The Euro: A Failed Experiment

The summit that began this morning in Brussels for the 27 members of the European Union is the 19th since the Greek crisis began two and a half years ago. While the meeting is for the entire EU, the focus will be on the 17 nations that comprise the Eurozone, especially Germany who holds all the aces, and on Italy, Spain, Greece and Crete who have real problems.

The dictionary has as its second definition of summit as the “highest attainable level of achievement.” Having a “summit” every couple of months would seem to trivialize the term. In any case, previous summits have done little to alleviate the crisis. The typical summit lasts 36 hours of posturing and haggling, and concludes with a communiqué promising little more than a willingness to continue to work together, with plans for the next summit. More than anything, the content of these summits seems to consist of what my mother-in-law used to call “air pudding with wind sauce.” 

The one thing we should get but won’t is an acknowledgement that the experiment with a single currency has failed. In the land of nod, hope springs eternal.

In a game of musical chairs, banks in Italy and Spain are buying their respective sovereign debt, while governments are committing funds to rescue failing banks. Italian banks, as of April, owned €294.9 billion in Italian government debt, up 44% in five months. Spanish banks owned €167.3 billion in Spanish Sovereigns in April debt versus €70.3 billion in November, up more than 100%. Last month, the Spanish government committed €19 billion to rescue Bankia, which suggests that Spanish bank’s ownership of sovereign debt is likely to increase again.

We are left in a vicious cycle, with default fears eroding the value of sovereign bonds placing greater pressure on banks’ balance sheets, causing governments to borrow to salvage failing banks. At some point the music stops and there won’t be enough chairs to go around. While the Council claims to have a “Grand Plan,” I wouldn’t bet my last dollar on that as an outcome.

There are many lessons from Europe for the U.S., in terms of the ineluctability of our operating deficits on our economic growth, on the damage that “too big to fail” banks can cause, and on governments and unions that promise what can never be delivered. With the U.S. in the weakest economic recovery in its history, the President is in no position to offer financial advice to the Germans who are struggling to deal with their profligate neighbors. As German’s Chancellor, Angela Merkel recently replied to Mr. Obama, according to the New York Times, “Look, Mr. President, I have some problems that I need to respond to that don’t correspond with your need to be reelected.”

The genesis of Europe’s problems goes back to the simple fact that a currency was created before political or fiscal union. It allowed profligate nations like Greece to borrow at lower rates than would otherwise have been the case, with no responsible adult to rein them in. In fact in 2001, with the help of Goldman Sachs, Greece was only able to meet the conditions of Euro membership by demonstrating the “directionality” of their public debt, which was far above the standard of 60% of GDP requested by the Eurozone. (Greek debt currently is about 170% of GDP.) 

A swap was entered into which removed €2.8 billion in public debt, allowing them to join the Euro. While the swap was perfectly legal, and Goldman claims that Eurostat, the European accounting agency, was informed by e-mail, the fact of the matter is that for all intents the swap remained secret. Even so, the swap has since ballooned to €5.7 billion (demonstrating that being on the other side of a Goldman trade is not always a good idea), an amount that represents a drop in the bucket of Greece’s total public debt, estimated at €356 billion.

The markets momentarily breathed a sigh of relief when Greece’s New Democracy Party (a center-right party) won a plurality, but far from a majority, on June 17. (They won 29.6% of the vote.) Antonis Samaras, the party’s leader was supposed to be the “responsible” choice, as he had vowed to keep Greece in the Euro. But if one took the combined votes of the radical-left Syriza (27%), the socialist Pasok (12.3%) and the Communist Party (4.5%) they add to 43.8%. Throw in the center-left Democratic Left (6.2%) and 50% of the voters preferred left-of-center leadership. 

It still seems to me that the most likely outcome is for Greece to exit the Euro. Such an event is bound to be disruptive, but it should also provide the beginning of recovery and reform.

