Why the Euro Will Survive: Completing the Continent's Half-Built House

Article in the September/October issue of Foreign Affairs

August 22, 2012

As doom and gloom about the euro abounds, an increasing number of commentators and economists question whether the common currency can survive. An even deeper crisis allegedly threatens the world economy.

To be sure, the euro area faces serious economic and financial problems. The area is in the midst of multiple overlapping and mutually reinforcing crises. The first is a fiscal crisis, which has become most acute in Greece but pervades the southern euro area and Ireland. The second is a competitiveness crisis, long evident in the large current account deficits along the euro area's periphery and the even larger current account imbalances between euro area countries. The third is a banking crisis, which first unfolded in Ireland and has become particularly acute in Spain.

Yet for all the turmoil, fears of serial defaults or the total collapse of the euro are vastly overblown. The euro area has demonstrated that it can and will successfully resolve each successive stage of the crisis by further pooling the sovereignty of its members. It has created a host of new pan-European institutions to respond further as needed. It has built a substantial financial firewall to prevent contagion. It is well on its way to creating a banking union and a partial fiscal union. The common currency and indeed the entire European integration project are likely to not only survive but to emerge from the crisis greatly strengthened.

Watch What They Do, Not What They Say

The European crisis is rooted in a failure of institutional design. The Economic and Monetary Union (EMU) that Europe adopted in the 1990s comprised an extensive if incomplete monetary union, anchored by the euro and the European Central Bank (ECB). But it included virtually no economic union: no fiscal union, no banking union, no shared economic governance institutions, and no meaningful coordination of structural economic policies.

It was assumed by the EMU's architects that economic union would inexorably follow monetary union. But European countries faced no pressure to create one during the years of expansion prior to the Great Recession. When the crisis hit, the absence of needed policy tools constrained Europe's ability to reach a solution quickly, triggering severe market reactions that continue to this day. Europe now has only two options. It can jettison the monetary union or it can adopt a complementary economic union. Given how much is at stake, Europe will almost certainly complete the original concept of a comprehensive economic and monetary union and come out of the crisis much stronger as a result.

From its creation in the 1990s, the common currency has lacked the institutions necessary to ensure that financial stability can be restored during times of acute uncertainty and the market volatility that comes with it. The task before euro area leaders today therefore consists of much more than putting together a financial bailout sufficient to restore market confidence. They must rewrite the euro area's rulebook and complete the half-built euro house. This will require both creative financial engineering to resolve the immediate crisis and a wave of new institutions to strengthen the real economy and restore sustained growth.

Understanding the likely trajectory of the euro requires an analysis of what the Europeans do rather than what they say. They have resolved the many crises that have threatened the integration project throughout its more than six-decade history in ways that ultimately resulted in a more unified Europe. At each key stage of the current crisis, they have done whatever is necessary to avoid the common currency's collapse. In the crunch, both Germany and the ECB—the continent's financial powerhouses—have demonstrated that they will pay whatever is necessary to avert disaster.

The problem for the markets is that, for two reasons, these central players cannot say outright that they will always come to the euro's rescue. First, an explicit commitment to unlimited bailouts would represent the ultimate moral hazard. It would relieve the debtor countries of the pressure their leaders need to sell tough political decisions to their parliaments and publics to effectively adjust their economies.

Indeed, it is not the intention of either Germany or especially the ECB to end the crisis quickly. Their goal is rather to use the crisis to further the economic reforms that are needed to create a strong European economy over the longer run. This is a central reason why the euro area authorities have not built as large a financial firewall as the markets crave for their own comfort.

Second, each of the four main classes of creditors—Germany and the other strong northern European governments; the ECB; private-sector lenders; and the International Monetary Fund, acting as a conduit for funding from non-EU governments such as China—will naturally try to transfer as much as possible of the cost of a financial rescue onto the other three.

Hence the crisis is presentational as well as institutional. The markets will not receive the sweeping declarations they want and will periodically revert to states of high anxiety. But every policymaker in Europe, and even the European publics, know that the collapse of the euro would be a political and economic disaster. And fortunately, since Europe is an affluent region, solving the crisis is a matter of mobilizing the political will to pay, rather than the economic ability.

