The Greek debt crisis has revealed the flaws in the Euro’s construction. While it was still on the drawing board, many commentators pointed out that a federal currency required a federal political system to underpin it. We are still far from that in the EU. That does not mean that the prospect is for a rapid demise of the Euro, and a return to national currencies. Too much political capital has been sunk in the project. The more likely outcome is that France+the Club Med countries will have to purge their economies, as the price for winning back the confidence of German public opinion as a prelude to considering going any further down the road to union. And Germany will have to accept that the price for keeping the Euro is that it becomes the payer in a European ‘transferunion”—a Europayer, but which no longer determines the allocation of resources in Euroland.
Ten years after the launch of the Euro in January 1999 to a fanfare of expectations about the new multi-national currency as a challenge to the dollar’s primacy in global finance, the news is full of speculations about Germany reverting to the DM, and the Greeks to the drachma. At the height of the meltdown in the New York markets following the bankruptcy of Lehmann’s in September 2008, flight capital flowed in to the dollar to the tune of a net $2.1 trillion by late 2009, rather than move into Euroland, where governments were initially celebrating their immunity to the crash. What was it that the markets sensed that escaped Euroland leaders?
The initial response across Euroland to the Lehmann Brothers collapse was that this was the result of Anglo-American turbo-capitalism. In Israel, I remember at a conference in December 2009 sitting through a talk by a former Polish centre-left finance minister explaining in no uncertain terms that since the EU’s financial legislation and Central Bank arrangements had, and were being modeled on Germany, this crisis was due to “Anglo-Saxon” finance, and was somehow external to the continent.
It therefore came as a surprise to many when in October 2009, the Greek government reported that its 2009 budget deficit would be about 13% of gdp, 7% of gdp more than had been anticipated. It was also observed that Greek banks were relying on ECB funding. Not surprisingly, analysts focused their attention on the state of Greek public finances, and its relation to bank funding. Using a variety of indicators, what they turned up was: a poor sovereign rating; an average current account deficit from 1992-2008 amounting to near 6% gdp; net interest payments of 7.5% over the period; a debt to gdp of 98%; and a significant structural budget deficit.
It was not as if Euroland’s performance over the period has been stellar either. Growth in Euroland for its first decade was below what it had been the previous decade, sticky labour markets kept unemployment rates obstinately high, debt to gdp averaged near 70%–well above the criteria which had been laboriously negotiated to accompany the introduction of the Euro. In addition, despite apparent improvements in Italy’s budget balance, the average Italian deficit for the period was over 4% gdp, with interest payments on public debt running at an annual 7.7% gdp. France’s last government surplus has been in 1974, debt was piling up, and the banks were massaging their balance sheets, a practice which they took to as soon as they had been obliged to raise capital in the 1980s.
In addition, Club Med countries, with the exception of Italy, were running significant current account deficits. The typical pattern of Club Med countries and France from the late 1960s until the introduction of the Euro in 1999, has been to stimulate domestic inflation and watch the exchange rate take the burden. The result had been flourishing export sectors, particularly in Spain and in Italy. But once in the Euro, Club Med current account deficits widened, a sure sign of trouble.
Greece’ current account deficit was over 14% gdp; Spain’s at 10%; and Portugal’s at 9% for 2009. The low value added manufacturing exporters along Club Med countries were faced with rigid labour markets; a flood of imports from China, once textile markets around the world were opened in 2006. When finance dried up for construction in 2008, that was the end of the Club Med bubble.
All rich country governments presided over an explosion of public debt from 2007 onwards, heading towards an OECD average of over 100% by 2010. That was the way which the western world took, urged on by Gordon Brown, one of the most irresponsible Finance Ministers the UK has had the misfortune to have. With bank debts in addition to liabilities accumulated in the past, by 2010, it was inevitable that world bond markets were no longer ready to countenance deficit spending to keep demand up—as so-called Keynesians were calling for. So called because Keynes proposal for government pump priming by capital investments in 1936 was made when government debts were microscopic compared to 2010 Circumstances had changed, but the pundits’ proposals did not keep up with cruel realities.
This surge in rich country government liabilities coincides with a surge in unfunded, age-related liabilities. Driven by the countries demographic profiles, the ratio of old-age population to working age population is anticipated as rising sharply. This rise is particularly sharp in Spain, Italy and Greece. So why, if the crisis has been so general, have markets come to focus on the Club Med countries in particular?