Yesterday, London’s Telegraph printed a copy of the invitation from European Council president, Herman Van Rompuy to today’s summit. A former Prime Minister of Belgium, Mr. Van Rompuy is the first full time president of the Council. He wrote of four things they hope to accomplish: endorsing country-specific recommendations to guide policies and budgets; adopting the “Compact for growth and jobs;” launching the final phase of a new Multiannual Financial Framework (MFF) mobilized in support of growth and jobs, and setting our Economic and Monetary Union (EMU) on a new path. I am sure all these issues are critical and deserve attention, but the real problem has been that issuing a common currency without centralized legislative and fiscal authority is akin to putting the cart before the horse. It hasn’t worked. Somebody needs to do a mea culpa.

The cultural differences between the nations can perhaps be overcome, but it won’t be easy. Cultures within individual nations go back a thousand years and more. A recent and simple manifestation of the difference can be seen in France’s intent to roll back retirement age to 60, while Germany is considering extending it to 67. 

Commentators like to compare the crisis in Europe to that facing Alexander Hamilton at the end of the Revolutionary War when war debt of individual states was assumed by the central government. Some states had financed the war effort concurrent with the war. Others had not. Nevertheless, it is an unfair comparison. In the case of the newly created United States, the debt was incurred fighting a common enemy. 

In the case of Europe, much of the debt of the Mediterranean countries was to support an unsustainable life style (Greece and Italy,) or to speculate in housing and real estate (Spain and Ireland.)

The most important questions for Europe (as they are for the U.S.) are how to rein in debt and deficit spending, and, at the same time, reignite growth. Can it be done in Europe while maintaining a single currency? Can it be done without? To those that argue that a single currency is crucial to growth, how does one explain growth in Euroland before the advent of the Euro? Additionally, European nations must come to grips with the fact that the socialism of the post war years does not work. Demographics do not allow it. 

It was the conclusion reached by Margaret Thatcher thirty-three years ago and which gave birth to a renaissance in Britain. Unemployment of 12%, when she became Prime Minister, was 6.9% when she left twelve years later. While deficits are today’s problem, inflation was the problem in 1979. It was reduced by Mrs. Thatcher from 21% to 4%. Net migration from Britain became net immigration. Unlike the more temperate moves of current European leaders, Margaret Thatcher and her counterpart in the U.S., Ronald Reagan, opted for revolutionary action.

Bold action is required in Europe; not more meetings whose principal purpose appears to be to schedule the next meeting. The answer may necessitate the dissolution of the Euro.

To use Greece as an example – its stock market is valued at about 10% of GDP. (In contrast, the U.S. equity markets are valued at about 125% of our GDP.) The Dalmatian Coast is one of the most beautiful areas in the world. People are hesitant about investing in the country because of uncertainty created by the crisis. A reintroduction of the Drachma would certainly cause some temporary dislocations, but would that be worse than the uncertainty caused by the pride of staying with a currency that may not be in the country’s best interest? Is hubris overwhelming common sense? Is it not possible that Greek assets would look far more attractive if the buyer did not have to worry about the currency? 

Alternatively a TARP-like plan allowing the ECB or the European Financial Stability Facility (EFSF) to take equity positions in the country’s banks may work; but as long as there is uncertainty about the fate of the currency, investors will stay away, and investments are the oil that lubricates the machinery of commerce.

Greece is a small country whose economy represents about 2.4% of the Eurozone’s GDP. But what is true for Greece is also true for Italy, Spain, Portugal and Ireland. Italy and Spain, combined, constitute roughly 26% of the area’s GDP, smaller than the 42% represented by Germany and France, but still significant. Another question European officials must consider is – has the Euro been acting as an accelerant or a governor on the respective states’ economies? It is hard to see it as an accelerant. A cheaper currency is necessary for the Mediterranean nations to reinvigorate their economies.

Germany is the one country that has benefitted, as the Deutschmark would be priced more expensively. The rest have been hamstrung. More than anything, well intentioned European officials have created an aura of uncertainty and doubt – the opposite of what is needed to permit economic growth, and the emergence from despair and disillusion.

European leaders, in their desire to maintain the currency they fought so hard for and for so long, speak of its demise in dystopian terms. I am not so sure, but of this I feel certain – more of the same may promise hope, but nothing more. Let the Euro go. Defense of the indefensible is no defense.


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