Politics keeping the euro alive

Political rather than economic realities will determine the fate of the EU's common currency

By Jonathan Eyal, The Straits Times, 6 Jan 2014

PUNDITS - including, occasionally, this author - have an annoying habit of boasting about any of their predictions which turn out to be correct, but simply ignore those which prove to be wide off the mark.

That's precisely what happened with most of the financial experts trying to guess the fate of the euro. Some remained optimistic about the future of Europe's common currency, but the majority predicted that the euro would not survive the global financial crisis, that it would break up with an almighty bang.

Not only did this not happen, but the euro was also one of the best-performing currencies last year. And, far from shrinking in size as some predicted, the number of countries using the currency increased: Latvia, a small republic on northern Europe's Baltic shores, ditched its national bank- notes in favour of the euro at the start of this year.

How could armies of erudite academics, financial specialists and media commentators get it so spectacularly wrong? Largely because they failed to realise that the euro's biggest flaw - the fact that it is a currency driven by politics rather than economic realities - is ironically also the euro's most durable asset. The euro remains under threat but it is Europe's political map, rather than complicated indexes of sovereign debt and money supply, which will decide the currency's fate.

Those who invented the currency two decades ago were careful to speak the language of economic necessity. The euro, they claimed, would spur cross-border investments, encourage competition and make it easier to travel and work across frontiers. But the reality was that the euro was a largely political enterprise designed to prevent a reunified Germany from translating its economic might into continental domination by depriving all nation states of one of their most important instruments of statehood: their currency. As a result, the purely economic criteria for managing the euro were largely ignored.

The outcome is, by now, well known. European countries whose finances were in shambles for decades borrowed cheaply in euros until their debts became unsustainable and drove some of them to the brink of bankruptcy.

Failures of project

YET less familiar although equally important are the other failures of the euro project. It did not spur cross-European investment: European corporations switched their production lines to Asia instead. It did not prompt a boom in financial services: London, the British capital resolutely outside the euro zone, increased its domination in these fields. And because individual countries continued to apply their own separate taxes and trade regulations, the euro did not reduce retail prices either. Seldom has any project failed in so many of its stated objectives and in such a comprehensive manner.

Given all these considerations, the smartest course when the financial crisis struck would have been for nearly bankrupt countries such as Greece or Portugal to leave the euro zone. And, if they refused, the equally logical response would have been for a country like Germany - which ultimately bankrolls every European project - to kick them out.

But nothing of the kind happened. About ¤1 trillion (S$1.7 trillion) was lent by Germany and other rich EU countries to bail out their poorer cousins. And the bankrupt states implemented draconian austerity measures of the kind nations contemplate only in wartime. Greece's gross domestic product, for instance, cumulatively dropped by a quarter during the past four years, equivalent to about 15 average European economic recessions all rolled into one.

One explanation why so many Europeans tolerated this massive exercise in self-flagellation is that the act of joining the euro was similar to that of jumping into the deep end of a pool without knowing how to swim: The only options available are either to somehow paddle along, or to drown. The Greeks could have exited the euro, but only at the cost of pulverising the bank savings of their population. And the Germans could have refused to pay for the Greek bailout, but the result would have been a default among German banks holding bad Greek bonds.

Coin with identical sides

HOWEVER, the chief reason that countries were prepared to bear the pain of austerity was political: the fear that, once out of the euro zone, they would be ejected out of Europe altogether.

That fear may seem odd for the British who never wanted the currency, but not for those who actually faced the danger of losing the euro. If Greece had been evicted from the euro zone, it would have been destined to play second fiddle to Turkey, its perennial rival and far bigger neighbour. An Ireland out of the euro would have meant its return to the British economic sphere of influence which the Irish spent a century trying to escape from. Running away from an unhappy past is also the logic which prompted Latvia to join the euro zone now: It's the only way to avoid the clutches of Russia.

And the countries which bankrolled the bailouts had their own equally powerful political incentives to throw good money after bad. The disintegration of the currency would have confronted France with its biggest foreign policy defeat since World War II: It would have meant that all the French attempts to tie Germany in as many political knots as possible had failed. And for the Germans, the demise of the euro would have spelt the end of the country's post-war policies of anchoring their nation in a peaceful, prosperous Europe.

In short, precisely the political elements which prompted Europe's financial crisis also provided the glue which held the currency together. The euro resembles a coin with two identical sides, a currency doomed to prevail regardless of how one tosses it: Heads I lose, tails you win.

Given all this, does it mean that the possibility of the euro's demise is now completely discounted? The short-term omens are good. Ireland has already exited its bailout programme. Spain no longer needs cash. Speculators worldwide continue to be deterred by the warning from European Central Bank presidentMario Draghi to do "whatever it takes to preserve the euro". And German Chancellor Angela Merkel, only recently re-elected, continues to believe that "if the euro collapses, Europe collapses", so she will pay for any mishap.

