Failed euro experiment dealing a fatal blow to hopes of economic integration
Only a stable, functioning banking union with centralised oversight can save the eurozone, writes Colm McCarthy
Published 23/03/2014 | 02:30
Eleven European countries abolished their national currencies in 1999 and adopted the euro. Abolishing the national currency is a big decision, much bigger than fixing your exchange rate against other currencies. If that goes wrong, you can always change it. If you no longer have a currency and get into trouble, it is virtually impossible, as a practical matter, to introduce a fresh one from scratch. Scrapping national currencies has turned out to be an irreversible decision. Two-thirds of the EU's population of just over 500 million live in eurozone countries. If the euro turns out to have been a macro policy mistake, it will go down as one of the biggest ever made.
The number of people who live in the 18 eurozone members is roughly the same as the number of dollar-using citizens of the USA. The US citizens have got the better deal. They live in a well-designed and fully-functioning monetary union whose boundaries coincide with those of a long-established single federal state. Their eurozone counterparts live in a common currency area whose boundaries do not even coincide with those of the European Union, which is in any event not a single state. A US-style monetary union is a more stable construct than a common currency area. The big difference is that a monetary union is protected by design from the risk of break-up, particularly through a unified system of bank supervision and resolution. A common currency area, designed and managed with sufficient carelessness, is just a bunch of countries using the same currency but without common banking and financial policies and permanently vulnerable to financial disintegration. Both Greece and Cyprus almost fell overboard.
It is sometimes argued that you cannot really have a durable monetary union without political union, in which case the 1999 decision was, to say the least, a little premature. But most economists agree that a common currency area can be converted into a durable monetary union without going as far as full political integration. This is just as well, since European political union is hardly about to happen. But numerous eurozone countries are now stuck in the dysfunctional common currency with no viable escape hatch. Had they understood the risks, they might have chosen to stay out, but there is no practical exit option.
Accordingly, it is a political imperative, if the European integration project is to stay on track, that the ill-designed and mismanaged common currency area gets fixed. This has been understood at European political level since about the summer of 2010. Prior to that point, it was routinely and ludicrously asserted that the eurozone's problems had arisen from the fiddling of public finance accounts in Greece, a state amounting to one-fiftieth of the eurozone economy, or to the failure of banks in the USA, or to the belated downgrades of dodgy sovereign debt by rating agencies. In the years since, more serious efforts have been made to think through what new features and systems should be put in place, particularly a banking union, in order to rescue the common currency project.
A compromise deal on resolving failed banks was reached in Brussels at 7am last Thursday after a 16-hour meeting. The deal is another disappointment. It lacks provisions adequate to sever the doom-loop between bust sovereigns and bust banks. This means that the eurozone countries have still not agreed to turn their common currency area into a monetary union. The essential weakness of a common currency is that the members have sacrificed the ability to create domestic credit when faced with a sudden outflow of capital and the incapacity to borrow. Any country which possesses a currency can create liquidity through its central bank, but once the currency has been abolished this is no longer possible. Thus the banks, the government, or both, can go illiquid, meaning financial collapse. A proper monetary union must have centralised and automatic arrangements for the provision of liquidity in these circumstances.
The eurozone, with help from the International Monetary Fund, has come up with measures which have temporarily plugged the gaps in bank and government liquidity. Reluctantly the IMF has found itself lending enormous sums to governments in the world's richest region, not because this region was unable to finance itself but because it could not agree politically on how this should be done.
No European currency could survive if every government and every central bank was free to create euro at will. So there had to be rules about excessive government borrowing. There were rules, and the first to break them (only by a little in fairness) was not Greece but France and Germany, so the rules got changed. There are new, and better, rules now about public finances. But banking systems which import funds too freely and lend on foolishly can screw things up too, and there were essentially no rules. No centralised bank supervision, no centralised system for dealing with bust banks, and no insurance for retail deposits. The latter is a central feature of the US monetary union. The city of Detroit went bust recently, but there was no run on banks in Detroit, since neither the city nor the state of Michigan is expected to provide unlimited free insurance on bank liabilities. A monetary union, to be stable in the long term, needs a banking union, that is, a centralised system of oversight for banks designed to minimise the risk of bank failures and to resolve them without bankrupting member states whenever they occur.
There has been limited progress towards a better bank supervision system but agreement only on a flawed system of bank resolution and none at all on centralised insurance for retail deposits. Destabilising capital outflows from some eurozone countries are bound to happen again at some stage, and the only mechanism certain to swing into action is a late-night meeting of tired officials and politicians in Brussels. Thursday's compromise on bank resolution means that a decision to close a bust bank would require the assent of over 100 central bankers, politicians and other officials. The common fund created to deal with bank resolution risks is far too small to handle a serious failure. Six years into the crisis, when the flaws in the eurozone architecture are clear to all, this can only mean that the political will to create a proper monetary union is still absent. The ECB president, Mario Draghi, will be expected to resolve the next crisis with some magic solution inside this inadequate architecture.
It is remarkable that the design flaws in the eurozone were permitted to arise in the first instance and entirely untrue that nobody foresaw what might go wrong. The Belgian economist Paul de Grauwe, for example, predicted in 1998 something uncannily close to what happened through the banking excesses in Ireland and Spain and warned that the eurozone was not designed to prevent them, or to deal with the fallout. His concerns were published not in some obscure economics journal but in the op-ed pages of the Financial Times. There were several other economists, mainly British and American, who also drew attention to the risks inherent in the common currency design, and were dismissed as practitioners of 'Anglo-Saxon' economics for their pains.
Since the measures needed to create a proper monetary union have not been taken, the broader European project remains in serious trouble. Things could stay calm in financial markets for quite a while (they were deceptively calm from 1999 until around mid-2007) but there is nothing surer than that the eurozone architecture will be tested again at some stage. If the test is in a large country, the architecture will fail, since it has not been fixed. The prestige of the European Union, both in world affairs but also in the esteem of European voters, has been severely damaged by the ill-begotten common currency experiment. For countries like Ireland, there is nothing that can be done to spur political leaders in France and Germany to admit the design flaws and to address seriously the task of creating a durable monetary union. If the worst comes to the worst, there will always be options for Ireland provided the tasks of economic reform are attended to. But for the dream of economic and political integration in Europe, the failed common currency experiment is doing damage that could prove fatal.