Architects of a currency in crisis

Posted at 01/01/12 11:16 AM

PARIS - Ten years ago Saturday, the European Union celebrated the launch of the first euro coins and notes with fireworks, parties and solemn speeches.

Today, several members are on the edge of bankruptcy. First-world Europe is reduced to asking the IMF and China for help. The euro itself is at risk of unraveling.

How could it all have gone so wrong?

In a series of interviews with architects of the euro - a former president, a former prime minister, two former finance ministers, a former central banker, a former EU commissioner and a former EU Affairs minister - common explanations emerged.

The single currency would not have sparked the euro zone debt crisis, they argued, if the pro-European dynamic that led to its creation had continued into its first decade. But instead of launching an economic and political integration of Europe, the low interest rates and easy money that arrived with the euro led peripheral states on a path of profligacy, widening the gap with frugal, export-oriented economies of the north.

Meanwhile, as rapid enlargement made EU decision-making more cumbersome and as citizens' enthusiasm for Europe waned, EU leaders hollowed out the authority of the European Commission, the union's chief executive body and guardian of its treaties and of fiscal probity.

Most of all, some of the architects now admit that after the first few euphoric years, it became clear the euro itself was a flawed concept, laying a single currency over a group of countries that stuck to national sovereignty over their economies.

The euro was a dare from the get-go. Former British Prime Minister Margaret Thatcher famously spurned the currency as unworkable and a threat to sovereignty; Sweden stayed out, too. Euro boosters themselves pushed ahead with the project despite sharing misgivings about its inherent political and economic flaws.

"One thing was evident to me from the beginning," said Guy Verhofstadt, leader of the European Parliament's Alliance of Liberals and Democrats, Belgian prime minister from 1999 to 2008, and one of Europe's most federalist politicians. "A state can exist without a currency, but a currency cannot exist without a state."

From union to disunion

One of the driving forces of European integration is former French President Valery Giscard d'Estaing. Now 85, he resides in a stately Parisian townhouse filled with museum-quality 18th-century furniture.

As president from 1974 to 1981, Giscard, with German Chancellor Helmut Schmidt, helped create the European Monetary System and the European Council summits of EU leaders. Early last decade, he chaired the drafting of the European Constitution that later became the Lisbon Treaty, which governs EU institutions as they function today.

For Giscard, one of the key reasons for today's euro zone debt crisis is the EU enlargement of the past decade, in particular in 2004, when 10 countries - mostly former East Bloc nations - joined the European Union. "By the time the euro was introduced, the group was no longer homogeneous," Giscard said in an interview.

The European Union now counts 27 members and is set to receive a 28th - Croatia - in 2013. Enlargement has made the European institutions hard to govern, he says, notably the executive European Commission, which has a commissioner for every member country.

The crisis erupted first in Greece. Giscard, a hellenophile, did as much as anyone to bring Athens into the European Union. He championed its EU candidacy at a crucial moment in 1979, fending off German objections and European Commission reservations at the time against admitting the country just seven years after the fall of its military junta.

Greece joined what was then called the European Economic Community in 1981. Two decades later, in 2001, it joined the euro.

Standing in his ballroom-sized entrance hall, decorated with deer antlers and two enormous elephant tusks, Giscard now voices the unthinkable: Greece should consider leaving the euro.

Giscard said that a deflation, or economy-wide drop in prices, of 40 or 50 percent would be necessary to restore competitiveness if Greece remains in the euro. That is probably too hard for its citizens to bear, which makes a euro exit and consequent devaluation a more acceptable outcome.

The Greek people need to study "seriously and honestly" whether to go back to the drachma or stay in the euro. "It's a Greek choice."

Walks with a limp

On the other side of the French political spectrum is Michel Sapin, 59, who was finance minister in a Socialist government from 1992 to 1993 and dealt with Europe's foreign exchange crisis of the early nineties. He is likely to hold a senior office if Socialist Francois Hollande beats conservative incumbent Nicolas Sarkozy in the April-May presidential election.

To Sapin, the euro zone's problems stem from a fundamental design flaw in the 1992 pact that created the European Union and led to the euro, the Maastricht Treaty.

"The Maastricht Treaty was built on two pillars. The monetary pillar has been an extraordinary success, because, say what you want, there is no monetary crisis - the euro is strong," he said. "The second pillar was the economic government. We knew from the start we had to build a second pillar for economic, budget and fiscal matters, because countries cannot share the same currency if they have divergent economic policies."

European Investment Bank President Philip Maystadt, a veteran of EU monetary integration, could not agree more. He took part in the Maastricht Treaty negotiations as Belgian finance minister from 1988 to 1998. He recalls that Germany at the time was suspicious of unified economic government, fearing it would impinge on the independence of the future European Central Bank. But protecting the bank's independence was not a good reason to abandon the concept of economic governance, he said.

