Inside Story

Who’s in charge of the euro?

Unlike its political counterpart, the seventeen-member eurozone has no government and no centre of political power, writes James Panichi. Debate is intensifying about whether more integration, or less, is the solution

James Panichi 12 December 2013 2892 words

Not Italian enough? European Central Bank president Mario Draghi has some room to manoeuvre, but the Germans are wary.
EU Council Eurozone

NICOLA and I go way back. We were sparring partners at the small-town Tuscan high school I attended in the 1980s, and we both have fond memories of the monthly assemblea d’istituto – the raucous, self-governed student assemblies in which political issues were thrashed out in a genuinely unsupportive and hostile environment.

Back then, Nicola was an avowed communist – and he wasn’t alone. The Partito Comunista Italiano, the biggest party of its kind in the Western world, did well among disenchanted and idealistic middle-class students. Then came the fall of the Berlin Wall. Most communists disappeared, shuffling inconspicuously towards the middle ground and claiming they’d been misunderstood social democrats all along.

Not Nicola. He continued to fight the fight long after the End of History. But one thing has changed: at school we would lock horns only over political issues, but when we caught up recently all Nicola wanted to talk about was monetary policy. Or rather, the euro. He really, really hates it. It’s not just the damage the common currency has wreaked on the Italian economy; the common currency is ideologically wrong.

This is not something observers outside Europe immediately pick up on: the popular sentiment against the single currency bubbling away in the seventeen countries that make up the eurozone is as likely to come from the far left as the far right.

To old-school revolutionaries the problem with the euro isn’t the loss of national sovereignty (class struggle always transcended the nation state). Rather, the fight against the moneta unica is a challenge to the elites who are perceived to have backed it, the capitalist cabal in the EU institutions that’s using the European sovereign debt crisis as a pretext to impose its austerity agenda and bring southern Europe to its knees.

In Italy, it’s an argument that can spark a kind of nostalgia for the often-maligned era of the Christian Democrats, when governments either controlled or directly owned the industrial output. It was a simpler time for monetary policy: if the economy stalled, politicians could tweak the value of the lira downwards. A boost in exports ensued, followed by an increase in industrial output.

But those currency devaluations also put pressure on wages and sparked inflation – hence the amusing reality of coughing up 500 lire for a cup of coffee. When I moved to Italy with my family in the late 1970s inflation was still hovering between 20 and 25 per cent, although back then no one seemed to care. The devaluation of currency was part of the alchemy of statesmanship; the real political battles were fought elsewhere.

Those were the great days, Nicola told me over dinner. A nimble lira was preferable to being locked into today’s currency craziness, in which Italy’s exporters are being killed off by a euro that is undervalued in Germany and overvalued in Greece, Cyprus, Italy and Spain. A return to a national currency was the panacea: a green light (if one were needed) for Italy to resist the Germans’ demand for economic reform.

It’s small wonder that economists in Europe are being driven to despair. Here in Brussels the argument that a national currency would enable Italy to side-step its poor productivity, its high levels of public debt and a sprawling bureaucracy are treated with derision. People in this town also point out how the country southern Europe loves to hate, Germany, owes its strong economy and low unemployment to the tough reforms pushed through in the late 1990s by former chancellor Gerhard Schroeder, a social democrat.

That’s not to say that the introduction of the euro wasn’t a monumental stuff-up – even the common currency’s supporters now concede that. To start with, many southern European countries shouldn’t have been admitted in the first place. Greece joined by cooking its economic books; Italy’s membership should have faced tougher scrutiny (its public debt at the time was above 100 per cent of GDP).

But the euro was never just about economics. The single currency became enmeshed in a broader agenda of European integration, and those adopting it embraced the rhetoric. But the euro was an oddity from the outset because it wasn’t underpinned by a fiscal union. The reason is simple: governments don’t hand over control of their taxes lightly. And so, when the single currency came into existence in 1999 (and began to circulate in 2002), the countries that had signed up knew they were taking a calculated risk. Those calculations were wrong.

It’s now recognised on all sides of this debate that the single currency has hindered southern Europe’s recovery. The problem isn’t just the value of the euro but the lack of a central policy with which to face the crisis. The mosaic of different approaches, whether it’s Italy’s reluctance to embrace macroeconomic reform or Germany’s unapologetic parsimony, reveals the absence of a common strategy.

The power and influence of the Frankfurt-based European Central Bank, or ECB, has been growing rapidly as a result of the crisis, in what is possibly the most stunning case of institutional mission-creep seen in Europe’s recent history. Even so, the problem of political authority remains: who is in charge of the euro?

