金融研究中心讲话

“How to Save the European Union from the Euro Crisis”

My objective in coming here today is to discuss the euro crisis. I think you will all agree that the crisis is far from resolved. It has already caused tremendous damage both financially and politically and taken an extensive human toll as well. It has transformed the European Union into something radically different from what was originally intended. The European Union was meant to be a voluntary association of equal states but the crisis has turned it into a creditor/debtor relationship from which there is no easy escape. The creditors stand to lose large sums of money should a member state exit the union, yet debtors are subjected to policies that deepen their depression, aggravate their debt burden and perpetuate their subordinate status.

This has created political tensions as demonstrated by the stalemate in Italy. A majority is now opposed to the euro and the trend is growing. There is a real danger that the euro will destroy the European Union. A disorderly disintegration would leave Europe worse off than it was when the bold experiment of creating a European Union was begun. That would be a tragedy of historic proportions. It can be prevented but it can be prevented only with Germany’s leadership. Germany didn’t seek to occupy a dominant position and has been reluctant to accept the responsibilities and liabilities that go with it. That’s one of the reasons for the crisis. But willingly or not, Germany is in the driver’s seat and that is what brings me here.

What caused the crisis? And how can Europe escape from it? These are the two questions I want to answer. The first question is extremely complicated. The euro crisis has both a political and a financial dimension. And the financial dimension has at least three components: a sovereign debt crisis and a banking crisis, as well as divergences in competitiveness. The various aspects are interconnected, making the situation so complicated that it boggles the mind. In my view it cannot be properly understood without realizing the crucial role that mistakes and misconceptions have played in creating it. The crisis is almost entirely self-inflicted. It has the quality of a nightmare.

By contrast, the answer to the second question is extremely simple. Once we have gained a proper understanding of the problems the solution practically suggests itself.

I shall attribute a large share of the responsibility to Germany. But I want to make it clear in advance that I am not blaming Germany. Whoever was in charge would have made similar mistakes. I can say from personal experience that nobody could have understood the problems in all their complexity at the time they arose.

I realize that I risk antagonizing you by putting the responsibility on Germany. But only Germany can put things right. I am a great believer in the European Union and I don’t want to see it destroyed. I also care about the immense and unnecessary human suffering that the crisis is causing and I want to do whatever I can to mitigate it. My perspective is very different from the views prevailing in Germany. I hope that by offering you a different interpretation I may get you to reconsider your policies before they do more damage. That is my goal in coming here.

The European Union was a bold project that fired many people’s imagination, including mine. I regarded the European Union as the embodiment of an open society – a voluntary association of equal states who surrendered part of their sovereignty for the common good. The European Union had five large and a number of small member states and they all subscribed to the principles of democracy, individual freedom, human rights and the rule of law. No nation or nationality occupied a dominant position.

The process of integration was spearheaded by a small group of far sighted statesmen who recognized that perfection was unattainable and practiced what Karl Popper called piecemeal social engineering. They set themselves limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they achieved it, it will prove inadequate and require a further step. The process fed on its own success, very much like a boom-bust sequence in financial markets. That is how the Coal and Steel Community was gradually transformed into the European Union, step by step.

France and Germany used to be in the forefront of the effort. When the Soviet empire started to disintegrate, Germany’s leaders realized that reunification was possible only in the context of a more united Europe and they were prepared to make considerable sacrifices to achieve it. When it came to bargaining, they were willing to contribute a little more and take a little less than the others, thereby facilitating agreement. At that time, German statesmen used to proclaim that Germany has no independent foreign policy, only a European one. This led to a dramatic acceleration of the process. It culminated with the reunification of Germany in 1990 and the signing of the Maastricht Treaty in 1992. That was followed by a period of consolidation which lasted until the financial crisis of 2007-8.

Unfortunately, the Maastricht Treaty was fundamentally flawed. The architects of the euro recognized that it was an incomplete construct: a currency union without a political union. They had reason to believe, however, that when the need arose, the political will could be mobilized to take the next step forward. After all, that was how the process of integration had worked until then.

