×

Europe Must Choose a Currency Union or a Financial Union

If there was one lesson to be learned from the European sovereign debt crisis, it was that monetary union by itself cannot work indefinitely. If Europe really wants to preserve the advantages of the euro currency, it will need far more fiscal and economic integration. Nations will have to give up a significant amount of sovereignty.

Euro coin in front of the giant symbol of the Euro outside the headquarters of the European Central Bank.
Thomas Lohnes | AFP | Getty Images
Euro coin in front of the giant symbol of the Euro outside the headquarters of the European Central Bank.

European leaders seem to be willing to accept that reality. But persuading publics may be far more difficult.

After more than a year of claiming that Greece could be bailed out without significant costs either for lenders or the rest of Europe, European leaders pledged on Thursdayto pump in large amounts of money to try to revive the Greek economy while delaying repayment and reducing interest rates on existing loans.

It appears that the deal will mean solvent European nations will have to write some very large checks. Lenders will suffer losses, and some banks may need more bailouts, which Europe will pay for through a collective fund that will be authorized to borrow money backed by European states individually and collectively.

That fund, called the European Financial Stability Facility, will also take over lending to Greece, at rates close to what the facility is forced to pay when it borrows money.

Other parts of the communiqué issued by the European leaders after their summit meeting in Brussels promise there will be more central control over national budgets and tax policies.

Call it the federalization of Europe.

Unlike in the first Greek bailout, in spring 2010, the European leaders now accept that the Continent has a responsibility not just to prevent collapse but to get the Greek economy moving again.

In effect, the new decisions recognize that a strategy that might have been called “prosperity through austerity” was a hopeless failure. While there is little doubt that Greek profligacy was an important cause of the mess it is in, a combination of reducing government spending and seeking to raise tax collections was never going to produce a recovery that would make it possible for Greece to pay its debts.

Over the 12 months ending in March, the Greek economy shrank by 5.5 percent, while unemployment, at 12.2 percent when the country was first bailed out, rose to 15 percent.

“We call for a comprehensive strategy for growth and investment in Greece,” said the statement. While it removed a reference to “a European ‘Marshall Plan’ ” that was in a preliminary version of the statement leaked earlier Thursday, it promised that the rest of Europe would “work with the Greek authorities on competiveness and growth, job creation and training.”

Pouring money in will not, in and of itself, make Greek industries competitive again and enable the nation to flourish. In fact, it was money pouring in for most of the past decade that helped to create the problem. Then investors were willing to lend money to Greece for basically the same rate they charged Germany, on the theory that a common currency should mean common interest rates. Those savings — Greece’s effective borrowing rate was cut by more than half from 1998 to 2005 — enabled the government to spend more and tax less than it otherwise would have been forced to do.

That was not what advocates of the euro forecast when it was being created more than a decade ago. Then the theory was that countries would enact reforms — in labor markets, fiscal policies and even work habits — to become more like Germany. They would do that because a failure to do so would result in a country losing competitiveness as its costs rose more rapidly than those of Germany while the prices it could charge could not do so, since both countries used the same currency.

Now, Europe claims it will change, but there is obviously some resistance to detailed commitments. The leaked draft included a promise to “introduce legally binding national fiscal frameworks” by the end of 2012. The final communiqué took out the words “legally binding.”

The countries previously promised not to run large budget deficits, but they all did when the world went into recession. This time, though, we are assured they really mean it.

With more control over fiscal policy at the European level, Europe is also moving toward something akin to a European monetary fund in the financial stability facility, known as the E.F.S.F. It would be able to buy Greek government bonds on the secondary market, effectively reducing the Greek national debt since Greece would owe what the bonds cost the E.F.S.F., not the higher face amounts.

If there was little enthusiasm in Europe for such centralization of power, there was even less for the obvious alternative: abandon the euro. Had Greece not been in the euro zone, it probably would have followed the Argentine path of nearly a decade ago: default and devalue. With Argentina’s industries newly competitive because the peso lost most of its value within weeks, Argentine exports and the economy recovered faster than many expected.

There is, however, no clear way for a country to leave the euro, and no leaders have advocated it.

But the effort to rescue Greece on the cheap clearly did not work. The deal Europe now advocates will force losses on banks. Major banks have signed on to plans that will force them to accept lower interest rates and extended maturities or — if they prefer — somewhat higher interest rates on bonds whose principal would be reduced by 20 percent. In return, Europe as a whole would effectively guarantee eventual principal repayment.

There is, in principle, no need for a more fiscally and economically unified Europe to be more like Germany and less like Italy or Greece. But Germany is unlikely to accept less fiscal discipline, and for the rest of Europe to regain competitiveness while sticking with the euro would seem to leave those countries with little choice.

It is of course possible that the decisions being made in Brussels will be negated or watered down as the details are considered. But the failure of the earlier bailouts, and the obvious risk of contagion, has forced Europe to move toward consolidation to preserve the euro. Those pressures will be there even if politicians want to step back at a later date.

The positive market reaction on Thursday should also be kept in perspective. The yield on 10-year Italian bonds, which had risen to more than 6 percent in panicked trading on Monday, fell below 5.4 percent on Thursday as word of the apparent agreement spread. But that is still higher than it was two weeks ago. Similarly, a 10-year Greek bond sold for more than 55 percent of its par value, up from less than 51 percent a few days ago. But it sold for nearly 75 percent of par value as recently as February.

A few weeks ago, the European Central Bank was unwilling to even consider allowing the admission that Greece would have to default. Germany was unwilling to agree to a bailout with open-ended costs. Both backed down in the face of economic and market realities.

Those realities will continue to pressure Europeans toward either abandoning the currency union or accepting much more financial union. For now, anyway, they are choosing the latter course.