Will the Euro survive the Coronavirus crisis?

So far in this astonishing episode, the world’s financial systems have held up well. Remarkably, lessons have been learned from the Great Financial Crisis, both in the behaviour of policymakers, and in the resilience of banks. But many claim that the Euro is especially vulnerable. Are they right?

The crisis so far has not been good for the egos of the Europocrats. The response has been led almost totally by the governments of its member states. It turns out that the EU really is just a free trade area after all. When something more important than trade comes along it has nothing important to do. And when its leaders at last got together to sort out a financial response, the outcome was pathetic, and spoiled by the sort of bickering shows that there is little solidarity amongst the member states.

Yanis Varoufakis, the former Greek finance minister, called this out on BBC Radio 4. The most important part of the EU’s infrastructure, the Euro, has turned into an instrument of oppression. The rich northern states, notably Germany and the Netherlands, were vetoing any serious aid to the most afflicted states, such as Italy and Spain, while not allowing them to help themselves. He said that German leaders should level with their public: the Euro was really good for their economy, but to keep it going they needed to be more generous to other members. The Italians, in particular, are throughly disillusioned and could provoke an existential crisis for the zone.

There is plenty of truth in what Mr Varoufakis is saying, but nobody should bet on the dissolution of the Euro just yet. Critics of the system miss two things. Firstly, as this week’s Buttonwood column in The Economist has pointed out, the European Central Bank (ECB) has learned a lot from the previous crisis and has now become the EU’s most effective institution, and not bogged down by the bickering that undermines the more overtly political arms. It has, amongst other things, rushed to buy up debt from Italy and Spain, thus greatly assisting a strong fiscal response to the crisis. This has the effect of mutualising their debt by stealth. The ECB has learnt the art of doing just enough to keep the Euro going, while being unable to fix its deeper flaws.

The second point is more subtle. It is wrong to suggest, as Mr Varoufakis does, the Euro is in effect a plot by Germany to rob Italy. It is better understood as a conspiracy between German workers and Italian savers. The Germans get plentiful and secure jobs, because their currency is held down, allowing its industry to run a surplus. Italian savers get more buying power for their money in a currency that is stronger than their own would be, with less risk of inflation. The victims are Italian workers, whose firms struggle to make progress with such a strong currency, and German savers, who lose buying power. It is arguments between these victims that drive the acrimonious politics of the Eurozone. Politicians like to blame an outsider, so German ones like to blame lazy Italian workers for low returns by their savers, and Italian ones like to blame the Germans for screwing their businesses.

So the Euro’s losers drive the day to day politics, but as soon as it looks as if they might succeed in their goal of causing the collapse of the Euro, the winners, German workers and Italian savers, hoist it out of trouble with a twitch upon a thread. The clearest example of this is Marine Le Pen’s tilt at the French presidency. Her bid featured resentment at the Euro, and it got her into the final round against Emmanuel Macron, but it rapidly collapsed when, in one of the debates, she floated the idea that France might leave the Euro. French savers, many of them older voters sympathetic to Ms Le Pen’s anger at liberal elites, suddenly realised that there could be a cost to their protest and deserted her. Something like this effect will happen in Italian politics if anti-Euro politicians get too much traction there.

So the Euro is safe but the politics is grim. What is needed are two things: more enlightened self-interest from northern leaders, and more willingness to embrace economic reforms by southern ones. The big trading surpluses by northern countries mean that they could easily be more generous to their southern neighbours by buying their goods and services or through direct aid (though lending them money simply builds trouble for later). Each of the southern economies has economic inefficiencies that their leaders should do more to tackle. In Italy it is excessive petty regulations to protect economic vested interests. In Spain it is lack of labour market flexibility. In Greece it is a failure to collect enough tax, especially from the better off. Until they tackle these they will always be supplicants and politically vulnerable.

For all that, the Euro has some very challenging times ahead (as do the US dollar and the Chinese Yuan, for differing reasons). Italy could easily be faced with a banking crisis, at a time when the attempts to mutualise banking risk across the Eurozone are incomplete. The acrimony will continue.

And this will set the EU on a trajectory that makes it more and more resemble the Holy Roman Empire. This was a tangle of German states, led by an Emperor with little practical authority. It was much despised by Enlightenment thinkers, and finally brought to an end by Napoleon. But it was the foundation of the strong commerce and devolved administration that makes Germany (and Austria) such successful states today. This is something Anglo-Saxon observers almost never understand.

Italian populists will find it easier to complain than to govern

Well one of my 2018 New Year predictions is bearing fruit. I predicted that the big issue in 2018 for the EU would be Italy, and its push back on how the Euro is run. Just how this will play out is very hard to judge, but it is now centre stage. Most of the coverage centres on threats by Italy’s Five Star Movement (M5S) and the Northern League to take Italy out of the Euro. But the politics of that is much trickier than many give credit for.

It is, of course, too easy for liberals like me to sneer as the disparate group of politicians we refer to as “populists”. The popular frustration they play on is real enough, and liberals are very reluctant to engage with it. We seek for ways round it and dismiss it. But for all the weakness of established political movements, populism does represent a threat to European (and American) society. What populists aim to do is stoke up a sense of grievance and victimhood to secure power for themselves, which they then proceed to use to for the purposes of self-enrichment and cronyism. Nobody should be surprised that a movement built on resentment at elitism and cronyism should, in practice, be much worse than the system it is replacing. Donald Trump made hay from Hillary Clinton’s minor lapses in data security, and talked of “draining the swamp” in Washington. And yet the new governing elite plays fast and loose with security and thinks nothing of placing its own friends and relatives in positions of influence. Its supporters don’t seem to mind.

