Saturday, April 19, 2014
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Making the Euro Whole

NEW YORK – The architects of the euro knew that it was incomplete when they designed it. The euro had a common central bank but no common treasury. This was unavoidable, because the Maastricht Treaty was meant to bring about a monetary union without a political union.

European authorities were confident, however, that if and when the euro ran into a crisis, they would be able to overcome it. After all, that is how the European Union was created, taking one step at a time, knowing full well that additional steps would be required.

With hindsight, one can identify other deficiencies in the euro of which its architects were unaware. The euro was supposed to bring about economic convergence, but it produced divergences instead, because its architects did not realize that imbalances may emerge not only in the public sector, but in the private sector as well.

After the euro came into force, commercial banks could refinance their holdings of government bonds at the discount window of the European Central Bank, and regulators treated government bonds as riskless. This caused interest-rate differentials between various countries to shrink, which generated real-estate booms in the weaker economies and reduced their competitiveness.

At the same time, Germany, suffering from the after-effects of reunification, had to tighten its belt. Trade unions agreed to concessions on wages and working conditions in exchange for job security. That is how the divergences emerged. Yet the banks continued to load up on the government bonds of the weaker countries in order to benefit from the minuscule interest-rate differentials that still remained.

The consequences of the lack of a common treasury first became apparent after the bankruptcy of Lehman Brothers in 2008, when governments, in order to prevent financial markets from collapsing, had to guarantee that no other systemically important financial institution would be allowed to fail. At that time, Angela Merkel rejected a Europe-wide guarantee, insisting that each country should guarantee its own institutions. Interestingly, interest-rate differentials widened only in 2010, when the newly elected Greek government announced that the previous government had vastly understated the true fiscal deficit.

That was the start of the euro crisis. The lack of a common treasury is now in the process of being remedied, first by a rescue package for Greece, then by creating a temporary emergency facility, and – the financial authorities being a little bit pregnant – eventually by establishing some permanent institution.

Unfortunately, it is equally certain that the new arrangements will also be flawed. Besides the lack of a common treasury, the euro suffers from other shortcomings, which the authorities do not seem to have fully understood. This complicates matters enormously. The authorities are confronted by not only a currency crisis, but also a banking crisis and a crisis in macroeconomic theory.

The authorities are committing at least two mistakes. One is that the bondholders of insolvent banks are being protected at the expense of taxpayers for fear of provoking a financial crisis. This is politically unacceptable. The Irish government elected next spring is bound to repudiate the current arrangements. Markets recognize this, which is why the Irish rescue brought no relief.

Second, high interest rates charged on rescue packages make it impossible for weaker countries to improve their competitiveness vis-à-vis stronger ones. Divergences will continue to widen, and weaker countries will continue to weaken indefinitely. Mutual resentment between creditors and debtors is liable to grow, and there is a real danger that the euro may destroy the EU’s political and social cohesion.

Both mistakes can be corrected. With regard to the first, emergency funds ought to be used to recapitalize the banking systems, as well as to provide loans to sovereign states. The former would be a more efficient use of funds than the latter. Properly capitalizing the banking system would leave countries with smaller deficits, enabling them to regain access to capital markets sooner.

It is better to inject equity into the banks now rather than later, and it is better to do it on a Europe-wide basis than leave each country to act on its own. This would create a European regulatory regime. Europe-wide regulation of banks encroaches on national sovereignty less than European control over fiscal policy. And European control over banks is less amenable to political abuse than national control.

With regard to the second problem, the interest rate on rescue packages should be reduced to the rate at which the EU itself can borrow on the market. This would have the advantage of developing an active Eurobond market.

These two structural changes may not be sufficient to provide the eurozone countries in need of rescue an escape route from their predicament. Additional measures, such as “haircuts” for holders of sovereign debt, may be needed. Having been properly recapitalized, banks could absorb this, and two obvious mistakes that condemn the EU to a bleak future would be remedied.

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