The next steps for the Euro

The next steps for the Euro

There have been two meetings to in which Ed. has been involved, aimed to think about the Euro and its future. One was in Andalucia last November. Last weekend offered a reunion. The aim was to think about the fundamentals of a currency union, why this one was not working and what fixes or failure modes we might see. The mix was Eurocrat-bureaucrat-multinational banks, with a scattering of licensed fools. This note is not a memo of discussion, but rather a "thoughts arising" piece.

I am not going to rehearse routes into and out of the crisis. The Economist has published a sensible piece (May 26 2012) that asks whether there is an alternative to the three obvious outcomes: Euro breakup, a retreat to a Euro core - of course, run to common disciplines on the basis of common trust - or, the now-favoured model, the effective formation of a superstate. The Economist did not know the answer, and neither do I. We seem to have moved beyond the remit of well-meaning muddle, however, and simple notions of stimulus cannot possibly work in time to settle current issues. Policy must pick one of the above, or tumble into it at random.

There is a text written a year ago that explores the financial crisis and the role of the Euro in this. It is one of he most accessed texts on this web site. This link takes you directly to the Eurozone-relevant section of it.

Two things struck me about the tone of the event.

First, whilst everyone had, clearly, been thinking about this issue for a considerable period, nobody would admit to this in public. It was also pretty clear that there was no bureaucrat- or industry-wide consensus as to what the consequences of the exercise of any of these options would be. The breakdown of the Euro would be an econoic catastrophe - everyone agreed - but by what means, catastrophic to whom and to what degree was at all clear.

Ostrich city; except that they all had pretty clear views in private. The character of 2007 was that nobody trusted anyone else, and that there was no reason to suppose that the current situation was any different. Money had been laid off in so many ways that who held what risk was impossible to guess. But guess they most certainly had, and the "least favoured creditor" list was already in secret ring binders. That said, all said that admitting to even thinking about the issue was taboo anywhere near a Euro-politician, still more so across departmental boundaries and - naturally - with the public. I have to say that I felt this to be dereliction of duty.

This brings me to the second feeling that I got from the meeting. The Economist quotes a German banker as saying that this is a less an economic crisis than one of legitimacy. Pretty much everyone knows what would have to be done and spent to keep the Euro structure intact, or largely intact. The problem is that this would, first, eat into national sovereignty and second, involve the passage of very large sums to other nations, countries about which the average voter feels strictly limited empathy. Neither such program would have any chance of acceptance in the nations that are not desperate, and scant chance of long run acceptance in those who were receiving forced loans; or selling off their national assets.

This led to a consideration of values and goals. People repeatedly asked: "How could we have got ourselves here?" "What should we most try to save from the fire?" In other words, what did the leaders over the past fifty years think that they were trying to achieve, and how much of the achievement is gesture politics and how much is of real value? I had never before heard this discussed by more or less major players, and it may be worth repeating what I got from this.

Someone mentioned that this crisis was an example of what Schiller called 'the disenchantment of the world', meaning by the word "disenchantment", the eclipse of a moral universe of emotion and heroic aspiration by rationality and bureaucratisation. From aspiration, we had to decend now to the messy commonplace of economic and political utility. The European project had never been, they said, an "economic" one, or even a particularly rational one.

There was a useful presentation of the "psychological history" of the formation of the EU, from which the following are my jottings, fleshed out by Wikipedia!

How did we get here?

After WWII, even Winston Churchill spoke for a "United States of Europe". The driving aim of the union was to prevent another European war through new supra-national institutions. The economic value of integration was a secondary issue.

"Europe's first helmsmen deliberately eschewed populism - the tool of fascists and communists, in their eyes - in favour of dispassionate well-planned gradualism as a road to an ever-closer union that would banish war from the continent."
Economist article.

Not, of course, that this 'dispassionate analysis' was entirely rational: Monnet, in particular, was obsessed by the notion that all European wars started over the coal and iron in the Ruhr, and that these needed to be the centre of a binding pact to share resources. Consequently, as a resolution to the annexation of the Saar after WWII, the 1951 Treaty of Paris, set up the European Coal and Steel Community. This in turn formed the nucleus of what would be the European Economic Community, established in 1958. The EEC was very much a French creation. and very much an entity that was intended to project political and social goals, rather than to achieve economic ends. The Treaty of Rome in fact preceded the emergence of the customs union - the first purely economic step - in 1958.