The populist system in Europe is most advanced in Hungary, where under Victor Orban’s Fidesz a crony state is becoming deeply entrenched. It is worth noting that when Fidesz first emerged from the post-Communist gloom it seemed fresh, modern and innovative. It has been corrupted by power. But Hungary does have some advantages. First it can claim subsidies from the European Union because of its relative lack of development. Second it has its own currency, so it is not beholden to the system of Euro governance. But note a key element of the system: it requires EU subsidies to keep going, and anti-EU resentment is one of its key themes. Staying within the system while complaining about it ever more loudly is Fidesz’s central political strategy.

The Italian populists are embarking on a similar strategy. I am perhaps being a little harsh on M5S. Its hatred of the old establishment cronyism is genuine and it does seem to want to move to something better. It refused to deal with Silvio Berlusconi, one of the pioneers of populist cronyism, for example – though its more cynical Northern League allies had long been associated with him. And yet Italy’s economic predicament makes something like the classic populist trajectory almost inevitable.

The central issue for Italy is the Euro. Both M5S and the League make this a central complaint. They complain that the Euro’s budget rules are too tight and prevent sensible fiscal policies from being implemented that might help lift Italy’s dismal economic growth rate. Plenty of economists from across the world agree with them. How much substance there is to these complaints is a complex topic for another time (my answer: yes some, but nearly as much as many make out). The real question for populists is just how serious about this do they want to be. Do they want to make genuine, credible threats to leave the Euro? The answer is surely not.

It is, in fact, institutionally and practically very hard to leave the Euro once you are in it. For all its extreme problems, Greece never seriously contemplated it. But there is a political problem too, which, for example, cost Marine Le Pen in France dear when she seemed to be on the threshold of power. That problem revolves around two things: interest rates and savings. One of the main reasons Italy joined the Euro was to reduce interest rates, especially on government debt. It should be remembered that, contrary to the populist narrative, Italy was not bullied and cajoled into joining the Euro by the Germans. The Germans never wanted them in, but Italy made it in thanks to both some fairly hefty austerity economics and diplomatic skill. This proved very successful. If Italy left the Euro, the country would surely have to raise interest rates on its debts and government finance, including a looser fiscal policy, would in fact be much harder. That is exactly why Italy joined the Euro and the basic dynamics haven’t changed. And this would not be some future prospect (like the dire predictions made about the British economy after Brexit), but would be immediately apparent should the prospect of Italy leaving the Euro look real. The rise in Italian government bond prices after the populist victory at the polls shows this.

The economics may not be quite as simple as I have made it sound. The Italian economy, for all its weakness, is roughly in balance on trade, which makes looser fiscal policy and monetary policy much easier – but that was true before. The real problem is that successive Italian governments have been unwilling to take on the economic reforms that might make the economy more productive, and a looser fiscal policy more sustainable. It is a popular misconception on the left that “Keynesian” loose fiscal policy can drive growth and pay for itself. That is only true of there is spare productive capacity, such as in a recession, or if productivity reforms form part of the government programme. In fact the left usually see “Keynesian” policy as an alternative to “neoliberal” reforms rather than a complement to them. I have written often that neoliberal reforms are played out – but that is not true of Italy, which used the gains made from joining the Euro to put off the evil day. The populist movement draws much of its strength from resistance to such reforms when they were belatedly embarked on by the Socialist government of Matteo Renzi – so embarking on a reform programme looks out of the question.

Still, politically, the interest rate problem is not the most serious. That is that leaving the euro would be seen as a threat to many Italians to the value of their savings. Economists talk about currency as a means to an end – a sort lubricant to help achieve real economic gains through higher levels of investment and consumption. Money means nothing in itself. But most people outside the elites have a different view. To them money is a sacred promise made by the government to the people that they can save now to spend later. Politicians forget that at their peril. If Italian savers start to think that threats to leave the Euro are serious, they will see a threat to their savings and support will drain away from M5S and the League faster than most people think is possible.

And so the populists need to maintain that balance: whinging about victimisation within the Euro straitjacket, while making no serious attempt to leave the system. This sort of have-your-cake-and-eat-it politics is, as it were, bread and butter to populist politicians. But it will surely be harder inside the Euro than out.

This is doubtless behind the Italian President Sergio Matterella’s rejection of the coalition’s proposed finance minister. What looked like a clumsy denial of democracy could in the longer term be part of a challenge to the populist parties to put up or shut up about the Euro. That could pay dividends if only the established political parties to put up a credible alternative government.













The British are bowing out. Now the EU is a battle between the French and German visions.

The European Union dominates British politics at the moment – but in a rather superficial way. It is focused on the short-term implications of the country’s relationship with it, and not on the institution itself. And that is true especially of continuing Remainers. They concentrate so much on stopping or diluting Brexit that they avoid tackling questions about what the Union is, and what it is turning into. More thoughtful Leavers will no doubt suggest that the focus on Brexit is a displacement activity from more uncomfortable questions about the EU. So it is worth taking a step back from the kerfuffle about Brexit to think about the Union itself.

I think it is helpful to view the debate over the EU as a conflict of three visions. I will characterise (or caricature) these as the British, the German and the French visions. The British vision is of the union as a free trade area; its fundamental purpose is economic, and to bring to its members the manifold benefits of free trade. The British are divided on whether this necessarily includes the free movement people, or, rather, labour (as opposed to temporary visitors, which most people are happy with). Many older people (and probably a majority) think emphatically that it doesn’t, and that goods are fundamentally separate from labour. Younger voters tend to say that it does – seeing free movement as a way to expand their personal horizons. Some are muddled – wanting all the benefits of retiring to Spain and using its health service for free, while stopping people from moving into Britain. But all sides treat this as a fundamentally economic question. and think of it individualistically – how does it benefit me?

