wasn’t an economic but a political one. He made that decision single-handedly on behalf of all Europeans.
- Greece was in a high-corruption, low-productivity trap. In 1996, PM Konstantinos Simitis began an effort to adopt the prospective single currency. It led to some improvement in a few macro indicators, but in May 1998, European leaders sensibly left out Greece from the first lot of euro entrants.
- By early 1999, the word was that Greece’s fiscal deficit was “under control,” and although the debt-to-GDP ratio was still at 90% of GDP, the defence offered that it was falling and was less than that of Italy and Belgium. One last hurdle remained. Greece’s inflation was too high to justify entry into the eurozone. But the Dutch FM, who had heroically resisted Italy’s membership, assured his Greek counterpart that the inflation criterion for entry “could be interpreted in some circumstances.” Of course, technical rules could always be “interpreted,” if politicians so desired!
- Being the new German chancellor, Gerhard Schr?der had to keep up a facade of pro-Europeanism. In his signature gesture, he waved Greece into the eurozone on Jan 1, 2001. He thought there would be no problem mopping up a Greek crisis.
- The media went berserk with tales of sly Greek officials pulling the wool over the eyes of officials, with?‘Greek statistics’ as their weapon of subterfuge. When former Greece FM Yanis Varoufakis asked an influential friend how they managed to convince Germany to let Greece in, his reply was fantastically candid: “We just copied everything the Italians had done, and a few tricks used by Germany itself. And when they threatened to veto our entry, we threatened them back that we would tell the world what Italy, and Germany, had been up to.“
- A Dec 2004 audit revealed that Greece’s fiscal deficit around the time of the euro entry decision was far higher than reported and thus was well above the limit to qualify for entry. “There was a clear under-reporting by the Greek authorities of military expenditure irrespective of the accounting method used, an over-reporting of revenues from social security and an incorrect treatment of a significant amount of capitalised interest on govt bonds.”
The essential flaw of the single currency was fundamental:
- In giving up their national currencies, eurozone members lost crucial policy levers. If a member country slipped into recession, it wouldn’t have a currency to devalue for its businesses to sell abroad at lower US-dollar prices in order to boost exports and employment.
- The member country would also not have a central bank that could reduce its interest rates to stimulate domestic spending and encourage growth.
- This leads to severe problems as soon as the economies of countries sharing the currency diverge from one another. If e.g. Italy is stagnating and the German economy is humming along, the common ECB interest rate will be too high for Italy and too low for Germany. Thus, Italy’s troubles will continue, and the German economy will get further boost. (In 2007, Germany’s GDP was 10.4 times that of Greece; in 2016, it was 15 times.)
- The Euro was more rigid than the gold standard that allowed a member to break the link with gold when the economic and political costs became too high, and to re-join when things changed.
Far from fostering “ever closer union”, deficit nations’ resentment of Germany, and that of surplus countries against debtors, created rifts within the EU. In 2015, Greece toyed with Grexit briefly but pulled back from the brink. In 2018 a populist Italian govt was considering a parallel currency. Bulgarians are now split on joining the euro, with polls showing 49% in favour and a similar number against. But not a single member has left the monetary union so far. This is the most unexpected thing…..the Euro is still around, intact and, growing.
As Varoufakis explains, once in the monetary union, you lack a currency to cut loose of the euro; you have only the euro. To get out of the union, Greece or Italy e.g. would have first to create a new drachma or a new lira and then unpeg it from the euro. But creating a new paper currency, circulating it around the country, and recalibrating the banking and payment systems takes at least a year. Given that the goal of going thru the rigmarole of re-creating a lost currency is to devalue it v/s the currency in people’s pockets, leaving the euro is tantamount to announcing a major devaluation a year before it happens. At the drop of a hint of a devaluation a year hence, every Tom, Dick and Harry will rush to liquidate whatever wealth they have, convert it to euros, take their euros out of the banking system and either stash them under their mattress or lug them across the border to Germany or Switzerland for safekeeping. Before you can utter ‘panic’, banks collapse and the economy crashes.
It sounds like Europe has invented a machine from hell that cannot be turned off! There lies the beauty and the curse of the single currency.??