Long-term prospects

STILL, the euro's long-term future remains murky, for Europe is sitting on a ticking economic and social time bomb which can explode at any moment. The EU's current approach - cutting deficits to lower debt and enacting "structural reforms" to generate growth - has not done much to either cut debt or change Europe's economic structure.

According to a recently published paper from US economists Kenneth Rogoff and Carmen Reinhart, Europe's "debt overhang" can be resolved only by either "restructuring", a polite term which means that those who lent EU governments the cash will not get back all their money, inflation which reduces the overall value of the debt, or what the authors term "financial repression", namely forcing banks to provide cheap cash to the economy.

Encouraging inflation is out of the question since the Germans won't hear of it. Forcing banks to cough up cash is not realistic either until there is a debt relief for households that owe huge amounts to the same banks. So, the only viable solution is the further restructuring of debts, something which European governments have sworn they will not consider. Either way, the dangerous work of straightening Europe's finances has barely begun; much more pain is in the offing, at least until the end of the decade.

Identity crisis

BUT the far bigger problem is that what began as a financial and banking crisis has now turned into a crisis of European identity, for the euro, which was meant to bring Europe closer together, is tearing the continent apart. Northern Europe is doing well; Germany is bristling with optimism. But southern Europe is a disaster area, where half of those aged under 25 have never earned a salary in their lives and countries turn into ghoulish theme parks. In the Portuguese city of Porto, an architectural jewel and the capital of the region producing the port sweet red wine, the chief attraction now is the "austerity tours" which take visitors around the city's 70,000 derelict houses.

Those who still find Europe an object of desire are either Ukrainians demanding to be let in or African illegal migrants who risk their lives crossing the Mediterranean Sea; in Europe itself, a record 60 per cent of respondents no longer trust the EU to handle any of their aspirations.

The euro won't die because Europe's economics are wrong; it will only when its politics go awry. That has not happened yet but it may happen this year, when elections for the EU Parliament could result in a rise of anti-European parties and a continent-wide backlash against austerity.

Which is one reason why many of those pundits who predicted the currency's demise are still not ready to admit they were wrong.

On Monday, The Straits Times' Europe correspondent Jonathan Eyal wrote a commentary in these pages, titled Politics Keeping The Euro Alive. Below, two analysts familiar with Europe respond to the commentary, with a rejoinder from Dr Eyal.

Keep faith with Europe's vision of economic, monetary union

By Tommy Koh And Yeo Lay Hwee, Published The Straits Times, 9 Jan 2014

WE WOULD like to comment on six points in Dr Jonathan Eyal's column.

First, Dr Eyal asserted that "the euro was largely a political enterprise designed to prevent a reunified Germany from translating its economic might into continental domination".

The vision of economic and monetary union was conceived during the Cold War, when there was zero prospect for German reunification. In 1969, when the six original members of the European Union (EU) met at The Hague, Netherlands, they decided to establish an economic and monetary union.

In the same year, the Prime Minister of Luxembourg, Mr Pierre Werner, was asked to submit a report on how to achieve the objective. The Werner Plan of 1970 contained the first road map for economic and monetary union. One of us had the pleasure of meeting Mr Werner, in Luxembourg, in the nearly 1990s.

It is certainly true, however, that the euro is part of the broader political enterprise of building a European Union of peace and prosperity. And it is this broader shared political vision that will drive the EU towards much needed reforms to realise a full economic and monetary union.

Second, Dr Eyal stated that "the purely economic criteria for managing the euro were largely ignored".

The architects of the euro were determined that the new currency should be as strong and credible as the Deutsche mark. The Maastricht Treaty prescribed very strict criteria for admission to the euro zone, namely: low inflation; sound public finances and monetary conditions; and sustainable balance of payments. All the applicants had to comply with these criteria before they were admitted to the euro zone. Greece inflated its numbers in order to qualify. If it had not done so, it would not have qualified.

The problem occurred after the euro had been successfully launched. Fiscal discipline was not observed. One of the agreements was that no budget deficit should exceed 3 per cent of gross domestic product (GDP). When the two largest countries in the euro zone, Germany and France, violated the agreed rule and were not punished, the battle was lost. Other countries, including those in southern Europe, followed suit.

The lack of fiscal discipline was one of the primary causes of the crisis in the euro zone. This problem has been recognised and the Fiscal Compact Treaty was signed in 2012 to address this issue.

Third, Dr Eyal asserted that the birth of the euro did not spur cross-European investment.

A comprehensive study commissioned in 2008 by the European Commission confirmed that in the decade since the launch of the euro, intra-euro zone foreign direct investment rose to one-third of GDP as compared to an initial one-fifth. Up to two-thirds of this increase can be directly attributed to the birth of the euro.

Fourth, Dr Eyal argued that the euro has not prompted a boom in financial services.

But a 2010 study by economists from the University of Houston showed that following the adoption of the euro, bilateral bank holdings and transactions increased by roughly 40 per cent from 1999 to 2008 among the euro zone countries. Another study in 2009 by economists from University of Valencia also showed that cross-border trade in securities, shares and other equity increased in the euro area from 1999 to 2007. The launch of the euro in 1999 has spurred cross-border financial integration and growth in the financial service sector.