"(Former European Commission President) Jacques Delors said the single currency walked with a limp - it had one strong leg, the monetary part, and one weak leg, the economic governance," he said. "Clearly, this ersatz economic government was utterly insufficient." TURNING POINT

European leaders were aware of the shortcomings of Maastricht. They spent two years negotiating the 1997 Stability and Growth Pact, which threatens escalating sanctions on states that fail to limit annual deficits to three percent of GDP and outstanding debt to 60 percent of GDP.

But the focus on these two indicators meant that other measures of economic health, such as private debt, wage costs and the current account balance, were ignored.

As a result, EU finance ministers overlooked the build-up of tensions in the Irish and Spanish economies. Their public finances looked to be in excellent shape by Maastricht Treaty standards, until Ireland's banking crisis and the Spanish real estate collapse. Those implosions forced authorities to turn private debt into public debt, wrecking their nations' finances.

Imperfect as it was, the Stability Pact was the one mechanism that could have kept the single currency on the rails. But it was discarded the first time it was tested.

When the 2002-2003 economic crisis pushed French and German public finance indicators beyond Maastricht limits, the two big EU nations cast it aside. Exceptions were made, and in 2005 the pact's provisions were watered down further.

"That was a real turning point. When the other finance ministers saw what France and Germany were getting away with, that's when they said, 'Ah, ok, we don't have to respect the Stability Pact'," Maystadt said.

In the debt-fueled prosperity of the first half decade of this century, this did not seem to matter. Euro zone interest rates were low, growth was fast, stock markets went up. At the start of the decade it looked like the lack of policy coordination would only cause member states' economies to be a bit out of sync.

From around 2004 that changed. It became obvious that two very different models were cutting Europe in two: export-oriented manufacturing with strong wage control in the north, and debt-financed consumption in the south.

Books have been written about this trend, but a picture says more than a thousand words: the charts of net foreign assets and current account balances in north and south look like mirror images.

The combined net foreign assets of Germany, the Netherlands, Belgium, Austria and Finland grew more than four-fold to nearly two trillion euros by the end of the decade, as their current account surplus swelled to more than six percent of GDP, according to figures from Thomson Reuters Datastream and French investment bank Natixis.

But net foreign debt in France, Italy, Spain, Greece, Portugal and Ireland grew to more than 1.5 trillion euros as the southern zone's current account deficit widened to around four percent.

"When we voted the Maastricht Treaty, it was with the firm intention to continue on the path of political integration. Then there was a sort of sigh of relief when we saw that, actually, the single currency could work without it," said Sapin, the former French finance minister. "It has taken us ten years to understand that it could not."

After a decade of defying common sense and with their countries' credit ratings crumbling, euro zone leaders are finally admitting that Maastricht was flawed.

In a letter to European Council President Herman Van Rompuy before the December 9 EU summit, French President Nicolas Sarkozy and German Chancellor Angela Merkel made a remarkable admission: "The current crisis has uncovered the deficiencies in the construction of (European monetary union) mercilessly."

Commission defanged

The letter does not mention how Sarkozy and Merkel, and their predecessors Jacques Chirac and Gerhard Schroder, gradually undermined the foundations of economic governance that earlier generations of EU leaders built.

One of the oldest debates in the European Union is over who should drive EU affairs: the supranational body that is the European Commission or by the heads of state or government of its member nations, represented in the European Council. First created as an informal discussion forum in 1974, the Council formally became an EU institution in 2009 as part of the Lisbon Treaty reforms.

During the long reign of Jacques Delors - three successive terms, from 1985 to 1994 - the Commission played a leading role. With the backing of socialist French President Francois Mitterrand, under whom he had been a finance minister, Delors drove a strong federal agenda, often clashing with eurosceptic EU leaders, most famously with Margaret Thatcher.

The Delors Commission created the single market, shepherded the Maastricht Treaty and set the continent on track for the single currency. None of his successors would have that kind of influence again.

"After Delors' departure, the EU leaders did not want such an active Commission president again. They wanted someone who would not bother them," said Yves-Thibault de Silguy, who was commissioner for economic, monetary and financial affairs in the 1995-99 Jacques Santer commission.

Santer, then prime minister of Luxembourg, was chosen after the UK had vetoed the candidacy of Belgian Prime Minister Jean-Luc Dehaene, saying he represented an outdated tradition of centralism and "big government".

"What happened was a progressive loss of confidence in the very thing that had made Europe successful: the community method," de Silguy said.

Under this method, an independent European Commission makes proposals to the Council and the European Parliament, and implements them once they are approved.

But in the past decade, governments clipped the Commission's wings year after year, in favour of an "intergovernmental" approach whereby governments make decisions for the Commission to execute, often in ad-hoc summits that rubber-stamp decisions prepared in an even closer circle of French and German leaders.

Intergovernmental decision-making itself is a source of delay and dilution, as it requires unanimity, giving each member state a blocking veto.

