Are we are witnessing the final months of the euro as we know it? Predictions about political events are hazardous, but it is likely the single currency (with a membership of 17 countries) does not have much time left in its current form. Consider the difficulties the markets have in digesting — let alone believing— that Greece will not eventually default on its debt.
The recent agreement to ratify a new treaty, also known as the Fiscal Compact, has failed to stem pessimism about the survival of the euro zone. The European Central Bank (ECB) risks creating ‘zombie banks’ if it keeps providing liquidity, much like what afflicted the US and Japan. The recent deal to assist Greece with its sovereign debt problem may still unravel if the IMF’s ‘strictly confidential’ report suggests that Greece may not be able to carry out its part of the deal.
Also problematic is that the International Swaps and Derivatives Association declared the Greek debt restructuring plan did not constitute a ‘credit event,’ which would have triggered credit default swaps compensation. Finally, even before the ink was signed on the compact, Spain announced that it would defy the EU on its deficit target with the newly-elected Spanish prime minister announcing that "this is a sovereign decision made by Spain."
The final straw is that the Bundesbank (Germany's central bank) has raised alarms over the build-up of German claims in the euro zone’s central payment system, called Target 2, to the tune of 500 billion euros. The bank is concerned over counterparty risk in the event of a collapse of the euro zone. In doing so the Bundesbank has taken the side of German economist Hans-Werner Sinn who argues this reflects the persistent regional imbalance of payments in the euro zone.
In his farewell sddress to the nation on January 17, 1961, US President Dwight Eisenhower admonished us to understand that “Good judgment seeks balance and progress; lack of it eventually finds imbalance and frustration.” It would seem abundantly clear that such judgment is lacking today among EU policy makers. Rather than taking steps to re-design the euro zone and restore balance, politicians seem unable to come to terms with the flaws of the system that threaten to overtake them and lead to more serious crises.
Of course, this is easier said than done. When major crises take place there is often the temptation to promise ‘never again' and propose systems that are grandiose (such as Europe’s fiscal compact) without providing the institutions and the means to ensure success. European politicians still adhere to the belief that sovereignty can co-exist with the restrictions of a common currency and without European-wide institutions that have the power of oversight and ability to credibly sanction misbehaving members.
Having said all this there is some semblance of realism in the recently-approved document that forms the basis of the Treaty on Stability, Coordination and Governance on the Economic and Monetary Union (PDF).
First, the excessively harsh, and pro-cyclical, fines outlined in the predecessor Stability and Growth Pact (SGP) have been softened somewhat so that the treaty “…empowers the Court of Justice of the European Union to impose the payment of a lump-sum or penalty on a Member State of the European Union for failing to comply with one of its judgments…” This replaces the imposition of harsh penalties tied to GDP in the SGP which rose at precisely the time that a violating economy was least able to pay the fine. There is also a realization that fiscal stability must be evaluated on a cyclically adjusted basis in recognition that deficits are more likely when the economy is weak.
If history offers any lessons for monetary unions as well as individual states with their own currency, it is that fiscal and monetary policies must move in tandem. There is, however, no formal recognition of this goal; only indirect references to companion institutions such as the European Stability Mechanism which is supposed to keep the European Central Bank from becoming a lender of last resort. Indeed, there is a general failure to recognize that a monetary union creates new responsibilities for each one of its members and that the enterprise can only benefit all if there are institutions and mechanisms, such as the power of taxation or some pooling of debt, that credibly support the objectives of the union in the first place.
While it is advisable that EU member states not promise too much and carefully consider reforms to ensure the survival of the euro zone, the current set of responses to the financial and economic crisis that is engulfing the region is woefully inadequate.