Each of Europe's key political actors will exhaust all options in trying to secure the best possible deal for itself before at the last minute coming to an agreement. The result is a messy process, exacerbated by the rhetorical cacophony that inevitably emerges from a multiplicity of actors in a multiplicity of countries, which understandably unsettles markets and produces enormous instability. The possibility of miscalculation will continue to loom over Europe. But pressure from the financial markets will ultimately prod the euro area to find effective solutions. And Europe's overriding political imperative to preserve the project of integration will drive its leaders to secure the euro and restore the economic health of the continent. Watch what they do rather than what they say.

Why Will They Succeed?

More than anything else, the project of European integration was driven by the geopolitical goal of halting the carnage that had ravaged the continent for centuries and reached its murderous zenith in the first half of the twentieth century. This overriding imperative has driven successive generations of political leaders to subordinate their national sovereignty to the greater goal of maintaining and extending the European project.

The region's vision of that project always included the concept of a common currency. In early plans for monetary integration, such as the 1970 Werner Report and the 1989 Delors Report, monetary union was supposed to go hand in hand with an economic union that would place binding constraints on member states. But when the common currency finally came to be, it was not because of a carefully considered and detailed economic analysis. It was instead a result of geopolitics. The unforeseen shock of German reunification in October 1990—and the fear this produced in Paris of a dominant Germany—provided the impetus for the Maastricht Treaty, which in 1992 paved the way for the creation of the euro.

The imperative of quickly launching the euro required that politically necessary compromises, rather than unambiguous rules, would determine the currency's framework. For example, the divergence in the economic starting points among the founding members of the euro area made the imposition of firm fiscal criteria for membership politically infeasible. As a result, the euro area by 2005 was a common currency area consisting of a very dissimilar set of countries without a central fiscal authority or any credible enforcement of budget discipline, and having made virtually no progress toward bringing the countries' macroeconomic policies into line.

Initially, none of these fundamental design flaws mattered. But as borrowing costs in private financial markets across the euro area fell toward the traditionally low interest rates of Germany, many new members suddenly had access to unprecedented amounts of credit regardless of their economic fundamentals. Financial markets failed to assess the riskiness of different countries, and European leaders continued to deny any problems in the common currency's design. As a result, in the run-up to the global financial crisis, governments and private sectors built up unsustainable amounts of debt. So when the euro area was finally struck by its first serious financial crisis in 2009, it had to contend not only with huge private and public debt overhangs but also with a faulty institutional design that prevented an expeditious solution.

The Fight to Save the Euro

The euro area was woefully unprepared for the Great Recession. It entered the crisis as a common currency zone flying on just one engine—the ECB—without the kind of unified fiscal entity that traditionally helps countries combat large financial crises. The euro area's leaders have had to build from scratch their crisis-fighting capacities and bailout institutions, the European Financial Stability Facility (EFSF) and subsequently the European Stability Mechanism (ESM). And in the midst of stemming an immediate crisis, they have had to simultaneously reform the flawed foundational institutions of the area.

The ECB, as the only euro area institution capable of affecting financial markets in real time, wields tremendous power. Its institutional independence is enshrined in the EU treaty and it does not answer to any government. Quite unlike normal central banks, which always have to worry about losing their independence, in this crisis the ECB has been able to issue direct political demands to national leaders, as in August 2011, when it conveyed an ultimatum for reform to then Italian Prime Minister Silvio Berlusconi and engineered his ouster when he failed to comply.

On the other hand, unlike the Federal Reserve in the United States, the ECB has not had the luxury of responding to the crisis within a fixed set of national institutions. In the United States, the Fed could immediately create trillions of dollars to steady market confidence with the knowledge that it had a federal government that could formulate a longer-term response (though it has not yet fully done so). The ECB cannot act similarly because there is no euro area fiscal entity to which it can hand off responsibility. Moreover, to commit to a major monetary rescue would undermine the chances of a permanent political resolution to the euro area's underlying problem: a lack of effective institutions. Were the ECB to cap governments' financing costs at no more than 5 percent, for instance, national politicians would probably never adopt the needed adjustment policies and structural reforms.