De Silguy said the intergovernmental approach explains a lot of today's problems and is particularly inappropriate for economic matters.

"Europe needs fluid and homogenous markets, with a policeman to make sure the rules are obeyed, and that policeman is the European Commission. The entire European construct is based on that premise," he said.

In October 2001, a group of elder statesmen led by Delors and including former German chancellors Helmut Kohl and Helmut Schmidt raised the alarm, criticising their successors' growing tendency to bypass the Commission and micro-manage EU affairs. To no avail.

Giscard sums it up like this: "The Commission murmurs in Brussels and nobody listens."

European hangover

The German and French leaders who bucked Brussels, to be sure, had a sound argument for doing so.

Their nations have the euro zone's largest and second-largest economies and populations, respectively. But the European Commission gives each of the 27 nations one representative. That ties down Germany and France like Gulliver to their Lilliputian neighbors - a non-starter for their peoples.

"The problem with the Commission is that the Baltic states have a bigger weight than Germany," said Giscard. "That is not reasonable."

Indeed, the EU leaders' increasingly nationalistic stance went hand in hand with a growing disenchantment of the European public with the federal ideal, as can be read from the EU's "Eurobarometer" opinion polls.

Since 1974, the EU has asked citizens twice a year whether they think their country's EU membership is "a good thing". The percentage of people agreeing with that slipped from 63 percent in 1975 to 50 percent in 1981, the year Mitterrand was elected French president.

From 1981, positive feeling about European integration rose non-stop for a decade, to hit an all-time high of 71 percent in 1991, the year before the Maastricht Treaty was signed.

But in 60 years of European construction, the eighties and early nineties were the exception to a general climate of reluctant stop-and-go integration.

After Maastricht, pro-European feeling fell off a cliff, with the number of people considering their countries' EU membership a good thing falling to an all-time low of 46 percent in the spring of 1997.

The launch of the euro as an accounting currency in 1999 and the arrival of the euro notes and coins in 2002 restored good feeling for a few years. But the rejection of the European Constitution in French and Dutch referendums in 2005 showed the tide had turned again.

Pro-European feeling slid from 59 percent in a Continent-wide poll in autumn 2004 to 50 percent in autumn 2005 and to 47 percent in spring 2011. It will likely hit a new all-time low in the next wave of measurement, according to an official involved with the poll. BRIDGE OF DISCORD

With a flawed single currency, an emasculated EU Commission, and an increasingly eurosceptic public, the euro zone would have hit a bump sooner or later.

But there was one euro side-effect that magnified all the other problems.

Besides being a medium of exchange, an accounting unit and a store of value, a currency is also a feedback mechanism for economic policy.

If a country's policies are lax, and spending and wages are out of control, then its currency weakens and its interest rates rise, forcing the government to correct course with a devaluation or austerity programmes. With one currency for many states, devaluation is no longer an option.

The introduction of the euro brought a stable exchange rate, low interest rates and a flow of money to southern European countries that for decades had used devaluation as their main policy adjustment factor.

This caused speculative bubbles in real estate and banking, pushed up wages to uncompetitive levels, and led to a build-up of debt that in 2010 began to collapse.

One of the few founding fathers to have clearly articulated the euro's flaws was Otmar Issing, the German former European Central Bank chief economist and board member. In a 1996 paper, he warned that inherent in the currency was the potential for requiring transfers of cash from wealthier states to poorer ones. That could spark political tensions, he warned. "There is no example in history of a lasting monetary union that was not linked to a state entity," Issing wrote.

Fifteen years later he recalls that the warning signals appeared very early in the euro's life - divergences in labor costs among euro members, the violation of the budget-deficit cap. "What I didn't foresee was the dimension of the crisis," he told Reuters.

Another thing few forecast was the degree of discord the euro-zone crisis would engender: the EU flag being burnt in Athens, Greek street theatre portraying German leaders as Nazis, and a French socialist politician comparing Angela Merkel to Otto von Bismarck, who unified Germany by waging war on France.

In this climate, Europe's far-right parties have flourished, and few more than France's Front National, led by Marine Le Pen. She is running for president in the 2012 election on a pledge to take France out of the euro.

With an acute sense of history, Le Pen organised a little ceremony at the river Seine. On September 6 this year, Le Pen and activists of her party threw fake 500 euro notes off the Pont de la Concorde, which connects Place de la Concorde, site of the guillotine used for public executions during the French Revolution, to the French parliament.

"I will put an immediate end to all bail-outs of countries that have fallen victim to the euro," said Le Pen in front of a wall of cameras. "It is time for France to rediscover its national interest."

In the months ahead, as today's leaders hammer out a new treaty for deeper integration, they will have the voices of their predecessors ringing in their ears.

"The call for a more federal Europe has never been stronger than today, not out of conviction, but out of necessity," said Verhofstadt, the fomer Belgian prime minister. "I hope we make the jump. If we dither, we'll end up in the ravine."