The Germans feel that the fundamental point of the EU is to create transnational order. This affects trade, so that manufactures and services are based on common rules, and that countries don’t get an unfair trading advantage through lax labour or environmental laws. But it goes deeper; they see nothing wrong with rules that secure fundamental political principles, such as human rights and the democratic order. Britons tend to resent this as an unnecessary intrusion, feeling secure in their own country’s institutions – different histories do much to explain the different attitudes. Britons have learnt to trust domestic institutions; Germans (right up to 1990 in the East) have learnt that trust can be abused. The Germans’ outlook is more collective than the Britons’ – but they share Britons’ distaste for political meddling from EU institutions.

But the French, on the other hand, emphasise the political union. To them it is a joint political project, in which their country must take a leading role. They tend to see the EU as a counter to the giants that stalk the world stage, and in particular to the US – but also to Russia and China. Internally they advocate a greater use of political mechanisms to resolve the problems and conflicts within the Union itself. This is the most collectivist view. If Europe as a whole advances, the logic goes, then we all do as individuals. The British tend to view it the other way round.

It is tempting to suggest that these three visions are all right, and that some form of reconciliation or compromise must be found. But I find it more helpful to see the three visions as varying stages of understanding of what the European project implies. A free trade area cannot reach its potential without transnational rules, including some form of transnational arbitration. And you cannot have such a transnational system of rules in the long run without common political processes to manage them. The North American Free Trade Area (NAFTA) was often held up as an example of what “just” a free trade area might look like – but it first lost momentum and is now in imminent danger of collapse, as it has been unable to handle the  political tensions it has created. The French understand the implications of the EU the best, the British the least – which, of course, is the main reason why Britain is leaving. Most of the British public do not want to accept the political implications of the EU; many of those that voted Remain were in denial, and voted that way to maintain their own short-term economic prospects. The whole Remain campaign last year was based on little more – one reason that the more thoughtful Leavers feel that it is they that hold the high ground.

With Britain on the way out, the driving tension will now between the German and French visions. The British view was shared by other members, especially the Scandinavians (as a matter of principle) and the eastern members (as a matter of political convenience). Brexit not only removes the British view’s biggest advocate, but also it points to the ultimate destination of countries that follow it.

The Franco-German tension could ultimately destroy the union. The Germans are easily the union’s most powerful member; but the French are ultimately right – the Germans are simply postponing an inevitable reckoning. This tension is most easily seen in the management of the Eurozone. The EU’s treatment of Greece, for example, was brutal and surely misguided – even if I find most of the pleadings by Greek politicians such as Yanis Varoufakis to be self-serving and evasive. To the Germans, the Greeks simply broke the rules. They lied about their economy to get it into the Euro, and then milked the Union for all they could get with no attempt to make their economy more productive or less corrupt. The crisis was a reckoning, and it must be played out according to the rules. That Greek voters approved of gobbling up their neighbours’ resources as an easier alternative to fixing deeper problems at home did not make what they were doing democratic. But this view is also self-serving and evasive. German banks contributed mightily to the Greek bubble, and German businesses where happy to sell things to people who could not afford them. There must be a principle of caveat emptor. Instead the German taxpayer bailed out their banks, and their government is trying to blame the Greeks. It is a political mess that requires a political solution, and that means some of the rules must be changed. It is clear, for example, that much of the Greek government debt must be forgiven. The country also needs financial aid to help its economy to grow on a financially sustainable path. But that implies accountability from the Greek government.

And yet the French view, which is now being vigorously pursued by its new president, Emmanuel Macron, leaves hard questions at its core. It requires stronger and deeper transnational institutions, whether at the EU or Eurozone level. But are the democratic institutions up to the job? And is there democratic consent for them? And how deep must these central institutions go? The type of problem posed by Greece persists: member states trying to take the rest of the union for a ride – to take the money, but without any any serious attempt to develop an open and efficient economy, buttressed by democratic institutions, based on the rule of law applied without corruption. Challenges aren’t just being presented by such countries as Hungary and Poland, but by countries closer to the heart of the picture, like Italy. And France. And even Germany with its destabilising surplus savings. Mr Macron’s strategy is to boost France’s credibility by reforming its economic institutions. But what will make other countries follow this path?

What will happen next will be the usual European muddle and fudge. That muddle and fudge will either lead to disintegration, or to something that looks much more like a federal state. Or both – if more countries leave but a more integrated core remains.

And that poses a challenge to British Remainers, who either want to reverse Brexit, or to rejoin the union at some later stage. If Britons remain wedded to what I have called the British view, this will end badly. Britons must accept that they are signing up to a political project that reduces the sovereignty of the British state. Liberal Democrats, in particular, need to understand when there will be too much European centralisation, and when they would say no. After all their other rallying cry is the decentralisation of political power.

And me? Fundamentally I am a Frenchman on this. Proud though I am of my British and English identity, I also have a strong sense of European history and identity. I long to be part of a joint European political project. But not even I have thought through the full implications – and I am in what looks like a small minority. For that minority to grow, more persuasive arguments must be made.


Is the Euro worth saving?

Anglo-Saxon economists were always sceptical. And so was much of the British establishment, though less so in the early days. But sponsors of the European dream were determined. And at first European Monetary Union defied the sceptics. But now the dreams are vanished and the only people defending the union seem to be those that have face to lose. Is it all over for the Euro?

It is Greece that seems to prove the scheme’s futility. The Greek government cannot repay its debts; its banking system depends on a bankrupt government for solvency and the European Central Bank (ECB) for liquidity. Greece cannot print its own money to inflate its way out of the hole. Instead European institutions and the IMF have to bail it out, and they are demanding conditions that add up to a loss of the Greek government’s sovereignty over its economic policy. Both sides blame the other, and the more the blame game goes on, the more trust and solidarity break down. The Euro is tearing the union apart, when it was supposed to bring Europe’s peoples together.

