The seeds of the euro crisis are as old as the euro itself.
The European debt crisis — which saw its latest iteration inaugurated on Wednesday, April 6, when Portugal indicated it would request an EU bailout — has exposed every single lie, every fudge, and every political, legal, and economic loophole that went into making the continent’s common currency. One reason Europeans have yet to set the euro right is that they still haven’t reckoned with the extent of bad faith that went into its creation.
To sell the euro to a diverse populace back in the 1990s, its advocates made a series of mostly inconstant promises. The Germans were promised that monetary union would not give rise to fiscal transfers, and would create a currency at least as stable as the Deutschmark. The French understood the euro as a vehicle for improved domestic competitiveness and global reach. For the Italians and the Spanish, it offered an opportunity for monetary stability and permanently low interest rates. And in countries with highly deregulated banking systems, such as Spain and Ireland, it brought the prospect of sudden wealth.
The various promises culminated in a lowest-common-denominator governance regime. Monetary discipline would be enforced by an independent central bank tasked with ensuring price stability. Fiscal discipline was supposed to be covered by the stability and growth pact, which set the famous 3 percent rule — the ceiling of permitted annual deficits in relation to gross domestic product. And that was it.
Given this wishful thinking, the eurozone was always vulnerable to a financial crisis. But in a fit of denial, Europe never developed a crisis-resolution mechanism. Instead, it promoted a set of logically inconsistent principles: no exit (no leaving the eurozone and reintroducing national currencies), no default (all sovereign debt contracts should be honored), and no bailout (no fiscal transfers between member states). While the no-bailout pledge was explicitly enshrined in European law, and the no-default principle was tacitly agreed upon by European leaders, the no-exit principle was rarely, if ever, explicitly mentioned. The various EU treaties simply allow no procedure for it. The only formal exit procedure is the nuclear option — a complete withdrawal from the European Union. While the absence of real governance meant some sort of crisis was likely, the lack of any sensible management plan meant such crises were always liable to spin out of control.
The current crisis was sparked when the continent’s macroeconomic imbalances collided with a badly regulated and badly capitalized banking system. Germans tended to have excess savings — their country ran an 8 percent account surplus in 2008 — and European banks enabled them to easily and massively invest in Spain and Ireland. With the influx of cash, housing bubbles subsequently grew in both countries, with housing prices rising more than threefold in the span of a few years.
This was originally mostly a private, not a public, sector problem: If Europe has a sovereign debt crisis today, that’s not what it was at its origin. Indeed, Spain and Ireland ran fiscal surpluses for most of the last decade, and both countries were considered fiscally righteous at the time. Portugal ran deficits, but its debt-to-GDP ratio was only a little higher than that of France and Germany. Greece was the only country in the eurozone’s periphery that experienced a classic fiscal crisis: In the year 2009, the country ran a deficit of 15 percent of GDP.
It was the political decisions made by European leaders that ultimately put the solvency of individual countries at risk. The single gravest error in the EU crisis-resolution process was the decision by eurozone leaders back in October 2008, following the collapse of Lehman Brothers, to pursue a chacun-pour-soi (every-man-for-himself) approach to banking resolution: Each country would guarantee its own banks. With that decision, the banking crises in the eurozone’s periphery became a series of contagious, national fiscal crises. If eurozone leaders had set up a eurozone-wide rescue fund for ailing banks, accompanied by a bank resolution regime, the crisis would have remained contained in the private sector. If the EU had sorted out the banks back then, it could have chosen among a variety of options in dealing with the one genuine fiscal crisis it had in Greece.
Eurozone leaders then doubled the error by focusing on the symptoms rather than the cause of their troubles.
European leaders identified excess national debt — not the insolvent banks that lay at the root of that debt — as the main threat to the stability of the euro. The answer they prescribed was austerity, even though that did nothing to resolve the true, lingering problem. Budget cutbacks, not bank resolution, became the quid pro quo for European financial assistance, the underlying philosophy of all three anti-crisis mechanisms designed so far: the Greek loan program of May 2010; the European Financial Stability Facility (EFSF) to provide emergency help for countries in acute funding difficulty; and the European Stability Mechanism (ESM), a permanent anti-crisis mechanism, designed with future breakdowns in mind.
