Excellent George Soros essay on NyBooks – The Crisis & the Euro. In it he forensically examines the structural issues with the single currency, points out Germany’s critical role within the project and how they have been making bad policy decisions, and how this threatens political and social stability within the union. All is not lost, as he outlines three steps that need to be taken (cleansing the banks, huge monetary stimulus to offset fiscal tightening, European infrastructure investment funded by the Europen Investment Bank). The full essay is well worth reading, but ends on a downer as the postscipt makes clear that events since this essay was penned have taken a turn for the worse with the liklihood of any of his solutions being adopted diminishing at the recent G20 conference.
Let me first analyze the defects of the euro and then examine Germany’s attitude. The biggest deficiency in the euro, the absence of a common fiscal policy, is well known. But there is another defect that has received less recognition: a false belief in the stability of financial markets. As I have tried to explain in my writings, the crash of 2008 conclusively demonstrated that financial markets do not necessarily tend toward equilibrium; they are just as likely to produce bubbles. I don’t want to repeat my arguments here because you can find them in my lectures, which have recently been published.
All I need to do is remind you that the introduction of the euro created its own bubble in the countries whose borrowing costs were greatly reduced. Greece abused the privilege by cheating, but Spain didn’t. Spain followed sound macroeconomic policies, maintained its sovereign debt level below the European average, and exercised exemplary supervision over its banking system. Yet it enjoyed a tremendous real estate boom that has turned into a bust resulting in 20 percent unemployment. Now it has to rescue the savings banks, called cajas, and the municipalities. And the entire European banking system is weighed down by bad debts and needs to be recapitalized. The design of the euro did not take this possibility into account.
Another structural flaw in the euro is that it guards only against the danger of inflation and ignores the possibility of deflation. In this respect the task assigned to the European Central Bank is asymmetric. This is due to Germany’s fear of inflation. When Germany agreed to substitute the euro for the Deutschmark it insisted on strong safeguards to maintain the value of the currency. The Maastricht Treaty contained a clause that expressly prohibited bailouts and that ban has been reaffirmed by the German constitutional court. It is this clause that has made the current situation so difficult to deal with.
And this brings me to the gravest defect in the euro’s design: it does not allow for error. It expects member states to abide by the Maastricht criteria—which state that the budget deficit must not exceed 3 percent and total government debt 60 percent of GDP—without establishing an adequate enforcement mechanism. And now that several countries are far away from the Maastricht criteria, there is neither an adjustment mechanism nor an exit mechanism. Now these countries are expected to return to the Maastricht criteria even if such a move sets in motion a deflationary spiral. This is in direct conflict with the lessons learned from the Great Depression of the 1930s, and is liable to push Europe into a period of prolonged stagnation or worse. That will, in turn, generate discontent and social unrest. It is difficult to predict how the anger and frustration will express itself.
He also details the dangers for Germany in leaving the Euro –
The Deutschmark would go through the roof and the euro would fall through the floor. This would indeed help the adjustment process of the other countries but Germany would find out how painful it can be to have an overvalued currency. Its trade balance would turn negative and there would be widespread unemployment. German banks would suffer severe exchange rate losses and require large injections of public funds. But the government would find it politically more acceptable to rescue German banks than Greece or Spain. And there would be other compensations: pensioners could retire to Spain and live like kings, helping Spanish real estate to recover.