The Euro and the Scalpel

Looking back over the last 18 months of Europe’s debt crisis, economist Lorenzo Bini Smaghi, a member of the European Central Bank’s executive board, recently invoked Winston Churchill’s famous quip, "You can always count on Americans to do the right thing — after they’ve tried everything else."

And Europeans too, he assured his audience, would also get it right — eventually. But all the coming and going since the Greek crisis broke out has taken its toll, which can be seen in the growing lack of market confidence that a lasting solution to the underlying problems will finally be found. Even the Americans seem to be having difficulty doing the right thing this time around, or at least doing it at the right moment, as the market turbulence following Standard & Poor’s downgrade of U.S. overeign debt served to underline.

It’s probably too soon to say whether Europe’s leaders have actually agreed on what would be the "right thing" to do, but at least they now seem to recognize the full extent of the problems they’re facing. Fundamental changes to the continent’s financial system are now on the table. Options now being openly debated even include a measure thought unthinkable a year ago: ending Europe’s 13-year experiment with a single currency. But even if this ultimate possibility — the so-called nuclear option — were to come to pass, as always there would be a right way and a wrong way of going about it.

So how bad is it? In a word, very. The latest round in the European sovereign debt crisis has been, without a shadow of a doubt, the most serious and the most potentially destabilizing for the global financial system of any we have seen to date. Pressure on the bond spreads in the debt markets of the countries on Europe’s troubled periphery have become so extreme that the European Central Bank (ECB) was forced to change course only three days after its regular monthly meeting in August, intervening with shock and awe in the Spanish and Italian bond markets. While the size of the intervention is still unknown, market estimates range from between 4 billion euros and 9 billion euros in the space of two days. To put this number in some sort of perspective, the entire bond-purchasing program to date for Greece, Ireland, and Portugal has only involved some 74 billion euros, and this in more than a year of intervention.

Along with earlier interventions in Ireland, Portugal, and Greece, the ECB has become the "buyer of last resort" of peripheral Europe’s bonds, but this can only be an interim measure because the volume of bonds that would need to be purchased on an ongoing basis is so massive that it would put the bank well outside the limits of its original founding charter.

The gravity of the situation was highlighted on Aug. 3, when European Commission President José Manuel Barroso explained to reporters that the current "tensions in bond markets reflect a growing concern among investors about the systemic capacity of the euro area to respond to the evolving crisis."

To be clear, what is involved is no longer an issue of Greek debt restructuring or of the extent of private-sector involvement in any such debt adjustment. The current crisis is an existential one, which if left unresolved will result in a contagion — a matter of life of death for Europe’s single currency. At the very same moment in which the ECB was deciding on its latest program of bond purchases, concerns were already being aired in the German media that the sums involved in a generalized rescue might be too large for even the richest countries in the core to accept.

As former British Prime Minister Gordon Brown put it Aug. 7: "Now no number of weekend phone calls can solve what is a financial, macroeconomic, and fiscal crisis rolled into one." Solving the crisis involves "a radical restructuring of both Europe’s banks and the euro, and will almost certainly require intervention by the G-20 and the International Monetary Fund."

Original Sin?

Perceived by many as being ill-gotten and ill-born, the issue of euro parentage has long been a topic of intense debate and controversy, in particular between economists on one side of the Atlantic and those on the other. As Smaghi put it in his July speech to the Hellenic Foundation for European and Foreign Policy, in the United States a significant financial crisis does not call into question the whole institutional and political setup, and the dollar itself is not considered to be at risk. In Europe, in contrast, a crisis is often considered by outside observers as putting the euro, and the union itself, at risk of disintegration. "Academics and other experts deliberate on whether the euro area is viable and how it can be rescued," he said. "Closet euroskeptics suddenly reappear, dusting off their I-told-you-so commentaries."

But it is not simply a question of "closet" (or open) euroskeptics suddenly reappearing, but of the monetary union repeatedly showing fault lines exactly where those much berated macroeconomists had expected they might appear. This is why Brown is undoubtedly right to focus on the fact that, beyond an immediate fiscal crisis, what we have in Europe is also a crisis of macroeconomic management and of financial stability.

Undoubtedly, Europe’s leaders have made huge strides in their attempts to get to grips with the issues, even if the measures taken so far still fall woefully short of what will be needed. As the crisis has moved on from the initial concerns about Greek accounting, the piecemeal approach adopted by European policymakers has lead them to erect what is now a veritable production line of crisis-resolution tools and departments, with each of the needy patients being situated at different stages of the treatment process. But this piecemeal approach cannot work for long.