It doesn’t take hindsight to see what went wrong. Mostly the scheme’s weaknesses were pointed out at the start. Its supporters (who included me) just thought that this time it would be different.

Monetary policy is set at continental level, and yet there isn’t a great deal of economic integration. In order to adjust to local business cycles and local economic shocks, national governments have only a very limited set of tools. And the most important, fiscal policy, is constrained by the Stability & Growth Pact. This was instituted to try and prevent member governments becoming insolvent, a contingency that the zone had no process to deal with. This made it quite unlike a federal system, like the US, the only comparable monetary system that most knew. In the US there is a strong federal level of government, which draws substantial taxes from all parts of the union, and can make big fiscal transfers between the union’s members to compensate for the lack of monetary flexibility.

Funnily enough the problems with this set up did not play out in the way that most critics foresaw.  They thought that different business cycles or local shocks in different parts of the union would be the big problem. This happened – especially when the central economies of Germany and France endured recession, while peripheral economies, such as Spain and Ireland fizzed. But these were not the main cause of the crisis that emerged following the global financial meltdown in 2008.

The first problem was that investors assumed that member governments could not go bust, and that if they got into difficulties somebody would bail them out. As a result, it became much easier for the peripheral governments to borrow, and this allowed them to run their economies with a looser hand than they should. This was most egregious in the case of Greece, who produced misleading economic statistics, which put their government into a completely unsustainable position. And when it was clear Greece could not repay its debts, the system had no set of processes with which to manage the crisis.

Perhaps Portugal and Italy were guilty of something similar without the fraud, though Italy has not needed a bailout. But the other bailout cases (Spain, Ireland, and Cyprus, though I am less confident that Cyprus follows quite the same narrative) the main problem was not government finances, but a reckless private sector that fuelled property bubbles. What added fuel to these bubbles was cross-border flows from elsewhere in the Euro area, and especially German banks. The Euro system had greatly facilitated such flows. When the bubble burst, it brought down the countries’ respective banks, and this in turn draw their governments down with them. Governments couldn’t let the banks go bust, since they controlled local payments systems and economic chaos would have resulted. Like Greece these countries then needed external support and bail-out.

The important point to make about this series of crises was that they were to great extent “endogenous” as economists like to say – they have to do with the way the system itself operated – and not exogenous – the external shocks and uncontrollable factors which most economists thought was the system’s weakness. That suggests that bad systems design was a large part of the problem – and that, in theory, could be fixed. Most suggest that it implies a fully federalised system, with a federal government, supported by federal taxes and federal debt. An alternative route would have two main elements: a national insolvency regime (a bit like US states, but not Puerto Rico, which is on the path to creating a US version of the Greek crisis); and banking reform to produce a more federalised banking system firewalled from member governments.

But either route would leave member governments facing a grim reality. The Euro offers a straitjacket for government finances, and not a liberation. In the fully federalised case, the scope of government responsibilities would be curtailed and handed over to a federal government. In the alternative governments would be heavily restricted by their ability to borrow in financial markets (which would do away with the need for the Stability & Growth Pact). This latter is, in fact, what many supporters of the Euro (including me) envisaged all along (though in my case I completely failed to grasp the difficulties of managing the banking system). It was rather a Thatcherite project. But others thought EMU would be a step along the path towards a federalised Europe. It was the unresolved conflict between these two visions of the Euro that got the system into its current mess.

And this conflict is still unresolved. But the federal vision is losing ground; there simply isn’t the political support for it. That doesn’t stop people in the European Commission from quietly pushing for it though. But those who aren’t convinced by the federal idea, aren’t convinced by the multi-state currency area alternative either. Why opt for a straitjacket? Wouldn’t it be more democratic and easier to say goodbye to monetary union altogether and let each country go its own way with its own currency?

And I don’t have the answer to that. One thing I will say is that the quality of economic commentary in the media is pretty dire. From this you would think that the advantages of having a floating currency make doing anything else foolish. But all Economics students are asked to do an essay on the pros and cons of floating currencies, and frankly it is not that obvious that either route is a winner. As a rule, the smaller and more open the economy, the more there is to be said for a fixed currency regime – which is why the Euro is popular with so many smaller EU members. Floating currencies reduce the effectiveness of fiscal policy, especially in such small and open economies. The rather loose fiscal policy of the Britain’s government in the 2000s caused the exchange rate to be too high, leading to a trade deficit and a hollowing out of British industry the country still have not recovered from. By contrast Germany has been able to maintain its industrial base within the Euro, albeit with some painful restructuring.

And a floating rate does not prevent banking bubbles. Iceland had one in parallel with Ireland, with its own currency. Recovering from the bust best no less painful for Iceland than for Ireland, though arguably not really any worse either.

But setting up a more secure banking system across the Euro area is no small thing, and its feasibility is an unknown. Against this, taking the Euro apart would be a huge undertaking, so there is there is much to say for trying to make it work on a rather less ambitious scope. Inertia is on the side of the Euro. But the starry-eyed enthusiam is gone



Greek crisis: the problem is loss of trust

The leaders of Greece’s Syriza government are clever people. They include university academics, well versed in modern economics, including game theory and the theory of negotiations. After yesterday’s decisive No vote in the referendum on settlement terms, these negotiators now feel they have a strong hand. I don’t share their optimism.

Unless you believe the conspiracy theories that Syriza’s real aim is to create a Venezuela in the Mediterranean, they appear to think that their EU counterparts and the IMF will be forced to negotiate because the consequences of not doing so are dire. What they seek are two things. First is that the level of government debt be reduced through forgiveness. The second is that the Greek government has a free, or freer, hand to follow an economic policy of its choosing, supported by fresh funding, primarily in the form of support for the Greek banking system by the European central Bank (ECB).

