The story that follows is a hypothetical one, motivated by the apparent inability of policy makers in Europe, and elsewhere, to deal with the consequences of mounting sovereign debt in an era of slow growth and the flaws in the institutional design and operation of monetary union.

After a decade of slow growth and an inability to deal with the debt crisis facing the GIPSI countries (Greece, Italy, Portugal, Spain and Ireland), in 2019 euro zone leaders were again forced to negotiate at Versailles, a mere 100 years after the treaty with the same name redrew the political map of Europe.

Fortunately, this time around, the motivation for reforming the European Union (EU) stems not from the ravages of a war, but from failure to deal with the onerous debt problems of Greece and its Southern neighbours, not to mention the institutional flaws in a monetary union among sovereign states. A confidential report produced by the IMF back in 2012 was pessimistic about the ability of Greece to extricate itself from its heavy debt burden. Indeed, the debt to GDP ratio expectations revealed an economy stuck in a state of high debt, in spite of one austerity package after another. Unfortunately, that scenario proved to be an optimistic one as the debt to GDP ratio in Greece continues to exceed 160% of GDP.

Just as in 1919 when Germans were convinced that reparations would produce financial ruin (leading a Germany unwilling to meet its financial obligations while the Allies tired of trying to impose sanctions), Greece and other countries were unable to carry out the agreement to allow them to remain in the euro zone. Not surprisingly, there has been continuing civil unrest and a succession of government coalitions that appear unable to address the problem, or to convince the rest of Europe of the seriousness of the situation. Much the same has been true in the other GIPSI countries.

There is also a deepening sense of frustration in the rest of the euro zone — especially at the thought of maintaining a single currency which appears to be making everyone poorer in the name of maintaining European cohesion. Southern countries suffer from contraction in fiscal policy and Northern countries face high inflation and eroding of purchasing power, while the ECB is powerless to set a different course of monetary policy than one for the euro zone as a whole.

Much as the 2012 deal to address the Greek fiscal and debt crisis was felt to be punitive and savage (echoing the words used 100 years ago used by Germans and others to describe the Treaty of Versailles), similar acords with other GIPSI countries also generated worldwide criticism. Matters have become so critical that China, the United States and other G20 members are now insisting that they also have a seat at the table in an attempt to salvage monetary union. That the G20 has failed to recognize the benefits of acting collectively in the face of global challenges is not lost on observers who feel that this group, like the G8 it emasculated many years ago, is also in need of reform.

The events of the past decade may not have taken the human toll that wars usually take but the implications have been no less devastating. The consequences of a protracted financial crisis are just as severe in some respects as those of a conventional war: lives financially ruined, entire generations of productive workers sidelined and governments stuck in a series of austerity budgets whose goals are frequently missed, thereby adding to the loss of trust and credibility in public institutions among voters.

The fact that the financial crises that began in 2008 and continues to have repercussions today suggest that the real economic consequences of a truly global financial crisis can exceed the dire warnings outlined in 2009 by Reinhart and Rogoff, in This Time Is Different. The European Central Bank (ECB) has tried to do its part to facilitate the recovery in Europe, continually stretching the limits of its mandate by extending ever longer term loans to private banks at interest rates that continue to flirt with the zero lower bound. This allows banks to hold sovereign debt which promises a much higher return but, owing to the general state of affairs in Europe, there is little commercial lending reflective of a healthy and growing economy.

At the Fed, where the majority of FOMC members began to coalesce around the expectation that the fed funds rate would rise from the zero lower bound around 2016, two years later than originally thought back in early 2012, interest rates have still to reach anything approach ‘normal’ historical levels. This has made it easier for the ECB to continue providing a relatively easy monetary policy.

The accession countries in the European Union, meanwhile, who agreed to someday join the euro zone after they were admitted into the EU in 2004, continue to be hold-outs as they fear the loss of monetary sovereignty will not be offset by any of the benefits from adopting the euro. They, and the few other countries that joined the EU after 2004, want an economic and monetary union that functions more efficiently, is sufficiently flexible to deal with major economic shocks, and clearly recognizes that members countries not only have rights and privileges but that a successful union must recognize members who are justifiably in need of support deserve assistance from EU member states. As a result, it is not enough to specify who is admitted into the union, but conditions must also exist for the potential expulsion of a member of the common currency area.

Recognizing that the Maastricht Treaty and the new ‘Fiscal Compact’ in Europe ratified in 2013 were incoherent and unworkable, euro zone members agreed to rewrite the way Europe functions. EU-wide institutions need the authority not only to monitor and assist members in the fiscal and monetary sphere, but also the authority to independently collect tax revenues and apply fiscal tools to ensure that EU-wide standards are met. In addition, a central bank that resembles central banks elsewhere in the advanced economies, and a fiscal authority that supplements the authority of those representing individual member states are necessary conditions for sustaining the euro zone.

Therefore, instead of asking how much sovereignty can be retained and still pretend that the EU acts as a coherent whole, the political leaders have finally come to the realization that they must ask how little sovereignty they are prepared to keep to ensure that the euro zone, and the EU more generally, takes on more of the functions of a normal state.

Just as in 1919 when Germans were convinced that reparations would produce financial ruin, Greece and other countries were unable to carry out the agreement to allow them to remain in the euro zone.
The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.
  • Pierre Siklos is a CIGI senior fellow. His research interests include applied time series analysis and monetary policy, with a focus on inflation and financial markets.