Project Syndicate, July 30th, 2018
Twenty years after the formal creation of the euro, few can honestly say that the single currency has been a success. After fueling a massive credit bubble in Southern Europe in its first decade, it gave rise to an array of complex monetary-policy and transfer schemes in its second – and more trouble is looming as it enters its third.
In May 1998, irrevocable conversion rates for the currencies that would be merged into the euro were implemented. In a sense, this makes the single currency just over 20 years old. The first decade of its life had the feeling of a party, particularly in Southern Europe; but the second decade brought the inevitable hangover. Now, as we enter the third decade, the prevailing mood seems to be one of increasing political radicalization.
The original party was a cornucopia of cheap credit, which capital markets happily issued to the countries of Southern Europe under the protection of the euro. For a while, these countries finally had enough money to increase public-sector salaries and pensions, as well as spur private consumption and investment.
But the credit flooding into these countries created inflationary bubbles, which burst when the 2008 financial crisis in the United States spread to Europe. As capital markets refused to extend further credit, Southern Europe’s previously halfway-competitive but now overpriced economies soon ran into serious trouble.
The Southern Europeans’ response was to start printing what they could no longer borrow. Aided by the European Central Bank – which loosened its collateral policy for refinancing credits and increased its tolerance for emergency liquidity assistance and credits under the Agreement on Net Financial Assets – they drew hundreds of billions of euros out of the monetary system through so-called Target overdrafts. And from 2010 onward, they were the recipients of EU fiscal rescue packages.
But, because financial markets viewed these rescue packages as insufficient, the ECB, in 2012, issued a promise to cover unlimited member-state government bonds under its “outright monetary transactions” program, turning them into de facto euro bonds. Finally, in 2015, the ECB launched its quantitative-easing program, whereby member states’ central banks bought €2.4 billion ($2.8 billion) worth of securities, including €2 billion of government bonds. Accordingly, the eurozone’s monetary base grew dramatically, from €1.2 trillion to over €3 trillion.
But, rather than using the extra money to lubricate their domestic economies, Southern European countries used it to carry out payment orders to Germany. They forced the Bundesbank to credit the purchase of goods, services, real estate, corporate shares, and even whole companies – or at least to credit the filling of bank accounts in Germany that would be readily available for asset purchase should the risk of a euro breakup arise. The purchases of goods and services are one of the reasons for Germany’s huge export surpluses.
By mid-2018, the net amount of payment orders to Germany through the Target system had risen to €976 billion. As a perpetual overdraft drawn from the Bundesbank, this money was not unlike the International Monetary Fund’s Special Drawing Rights, except that there is much more of it – a sum greater than all of the funds IMF countries are willing to loan to one another. Spain and Italy alone drew down about €400 and €500 billion, respectively.
Despite – or because of – this windfall, Southern European countries’ manufacturing sectors are still a long way from regaining competitiveness. In Portugal, for example, the output of the manufacturing sector is still 14% below what it was in the third quarter of 2007, after the first breakdown of the European interbank market. And for Italy, Greece, and Spain, that figure is 17%, 19%, and 21%, respectively. Meanwhile, youth unemployment is above 20% in Portugal, more than 30% in Spain and Italy, and almost 45% in Greece.
Now that we are entering the euro’s third decade, it is worth noting that Portugal, Spain, and Greece are all governed by radical socialists who have abandoned the concept of fiscal responsibility, which they call “austerity policy.” Worse still, Italy’s establishment parties have all been swept away. The country’s new populist government – comprising the Five Star Movement and Lega Nord – intends to increase the country’s debt substantially to pay for its proposed tax cuts and guaranteed-income scheme; and it might threaten to abandon the euro altogether if the EU refuses to play along.
In view of these facts, even the most committed euro enthusiast cannot honestly say that the single currency has been a success. Europe has quite plainly overextended itself. Unfortunately, the great sociologist Ralf Dahrendorf was right to conclude that, “The currency union is a grave error, a quixotic, reckless, and misguided goal, that will not unite but break up Europe.”
It is hard to see a clear path forward. Some argue for still more debt socialization and risk sharing at the European level. Others warn that this would push Europe into an even deeper quagmire of financial irresponsibility. The attendant capital-market distortion would cause severe economic damage, which Europe can scarcely afford, given its difficult global competitive position vis-à-vis an emerging China and an increasingly aggressive Russia and America. One way or another, the euro’s third decade will decide its fate.
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