On the face of it neither of these requests is all that unreasonable. The moral case for debt forgiveness is a sound one. In the modern age more responsibility needs to be pinned on creditors to lend responsibly, and to suffer losses otherwise. The lending made to Greece before the crisis was not responsible, although misinformation from the Greek government contributed. This moral case is softened but still stands after two things. The Greek debt has already been substantially restructured so that the country’s interest rate burden is proportionately less than even Germany’s; the net present value of Greece’s debt is not nearly as high as you might assume for its nominal size. And now the debt has been taken over mostly by government agencies; the private sector banks that originally lent the money have mostly been paid off, after significant losses were forced on them.

And as for economic policy, the nominal Greek aim is to set up a virtuous circle of increasing demand that will help the economy to recover, so that its banks can repay the ECB, and that other lending becomes more sustainable. There is a familiar, Keynesian demand management logic to this. I think this is why so many respectable economists (especially based far away in the US)  support the Greek government’s standpoint. There is also a powerful argument about democracy – surely a democratic Greek government should choose its own path to a sustainable economy? The sight of so many unelected functionaries dictating terms to the Greek government has angered not just Greek citizens. I have seen many comments this morning about how the Greek referendum vote was a blow for democracy. The People have spoken!

So what’s the problem? International leaders are masters of fudge and pragmatism. Surely some kind of face-saving formula can be found that will be better than the consequences of a collapse of the Greek banking system? This is now a clear and present danger. Greeks having been withdrawing deposits from their banks, making the system insolvent. Since this looks like a temporary problem, the ECB has been prepared to prop the system up with emergency funding, awaiting the return of those deposits once a new deal has been struck. But last week this support was cut off, as the confidence of European governments was shaken about the ability to do any deal, when the Greek government called the referendum. With the referendum done the outgoing Greek Finance Minister, Yanis Varoufakis, suggested that this funding would return while a new and more reasonable deal was in prospect. Mr Varoufakis, who had taken to lecturing his European colleagues on basic economics, even resigned to make such a deal easier to negotiate.

But all negotiations are built on trust. You have to believe that your counterpart will stick to their side of the deal. And this has always been the problem with Greece and its creditors. What these creditors fear is that the Greek government do not put their economy on the path to true sustainability, and that it and the country’s banks will continue to need injections of foreign money without any real prospect of these being repaid. And this further support will have to supplied or underwritten by fellow European governments. There is little feeling of solidarity with the Greeks from other European electorates. Better off countries, like Germany, Finland and the Netherlands are outraged about the prospect of more taxpayers’ money being sent to countries that they see as feckless. Many east European governments, like Slovakia or Lithuania, are poorer than the Greeks overall, and see no reason to let the Greeks off; in some cases they have been forced to endure harsher austerity regimes than the Greeks were. Governments in other countries that have been subject to bailouts, Spain and Portugal in particular, do not want to give an easy victory to Syriza, lest it encourage similar movements in their own countries.

And why isn’t the Greek economy sustainable? This is a familiar combination of corruption, clientalism and ineffective government. Tax collection is inefficient; many benefits are too generous; there are too many meaningless publicly funded jobs. Many Greeks are entrepreneurial and hard working, but overall the economy does not pay its way – consumption is sustained by net imports. To create something more sustainable would require a programme of reforms, most of which would be politically unpopular. They would also suck demand out of the economy in the short term, i.e. they involve what has become known as “austerity”. Some theoretical economists, like Joe Stiglitz and Paul Krugman, seem to think that economic reform programmes can be designed without austerity. But this requires a favourable context and an efficient government – which does not apply here. The commonest way for such reforms to be imposed is through the government following a programme designed by outsiders, such as the IMF. Or else it is the threat of such an intervention that forces governments to act. These outsiders become convenient scapegoats, but in the longer term the reforms may be popular, as they deliver a healthier economy.

But the hidden background to the current crisis is that the Syriza government has not offered any convincing programme of reforms, while reversing reforms enacted by its predecessor. You wouldn’t guess this from listening to their smooth-talking spokespeople on the international media. But the Syriza movement contains many with more extreme, anti-foreigner views, limiting the government’s ability to act. The IMF in particular have found their plans utterly unconvincing. Politically they seem happy to go after rich people to tax them more. But rich people’s money is a notoriously elusive quarry; and the government is unwilling to take on any other reform with a political cost.

So what are the European governments to do? They are the critical parties on whom a deal depends. They have been humiliated by the referendum. Their electorates are telling them to not throw good money after bad. Their expert advisers suggest the Greek offers of reform are unconvincing, which means that the crisis will simply repeat itself. Over the years they have increasingly embraced an idea that had been unthinkable: that countries may be able to drop out of the Eurozone. The political costs of a negotiating failure have never been lower.

So what might happen? This depends in some measure on how well-prepared the Greek government is for this moment. If they have in their back pocket a credible compromise deal that saves some face for the European governments, we might pull back from the brink. Mr Varoufakis’s resignation is a good start, it has to be said.

What are the ingredients of such a deal? The Greek banking system must be at its heart. The banks must be recapitalised using external capital. They need to be insulated from the Greek government – in other words the money supplied by outsiders shouldn’t be simply channelled into government debt. Something needs to be offered to reduce the principal of older debts – though perhaps the interest bill can be kept intact. The Greek government can then be left to work its own way out of its short-term economic problems.

Such a deal would point towards the sort of reforms that might make the Euro more sustainable. Separating the banking system from government, with a more centralised regulatory and ultimately deposit insurance scheme. A resolution system for insolvent governments that means debts can get written down quickly. More nominal freedom for government fiscal policy – with discipline forced by bond markets, not EU agencies.

Such a deal would be a way forward. But it still needs trust. Alternatively the Greeks will have to create a quasi-currency of their own to keep their banks afloat – a first step towards the Euro exit. I am not optimistic.