The notion of the EEC as an primarily economic entity had to wait until much later. The Union had reacted to the rise of Japan chiefly by ignoring it, or building barriers against it. The 1980s were, however, a decade in which a great number of assumptions had to change: about the role of state and the market, about the organisation of commerce and the role of IT in this, and about the specific impact of IT on banking, asset trading and shareholder power. The 'mixed economy, capitalist model' was on a roll, and social collectivism was not. The nation state was, it seemed, to be less sovereign and to have policy increasingly mandated by the economic facts of life. If European values were to survive in this environment, European economic power needed to consolidate itself into a block.

This prescription was designed to meet a specific diagnosis - that by acting as a block, Europe could project its identity against those of the Soviets and the Japanese, to be sure, but chiefly against that of the US. This set up a tension, between the intensely economic focus of the US style - with its winners and losers, fast commercial churning and lack of sentiment about traditional identity and the past - and Europe, seen as primarily a set of values, supported as an afterthought by commerce.

The notion of a single currency had been mentioned very early in the European project. From the outset, the chief objection had been that this would require very considerable incursion by the EU institutions into hitherto sovereign issues. This simple fact was suppressed or ignored in what followed.

The Exchange Rate Mechanism, by which sovereign currencies were managed within bands, began to operate in 1979. Analysis of its effects are mixed, but many believe that it had the effect of not only of purging the 1970s "great inflation", but also substantially slowing the growth of its participants. Nevertheless, progress towards a common currency was presented as being both inevitable and desirable. Inevitable, because it was required by the "European project". Desirable, because it would - and here the rhetoric becomes circular - give the European project weight on the global stage. Specifically economic advantages were said to include - essentially be limited to - the removal of transaction costs. As these costs were to became tiny as banking integration grew, the rationale had evaporated long before the integration occurred.

Integration into the Euro was set for the turn of the millennium. However, both as more countries flagged their interest in joining, and as individual currencies were targetted by speculators, so the bands around the ERM were loosened in polite accommodation. The exchange rates were frozen in 1998, and the Euro launched in 1999. Europe's collective currency and monetary policy was vested on trust in a band of highly dissimilar nations, with a highly imperfect system of oversight and political integration. The economics of this were broadly to take care of themselves. Early years showed country after country flouting such agreements, with nothing being said by the remainder. Markets, enjoying the dot.com boom as a canape before the build up to 2007, tended to give the system the benefit of the doubt. After all, it had the Germans in it.

The global context of the Euro's formation

The sequence that has just been outlined has to be set against the world of the 1990s. The Soviets were gone, the market system was triumphant and even China was opening itself up to market reforms. The effective world labour force nearly doubled over the decade. That had two chief effects.

First, it took the pressure off supply side inflation, allowing considerable expansion in money supply, and of debt.
Second, it transferred a greater proportion of corporate profit to capital, rather than to labour. Working class incomes were largely real-terms static, although augmented by debt and by more effective appliances. The middle classes saw weakly rising real incomes, but experienced asset price inflation against which they could borrow. Meanwhilem the top few percent soaked up almost all incremental product in the Western economies. The dollar was the world's fiat currency, and the US could, in effect, print as much of it as it wished.

This was a markedly unpromising environment in which to launch a new currency, based on highly dissimilar participants, the credibility of any one of which relied upon a promise of discipline. Participation in the Euro made it very much easier for the weak economies to borrow, and borrowing - but no, investment - allowed the less capable to simulate growth and please their citizens.

Surely the Dollar went through the same process?

In a world of economic sense, one would ask: In what way does a common currency aid a customs union? The answers are many, but they are all individually small and collectively unconvincing.

