Tuesday 22 May 2012

Euro: Denial or delusion?

By Jonathan Eyal, The Straits Times, 21 May 2012

EUROPE is rapidly approaching one of the most critical decisions in its post-war history.

It can either offer an unlimited amount of cash to failed states such as Greece thereby unleashing high inflation, or it can start ejecting some countries from the euro, and risk the collapse of the continent's single currency.

European leaders still like to pretend that the current crisis is temporary and containable. In fact, the real problem lies with a euro project which was always misconceived.

And, as secret diplomatic documents recently made public indicate, the warning signs were there from the start. The history of the euro is a copybook case on how not to construct policy.

It is by now largely forgotten that, when the idea of creating one currency for Europe was first mooted over two decades ago, leading economists reacted with astonishment.

In a memorable article published in 1992, Professor Martin Feldstein from Harvard University predicted - with astonishing accuracy - that a euro without a single government or a single national budget was bound to fail.

But as Prof Feldstein and all his colleagues soon found out, Europe's leaders were simply not interested in their views.

For the impetus that led to the continent's monetary union was politics at its most basic: raw emotions. In essence, the euro was the result of a deal under which a newly reunified Germany gave up its own currency in order to reassure the rest of Europe that it had no intention of becoming the dominant power.

It was a deal hatched between French President Francois Mitterrand, born during World War I and obsessed with the tragedies of World War II, and German Chancellor Helmut Kohl who believed that his own German people are part-nation and part-incurable disease - people who must have their hands tied behind their backs, for otherwise they would unleash another war.

Both leaders knew that the euro amounted to the riskiest project the European Union had ever undertaken, as well as being the most audacious currency innovation since the establishment of the US dollar in 1792.

But, then, so were the anticipated political rewards: a common currency resulting in a true European union.

And the parallels with the greenback made the effort seem even more worthwhile: European politicians felt giddy at the idea that the euro could supplant the US dollar as a global reserve currency. Compared to such a grand vision, the question of whether the euro could actually work seemed trivial.

The historic context of the time when the euro was hatched is the only explanation as to why otherwise intelligent and educated people fell for such schemes.

For those were the heady days immediately after the end of the Cold War, the time when the West's political model appeared triumphant.

European leaders acted like they believed they could walk on water, that they could shape their destiny in any way they wished. Ironically, therefore, just when communism died in Eastern Europe, Western Europe embarked on its biggest Marxist exercise: that of creating a currency which defied all economic logic, on the assumption that politicians dictate markets, not the other way around.

Karl Marx would have approved.

The Maastricht Treaty which eventually led to the creation of the euro did contain some safeguards: the currency is run by a fiercely independent European Central Bank (ECB); countries which behave irresponsibly cannot expect to be bailed out; and penalties are to be applied on nations which exceed specific budget deficit criteria.

However, as John Maynard Keynes, the British economist now back in fashion, famously warned, 'treaties often solve one problem, but cause the next'.

And so it proved. The ECB's narrow mandate to ensure just price stability without any reference to problems such as unemployment or economic growth became part of the euro's problem.

So did many of the targets which euro zone governments were expected to meet.

The definition of price stability, as an increase of no more than 2 per cent yearly, is one example of targets gone mad.

No modern economy has ever achieved this consistently, over a long period of time. In the decade preceding the introduction of the euro, price inflation in the United States averaged 3.3 per cent, and in Germany it was 2.8 per cent.

So, a totally unaccountable institution like the ECB was tasked with the job of achieving the unachievable.

The same applied to the famed limit on budget deficits, which was set by treaties at 3 per cent of gross domestic product.

The figure was invented by President Mitterrand in France during the 1980s, and nobody ever explained why it was significant. Nevertheless, it became one of Europe's fetishes, and remains so to this day.

Paradoxically, therefore, while political leadership of the euro remained non-existent, it was the statistical straitjacket that proved too tight.

Still, the euro could have worked - had it been limited to a core number of member countries whose economies and government standards were roughly similar.

But, as the hitherto-secret German diplomatic documents that were published for the first time last week reveal, the decision was taken early on to admit almost everyone into the euro, regardless of their performance.

When Germany's finance ministry warned the country's leader in 1998 that the admission of Italy carried 'enormous risks', the response from Chancellor Kohl was dismissive. 'We all shared a certain love for Italy,' wrote his top adviser at that time.

The German magazine Der Spiegel, which had obtained those secret documents, calls the decision to admit everyone as 'Operation Self-Deceit'.

And for good reasons: it has rebounded on the Germans and may yet doom the euro altogether.

Southern European economies had been suffering from deep structural problems well before the introduction of the euro: Italy's governance was always faulty, Spain's unemployment rates were always higher, and Greece had been in default of its debts for nearly half of its modern history as an independent nation-state.

Yet all were admitted into the euro in the hope that the new currency would persuade them to change centuries of old bad habits.

None of that happened. The abundance of credit allowed everyone to avoid making structural reforms. And, because interest rates were roughly the same across the continent, nobody noticed that some countries were sinking.

The result was that, by the time the crisis struck, Greece was already beyond salvation, while Italy remains too big to save.

The euro may survive, even if - as it now seems increasingly likely - Greece is evicted from the currency zone.

But whatever happens, the original objectives of this enterprise already lie in ruins. The euro has failed to create a European government, and doing so now will be even more difficult.

The currency has not transformed Europe into a superpower, and it has not generated prosperity. The euro failed even in the most basic of its objectives: equalising economic disparities across the continent.

And Germany is still expected to call the shots, precisely what the Germans did not want. Seldom before has there been such a comprehensive failure.

But that's what happens when an abstract idea is pushed forward by a small group of leaders obsessed with exorcising the ghosts of history, rather than with handling the present realities.

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