But the euro had many other defects, which went unrecognized. For instance, the Maastricht Treaty took it for granted that only the public sector could produce chronic deficits because the private sector would always correct its own excesses. The financial crisis of 2007-8 proved that wrong. The fatal defect was that by creating an independent central bank, member countries became indebted in a currency they did not control. This exposed them to the risk of default.

Developed countries outside a currency union have no reason to default; they can always print money. Their currency may depreciate in value, but the risk of default doesn’t arise. By contrast, third world countries that have to borrow in a foreign currency like the dollar run the risk of default. To make matters worse, such countries are exposed to bear raids. In short, the euro relegated what is now called the periphery to the status of third world countries.

Prior to the financial crisis of 2007-8 both the authorities and the financial markets ignored this feature of the euro. When the euro was introduced, government bonds were treated as riskless. The regulators didn’t require commercial banks to set aside any equity capital, and the European Central Bank discounted all government bonds on equal terms. This created a perverse incentive for commercial banks to accumulate the bonds of the weaker member countries in order to earn a few extra basis points. As a result interest rate differentials practically disappeared.

The convergence of interest rates caused a divergence in economic performance. The so-called periphery countries, Spain and Ireland foremost among them, enjoyed real estate, investment and consumption booms that made them less competitive, while Germany, weighed down by the cost of reunification, engaged in far-reaching labor market and other structural reforms that made it morecompetitive.

In the week following the bankruptcy of Lehman Brothers, the global financial markets literally collapsed and had to be put on artificial life support. This required substituting sovereign credit, backed by taxpayers’ money, for the credit of the financial institutions whose standing was impaired.

That would have been the moment to take the next step forward towards fiscal and political union but the political will was lacking. Germany, weighed down by the costs of reunification, was no longer in the forefront of integration. Chancellor Merkel read public opinion correctly when she declared that each country should look after its own financial institutions individually instead of the European Union doing it collectively. In retrospect that was the first step in a process of disintegration.

It took financial markets more than a year to realize the implications of Chancellor Merkel’s declaration, demonstrating that they too operate with far-from-perfect knowledge. Only at the end of 2009, when the extent of the Greek deficit was revealed, did the markets realize that a Eurozone country could actually default. But then they raised risk premiums on all the weaker countries with a vengeance. This rendered commercial banks, whose balance sheets were loaded with those bonds, potentially insolvent and that created both a sovereign debt and a banking crisis – the two are linked together like Siamese twins.

There is a close parallel between the euro crisis and the international banking crisis of 1982. Then the IMF and the international banking authorities saved the international banking system by lending just enough money to the heavily indebted countries to enable them to avoid default but at the cost of pushing them into a lasting depression. Latin America suffered a lost decade.

Today Germany is playing the same role as the IMF did then. The setting differs, but the effect is the same. The creditors are in effect shifting the whole burden of adjustment on to the debtor countries. Please note how the terms “center” and “periphery” have crept into usage almost unnoticed, although in political terms it is obviously inappropriate to describe Italy and Spain as the periphery of the European Union. In effect, however, the euro has turned them into third world countries over-indebted in a foreign currency.

Just as in the 1980’s, all the blame and burden is falling on the “periphery” and the responsibility of the “center” remains unacknowledged. The periphery countries are criticized for their lack of fiscal discipline and work ethic, but there is more to it than that. Admittedly the periphery countries need to make structural reforms, just as Germany did after reunification. But to deny that the euro itself has some structural problems that need to be corrected is to ignore the root cause of the euro crisis. Yet that is what is happening.

In this context the German word “Schuld” plays a key role. As you know it means both debt and guilt. This has made it natural or “selbstverständlich” for German public opinion to blame the heavily indebted countries for their misfortune. The fact that Greece blatantly broke the rules has helped to support this attitude. But other countries like Spain and Ireland had played by the rules; indeed Spain used to be held up as a paragon of virtue. Clearly, the faults are systemic and the misfortunes of the heavily indebted countries are largely caused by the rules that govern the euro. That is the point I should like to drive home today.