The twenty-eight-member European Union has a set of governing institutions, but the seventeen-member eurozone has no government and no centre of political power. It’s a bit like the Australian states and territories trying to manage monetary policy without any federal government involvement.

This is the euro today: a political halfway house that is fast becoming uninhabitable. The choice is either to move forward with greater economic integration and create centralised structures, or to reverse the process and prepare for a eurozone break-up. It’s do-or-die. The problem is that tough decisions are not the eurozone’s forte.

THE headquarters of the European Council, Europe’s powerful house of review at the heart of the European precinct of Brussels, has become a hive of activity as finance ministers of the eurozone (known collectively as the Eurogroup) attempt to find a solution to their pressing banking problem. There are too many bad loans on the balance sheets and in some parts of the euro area things are looking distinctly dicey.

A recent Financial Times story revealed a “huge black hole” behind Slovenia’s banks. Other commentators are even more concerned about the precarious position of Germany’s state-based lending institutions, which haven’t recovered from bad investments made before the global downturn. The drawn-out negotiations in Berlin to create a new government are also preying on people’s minds, but the eventual announcement of a coalition will do little to allay the fears of those clamouring for greater reform. (The Economist dubbed the new executive “Back in the GDR.”)

As the ministers start to arrive and their doorstop statements filter through the building, there is a sense that decisive action may be just around the corner. It’s what Europeans call “falling forward” – lurching ahead in response to a crisis rather than through considered policy development. And by “forward” they mean greater integration: the banking union on the table today amounts to a deepening of the economic ties among eurozone members. The ECB will set the standards of capitalisation required for the banks and will then throw its weight around, making sure the rules are adhered to.

Europe is no stranger to integration by panic: the European Union does it as well. But while the EU can rely upon recalcitrant members like Britain to oppose power grabs by Brussels, for the eurozone the ECB’s forward motion is seen as a necessary evil, given the size of the area’s power vacuum and the seriousness of its woes (six successive quarters of shrinking GDP; unemployment at 12 per cent).

Which is not to say the Germans like the ECB. Its recent decision to lower interest rates to a record-low 0.25 per cent (from 0.5 per cent) was seen by many as typical eurozone injustice: throwing southern European economies another lifeline while the savings of cautious German mums-and-dads struggle to stay above inflation.

But if falling forward is indeed the eurozone’s destiny, how much further does that process need to go for the currency to get out of the monetary limbo in which it now finds itself? Zsolt Darvas, a Hungarian economist and a senior fellow with economic think-tank Bruegel, thinks the process requires just a few more steps. “There’s a need for more integration in the euro area – but not much more,” he says. “I think if there were a euro area budget, that would be able to smooth economic cycles. That would help the southern European countries to overcome the huge unemployment problem that they have at the moment.”

If you add to that the mooted banking union, Darvas reckons the process of centralisation wouldn’t have to go much further. “Look, for example, at the United States,” he says. “[Their states] have separate tax rates, huge tax competition, some have different regulation. They are fully independent in formulating economic policies.” In Europe, he goes on, “many politicians express the desire to be independent when deciding upon economic matters. And I have no problem with that.”

But while a banking union in the eurozone is possible, a shared budget wouldn’t be acceptable to the Germans – at least, not now. Which brings us back to where we started: a two-speed economy anchored to an inappropriately valued common currency and no consensus on the way forward.

Darvas argues that a form of “Eurobond” might be part of a quick fix – in other words, government bonds issued by all seventeen eurozone members that would allow investors to buy up government debt and be paid interest. The European Commission floated the idea in a 2011 “Green Paper” and the idea was taken seriously by most southern European economies. But Berlin fears the bonds would force it into having to share the burden of other eurozone members’ debt and has until now been unwilling to sign up.

Darvas also believes that the ECB could lower interest rates further and even, by buying up financial assets to get more money flowing through the system, explore quantitative easing. The ECB hasn’t ruled out any of this, but it’s clear that anything designed to stimulate Europe’s economy will antagonise the Germans, who have traditionally seen low inflation as the main game. Getting money into the economy, they fear, will put pressure on wages and fuel inflation, which is why Berlin is clinging on to its savings and deferring expenditure on infrastructure.

All the same, ECB president Mario Draghi does have some room to move: the bank’s target is to keep inflation just below 2 per cent and in October it was down to 0.7 per cent. But any decision along these lines will no doubt add to German mutterings that Draghi – a former governor of the Bank of Italy – is doing southern Europe’s bidding. The irony being that back in Italy, American-educated economists such as Draghi are often suspected of being fiscal conservatives and, by implication, not Italian enough.