Fifth, Dr Eyal stated that the euro did not reduce retail prices. But the creation of the euro has helped to curb inflation and brought about price stability for European consumers.

Sixth, we are astonished by Dr Eyal's statement: "Those who still find Europe an object of desire are Ukrainians demanding to be let in or African illegal migrants, who risk their lives crossing the Mediterranean Sea".

The EU remains an attractive and safe place to live and work because of the rule of law, and its balance of individual freedom and a certain sense of solidarity. Its power of attraction remains considerable.

We would encourage Dr Eyal to have a little more faith in his own continent. Hundreds of thousands of talented young Asians study at Europe's leading universities. Thousands of young Asian scholars and scientists are doing research at centres all over Europe. Asian entrepreneurs are investing in Europe, making acquisitions and seeking mergers. Trade is booming between our two regions. Millions of Asian tourists visit Europe each year to enjoy Europe's rich cultures and modern amenities. Europe certainly faces many challenges but they are not indomitable. We are confident that Europe will overcome them.

Professor Tommy Koh is the Founding Executive Director of Asia-Europe Foundation (1997-2000) and Dr Yeo Lay Hwee is the Director of European Union Centre in Singapore.

Euro has little to do with Europe's enduring attraction

By Jonathan Eyal, The Straits Times, 9 Jan 2014

I CHERISH the debate with Professor Tommy Koh and Dr Yeo Lay Hwee, both eminent experts in their field. They are quite right to point out that European projects to create a common currency go back decades. Indeed, these are even more ancient than commonly assumed: Napoleon dreamt of imposing a single currency - French, naturally - as far back as 1807.

But the fact that all these schemes were touted in the past is no proof that the euro project as currently conceived belongs to this old European integration aspiration, as my sparring partners in this debate would like to suggest. For, as all the European diplomatic archives made public indicate, the euro was conceived as an explicit French-led attempt to prevent a unified Germany from exercising overwhelming power.

Dr Karl Otto Pohl, president of the Bundesbank at the time when the euro treaties were signed, wrote subsequently: "The European monetary union would not have come about without German reunification, and vice versa." It is quaint to discover that Professor Koh and Dr Yeo are still battling to refute the historical narrative which is now accepted by most of those who were present at the euro's creation.

Also, Greece was not the only country to violate the conditions for euro membership. Italy also did so, through the simple expedient of moving debts from the balance sheet off the national accounts. Again, this matter is documented incontrovertibly in the recently declassified documents of the German government. From these it has emerged that Chancellor Helmut Kohl instructed his officials to ignore evidence that Italy did not meet the euro entry criteria, precisely because the single currency was a political objective.

The authors take issue with my assertion that the introduction of the euro has not prompted a boom in cross-European financial services.

When Britain decided to stay out of the euro, the general assumption was that the City of London would be "dead" as a financial centre. In fact, the bulk of the euro financial services ended up in London. The expansion in financial services was bigger outside the euro zone than inside it.

It is true that the volume of financial transactions throughout Europe increased. But so did the volume of transactions elsewhere in the world during that period, and especially in Asia, where no common currency emerged.

There is, sadly, little evidence to support the authors' assertion that the elimination of currency risks has "spurred cross-border financial integration" in Europe. Instead, it is precisely the reverse, as some southern European states tottering on the brink of bankruptcy are now discovering.

Finally, the authors reject my claim that the euro did nothing to reduce retail prices. They wrote that "the creation of the euro has helped to curb inflation and brought about price stability for European consumers".

But inflation is only one ingredient in price formation. Retail legislation and tax regimes, both of which remain national responsibilities, are just as important. That's why a litre of milk - a commodity influenced by the European Union's (EU) common agricultural policy - still fetches a different price in Italy than in, say, Finland. Retail price movements are not synchronised.

The main thrust of my article, therefore, still stands: that the euro is more of a political project in search of a sound economic justification. It does not serve as an economic accounting unit with political ramifications, as other currencies around the world do.

Of course, the continent is still a pleasant place to live in, attracting students, other human talent and investment from around the world, as Professor Koh and Dr Yeo rightly point out. Nevertheless, it is also a fact that the biggest increase in foreign student intake in Europe has been recorded in Britain, and that over two- thirds of China's inward investment into Europe is directed at Britain, the one country which has resolutely remained outside the euro. In short, the euro as such has little to do with Europe's enduring attraction.

As someone who has worked all his life on European issues, speaks five European languages and holds three different EU passports, I am delighted to accept the challenge thrown at me by two distinguished Asian academics that I should have "a little more faith" in "my" continent. I don't take it as admonishment, but as a friendly encouragement. But I hope they would concur with me that this faith should be grounded in Europe's cold economic realities, rather than just the continent's noble aspirations. For the gap between the two is the chief reason Europe still languishes in its current predicament.