The analogy with the US Dollar is often advanced, but it is deeply misleading. As a gold-backed currency, the Dollar replaced the individual monies of the English colonies, doing so as an act of necessity. (The alternative had been to use the Mexican Peso, which would have changed history somewhat!) The value of the Dollar wandered about in real terms from its founding 1774 value, halving in the 1860s, reacquiring parity in 1900, sagging to 3% of its original purchasing power by 2010. Above all, save during the civil war, the Dollar has a firm central hand applied to it. Individual states could not print money - although there were many unofficial, local currencies in play even in the mid Twentieth century - and, save for various gaps, the currency was tied to gold until Nixon abandoned this in 1971. (After which, the purchasing power of the dollar fell by a factor of seven up to the present, certainly contributing to subsequent asset price inflation.)

The impact on individual states was very varied. States with low productivity lost their best people to more prosperous ones, which also attracted knowledge intensive projects. Weak states tended to attract primary production, due to their low labour costs.

The Dollar was not, therefore, created for vague reasons but out of necessity. It was managed centrally, and was tied to an objective standard. It took at least a hundred years to achieve solid status. Its importance on the world stage was based on the scale of the US economy, and whatever political power the US asserted globally came from the same economic strength, and not primarily or even largely from there being a common currency used between its states.

Now what?

There is no need to rehearse the current mess. Highly dissimilar horses have been harnessed to a cart with no driver. Whatever component of the Euro that remains a decade from now will necessarily be driven by a central authority, with powers over national monetary and fiscal policies. This has been noted - at last - by political leaders:

On May 25 2012, EU leaders asked the President of the Council, Herman Van Rompuy, to draft a plan to achieve this, clearly through a new treaty. He is reported to have said that "Our discussion also demonstrated that we need to take the economic and monetary union to a new stage. There was a general consensus that we need to strengthen the economic union to make it commensurate with the monetary union."

The meeting felt that there were three likely outcomes.

One was a core, formed chiefly by those prepared and able to subscribe to this new accord. Which countries would be in this very much depended on whether the accord spoke to management standards, or concrete numbers and ratios. Few of the afflicted countries could enter in if the accord set up concrete thresholds. Outside of the core could be an ERM-like structure for the willing, and a return to sovereign currencies for nations such as Greece.
The second outcome was a complete return to the ERM, the temporary abandonment of the Euro and its reformation under clearer structures of management and meaningful parity. Everyone thought that was how the project should have been conducted in the run up to 1999. Nobody though that this would happen now: too much prestige would be involved, nobody wanted this as their political epitaph, the Euro would never be trusted again.
The third outcome was closer to what Angela Merkel is supposed to be suggesting: an almost colonial structure whereby the problematic nations were taken into care. Their assets would be privatised, their institutions of government reformed and their populations re-educated. When stated bluntly, this sounded "too Soviet" to be credible. That East Germany required such treatment has, perhaps, influenced German thinking over-much. As someone remarked, "The Osties were used to be told what to do, and were just too happy to be out in the sun again. Now we are trying the same treatment on people who are separate nations, and where we are asking them to suffer for the good of something that they think caused contributed heavily to the problem, the Euro."

We had a show of hands on these, first on desirability, second on practicality, third on probability. The results looked roughly like this:

	Core countries	Return to ERM	Command and control
Desirability	60	30	10
Practicality	80	15	5
Probability	50	5	45

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Comment 1

I wish that I had been there. So does my government.

Our analysis of the Euro situation has the same roots as yours, but what we see as the problem is that they - EU leaders and wonks - know the "hows", but they don't know - cannot articulate - the "whys". All of the options that you give up there are about "how" you do something, but a something that nobody is able to articulate - except to say that the Euro is a great achievement. It it must be protected at the cost of however many billions and whatever risk to the economic outlook. What you show is that this isn't an oversight. It is a conscious policy to advance the Project, and the Euro is not something very useful in itself, it's a part of the Project. To go back on the Euro is to lessen the Project.

And what is this Project, really? It seems anachronistic, in many ways. Your first text talked about finding the right size to govern in ways that bring in the people and their opinions and knowledge. That size is definitely getting smaller, not bigger. So that can't be the primary thrust. Neither is not having European wars. So it is something about projecting European "culture"?