The answer lies in two related issues: first, markets have to count on continued rises in relative productivities in labour and capital, in order to fund projected expenditures related to ageing populations and rising health costs. But every indicator of competitiveness from unit labour costs, to innovation, investment in R&D, or market friendliness show that the gap between northern Europe and southern Europe was wide and deep. In fact, convergence had only been achieved in the 1990s by sleight-of-hand to get the Club Med economies into the Euro.
The reasons for extending the Euro to the south were multiple. German and French companies did not appreciate the competition coming from Mediterranean exporters, when their currencies fell. So in the mid-1990s, France and Germany invited Italy in to the Euro, in order to avoid competitive devaluations. Being in the single currency of course meant that the governments had to meet the criteria on deficits and debts to be allowed in. Paris and Berlin turned a blind eye when Club Med countries cooked their fiscal books to qualify for membership.
More importantly, the Club Med Countries just did not have the infrastructure of training, the density of small and medium businesses, the expanding technology hubs and the close ties between corporates, research institutes, governments and banks that exist in northern Europe. Put bluntly, the Club Med countries were playing in the first division, when they barely qualified for the third division.
Second, the Greek financial crisis alerted markets to the fact that the Euro, like the much denigrated composite “structured products” which had been packaged and sold in the boom years of the US, UK and Spanish real estate bubbles, was also a composite product. Banks, particularly in Euroland, lent to Club Med countries on the assumption that there was no country risk once the exchange rate risk had been disposed of. They went for market share, lending as if there was no tomorrow for real estate projects, construction or tourism. But for a French or German bank to lend to Greece was not like lending to a client in Marseilles or Munich. They were lending to, well, a Third World country
The flaws in the Euro-deal are political in origin.
This is the key difference between the Euro and the dollar. The Euro’s value depends on its member states organizing their affairs as if they were a unitary state. When Chancellor Kohl backed monetary union in 1990 as the price that the Federal Republic had to pay in return for French support for German unification, he hoped to flank the newly-minted European Central Bank with a political dimension, ceding more powers to EU institutions. The German Constitutional Court’s judgement on the EU’s new constitutional, delineated in the Lisbon Treaty, is that this is no more and no less than and international treaty between 27 sovereign member states.
The EU is not one and indivisible, as is the US, indeed is far from being so. The hope had been that national differences between member states would converge on a common norm, through the combined legislative initiatives of the EU institutions and the working of the internal market, underpinned by the Euro, in turn supervised by an independent European Central Bank. In practice, whenever the rules underpinning the Euro have bumped into the short term interests of the member states they have been shredded: in 2003, France and Germany walked roughshod over the 3% budget deficit rule; in 2008, EU governments soared past the 60% of gdp ratio for public debt in their determination to run counter-cyclical deficits, bail out banks, and maintain a minimum of economic activity; with the Greek fiscal crisis of early May 2010, the “no bail-out” clause underpinning the Euro’s introduction went out of the window , when the European Central Bank began to buy government bonds and the EU-IMF engineered a Euro 750 billion fund to stabilize the markets.
The Greek wake-up call.
Global banks had every reason to be spooked by the EU’s messy response to the Greek fiscal and financial crisis in May 2010. The widening spreads between Greek Euro bonds and German Bund bonds alerted global investors to the fact that the Euro was in fact a composite product, much like the composite financial products which financial engineers had sliced and diced to sell on to gullible buyers during the global boom of 2002-2007. The value of the Euro was not just a function of the stability-orientation of the European Central Bank, and the undoubted benefits of the single currency as underpinning the internal market programme. It was also a function of the varied tax, labour, social security, or business systems of the member states. And the startling news was that these had not converged, so much as diverged during the first decade of the Euro’s life. The divergences had been disguised by the workings of the Euro, and when the global crash came in 2008, the fundamental structural divide within the EU was laid bare.
The bottom line is that Greece—and its Club Med partners, Portugal, Spain and Italy– have not come close to keeping pace with the German manufacturing sector in driving down relative unit labor costs. The gap continues to widen. There is no escape for the Club Med countries through devaluation as the single currency and a single monetary policy joins them at the hip with the high productivity northern countries, including Germany. With the end of the boom years, the European economy is left with long-term overproduction at one end of the chain, overconsumption at the other end, and growing public-sector debt linking the two. Not least, as the Bank of International Settlements has recorded, global banks, excluding domestic banks, held loans outstanding to Greece, Spain, Portugal, Ireland and Italy, to the tune of $4 trillion dollars.
