The euro suffers from structural deficiencies. It has a central bank, but it does not have a central treasury, and the supervision of the banking system is left to national authorities. These defects are increasingly making their influence felt, aggravating the financial crisis.
The process began in earnest after the failure of Lehman Brothers when, on Oct. 12 last year, European finance ministers found it necessary to reassure their publics that no other systemically important financial institution would be allowed to fail.
In the absence of a central treasury, the task fell to national authorities. This arrangement created an immediate and severe financial crisis in the new EU member states that have not yet joined the euro. Eventually, it heightened tensions within the euro zone.
Most credit in the new member states is provided by euro-zone banks and most household debt is denominated in foreign currencies. As euro-zone banks sought the protection of their home countries by repatriating their capital, East European currencies and bond markets came under pressure, their economies sagged and the ability of households to service their debts diminished. Banks with large exposure to Eastern Europe found their balance sheets impaired.
The capacity of individual member states to protect their banks came into question and the interest-rate spread between different governments’ bonds began to widen alarmingly. Moreover, national regulators, in their efforts to protect their banks, have unwittingly engaged in “beggar thy neighbor” policies. All this is contributing to internal tensions.
At the same time, the unfolding financial crisis has convincingly demonstrated the advantages of a common currency. Without it, some members of the euro zone might have found themselves in the same difficulties as Eastern European countries.
As it is, Greece is hurting less than Denmark, although its fundamentals are much worse. The euro may be under stress, but it is here to stay. Weaker members will certainly cling to it; if there is any danger, it comes from its strongest member, Germany.
Germany’s attitude toward the financial crisis is at odds with that of most of the world, but it is easy to understand why. It remains traumatized by its historical memory of the 1930s, when runaway inflation in the Weimar Republic led to the rise of Adolf Hitler. While the rest of the world recognizes that the way to counteract the collapse of credit is to expand the monetary base, Germany remains opposed to any policy that might carry the seeds of eventual inflation. Moreover, while Germany has been a steadfast supporter of European integration, it is understandably reluctant to become the deep pocket that finances bailouts in the euro zone.
Yet the situation cries out for institutional reform, and Germany would benefit from it just as much as the others. Creating a euro-zone government bond market would bring immediate benefits, in addition to correcting a structural deficiency.
For one thing, it would lend credence to the rescue of the banking system and allow additional support to the EU’s newer and more vulnerable members. For another, it would serve as a financing mechanism for coordinated countercyclical fiscal policies. Properly structured, it would relieve Germany’s anxiety about other countries picking its pocket.