In the Greek case, the underlying issue is now acknowledged to be one of solvency, and teams of experts are hard at work in a seemingly endless struggle to decide what degree of restructuring (and/or "reprofiling") the Greek debt will need. In the Irish and Portuguese cases, the task still remains one of monitoring program implementation, with the focus being on whether they will eventually require a second-stage bailout package. Meanwhile, in the antechamber, the Spaniards and the Italians patiently wait their turn, while the doctors and health-system administrators hold a heated debate as to whether there is enough space available in the emergency ward and whether the patients have sufficient insurance to cover them should the surgery need to be drastic.

The Italian situation is by far the most complex one facing the eurozone. In years prior, Italy’s debt had long been a focus of attention with those who were worried about the effectiveness of the eurozone’s Stability and Growth Pact, which mandates that countries maintain deficit levels below 3 percent of GDP annually and cumulative debt levels below 60 percent of GDP. In fact, according to IMF data, gross Italian government debt hasn’t been below 100 percent of GDP since 1991, and the country entered the financial crisis in 2007 with a level of around 103 percent of GDP. During the crisis, the country remained beyond the searching gaze of financial-market interest by keeping its annual deficit at comparatively low levels, but a combination of recession, low growth, and a substantial interest-payment burden on the already accumulated debt saw the level rise steadily to an estimated 120 percent of GDP this year.

The Italian hit may well be coming, and it may well be the most spectacular problem the common currency has suffered in the 13 short years of its existence, but it really is only the latest example of a complex mix of fiscal, macroeconomic, and financial issues that have come to plague the euro, issues that can be traced by and large to an original design fault. So while Europe’s unhappy families may all be unhappy for a variety of reasons, the root of the problem is that the project as it was set up contained all the mechanisms for creating problems, but few of the ones needed for resolving them.

Righting the Ship

So the euro is now at a crossroads, and important decisions must be taken. Preserving the eurozone — as it is now — might be workable if it were possible to transform the region into a full fiscal union where budgetary policy was coordinated across countries by a central treasury, in much the same way as is done in the United States. But such an arrangement is now a political impossibility, as Europe’s core economies would inevitably reject what would be seen as a permanent transfer union between high-growth regions and their poorer neighbors.

With fiscal union off the table, there are basically three possibilities. The first is to stay more or less where we are, expanding the ECB’s bond-purchasing program and simply trying to hang in there. The stability fund could be increased, but the more numbers start being accounted for in detail, the further away the various parties get from being able to agree. If this continues, the ECB is likely to reach a ceiling beyond which it will be more than reluctant to continue buying, because the bank takes the view that the resolution has to come from the politicians.

But with Italy and Spain’s combined sovereign refinancing needs between now and the end of 2012 totaling about 660 billion euros, and given the financing needs of the banks on top of this figure, reaching agreement to expand the bailout mechanism looks pretty improbable, especially when one considers that there’s no turning back once it starts. So, at some point, the spreads will start to widen again as markets force the issue, with the inevitable outcome that the monetary union is pushed toward the brink of breakdown.

The second possibility would be to disband the union entirely, leaving each member to go back to its national currency. This would be a disastrous outcome for all concerned and for the global financial system. Coordinating the unwinding of cross-country counterliabilities would be a nightmare given the level of interlocking corporate and sovereign bond markets. The sudden disappearance of one of the major global currencies of reference would also cause havoc in financial markets. The dollar would most likely be pushed to unsustainably high levels in the rush for safety, and it is only necessary to look at what is happening to gold, the Swiss franc, and the Japanese yen to catch a glimpse of what would be in store. Of course, this kind of violent unwinding would never be undertaken voluntarily, but that doesn’t mean that it is impossible — particularly if solutions are not found and the force of market pressure continues.

Fortunately there is a third alternative: The eurozone could be split in two, creating two separate (and unequal) euro currencies. Naturally, the composition of the groups would be a matter of negotiation because some countries do not easily belong in either one group or the other. The broad outline is, however, clear enough. Germany would form the heart of one group, along with Finland, the Netherlands, and Austria. It might even take Estonia, which has been making it pretty clear that it would also be up for the ride. Spain, Italy, and Portugal would naturally form the nucleus of the second group, with Slovenia and Slovakia being possible candidates. Some countries, Ireland and Greece for example, might simply choose to opt out.