The European dream slowly unravels

I am one of nature’s political optimists. But 2015 is one of those years where it is all going wrong. The Lib Dem near wipe out in this year’s UK General Election, for one thing. The rise of Islamic State is another – along with the spread of vicious Islamophobia promoted by such outfits as Britain First. Meanwhile state after state in the Middle East and Africa is failing, with vicious dictatorships taking hold in other countries. This gives Israeli hardliners the cover they need advance their own brand of apartheid, and the ghettoisation of Gaza. Any attempt at finding a humane middle way is undermined by extremists of one sort or another, in country after country.

And now, as Gideon Rachman points out in yesterday’s FT, the European dream is dying before our eyes. The idea of ever closer European union was one of the formative ones in my own politics. In 1975 I was a 17-year old that was definitely ready to vote in that year’s British referendum on Europe. I’m not sure why it should have caught my imagination so – I grew up in postwar prosperity, where the World War was just an interesting piece of history. I suppose I found British society so staid and constricting that I wished for its institutions to be subsumed into something much more modern and exciting. I meet many people of my age that feel the same way though.

But apart from opening out British society and commerce, the EU represented a path towards civilised governance and prosperity for the undemocratic countries on its fringes. Greece was the first country to take the path of throwing off dictatorship and coming in to the mothership of Europe. 35 years on and the achievements look hollow. Greece took on the trappings of a well-managed European democracy but did not take it to heart. It remained run by a rich elite which did as it pleased, while bribing the rest of society with generous pensions and meaningless public sector jobs. They became artful in keeping that show on the road by extracting grants and loans from the rest of the union at the same time as disregarding rules they did not like. They even managed to join the Euro, reducing borrowing costs, and allowing the fiction of a properly functioning European state to continue. But sooner or later the music had to stop. And when it did the foundations of the European project looked shallow. There is an absence of trust and solidarity.

The Greeks themselves, or at least those that govern them, seem in denial about the sort of reforms that will be needed to get them on the path to prosperity. They claim to be victims, condemned as to doom-spiral of “austerity”, with many Anglo-Saxon economic commentators (Noble Laureates Paul Krugman and Joseph Stiglitz among them) cheering them on. But dig a bit deeper and we find that words such as “austerity” and “reform” have been abused so that a lot of the dialogue is at cross purposes. The Syriza government wants to reform some aspects of the Greek state, but sees no problem with those aspects that I have referred to as “bribery”: maintaining ineffective public sector jobs and unaffordable state benefits, such as pensions.This leads to the suspicion, especially amongst Germans, that all the Greek government want to do is to keep the old, failed way of running the state on the road, lurching from bailout to bailout, using moral blackmail each time.

The Germans, of course, are hardly blameless. Their banks kept the Greek show on the road, in the apparent anticipation that their government would bail them out if things went wrong. That expectation proved sound enough – most of the bailout money went to them, and practically nothing towards providing the investment the Greeks so badly need. The Greek government’s moral case is not entirely hollow – but their combative approach to negotiation is destroying trust. No wonder that British Eurosceptics urge the UK government to emulate such tactics in their dealings with the EU! Even now the Greek Prime Minister, Alexis Tsipras, suggests that a No vote in the forthcoming referendum is just a step in the negotiation, not a real moment of decision. Those European leaders who have been trying to fudge things to get a deal, like Claude Juncker, the President of the EU Commission, feel betrayed.

The prospect of Greece dropping out of the Euro and then the EU is steadily growing. This would be a calamity for Greeks, and raises the prospect of yet another failed state. As more than one commentator has suggested, if the Greek ruling elites had what ti takes to run an independent monetary policy, they would not have got into this mess in the first place. It would mark a big moment for the EU too. Its first major defeat. But it has limited powers; it cannot make an unwilling partner reform itself.

And old Europhiles like me must wake up and acknowledge the truth behind that. Our dream cannot be fulfilled. The EU is a confederation, not a federal state. It cannot bind its members by force of arms, as the United Stares did when some of its members tried to secede over 150 years ago.

The question now is whether the EU can survive a Greek exit, or will it be the start of a general process of disintegration. Greece is not the only country to be a cause for concern. The other bailout cases -Spain, Portugal and Ireland – were always more serious about reform and integration, and I do not see these as being of immediate concern. Cyprus, with its cultural ties to Greece, may be different. But the future integration of Hungary, Romania and Bulgaria are far from secure.  At least they are not members of the Euro.

Greece seems to be the lesson that the EU learns by. After its entry to the Euro, the EU became much stricter about allowing further new members. After its flawed bailout, which let many private sector investors off the hook, it was much stricter with Cyprus.

But what is emerging is a different Europe. One where much less solidarity is expected. And one with an Exit door. It is a system of rules and standards that facilitate free trade, environmental cooperation and good governance – but one where it if you fail you are out. Integration is not necessarily in one direction. The union will no longer be ever closer.

Into this sad situation the British Prime Minister David Cameron enters with his attempt at British renegotiation, leading to a referendum. This may seem to be the last thing that Europe needs. But Mr Cameron’s negotiating skills are far more advanced than Mr Tsipras’s, and he is showing much more application than hitherto. This cloud offers a silver lining. It may define a looser union, but if the British public votes to stay in it will offer a counter-narrative to the slow disintegration that is happening elsewhere. Such is what is left of my European dream.

Should I apologise for supporting the Euro?

The this week’s FT Janan Ganesh suggests that those who supported Britain’s entry to the Euro back in the late 1990s and early 2000s should own up to to their error and apologise for it. He feels that the arrogance of that generation of Europhiles is undermining the pro EU case as we face a referendum on membership. Well he won’t have me in mind. I am not a prominent politician; I wasn’t even blogging in those days. But I did have an opinion – and that was that that the country should be part of the Euro – though not at the exchange rate then on offer (about 65p per Euro). Should I hang my head in shame?

