Survival Isn't Guaranteed

Hans-Werner Sinn
The Wall Street Journal online, 10.03.2011

In my opinion the euro should survive. Though its members are too many and too disparate, the monetary union must be maintained, largely with its current number of states, for the benefit of political stability. The euro also offers measurable economic benefits, among them substantial reductions in transaction costs and exchange risks, which are prerequisites for exploiting the benefits of free trade.

Whether the euro will survive is another matter. This very much depends on whether European countries implement political and private debt constraints that effectively limit capital flows. The trade imbalances from which the euro zone is currently suffering have resulted from excessive capital flows brought about by interest-rate convergence and the apparent elimination of investment risks after the currency conversion was announced some 15 years ago. While huge capital exports brought a slump to Germany, the countries at the euro zone's southern and western peripheries overheated, with the bust and boom resulting in current-account surpluses and deficits respectively.

Automatic sanctions for excessive public borrowing, and a reform of the Basel system that forces banks to hold equity capital if they invest in government bonds, are among the political constraints necessary for the euro to survive. But much more important are private constraints.

After years of negligence, private markets have recently started to impose more rigid debt constraints on overheated euro economies. So the brakes kicked in eventually, but much too abruptly, triggering Europe's sovereign debt crisis. What Europe needs is a crisis mechanism that is able to activate markets earlier and allow for a fine-tuning of the brakes they impose on capital flows; in sum, a crisis mechanism that helps to prevent a crisis in the first place and mitigates it when it occurs.

Such a system has recently been proposed by the European Economic Advisory Group at the Center for Economic Studies and the Ifo Institute for Economic Research (CESifo). The plan's essential feature is a three-stage rescue mechanism that distinguishes between a liquidity crisis, impending insolvency, and full insolvency, and offers specific measures in each of these stages. The system places the most emphasis on a piecemeal debt-conversion procedure that contemplates haircuts in the second of these stages, which could help to avoid full insolvency by acting as an early warning signal for investors and debtors alike.

The system would allow Germany to gradually appreciate in real terms by living through a boom that generates higher wages and prices and thus reduces the country's competitiveness, while cooling down the overheated economies of the south such that the resulting wage and price moderation would improve their competitiveness. European trade imbalances would gradually reduce.

If Europe, on the other hand, moves to a system of community bonds, where national debts are jointly guaranteed by all countries, then excessive capital flows would persist, and so would trade imbalances. The countries at Europe's southern and western peripheries would abstain from necessary real depreciation, and Germany would not appreciate, with the result that trade imbalances would continue with ever-increasing foreign debt and asset positions respectively. In the end, Germans would own half of Europe. I do not dare to imagine the political tensions that would bring about. The death of the euro would be the least of our worries.

Mr. Sinn is president of Germany's Ifo Institute for Economic Research and the CESifo Group.