The Tragedy of the Euro

Italy, Spain, Belgium and Portugal will need to raise over $800 billion in 2011 to cover roll-over debt and new borrowing. It is unclear if the eurozone will withstand the pressure of bond markets or break apart. Why is the eurozone in such a situation and why was the euro in its current institutional setup doomed to fail from the beginning?

In order to understand the common currency and its tragic consequences, one must approach it in a twofold way: politically and economically.

There exist two opposed political visions for Europe: the classical liberal and the socialist one. The classical liberal vision has traditionally been supported by Great Britain, Germany and the Netherlands. The socialist vision for Europe has been supported by a French-led coalition. Classical liberals support a Europe of free borders. Socialists are in favour of a centralised European state, that harmonises legislation and tax rates. While the beginning of European integration was influenced strongly by the classical liberal approach, nowadays the socialist vision prevails.

In this sense, the euro is also a political project. Politicians interested in the centralisation of the EU and the disempowerment of the German Bundesbank pushed for the euro. The Bundesbank had disciplined European monetary policies for decades. Central banks that did not follow the Bundesbank´s conservative monetary policy had to follow the embarrassing path of devaluation.

Thus, the Bundesbank, called the German ‘atomic bomb’, was hated by European politicians. When the Berlin Wall fell in 1989, these politicians used the unique historical situation to push for the common currency. Great Britain, fortunately, did not participate.

From the very beginning, the euro was a political project towards more political integration in Europe. Politicians made the euro a symbol of European unity. A failure of the euro would be a failure of the socialist vision for Europe with a strong centralised state in Brussels.

Indeed, the Maastricht Treaty does not provide for the possibility to exit the eurozone. The euro is made for eternity. Thus, market participants expected that politicians would do anything they could to save the euro. They assumed that fiscally stronger states would support weaker governments in a crisis.

As a consequence interest rates in peripheral countries such as Ireland or Spain dropped towards German levels, when it became clear that these countries would participate in the monetary union. Germany implicitly guaranteed the debts of the future euro area countries.

The rapid fall of interest rates in peripheral countries raised capital values, especially house prices. As house prices soared, a housing boom developed. Credit expansion in the eurozone concentrated on the periphery and financed construction projects and long-term consumption goods such as cars. 

The main economic problem of the eurosystem is how it entails monetary redistribution, which I discuss in detail in my new book,  The Tragedy of the Euro. Governments can finance their expenditures by printing government bonds. Banks buy a large amount of these bonds and use them as collateral for loans granted by the ESCB (European System of Central Banks).

In other words, the ESCB creates new money in form of loans to banks when banks pledge government bonds as collateral. In this way governments monetise their debts. Governments receive new money and spend it. The new money spreads through the whole monetary union and bids up prices. It might be thought that national governments, by financing their deficits by selling bonds rather than through national banking systems, avoided the temptation to monetise their debts. However, the monetisation is coming through the back door via the relationship between the European Central Bank and the banking system.

The result is a monetary redistribution. Governments that have higher deficits than others benefit at the expense of all money users in the eurozone. This creates incentives towards ever higher deficits and debts. The Stability and Growth Pact (SGP) was intended to curb these perverse incentives by limiting government deficits to 3% of GDP. However, the SGP was never enforced. The main problem is that governments decide themselves if sanctions are applied or not. The SGP was, consequently, a monumental failure.

The eurosystem is a tragedy of the commons. Several independent and sovereign governments can use the (central) banking system in Europe to finance their deficits, pushing up prices throughout the union. The consequences are sovereign debt crises and the possibility of financing a permanent lack of competitiveness in particular countries.

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