In fact this also seems to be a rather desperate line of attack by the Eurosceptics, who are at last realising to their horror that they are being out-manoeuvred. They want to discredit the whole pro-Europe cause. In today’s FT , one its other writers, Martin Sandbu, comes out with a robust defence of British entry to the Euro. He suggests that if the UK had been part of the Euro economic disaster would have been averted, because the European approach to fiscal and monetary policy would have been more pragmatically British. I have also heard a that idea suggested by a commentator from within the Euro zone, though I can’t remember who.

I’m not entirely convinced. But it at least raises the big question. It is treated as entirely self evident that the Euro is a disaster, and that British membership would have made things worse for the country. But both these are counterfactuals. We don’t know what would have happened if the Euro had never got off the ground, or if Britain had been a member.

Let’s consider the first of these. When the Euro was being formed the economies of Italy, Greece and Portugal were in real trouble. Their governments were losing the confidence of the markets; stagflation followed by hyperinflation beckoned. The Euro lifted these economies – before joining the governments were forced to bring fiscal policy under control; after joining interest rates fell dramatically. But these countries failed to deal with deeper seated problems, and eventually the chickens had to come home to roost. Membership of the Euro delayed the denouement rather than caused it. Indeed it gave these countries an opportunity to head off disaster which they failed to take. Contrast this, for example, to Belgium, also considered a bit of a basket case before the Euro, whose economy now prospers, relatively speaking at least. And for each of the other members of the  Euro that ran into trouble something similar can be said. Ireland suffered the consequences of a reckless expansion of its financial system not unlike that of Iceland, outside the zone. Iceland’s crash was at least as painful as Ireland’s. Their problems reflect underlying economic weaknesses that governments failed to tackle. The signs were there. Indeed no members inside the zone seem to want to return to life outside it, with the possible exception of Germany (and Finland perhaps).

The ambiguity of Germans is understandable. The interesting thing about that country though is that they were the only, or at least the first, country in the zone to understand the implications of membership for economic management. In the early days they realised they were uncompetitive, and embarked on a programme of “real” devaluation. This was a combination of holding pay rates down and economic reforms to improve productivity. The reluctance of other countries to embrace this style of economic management is the main failure of the Euro project.

And what of the second counterfactual? What if the UK had joined? Well the first thing to be said is that the country did not do so well out of the zone. The financial crash of 2008 was deeper, and the recovery slower, than the major Eurozone economies. Britain suffered a persistent current account deficit, supported by an unsustainable exchange rate. We were in a not dissimilar space to countries like Spain and Ireland, going through a financial boom offering the illusion of wealth while not enough was being done to fix the fundamentals. It is not so self-evident that things would have been worse inside the zone.

Or perhaps not. I would like to think inside the Euro the UK would have been locked into an exchange rate that suited exporting industries (like Germany after its reform/adjustment programme) and not so subject to financial shenanigans. That would have left the economy in a stronger position after the bust. But such an exchange rate wasSterling Euro X ratesnot on offer. The chart above shows the average exchange rate between the Euro and Sterling for each year of the currency (source: stastica.com). My view is (and was at the time) that the rate of 65p was high (or too low in terms of the graph). It was distorted by excessive government spending and a booming financial sector – there was a substantial current account deficit to show that it was unsustainable. It did not drop to a more realistic level until 2007-2008. That was too late. There was no chance that the government would have followed Germany’s example in conducting reforms to improve the real exchange rate – not while everything was rosy on the surface.

So If Britain had joined the Euro at its start or early in its existence, then the exchange rate would have been too high. Which would have made the adjustment period after the crash even more difficult. I’m not going to apologise for this because I understood that at the time (or that’s how I remember it!).

But there is a bigger issue that I will have to own up to. The design and operation of the Euro zone was flawed. There are two sustainable ways of running such a common currency area. One is part of an explicitly federal system of government, which allows substantial fiscal transfers between its members and a robust system of federal political control to match.  In this system members bail each other out if they get into trouble.To judge from most commentary, you would think that this is the only way to run the zone – and that because the European polity is not ready for such a federal system, then it will never work. But there is an alternative, where each member is not so tied to the others. Each country is left to run its affairs as it sees fit, and if it can’t pay its debts, it goes bust. It requires a sovereign insolvency regime. Nobody bails failing states out.

This latter arrangement is what the Germans wanted, and it is what most Britons that supported membership wanted too. But Euro-federalists in Brussels and the southern states saw the currency as a step towards federalism. The Germans didn’t help matters by insisting on  system of fiscal rules for members – the “Stability & Growth Pact” – which is only necessary if you are heading for a federal arrangement. The idea that the system was in fact of the federal type was implied by the fact that government bond rates for the different members were almost identical for much of the Euro’s life before the crisis. This was a bad sign – and yet most European leaders though it was a good one. When crisis approached European leaders were complacent. And when things went wrong, there was muddle and confusion. This problem is still not resolved.

And here I have to own up. While I saw some of the signs, I did not appreciate the full implications of this ambiguity. I thought it was a problem that could be solved by evolution from within.

I still believe that. But the politics of EU membership in Britain are toxic enough as it is. It is better that the country is not part of the tortuous politics of the Eurozone. That is why I accept the consensus that Britain probably never will be be part of  the Euro zone. Or not until firstly the zone finds a new and sustainable equilibrium, and secondly that Britain sinks into an economic mire that destroys its self-confidence as an independent nation. Both are possibilities.

Meanwhile I am not a fan of an independent Sterling. It has a way of distracting the political elite from dealing with deep-seated economic issues, like our current account deficit, our inefficient underlying economy and our over-dependence on volatile financial flows. But, it has to be admitted, that, with the exception of Germany, the Eurozone members were equally blind to the self-same issues. I apologise for not appreciating that enough.