But in the meantime, the actual problem remained unresolved. While the Troubled Asset Relief Program (TARP) in the United States succeeded in quelling that country’s banking crisis by forcing banks to take government money, there was no equivalent European response. The European banking system remains fragile. It is hard to give precise estimates of the degree of under-capitalization: Estimates by investment banks, rating agencies, and official bodies vary, but the problems are clearly not getting any better. The recapitalization needed for Ireland’s banks is now heading toward €70 billion. In Spain, the estimates for the recapitalization needs for the Cajas — the savings banks most exposed to the property sector — vary from €20 billion to €200 billion. Total recapitalization needs for the German banking sector are likely to be well over €100 billion, possibly more. The German banking system is far more vulnerable than generally understood. One German real estate bank, HRE, has already had to be nationalized. The Greek banks will also need to be recapitalized at some point, and the same is very likely to happen in Portugal, too. The total recapitalization needs for the eurozone could well run up to €500 billion.
A policy along the lines of the TARP program would go a long way to stemming Europe’s problems. I would go further and argue that it would end the crisis entirely. Unfortunately, there are significant political impediments. Some European elites simply don’t grasp the nature of the problem: The traditional European solution to banking crises is to sit them out — to do nothing and wait for the next economic recovery. Indeed, that’s what Germany did to overcome the costs of unification. And if you make unrealistically rosy assumptions about property values, sovereign default, and economic growth — as some European economists have proven willing — you could even argue that the banking sector is in no real trouble at all. Unfortunately, this is a situation where such optimism is unfounded.
The close ties between banks and their respective governments are also making it difficult to achieve clarity. In Germany, the six regional banks (Landesbanken) that are most in need of recapitalization have cozy ties with local government. In Spain, too, the Cajas are controlled by powerful interests of both major parties. In Ireland, commentators have frequently highlighted the close relationships between Fianna Fail, the party of the previous Irish government, and the banking sector. Indeed, the presence of a highly politicized banking sector was the main reason why eurozone leaders, back in October 2008, decided to provide large safety nets to the banking system on a nation-by-nation basis; no country wanted to expose its banks to the embarrassments and competitive disadvantages of an objective assessment. The former German finance minister, Peer Steinbrück, was explicit in acknowledging this at the time, stating that his country was against transferring regulatory powers to the EU because it would have deprived Germany of political control of its banks.
But some member states, like Ireland, have proved too weak to deal with their banking system, while others, like Germany, have proved simply unwilling. The German government even allowed its national bank recapitalization fund, SoFFin, to expire in 2010 without any replacement — despite the fact that the EU was planning a new round of stress tests in the spring of 2011. The decision was a clear indication that the German government had no intention to agree to bank recapitalization; the stress tests are carried out at EU level, but the Germans were confident they could defang them before they started. One senior German official admitted to me that it was impossible for his government to ask parliament to bail out the eurozone’s periphery and its own banking sector at the same time.
As long as there’s no bank resolution — one that disentangles national debt from the financial sector’s problems — the European crisis will continue until a cascade of national defaults becomes inevitable. It’s true that cleaning up the banking sector will be costly and unpopular, but it need not be crippling for the eurozone as a whole. Even my maximum estimate of a bank recapitalization costing some €500 billion is still less than 10 percent of the eurozone’s total GDP. This should be manageable — on aggregate — since the eurozone has a lower debt-to-GDP ratio than both the United Kingdom and the United States. But it might not be manageable for each individual country to handle its share of recapitalization costs. That’s why the banking crisis will inevitably have to be solved through the cooperation of all the countries that use the euro.
For now, Europe is mired in a classic collective action problem: the pursuit of national interests prevents a joint solution. But member states still do not comprehend what a momentous political step they took in the 1990s when they introduced the euro. And this brings us back to the eurozone’s original sin — the lies, the fudges, and the loopholes at the moment of its creation. Until they are acknowledged forthrightly, the continent will continue to be haunted by them. A breakup of the euro is unlikely, but a far worse outcome — a perpetually malfunctioning and divided monetary union — seems increasingly on the horizon.
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