The big unknown is what France would do. In many ways it belongs with the first group, but cultural ties with Southern Europe and political ambitions across the Mediterranean could well mean the country would decide to lead the second group. If such a plan meant not ultimate divorce but temporary separation, then French participation with the southern economies would also have a lot of political rationale. The term Franco-German axis would gain a whole new meaning.

Naturally, the technical challenge would be enormous, but it would not be insurmountable. The great advantage of such a move would be that two of the major burdens under which the monetary union is laboring — the lack of price competitiveness on the periphery and the lack of cultural consensus between the participants — would be resolved at a stroke.

The Great Divide

No one knows the values at which the two new currencies would initially operate, but for the purpose of a thought experiment, let’s assume a Euro1 at around U.S. $1.80 (the current dollar-euro exchange rate hovers around $1.40 to 1 euro), and a Euro2, at around $1. Obviously, in the short term, the winners of this operation would be the members of Euro2, which would get the devaluation their economies have been yearning for. Why would this be? At a time when the countries concerned are loaded down with debt and domestic demand is correspondingly weak, export growth is the only way for their economies to move forward, and the change would allow cheaper labor and production costs, giving them an enormous push in this direction.

It would encourage growth in other ways. Take Spain, for example: The country has a large pool of surplus property — some estimate as many as 1 million unsold new housing units. Many have criticized the banking sector for not reducing prices sharply to enable the market to clear, but the banks are understandably reluctant to do so due to the impact this would have on their balance sheets. The beauty of the split-eurozone solution is that no further drop in price would be needed, because for external buyers the real price of all this housing would suddenly become much cheaper.

Spain’s troubled savings-bank sector has been desperately looking for foreign investors to help it recapitalize, but though many have shown interest, virtually none has participated. After the devaluation, all this would change — because investors would be able to buy shares at attractive prices, without the worry about a sudden drop in prices.

And there would be follow-on benefits, too: Spain’s 4.5 million unemployed would gradually start to go back to work, new investment could steadily be attracted for productive projects in manufacturing and other industries, no one would doubt the solvency of the Spanish state, and the private sector would be in a better position to start paying back its debts as the economy grew.

The advantage that the split option has over all the other proposals on the table is that it would address the growth issue head-on. Europe’s peripheral countries could return to promoting economic growth, which would significantly increase the proportion of the liabilities they are likely to pay back. It is much more difficult to collect debts from a bum than it is from someone who has a job.

Obviously, in economics as in life, there are no free lunches, so there must be a catch. Those countries that joined to form Euro1 would be making a big sacrifice, because many also depend on exports for their livelihood, and their manufacturers would suddenly and sharply find themselves at a disadvantage. In particular, Germany, the world’s second-largest exporter, would suffer.

Assuming, however, that all can agree that the current arrangements are unworkable and that going back to individual national currencies would be a disaster, then the German sense of responsibility and the country’s commitment to the European project might well make the acceptance of some sort of sacrifice bearable. What is needed at this point is an appeal to the European spirit of the Euro1 countries, in a way that helps them see that some costs are unavoidable, but that any agreed costs will be shared and above all that the game-changing solution is workable and offers some sort of constructive positive future — for all Europeans. Put in other words, what Europe needs is a mechanism that contains both realism and idealism in just sufficient proportions.

Another attractive feature of this proposal is that no final and binding decisions would need to be taken about the long-term structure of the European financial system. The ECB could be retained as a kind of holding entity and clearinghouse for the outstanding financial mismatch, and the current national central banks could be grouped into two separate subentities. This would leave open the possibility of reconvergence at a later date should there arise conditions that would make the move viable.

The first stab at creating a currency union has failed, but this doesn’t mean that any possibility of creating one in the future should be abandoned. Hard, costly lessons have been learned, and now needed is a full, open discussion of the reasons for failure, precisely to avoid similar mistakes in the future.

Effectively, Europe’s leaders are caught in a kind of Pavlovian trap. There are no easy choices, though there are good ones and bad ones. Staying where they are leaves them in a kind of permanent electric-shock zone where their constant feeling of failure only serves to further eat away at their own sense of personal and political worth. Advancing also seems painful, but more than the intensity of the shock it is the sensation of fear and angst that dominates. But whatever the cost, there is now no other alternative but to march forward into the uncertain future.