The entire world worries about the state and future of the “Euro.”
America’s common man on the streets can be heard sniping, “See, Europe’s social-welfare system bankrupt it… socialist fools.”
Even billionaire investor Warren Buffett said Europe’s debt crisis had shown up a “major flaw” in the 17-member euro zone system and it would take more than words to fix it. “There is a major flaw in the euro system… I do know the system as presently designed has a major flaw and that flaw won’t be corrected just by words.”
Of the two comments and sentiments, Buffett is correct.
Europeans think it is all quite unfair. They point out that, in sum, the eurozone is in no worse an economic position than the US: 1) its public finances are in better shape than the US, and 2) its overall level of private sector debt is actually lower.
Yet for the past two years, financial markets have beat up the eurozone with increasing brutality. While the cited facts may be correct, European leaders and citizens would be better served reflecting on why the eurozone faces crisis while the US does not: the two are very different monetary unions.
First off, the eurozone is a much more decentralized monetary union than the US.
The eurozone has no federal budget to speak of. The EU budget, is minuscule by comparison (at just 1 per cent of GDP) and cannot go into deficit. Transfer payments are paid out of the EU budget, and these are not welfare-related but, rather, farm subsidies. The problem is that the euro is a currency shared by fiscally independent countries, much like American conservatives would prefer to see in the US – deficit-financing, debt issuance, welfare payments, bank deposit protection, and so on.. issues at federal level… taking place at state level, or national level in the eurozone.
Sitting atop the eurozone’s fiscally decentralized structure is a central bank (the ECB) which — as really just a successor to the former Deutsche Bundesbank (German Federal Bank) — is a more cautious institution than the US Federal Reserve, with a narrower interpretation of its function, resulting in it being more inflation-averse than the US Fed and more reluctant to implement “monetary financing” (acting as a lender of last resort to governments). In the current extreme situation, the ECB has implemented limited government bond purchase programs, but it has done so with aversion at meaningless levels.
Thus, second off, the US is a full-fledged federation with a relatively flexible central bank… while the eurozone is a fiscally decentralized confederation with a conservative and limited purpose central bank.
These differences are critical to understanding why the eurozone is the focus of market turmoil and the US is not. The eurozone’s constituents interact very differently with each other than do those of the US: Germany does not stand in relation to Spain the way that New York does to North Carolina, or eurozone countries in relation to the ECB the way that US states do to the Fed.
The structure of the eurozone creates a whole host of problems that do not arise in a full-fledged federation such as the US. Consider three problems:
First, because they do not monopolize control of the currency in which they issue their debt, some countries are treated as if they issued sovereign debt in a foreign currency — witness Spain paying 5 percentage points more than the UK to issue 10-year debt, even though its public finances are in no worse shape.
Second, unlike the US, the eurozone lacks a joint fiscal backstop to the banking sector — thus plunging Ireland into a sovereign debt crisis, while the U.S. State of Delaware (where AIG is incorporated) was not.
Third, banks and individual states interact differently: in the US, confidence in banks is not affected by the fiscal position of the state in which they are incorporated, but in the eurozone it is thus.
The eurozone’s structure, therefore, makes it a more fragile monetary union than the US.
As a fiscally decentralized monetary union, the euro zone is vulnerable to ‘death spirals’ in some of its member countries, driven by negative feed-back loops in which concerns about bank and sovereign solvency feed on and amplify each other. So far, eurozone policy-makers have done nothing to repair the inadequate structure that gives rise to these deadly spirals. Instead, Germany has led an effort to preserve the feeble structure while making it more rigid and less accommodating.
The eurozone remains a fiscally decentralized currency bloc, with a Germanic central bank. The only change implemented — and driven by Germany — is that member-states are now subject to tighter (and more pro-cyclical) fiscal rules. More instability and crashing economies is this arrangement’s future.
The Germans — willfully — do not accept that the eurozone is institutionally flawed. Germany argues that the cause of the crisis is primarily behavioral, not institutional. The road to salvation, from the German perspective, is not to deepen integration by establishing a common bank deposit protection scheme or issuing debt jointly (thereby increasing moral hazard [oh my!]). No, the German-imposed road to salvation is to deepen integration by imposing puritan fiscal rules to stop errant conduct.
Ever since the crisis broke out, the German mantra has all been about fiscal consolidation and structural reforms, undergirded by their assumption that the eurozone will be fine — thank you, very much — if it will turn itself economically into a larger version of Germany: countries that consolidate their public finances and reform their economies will end up with low German borrowing costs.
German citizens feel like they have made very real sacrifices for the euro over the years (for the past decade, German workers’ wages have barely increased in real terms). Plus, their feelings of being slighted are supported by clear evidence of corruption and poor decision-making elsewhere: Greece certainly mismanaged its public finances and Europe’s Mediterranean countries did too little to reform their economies. Nonetheless, what the German narrative failed to address is why the eurozone has proven so much less stable than the US, even though some of its underlying problems are no worse.
Rather than a vote of confidence in the German economy, the significant disparity in government bond yields inside the eurozone represents a loss of confidence in the eurozone structure, itself. Perhaps financial markets now understand that… the euro is a post-national/federal currency shared by resistant countries that remain attached to an outdated fiscal sovereignty.
The problem, in other words, is not financial, but political.
The eurozone does not need financial assistance from China, the IMF, United States, or anyone else. Rather, Europe needs its leaders to pool their fiscal resources together into a federal reserve and treasury. Whether citizens will provide permission and momentum to their elected representatives for such an endeavor is also whether or not Europe will grow into a modern, thriving economy able to perform on the world stage.
Perhaps success on this modernization will come from pressure within the European Commission and its impact on Germany. Chancellor Merkel clearly seeks to first implement German financial governance standards through an enforced fiscal unity before acquiescing to establishing a proper monetary union. The Eurozone member nations, however, may force the issue by seeking first to establish “Eurobonds,” in a first step to full monetary and fiscal union . A proper activist “Fed” [ECB] and federalized euro zone “Treasury Department” would next be required… Alexander Hamilton would approve.
This week, the European Commission is set to make its clearest demand yet that Merkel agree to the creation of such eurobonds. According to media reports, European Commission President Jose Manuel Barroso plans on Wednesday to present three different options for issuing such bonds, backed by the euro zone as a whole instead of by individual members of the common currency area. Doing so — according to the European Commission report — would “stabilize the euro zone, make the financial sector more robust and would make the refinancing of state debt cheaper.”
Long-term, the viable solution is for all government bond issues in the euro zone to be replaced by euro bonds. Credit risk would be pooled, meaning that all currency union members would guarantee the debt of all the others.
Such a model would require significant changes to the Lisbon Treaty because of the treaty’s prohibition of one member state bailing out another.
Treaty change should begin immediately, with all national political heads aligning with the change or removing themselves or their nation from the process and the euro zone.