Saddled with administering a common currency, and endowed with governing institutions flawed by early political compromises, it is hardly surprising that the ECB's dominant concern as it manages this crisis has been to force euro area leaders to adopt the needed policies. It is not the primary purpose of the ECB to end market anxieties and thus resolve the euro area crisis as soon as possible. It instead aims to induce national leaders to fundamentally reform the euro area's institutions and structurally overhaul their economies. Frankfurt cannot directly compel democratically elected leaders to comply with its wishes, but it can refuse to bail them out and thereby permit the crisis to pressure them to act.

So far, the ECB as a de facto supranational government has been quite effective in its strategic bargaining with euro area national authorities. The initial Greek crisis in May 2010 led to a deal whereby the ECB agreed to set up the Securities Market Program (SMP) to buy bonds of European sovereigns in exchange for a commitment from euro area governments of 440 billion euros for the newly created EFSF, which proved to be an effective way of channeling resources to Greece, Ireland, and Portugal.

The EFSF, however, would simply not be large enough to rescue Italy and Spain. Hence the ECB, in August 2011, itself bought Spanish and Italian bonds to trim their interest costs in return for reform commitments from those governments, which the ECB itself specified in secret letters to their leaders. In December 2011, it provided huge amounts of fresh liquidity for three years (the long-term refinancing operation, or LTRO) as a quid pro quo for intergovernmental agreement to the new Fiscal Compact, which seeks to assure euro area budget discipline. Most recently, in June 2012, the euro area governments agreed to accept mutualization of banking supervision (probably by the ECB itself) and the ECB both signaled a willingness to conduct targeted support for Spanish banks and subsequently reduced its policy interest rates.

At each of these stages of the crisis, many pundits and even serious economists proclaimed "the end of the euro". This notion is nonsense and utterly fails to recognize the vitality of the bargaining and evolutionary reform process that is so effectively underway. All the key political decisionmakers in Europe—the ECB, the German government, the French government, Italy, Spain, and even Greece—harbor no illusions about the catastrophic costs of such an outcome. Greek politicians and even the Greek public, as indicated by its latest elections, know that, without the euro, their country would collapse into a vulnerable economic wasteland. German Chancellor Angela Merkel knows that, were the euro to collapse, Germany's banks would also fall under the weight of their losses on loans to the periphery; the new Deutsche mark would skyrocket, undermining the entire German export economy; and Germany would once again be blamed for destroying Europe. The ECB, of course, would not want to put itself out of business.

These actors are playing a game of political chicken, but in the end, they will all compromise. Once Germany and the ECB feel they have gotten the best possible deal, they will pay whatever it takes to hold the euro together. Neither can afford the alternative. But, as noted above, neither can say so in advance.

It is still possible that Greece will exit the euro. But this would leave the common currency stronger rather than weaker. It would be rid of its weakest economy. It would have to pair "Grexit" with sharp increases in both its financial firewall and the pace of its integration process, particularly with respect to banking union, to counter the resulting risks of contagion. Most importantly, the total chaos that would descend on Greece would send a decisive message to the other debtor countries to do whatever was necessary to avoid suffering the same fate. "Grexit" is to be prevented if at all possible, and probably will be, but its eventuation would certainly not doom the euro.

Restoring Growth in Euroland

The euro area has taken initial but decisive steps to complete its economic as well as monetary union. It decided at its latest summit to implement a banking union, initially with pan-European supervision followed by regulation, resolution authority for failed banks and, most critically, region-wide deposit insurance like that of the Federal Deposit Insurance Corporation in the United States to prevent bank runs. It is developing a partial fiscal union with mutualization of modest amounts of debt via lending from the European Investment Bank, project bonds, the EFSF/ESM themselves and, most importantly because the bulk of EU public spending and taxation will remain at the national level for a long time, firm rules for budget discipline. Ideas abound for moving towards a political union that would address the questions of political legitimacy that surround these reforms.