Greece: can you have reform without austerity?











The Euro does not need a federal superstate to prosper

The Euro crisis is in one of its quiet phases. But few are foolish enough to think that its future is now secure. It is often said that the currency is destined to fail because of a fundamental economic law which means that you cannot operate a successful currency without the full authority and resources of a state behind it. The Euro needs to the apparatus of a federal superstate to survive, it is said. One Tory MP even suggested that the Euro’s promoters were committing fraud to suggest otherwise. But, for all that many in Brussels want it, establishing such a superstate is not politically feasible. And yet it is possible to see emerging the institutional architecture that will allow the Euro to survive and prosper without it. It’s a hard road, but there are enough benefits for the currency’s members to persist with it.

There are four key elements to the architecture. The first is an obvious one: a powerful European Central Bank (ECB), able to do what it takes to ride out the various crises that financial markets will throw at the system. The current ECB has proved up to the task, albeit by pushing at the boundaries of its formal powers, for example by buying the debt of member governments on the secondary market. Confidence that it can handle future crises is growing, adding to the overall stability of the system. And yet this power has its limits; it cannot transfer taxpayer funds from one country to another (referred to as “fiscal transfers” by economists), in the way a federal government could. The Euro has to find a way of existing without the sort of massive fiscal transfers that you see in the United States, for example.

In its place is the second element: provisions for states to default on their debts. This has been resisted tooth and nail by Euro federalists, but at long last it has been implemented for Greece. Alongside this, a crisis infrastructure is emerging, including crisis funds to support governments that are in the process of restructuring their obligations. This whole process needs to go further: publicly held government debt, e.g. that bought by the ECB, needs to be included, for example. Greece will surely need another restructure. But we are seeing the different nations’ bond prices reflecting the risk of default, and this imposes a discipline on government finances. And no government will want to follow the humiliating path of Greece into default, if they can help it.

There remains the problem of managing the banking system, which is very much run along national lines. While Greece got into trouble because of a profligate government, Ireland, Spain and Cyprus were brought down by banking crises. At first the response to a banking crisis was for governments to underwrite all banks’ creditors in order to restore confidence. Many applauded the Irish government when they did this early in the crisis; but it is a terrible idea, transferring liabilities from various people who should have known better to taxpayers who could ill afford it. Therefore the third element of the new architecture is to force bank creditors to pay, or at least contribute to, bailing out bust banks, referred to as “bailing in”. This solution was put in place for Cyprus, and hopefully will be the pattern in future. Of course it remains possible for financially strong governments, like Germany’s, to stand behind their own banks – but this should be discouraged. It is essential for discipline to be brought back into banking, and the system whereby bankers keep the profits and pass losses on to taxpayers has to be terminated.

But this approach is undeniably destabilising; it adds to the risk of bank runs. The obvious solution to this is to establish a Europe wide deposit insurance scheme, just as America has its federal scheme. Initially European governments seemed to favour this, but as they grew to understand its full implications, possible taxpayer transfers between states and increased central regulation, they have backed off. This has left us with the fourth and final element of the new architecture: emergency capital controls. This has been implemented for Cyprus, where depositors at Cyprus banks are suffering severe limits to their ability to move money out. It is an ugly process, and represents a big step bank from the integrated ideal of the Euro. The third and fourth elements in particular mean that a Euro held in a German bank is worth more than one held in a Portuguese one, say. But this is better than the alternatives, which attempt to wish financial risks away into an anonymous federal centre.

I believe that these four elements can evolve into a system that will give the Euro long lasting stability, and a better distribution of risk than a federal system would. We must remember that systems of human relations are only in a small part dependent of formal laws and powers, and much more based on expectations of how people should and will behave. This is how the management of the Euro is evolving. In the early days those expectations were wholly unrealistic, and ultimately required some kind of federal system to underwrite them. Now that we know this cannot be, new expectations are evolving. This is a bit like the way the British constitution and Common Law develops.

But is it worth it? Is it a loveless marriage between southern economies locked into permanent austerity, and more dynamic northern ones which are constantly being dragged down by their neighbours? (And France which manages to be on both sides of this equation at once!) If so the enterprise will lose political support and die anyway.

This question deserves a post all to itself, but I believe that all this pain has benefits to both sides. For the southern economies, joining the Euro was all about converging with their rich northern neighbours and their higher standard of living. Unfortunately they at first thought this would be easy. Lower interest rates and hot money from the north created a short term boom, but could not do the trick. Endless tax transfers (like between north and south Italy), are not on offer, and probably wouldn’t work either. In order to raise living standards the southern economies will have to undertake a painful series of reforms, rather in the way Britain did in the 1980s, Sweden in the 1990s, and, to a lesser extent, Germany in the 2000s. The process is starting, and the new disciplines of the Euro zone help this.

And for the northern economies of Germany, the Netherlands and Finland? Being in the Euro gives them a more stable economic environment, at a time when the global economy has been destabilised by the rising of China and other emerging markets. With a lower exchange rate than otherwise they have been able to preserves their exporting industries and maintain a degree of social stability. You only have to look at Britain to see what might have happened otherwise. There a short-term boom and appreciating exchange rate led to a flooding in of cheap imports and a hollowing out of export industries. Living standards grew for a while, but it could not last. The country is still struggling to escape the bust of 2008/09, with exports remaining weak.

The first decade and a half of the Euro has not been a happy experience, taken as a whole. But these are difficult times for developed world economies. In these circumstances the Euro remains a good idea, and indeed eastern European countries are still queuing to join. In the rough, interconnected world that is the modern economy, living with a freely floating currency is much harder than many would have you believe.