In my opinion, the “Schuld” of the “center” is even greater today than it was in the banking crisis of 1982. It may have been politically acceptable in 1982 to inflict austerity on less developed countries in order to save the international financial system; but doing the same within the Eurozone cannot be reconciled with the European Union as a voluntary association of equal states. There is an unresolved conflict between what is dictated by financial necessity and what is politically acceptable. That is the point the recent Italian elections should have driven home.

The burden of responsibility for the Maastricht Treaty falls mainly on France and Germany; for the course of events since the outbreak of the crisis on Germany alone, because the crisis put Germany into the driver’s seat. This has created two problems. One is political, the other financial. It is the combination of the two that has rendered the situation so intractable.

The political problem is that Germany did not seek the dominant position into which it has been thrust and it is unwilling to accept the obligations and liabilities that go with it. Germany understandably doesn’t want to be the “deep pocket” for the euro. So it extends just enough support to avoid default but nothing more, and as soon as the pressure from the financial markets abates it seeks to tighten the conditions on which the support is given.

The financial problem is that Germany is imposing the wrong policies on the Eurozone. Austerity doesn’t work. You cannot shrink the debt burden by shrinking the budget deficit. The debt burden is a ratio between the accumulated debt and the GDP, both expressed in nominal terms. And in conditions of inadequate demand, budget cuts cause a more than proportionate reduction in the GDP – in technical terms the so-called fiscal multiplier is greater than one.

The German public finds this difficult to understand. The fiscal and structural reforms undertaken by the Schroeder government worked in 2006; why shouldn’t they work for the Eurozone a few years later? The answer is that austerity in a single country works by increasing its exports and reducing imports. When everybody is doing the same thing it simply doesn’t work: it is clearly impossible for all members of the Eurozone to improve their balance of trade with one another.

The euro crisis reached a climax last summer. Financial markets started to anticipate a possible breakup and risk premiums reached unsustainable levels. As a last resort, Chancellor Merkel endorsed the President of the European Central Bank, Mario Draghi, against her own nominee, Jens Weidmann. And Draghi rose to the occasion. He declared that the ECB would do “whatever it takes” to protect the euro and backed it up by introducing first the LTRO and then the OMT. Financial markets were reassured and embarked on a powerful relief rally. But the jubilation was premature. As soon as the pressure from the financial markets abated, Germany started to whittle down the promises it had made at the height of the crisis.

In the bailout of Cyprus, Germany went too far. In order to minimize the cost of the bailout it insisted on bailing in bank depositors. This was premature. If it had happened after a banking union had been established and the banks recapitalized, it might have been a healthy reform. But it came at a time when the banking system was breaking up into national silos and remained very vulnerable. What happened in Cyprus undermined the business model of European banks, which relies heavily on deposits. Until then the authorities had gone out of their way to protect depositors. Cyprus has changed that. Attention is focused on the devastating impact of the rescue on Cyprus but the impact on the banking system is far more important. Banks will have to pay risk premiums that will fall more heavily on weaker banks and the banks of weaker countries. The insidious link between the cost of sovereign debt and bank debt will be reinforced and a banking union that would reestablish a more level playing field will become even more difficult to attain. Without access to credit on equal terms the periphery countries cannot possibly escape from the trap in which they are caught.

Chancellor Merkel would have liked to put the euro crisis on ice at least until after the elections, but it is back in force with a vengeance. The German public may be unaware of this because Cyprus was a tremendous political victory for Chancellor Merkel. No country will dare to challenge her will. Moreover, Germany itself remains relatively unaffected by the deepening depression that is enveloping the Eurozone. I expect, however, that by the time of the elections Germany will also be in recession. That is because the monetary policy pursued by the Eurozone is out of sync with the other major currencies. The others are engaged in quantitative easing. The Bank of Japan was the last holdout but it changed sides recently. A weaker Yen coupled with the weakness in Europe is bound to affect Germany’s exports.