ALL this assumes the eurozone will fall forward. But what if it went the other way? With the currency crisis still in full swing, centrifugal forces – both economic and political – remain strong. The Greek government might not have the support to keep its promised reforms on track; others may find the burden of an overvalued currency just too great.

In recent months, the idea of a currency break-up, or at least some form of currency devolution, has filtered through to the mainstream. Now, a break-up of the euro, or at least a breakaway by some Eurogroup members, is being entertained by serious economists and not just by people on the populist fringe.

French academics Jacques Mazier and Pascal Petit recently ventilated a euro break-up scenario that they see as offering the best of both worlds. Writing in the Cambridge Journal of Economics, the University of Paris economists conceded that political support for budgetary federalism is in short supply. Therefore, if forward motion is ruled out, a well-managed retreat may be the best option.

Putting forward an alternative, which they call “Multispeed Europe,” Mazier and Petit suggest the creation of an “external” euro that would coexist with “national euros with fixed intra-European parities.” In other words, there would be a euro for all international transactions but seventeen “national” euros that would fluctuate in line with local economic settings.

National euros could not be converted internationally and could only be used to buy international euros. Exports would be paid for in international euros, which would then be converted into national currency according to the rate of exchange. The national euros could even be grouped into regions – for example, a “southern European euro.”

But the financial news cycle in Brussels has been dominated by a scathing assessment of the euro’s prospects from a different, less predictable, source: Ashoka Mody, a former senior official of the International Monetary Fund, now with Bruegel, who is a supporter of the single currency. In a new paper, Mody argues that a fiscal union with the “necessary financial buffers” has “no realistic prospect of a political consensus,” meaning that the only way forward is back.

Mody isn’t suggesting a currency break-up. His idea is a monetary union that would resemble “the United States before the Great Depression,” when there was “virtually no system of fiscal transfers and states’ fiscal discipline was enforced by a ‘no-bailout’ commitment.” So, no bail-outs and no redistribution from rich to poor countries.

To achieve this the Eurogroup would have to dismantle the European Stability Mechanism, which was established in late 2012 (with €500 billion in the kitty) to assist struggling eurozone economies. The problem with the mechanism and, for that matter, Eurobonds is that they rely disproportionately on Germany’s goodwill – something Mody sees as unsustainable. Responsibility for monetary policy would be decentralised and repatriated though a series of compacts among EU member states – Mody’s “Schuman Compact” (a reference to Robert Schuman, the French foreign minister who in 1950 kick-started the process that led to the European Union).

Economist Zsolt Darvas says both scenarios are problematic. First, a break-up of the euro (even one of the kind described by Mazier and Petit) would be “disastrous” and far worse than the problems it is designed to address. “If there were a realistic prospect of a break-up, all money would exit those countries with a prospect of exiting: Spain, Greece or Cyprus,” he says. “Then the entire banking system would melt down. Policy-makers would respond by introducing capital controls” – which would restrict money flows out of a country – “but as we have already seen in Cyprus, those controls cannot be effective and even.”

As for Mody’s ideas on decentralisation, Darvas says it depends on where it is all heading. If it’s simply a prelude to a euro break-up, then it becomes too risky. “I would not go as far as Ashoka [Mody] in saying that we should be decentralising everything then hope that it will all work out,” Darvas told me.

The high-profile eurozone blogger and Financial Times columnist Wolfgang Münchau is also critical of Mody’s paper, arguing that “the only thing that is harder to do in Europe than to integrate is to disintegrate.” For Münchau, the best remedy for the absence of a central power at the heart of the euro is to create one. “Loose coordination has been tried, and it did not work,” he says. “One reason is that sovereignty entails the freedom by people and governments to disregard what previous generations inserted into their compacts.”

Münchau is not ready to give up on the “big idea” of a political union. “The history of the European Union has shown that integration can be irritatingly slow and grinding, but when it occurs it is ultimately forceful.”

In today’s climate, though, decentralisation – or even a break-up of the eurozone – may ultimately win the day. Disquiet is mounting in countries struggling under the weight of an overvalued euro, and the arguments of both the extreme left and extreme right are gaining traction.

Those balmy days of the 1980s, when Nicola and I could afford the luxury of not knowing what monetary policy was, are over. Economic sovereignty is like that: you don’t know what you’ve got till it’s gone. •