Hence it is highly likely that the euro area will, as it emerges from the crisis over the next couple of years, not only correct the design flaws that produced much of the current difficulties. As in every past crisis, the will to preserve Europe by enlarging its mandate will also produce a positive outcome that will lift the integration project to an even higher plane for the decades ahead.

Even the most successful financial and institutional engineering in the euro area will ultimately fail, however, if the debtor countries cannot get their economies to grow again.

This is not because political populism is about to break out and repudiate responsible economic (even "austerity") policies. Governments have been ousted in each of the main debtor countries but policies have been maintained, including in Greece, and even strengthened. The same is true in the main creditor countries, especially Germany, where the chief opposition party is even more pro-euro that Chancellor Merkel and is likely to enter a new Grand Coalition government next year.

There may be occasional spasmodic outbreaks, as when the Greeks elected an anti-adjustment (though still pro-euro) coalition in May just like the US House of Representatives initially rejected the TARP legislation before being forced back to reality three days later by a market collapse. But the center has held and indeed widened and, given the dire consequences of the alternatives, is likely to continue doing so.

But no policy can be regarded as successful unless it offers promise of restoring economic growth. This is now difficult in almost all high-income countries, including the United States, due to the prolonged slowdown for up to a decade that inevitably follows financial crises and the subsequent required deleveraging. But there must be light at the end of the tunnel if the euro area strategy is to succeed.

This will require at least three major steps. First, the borrowing countries must adopt convincing pro-growth structural reformism addition to budgetary austerity. In particular, they must greatly increase the flexibility of their labor markets by easing firing procedures and thus encouraging hiring, raising retirement ages as part of pension reforms and moving to firm-level or even plant-level rather than nationwide collective bargaining. They need to open up restricted professions, especially in their services sectors. And they can boost productivity through intensified competition policies, especially by enabling small firms and startup companies to grow rapidly. The OECD's latest studies demonstrate that some structural reforms can bring faster growth and increased competitiveness in as little as three years although many will take considerably longer.

The fiscal tightening that comes with austerity will of course lead to lower interest rates and more investment in the debtor countries. Combined with the structural reforms, especially wage bargaining at the firm level, this can produce the needed "internal devaluations" as we have witnessed in countries ranging from Germany over the last 20 years to Hong Kong after the Asian crisis to Latvia most recently—and as are already occurring across the European periphery inter alia through reductions in public-sector wages, which usually set the pattern for much of the labor force.

Second, the strong economies in the northern core of Europe, especially Germany, must terminate their own fiscal consolidations for a while and generate more spending and inflation. They should buy more of Italy and Greece's goods and services and less of their debt. Germany overdid its internal devaluation, creating competitiveness problems for everyone else in Europe, and now needs to engineer an "internal revaluation" to at least partially offset those results.

Third, a euro area-wide stimulus program is needed. Some of this is already underway. The June 2012 summit agreed to additional pan-European spending of about 1 percent of the region's GDP. The pending relaxations of fiscal consolidation targets in some of the debtor countries are also expansionary. The ECB cut interest rates by 25 basis points. But considerably more can be done on all these fronts, especially through quantitative easing by the central bank and the use of project bonds that will simultaneously accelerate the structural progress towards fiscal union.

Going forward, then, the euro area's agenda must combine the financial engineering that is necessary to overcome the immediate crisis and a growth strategy to restore the area to economic vitality. Fortunately, both the history of European integration and the way the euro area's leaders have responded to the current turmoil suggest that both the historical imperatives and economic self-interest of all the key countries, creditor as well as and debtor, will coalesce successfully. As the drama continues to unfold, watch what they do rather than what they say. Even the markets might begin to understand this reality and start betting on the euro rather than against it.

After Europe adopted a common currency, it took almost ten years for the first serious economic and political crisis to hit. Now that it has arrived, Europe must use the opportunity it presents to get the continent's basic economic institutions right and complete the euro's half-built house. This process will require more treaty revisions and fixes to the euro area's institutions. If the history of the continent's integration is any guide, however, Europe will emerge from its current turmoil not only with the euro intact but with far stronger institutions and far better economic prospects for the future.