Curiouser and curiouser, as Alice said in her adventures in Wonderland. The longer the crisis in the eurozone has gone on, the more it has come to resemble something penned by Lewis Carroll.
Here are just a few of the surreal aspects of the current state of affairs. The answer to a lack of growth in struggling countries such as Greece is austerity of such ferocity that recessions deepen. The solution to a financial crisis caused originally by the over-leveraging of banks and individuals is to turn Europe’s bailout fund into a leveraged 2 trillion euro (US$2.63 trillion) hedge fund. Meanwhile, many of the politicians in Britain who battled long and hard to keep the pound — the Conservative Chancellor of the Exchequer George Osborne and Labour lawmaker Ed Balls to name but two — are now born-again evangelists for full fiscal union.
How to make sense of all this? It’s hard, but as the king says as he presides over the court in Alice’s Adventures in Wonderland: “Begin at the beginning and go on till you come to the end: then stop.”
The monetary union was born out of two developments: The idea that there should be ever closer union in Europe and the breakup of the postwar fixed exchange rate system in the early 1970s.
The idea was that member states would pool their monetary sovereignty to form one currency that would have one interest rate set by one central bank. Architects of the grand design argued there would be multiple benefits from the new arrangements: Europe would grow closer together, it would become more stable and it would grow faster. To those who insisted that a one-size-fits-all monetary policy would never work and that slower, asymmetric growth would lead to the build-up of economic and financial pressures, the response from those banging the drum for the single currency was classic Carroll: “No, no! Sentence first — verdict afterwards.”
Predictably, the stresses and strains inherent in a monetary arrangement that involved yoking together countries as diverse (not just economically, but culturally) as Germany and Greece, Portugal and Finland, Austria and Spain quickly manifested themselves. The weaker countries on the periphery saw their costs of production rise more rapidly than those at the core and gradually became less competitive as a result. Although Europe as a whole saw its trade balance remain close to zero, Germany ran a hefty trade surplus at the expense of Italy, Spain and Greece.
Just as China recycled its trade surplus into the global economy through the purchase of US treasury bonds, so Germany’s surplus headed south to fuel property bubbles in Spain and to finance excessive borrowing by Greece. The actions of China and Germany kept the speculative orgy going for a while, but only by making the eventual hangover worse.
In the days before monetary union, a country that had seen its competitiveness eroded had an easy, if not painless, remedy. It would devalue its currency, making its exports cheaper and its imports dearer. Inflation would go up and structural weaknesses would be ignored, but it was a way of rubbing along. Inside the single currency, there is only one way a country such as Greece can compete with Germany and that is to lower the cost of the goods and services it produces. That means lower wages, smaller pensions and deep cuts in public spending. And not just for one or two years: The adjustment process within a monetary union involves decades of austerity. For the Greeks and the Italians, the message is jam tomorrow and jam yesterday, but never jam today.
The climax of Alice’s Adventures in Wonderland is the courtroom scene in which the issue is “Who stole the tarts?” In the case of the eurozone, the easy answer is that it is Greece, which failed to play by the rules, borrowing too much and cooking the books so that the rest of the members of the single currency club were ignorant of the dire state of the Hellenic public’s finances. In fact, the real culprit is Germany, which has failed to appreciate that for the monetary union to work, the big creditor nations have a responsibility to help the debtor nations by expanding domestic demand. The German political class appears to believe both that every country in the eurozone can be as competitive as Germany and that Germany, in those circumstances, will continue to run a massive trade surplus. That’s a logical absurdity the Carroll would certainly have appreciated.
To make matters even more deliciously weird, Berlin now faces a dilemma. The crisis in the euro area has been allowed to fester for the best part of two years, allowing the contagion to spread from Greece to other peripheral countries. As a result, the cost of cleaning up the mess has grown enormously. The first bailout for Greece in May last year was just over 100 billion euros. By the time of the emergency eurozone summit in July this year, it was deemed necessary to expand the European Financial Stability Facility (EFSF) to create a 440 billion euro fighting fund. Two months or so later, the perception is that Europe will need to have 2 trillion euros, perhaps even 3 trillion euros, to face down the financial markets.
It is unclear, as yet, how European policymakers intend to turn one euro into five, but it seems to involve setting up a special purpose vehicle backed by Germany and France. At its core will be the EFSF, which will be underpinned by financial guarantees from Berlin and Paris. The EFSF will not be increased from 440 billion euros, but will be used as collateral to expand the scale of bond purchases to support the weaker states. Even assuming the rating agencies are happy with this (and they may not be), Germany and France would be putting their creditworthiness at risk. Put simply, they would be betting the farm on a highly leveraged special purpose vehicle. Deja vu, anyone?
Yet the alternative does not look all that attractive either. Germany could, in theory, declare that it was no longer prepared to write the bailout checks for the rest of Europe. It could start printing some lovely new deutschmarks or perhaps start exploratory talks with the Austrians, Finns and Dutch about a hardcore euro made up of half a dozen broadly convergent economies. However, even assuming this could be achieved without plunging not just Europe, but the rest of the global economy into a second Great Depression (and it probably could not), the upshot would be that German banks would face potentially ruinous losses on a wave of sovereign debt defaults, while German exporters would be priced out of overseas markets because the new deutschmarks would appreciate sharply on the foreign exchanges.
Up until now, policymakers have solved this dilemma by refusing to admit that it exists. The assumption has been that the events of the recent past have all been a bad dream from which Europe will wake up. Only recently has it been recognized that the single currency really is plunging down a rabbit hole and is going to hit the ground with an almighty bump.
And to those who say that out of the wreckage will emerge a full-blown fiscal union that Britain stands apart from at its peril, the adventures of Alice provide the perfect riposte.
“If everybody minded their own business,” the Duchess said, “the world would go round a good deal faster than it does.”
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