If my analysis is correct, a solution practically suggests itself. It can be summed up in one word: Eurobonds. If countries that abide by the Fiscal Compact were allowed but not required to convert their entire existing stock of government debt into Eurobonds, the positive impact would be little short of the miraculous. The danger of default would disappear and so would the risk premiums. The balance sheets of banks would receive an immediate boost and so would the budgets of the heavily indebted countries because it would cost them less to service their existing stock of government debt. Italy, for instance, would save up to four percent of its GDP. Its budget would move into surplus and instead of austerity, there would be room for some fiscal stimulus. The economy would grow and the debt ratio would fall. Most of the seemingly intractable problems would vanish into thin air. Only the divergences in competitiveness would remain unresolved. Individual countries would still need structural reforms, but the main structural defect of the euro would be cured. It would be truly like waking from a nightmare.

Germany is opposed to Eurobonds on the grounds that once they are introduced there can be no assurance that the so-called periphery countries would not break the rules once again. I believe these fears are misplaced. In accordance with the Fiscal Compact member countries would be allowed to issue new Eurobonds only to replace maturing ones; after five years the debts outstanding would be gradually reduced to 60% of GDP. If a member country ran up additional debts it would have to borrow in its own name. Having to pay stiff risk premiums would be a powerful inducement to stay in compliance. Admittedly the Fiscal Compact needs some modifications to ensure that the penalties for non-compliance are automatic, prompt and not too severe to be credible; but a tighter Fiscal Compact would practically eliminate the risk of default.

Eurobonds would compare favorably with the bonds of US, UK and Japan in the financial markets. Admittedly, Germany would have to pay more on its own debt than it does today but the exceptionally low yields on Bunds is a symptom of the disease that plagues the periphery. The indirect benefit Germany would derive from the recovery of the periphery would far outweigh the additional cost incurred on its own national debt.

There are also widespread fears that Eurobonds would ruin Germany’s credit rating. Eurobonds are often compared with the Marshall Plan. The argument goes that the Marshall Plan cost only a few percentage points of America’s GDP while Eurobonds would cost a multiple of Germany’s GDP. That argument is comparing apples with oranges. The Marshall Plan was an actual expenditure while Eurobonds would involve a guarantee that will never be called upon.

Guarantees have a peculiar character: the more convincing they are, the less they are likely to be invoked. The US never had to pay off the debt it incurred when it converted the debt of individual states into Federal obligations. Germany has been willing to do only the minimum; that is why it had to keep escalating its commitments and is incurring actual losses.

To be sure, Eurobonds are not a panacea. The boost derived from Eurobonds may not be sufficient to ensure recovery. Additional fiscal and/or monetary stimulus may be needed – but having such a problem would be a luxury. More troubling is that Eurobonds do not eliminate divergences in competitiveness. Individual countries would still need to undertake structural reforms. Those that fail to do so would turn into permanent pockets of poverty and dependency similar to the ones that persist in many rich countries. They would survive on limited support from European Structural Funds and remittances. The European Union would also need a banking union to make credit available on equal terms in every country. The Cyprus rescue made these needs more acute by making the playing field more uneven. But Germany accepting Eurobonds would totally change the political atmosphere and facilitate the needed reforms.

Unfortunately, Germany is adamantly opposed to Eurobonds. Since Chancellor Merkel vetoed Eurobonds, the arguments I have put forward here have not even been considered. People don’t realize that agreeing to Eurobonds would be much less costly than doing only the minimum to preserve the euro.

It is up to Germany to decide whether it is willing to authorize Eurobonds or not. But it has no right to prevent the heavily indebted countries from escaping their misery by banding together and issuing Eurobonds. In other words, if Germany is opposed to Eurobonds it should consider leaving the euro and letting the others introduce them.

This exercise would yield a surprising result: Eurobonds issued by a Eurozone that excludes Germany would still compare favorably with those of the U.S., UK and Japan. The net debt of these three countries as a proportion of their GDP is actually higher than that of the Eurozone excluding Germany.