During the boom years, German business drove down unit labour costs faster than their southern neighbours, outsourced production to central-eastern European countries, unravel the inherited bank-industry cross-shareholding structures and embrace green ideas in their determination to harness all energies to the task of overcoming the titanic cost of absorbing eastern Germany. The result has been that the frugal Germans have won market share in the EU, which now absorbs over 65 % of total German exports as against 40-45% in the mid-1990s. This was possible because ECB-determined interest rates fell far below what would have been required for most of the economies on the periphery of the Euro heartland. This in turn stimulated bubble economies in Spain and Ireland and hid government profligacy in Greece and Italy, as well as in France.
The EU’s dilemma today is crystal clear: The German export machine needs aggregate EU demand to accelerate. But this can’t happen because the EU political structure places fiscal policy firmly in the hands of member states, while the Club Med countries are staring at a future where real wages may have to fall by anything from 20 to 60% in order to restore some semblance of balance. No wonder global financial markets are asking questions about the Euro’s sustainability.
Different routes into the future.
Going forward, the road forks in a number of directions. One points to the Euro shrinking to its core northern members around Germany, with France hanging on in there for dear life. This route would allow the Club Med countries to regain price competitiveness through devaluation, but it would also cause havoc in the bond markets where overvalued sovereign debt now priced in Euros would be repriced in local currencies. In favour of taking this fork in the road is German public opinion, outraged at how the EU policy process has trashed the implicit contract Chancellor Kohl entered into on its behalf in surrendering the DM. A European Central Bank, independent of political pressures and based on Frankfurt, would pursue a single objective of price stability. Member states would craft fiscal or labour market policies to the EU-norm. This has not happened.
An alternative route, more likely for the present, is that no country opts out of the Euro. The price for the southern countries would be exhorbitant, and in any case German business is fast discovering that the devaluation of the Euro against the dollar and the yuan has greatly increased the price competitiveness of German exports on global markets. This has reinforced the US role as the global consumer of last resort, thereby externalizing onto the US the weaknesses inherent in the Euro’s constitution. At the same time, the German government intends to impose its stability-orientation more forcefully on the southern European countries and France with the aid of the bond markets and through more forceful return to budgetary disciplines. The problem here is that German exports will suffer, while German banks have outstanding loans. In the medium term, the hope must be that greater convergence is achieved among Euroland member states in terms of labour market reforms, fiscal discipline and financial market reforms. No-one should hold their breath.
There is a third route, though, which is the more veiled support in France and in the EU institutions, for the development of a single European sovereign bond market as a fiscal forerunner of a much larger European federal government – much like permanent federal guarantees for all state government bonds in the US. A great deal is likely to be heard about this idea in the months and years ahead, because it contains the making of a grand bargain between Germany and its northern partners at the one end, and France and the Club Med countries at the other.
The Club Med countries are in effect saying to Germany: Look, if you want to continue working as efficiently as you do, and produce all these high quality products which we like, then provide us with the low-cost financing in a single sovereign debt market to specialize in leisure and consumption. And their natural allies in this pan-EU Keynesian vision are Germany’s champion Mittelstand manufacturing exporters, the troubled German state banks, and German politicians uncomfortable at the prospect of having Germany place itself in the position of being Europe’s policeman.
Fiscal federalism a distant target.
The way to an EU fiscal federalism may take decades, as did the negotiations for monetary union, which started in 1968 and culminated in the Euro in 1999. As during those negotiations, the key constituency to win over is German public opinion. For the meantime, the future of the Euro depends on Germany: German political leadership is heavily in favour of the Euro; German business recognizes its competitive value; but German public opinion is indignant that the EU’s profligates have failed to live up to their treaty commitments.
The conclusion is straitforward: Growth opportunities in Europe now hinge on Germany growing on the back of an export boom to the US. Club Med countries have to pass the demanding examination of German public opinion. So its going to be hard pounding as the purge on the Club Med and France bites.
Jonathan Story is Distinguished Visiting Professor at the Fordham University Business School, New York and is Emeritus Professor of International Political Economy at INSEAD.