Well, what is that and how much is it worth? Italian restaurants do a better job with European culture than the EU. Is this just a French desire to stick their finger up the nose of the US? I doubt if the US gives France two moments thought, except when choosing its wine. How many billions is pushing European culture out really worth? It's not as though the US or someone is trying to erase it. Yes, US makes lots of movies, and it sells a lot of fast food in French town. So why is "French culture" not selling on US high streets? Bratwurst and pilsner on Madison Avenue? The answer is that it already is.

India Day Parade on Madison Avenue, by Amitava Kumar

You've cast your dupatta aside and come out
wearing an ivory-hued kameez with the tiniest
mirrors that make your shape look thirsty like water.
The parade is not going to pass for another hour.
Passing my finger down the pale brown line in the middle,
in a South Indian restaurant two blocks away,
I pretend to read your palm.
The restaurant owner has stuck a sign "Giuliani for Mayor"
beside his ornate blue clay cow.
You wait here with a Hindu
communist for the India Day parade.

Comment 2

Eurosceptic English people do not understand. It is not about any old-fashioned format, like a federation or a state. It is about a community of people who feel the same about the world. It is pretty easy to sit on an island and talk American, and not to see that this is so.

But look, the thing now is that if we let it fail, it is really dangerous. If we keep it together, or mostly together, we know we may have a bad time for a while, but we will not have the really dreadful things.

Comment 3

I like the poem, Comment 1. I but I also have to say that maybe it is a bit more than cooking, though. It is not my intention to be rude about the US. Great country with a great spirit - but it needs a balancing force that it can respect. That's not in cooking - though my God!, have you tried US coffee? - but in foreign affairs. There is an absolutism to the US which needs a quiet voice asking of you have really tried talking? I agree that this is not a justification for throwing huge sums at the Euro. I also agree that the EU has put very little priority in this area. Please understand, though, that most of us who like the Union feel that we need this voice in the world. To get the voice, we need the weight that comes from economic strength.

Comment 4

I am a "Euro" sceptic, but not a "Eurosceptic." The concept of an customs union, with strong political ties and with the legislation that is needed to tie all of that together seems, to me, to be perfectly sensible. It also seems a stable end point to the current difficulties. Political union - across languages, for no clear benefits - will come generations into the future, if it comes at all. It seems to run against the tide of history, which is to smaller aggregates and to the specialisation, agility and democratic legitimacy that they bring.

Well, fine, you say: but when will we know which way it is going? I suggest that the fulcrum point may be seen at the end of June 2012.

At the end of June, will have results of the Greek elections. In the same week, Spain is to publish an independent assessment of the balance sheets of its banks. This is certain to find that they need of significant recapitalization. The small, regional Caja banks, which were forcibly merged into the big retail banks, were spectacularly bankrupt. The government cannot finance this requirement, foreign investors will not do so and the ECB does not have the scale to buy the debt. So it is Germans or nobody, with the political problems inherent in the purchase of the entire Spanish banking system by Germany. And, for the Germans, there is the indelicate thought of their taxpayers being exposed to all future Spanish losses and crises.

We all understand the Greek situation. How did Spain get to this extreme? There was a classical property bubble. There had been a decade of inflation above the EU average. Wages rose 30% in real terms, to greatly weaken Spanish competitiveness. The consequent current account and fiscal deficit led to unprecedented external debt. The Euro - as elsewhere - appeared to offer foreign lenders a guarantee that was based on the wealth of the other Eurozone countries.

The Euro has made distortion extremely easy to set up. The rigidity that comes from being pinned to the Eurozone does, however, make it extremely hard to unwind it. If the Eurozone were to be able to press a rest button, it would take a decade, at least, to come into effect. Meanwhile, uncertainty as to roles and goals - let alone outcomes - would continue.

There are four or five countries for which the Eurozone is not a credible economic framework. If one of them drops out, the rest will probably also go. No-one wants to go first, much as no individual penguin wants to be the first in the water, testing for sea lions. Once one has gone, however, and if the waters remain unbloodied, then the rest may well follow. This will leave the richer Eurozone countries with a great deal of bad debt to handle, whatever the surface camouflage. But, and here is the important point, although this gives a year or two of pain, it settles the matter. Investors will know where they are. The logic of Europe will have been made clear, and companies will feel free to invest their huge reserves.