Let me explain why. Since all the accumulated debt is denominated in euros, it makes all the difference which country remains in charge of the euro. If Germany left, the euro would depreciate. The debtor countries would regain their competitiveness. Their debt would diminish in real terms and, if they issued Eurobonds, the threat of default would disappear. Their debt would suddenly become sustainable. Most of the burden of adjustment would fall on the countries that left the euro. Their exports would become less competitive and they would encounter stiff competition from the euro area in their home markets. They would also incur losses on their claims and investments denominated in euro. That would include the Target2 balances, unless the losses were shared as part of an amicable parting of ways.

The extent of their losses would depend on the extent of the depreciation; therefore they would have an interest in keeping the depreciation within bounds. After initial dislocations, the eventual outcome would fulfill John Maynard Keynes’ dream of an international currency system in which both creditors and debtors share responsibility for maintaining stability. And Europe would escape the looming depression.

By contrast, if Italy left, its euro-denominated debt burden would become unsustainable and it would have to be restructured. This would plunge the rest of Europe and the rest of the world into an uncontrollable financial meltdown. The collapse of the Euro would likely lead to the disorderly disintegration of the European Union and Europe would be left worse off than it had been when it embarked on the noble experiment of creating a European Union. So, if anyone must leave it should be Germany, not Italy.

There is a strong case for Germany to make a definitive choice whether to accept Eurobonds or to leave the euro. That is the case I came here to argue. The trouble is that Germany has not been put to the choice, and it has another alternative at its disposal: it can continue along the current course, always doing the minimum to preserve the euro, but nothing more. If my analysis is correct that is not the best alternative even for Germany, except perhaps in the very near term. Nevertheless, that is Chancellor Merkel’s preferred choice, at least until after the elections.

I reflected long and hard whether I should present my case now or wait until after the elections. In the end I decided to go ahead, based on two considerations. One is that events have their own dynamics and the crisis is likely to become more acute even before the elections. The Cyprus rescue proved me right. The other is that my interpretation of events is so radically different from the one that prevails in Germany that it will take time for it to sink in and the sooner I start the better.

Let me sum up my argument. I contend that Europe would be better off if Germany decided between accepting Eurobonds and leaving the euro than if it continued on its current course of doing the minimum to hold the euro together. That holds true whether Germany chose Eurobonds or exit; and it holds true not only for Europe but also for Germany, except perhaps in the very near term.

Which of the two alternatives is better for Germany is less clear-cut. Only the German electorate is qualified to decide. If a referendum were called today the euro skeptics would win hands down. But more intensive consideration could change people’s mind. They would discover that authorizing Eurobonds would actually benefit Germany and the cost of leaving the euro has been greatly understated.

To state my own views, my first preference is for Eurobonds; my second for Germany leaving the euro. Either choice is infinitely better than not making a choice and perpetuating the crisis. Worst of all would be for a debtor country, like Italy, to leave the euro because it would lead to the disorderly dissolution of the European Union.

I have made some surprising assertions; notably how well Eurobonds could work even without Germany. My pro-European friends simply cannot believe it. They can’t imagine a euro without Germany. I think they are conflating the euro with the European Union. The two are not identical. The European Union is the goal and the euro is a means to an end. Therefore the euro ought not to be allowed to destroy the European Union.

But I may be too rational in my analysis. The European Union is conflated with the euro not only in popular narratives but also in law. Consequently the European Union may not survive Germany leaving the euro. In that case we must all do what we can to persuade the German public to abandon some of its most ingrained prejudices and misconceptions and accept Eurobonds.

I should like to end by emphasizing how important the European Union is not only for Europe, but for the world. The EU was meant to be the embodiment of the principles of open society. That means that perfect knowledge is unattainable. Nobody is free of prejudices and misconceptions; nobody should be blamed for having made mistakes. The blame or Schuld begins only when a mistake or misconception is identified but not corrected. That is when the principles on which the European Union was built are violated. It is in that spirit that Germany should agree to Eurobonds and save the European Union.

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