Escaping the trap that is the eurozone

The immediate threat of a so-called Grexit has passed, but the eurozone crisis is far from over. The eurozone has emerged weakened in the medium term from the events of this summer, as the deep flaws in its economic policy architecture have not been repaired. They must be urgently addressed before the next crisis hits.

It is now four years since September 2011 when the first appeals were made by the IMF, the U.S., the Polish presidency of the EU and many others for action to be taken, but nothing fundamental has changed. The single currency still has no permanent “firewall” to prevent debt and membership crises from spilling over from one country to another, as happened so ruinously in 2010-11. The eurozone also has no legitimate political mechanism to decide which countries are to continue as its members, benefiting fully from the protection of a firewall, and which should leave. These two weaknesses need to be confronted urgently, while in the medium term the eurozone would also benefit greatly from a common fiscal policy to help it avoid unnecessary recessions.

This year’s Greek membership crisis occurred when, fortuitously, temporary substitutes for the first two of these institutions existed. The European Central Bank’s Quantitative Easing Programme (QE) provided other peripheral countries with an effective firewall, while Greece’s default to the ECB would have provided the political trigger for exit. But QE is supposed to end in a year, and for all concerned there must be a less dangerous and chaotic way for a country to leave the euro than via the destruction of its banking system. As a result, the eurozone’s window of opportunity for a safe Grexit will likely have passed by 2017. Paradoxically, the bargaining power of potential “departees” vis-à-vis Germany and the rest of the eurozone’s orthodox north will then increase.

Following this summer’s Greek referendum on the bail-out terms, Germany’s finance minister Wolfgang Schäuble offered Greek prime minister Alexis Tsipras what was in fact a mouth-wateringly generous deal. It was a deal that neither Greece’s premier nor Germany’s chancellor Angela Merkel wanted, although they would probably have accepted it by accident during the final night-long negotiations in Brussels had the European Council’s president Donald Tusk not performed his mediating duties so effectively.

Having discovered a previously unknown principle of EU law, that only countries outside the euro could default on their debts, Schäuble offered Tsipras a five-year or more “time out” from the eurozone. Had Greece accepted Schäuble’s legal interpretation and his offer, the country would not only have had Germany’s acceptance of default but also, with time, it’s acceptance of a very large debt write-down. This is because, once default has occurred and the debtor has paid the initial costs involved, the balance of power shifts in its favour. Creditors have few instruments to encourage the resumption of debt servicing, while for the debtor the costs of servicing need to be smaller than the benefits of the renewed access to debt markets that an agreed debt reduction would bring.

Because the vast bulk of Greek debt is official, a politically-motivated and skilful Greek government should have been able to negotiate a reduction far in excess of the usual 50%. Patience and determination might have made even 90% ultimately attainable. The steep devaluation that would have followed Greece’s exit, combined with some supply side reforms, would probably have reignited an eventual economic recovery there.

The September 20 election showed that Greeks have decided to forgive their prime minister his failure of imagination and nerve on the night of July 12. What is more important for the rest of the world is that the eurozone then stood on the verge of a chaotic Greek exit, with potentially dire consequences for a Europe that then – as now – is totally bereft of the rules and even the institutions needed to manage possible exit cases.

As good for Greece in the medium term as it probably would have been, an acceptance of Schäuble’s offer by Tsipras would have seriously undermined the eurozone’s medium-term stability. Not only would it have transformed it from a supposedly permanent monetary union into a fixed exchange rate system (albeit a very “hard” one), but also the “Schäuble option” of default outside of the euro would actually have created a powerful new incentive for so-called “programme countries” with large shares of officially-held debt to exit. Financial markets would quickly have become aware of this.

Germany continues to fear a permanent firewall because the loans that the Bundesbank along with the other central banks of the Eurosystem would supply under such circumstances would turn into losses to be ultimately borne by taxpayers were any of these threatened countries to actually leave the euro.

At the same time, while many in Germany may favour an exit mechanism for countries that have proved insufficiently competitive to remain comfortably in the single currency, they also fear a “political” mechanism for ending a country’s membership of the euro because it would have to be based on current EU voting rules. As matters stand, these rules are likely to leave the countries of the austerity-minded north in a minority.

The same reasoning will, I believe, rule out such ideas as the creation of a eurozone “Minister of Finance”, to be controlled by a special Chamber of the European Parliament or by a Eurozone Committee of the whole Parliament.

While providing the eurozone with the capacity to conduct discretionary fiscal policy when necessary would be a great step forward, and would require a major strengthening of its policy institutions, I fear that proposals along these lines coming from Berlin are merely red herrings. The aim is to dissipate the disquiet over German power in the EU aroused by the way the Greek debt crisis, and more recently the refugee crisis, have been handled. In any final negotiations, if it ever comes to them, Germany is unlikely to favour a eurozone finance minister with a wide degree of discretionary authority over economic policy, and would rather stick to its long-established preference for “rules”.

Reforms of the eurozone will probably be acceptable to Germany only if their main effect is to further tighten the current rules rather than introducing scope for discretionary policy activism

Lured by its own mirage of structural reforms capable of ensuring that all eurozone members will be in long-term balance of payments surplus, or at least balance, while Germany itself is allowed to maintain massive surpluses, Berlin is likely to prefer the present system under which it has an effective veto on support to crisis-ridden countries. Thus, reforms of the eurozone will probably be acceptable to Germany only if their main effect is to further tighten the current rules rather than introducing scope for discretionary policy activism. But this leaves us with a eurozone that still risks chaotic exits, has no firewall and no common fiscal policy – in other words, a eurozone that permanently teeters on the edge of dissolution.

In this, Germany is paradoxically supported by France, Italy and Spain, all of which are still attached to their own mirage of a “no-exit” eurozone. Such a eurozone can of course be created, but it would certainly not be “Germany writ large”. Instead, with adequate common macro-economic fiscal and monetary policies, it would rather resemble the U.S., the UK or (heaven forbid!) France. Such a eurozone might not be as internationally competitive as in the German vision, for it might not be as good at producing goods rather than services. Its politics might also be a good deal messier than those of the Federal Republic – even if less confrontational than at present. But it would be a more accurate reflection of the cultures, politics and preferences of its member nations, and it would have one great advantage: a real chance of surviving.