The Future of the Euro

3CommentsJoin

Sign-up for free weekly updates from ForeignAffairs.com.

Reading List

What to Read on the European Union

Kathleen R. McNamara

An annotated Foreign Affairs syllabus on the European Union.

Reading List

What to Read on the Financial Crisis

Timothy Taylor

An annotated Foreign Affairs syllabus on the financial crisis.

Snapshot

Eurozone Crisis as Historical Legacy

Mary Elise Sarotte

For all the success of German reunification, it left behind fateful seeds that sprouted into the current eurozone crisis. To overcome the current downturn, Europe should finish the job started two decades ago and retrofit the European Union with stronger political institutions.

When the euro was conceived two decades ago, few people expected it to have to weather a storm as great as the recent global economic and financial crisis. And many observers now think the entire European construct -- its institutions and currency -- has been so damaged by the crisis that it might not survive. A careful analysis of the problems within individual eurozone economies, particularly Greece’s, and in the architecture of the monetary union among them reveals what went wrong, how the EU has responded, and what the prospects of the euro really are.

Between 2008 and 2010, several things went wrong in Europe, the biggest of which was Greece’s financial crisis. For years, Greek fiscal policy had been unsound. Although private debt had been rising, the country’s overall debt-to-GDP ratio had not ballooned, because the Greek economy was growing. But that growth turned out to be unsustainable. When the global economic crisis hit, Greece’s deficit more than doubled. The problem was compounded by revelations that the government had grossly falsified and padded its budget in the run up to the 2009 parliamentary elections.

Unlike countries with national currencies, Greece could not address its problems through monetary policy. It can neither print money to inflate its debt away nor depreciate its currency to recover the international competitiveness of Greek goods and grow the economy out of debt. And unlike a subnational federal region in trouble, Greece, as a sovereign unit itself, could not have its falling revenues and rising social expenditures offset through simple fiscal transfers from the rest of Europe. Its labor force, moreover, is not mobile enough for excess to be exported elsewhere in the eurozone.

As far as the euro’s architects were concerned, this kind of problem should never have arisen. European financial markets should have put pressure on countries with excessive debt-to-GDP ratios, such as Greece, by charging them higher interest rates for loans. The European Central Bank (ECB) prohibits loaning money to service national debts, and its no-bail-out clause should similarly have discouraged overspending. Additionally, the eurozone’s Stability and Growth Pact, which was meant to enforce fiscal discipline in member countries through rules against running high deficits and debts, should have constrained Greek politicians. Finally, the Lisbon process, a 2000 development plan for the eurozone, should have increased Greece’s economic competitiveness and spurred real growth.

Unexpectedly, however, European financial markets accommodated Greece’s public and private spending with relatively low interest rates. It was only when the global financial crisis gained momentum that the markets reacted and capital flows suddenly stopped. The Stability and Growth Pact was ineffective as well; member states proved unwilling to enforce restrictions against others for fear of being subject to restrictions themselves. Finally, the Lisbon process underestimated the true differences in the member countries’ economies and failed to adequately address them.

Once the Greek financial crisis was under way, there were two options for tackling it. The first was for Greece to implement fiscal and structural reform that would bring its debt and deficit under control. Greece, the International Monetary Fund (IMF), the European Commission (EC), and the ECB negotiated just such a plan in June, with the goal of turning Greece’s primary deficit of nine percent of GDP into a surplus of six percent by 2015. It rests on fairly standard IMF reforms: substantial expenditure cuts, increases in revenue creation, and improvements in tax collection. It also includes important structural reforms, such as pension reform and privatization, which are aimed at improving long-run debt sustainability and the performance of Greece’s labor and manufacturing sectors.

The plan was accompanied by financing from the IMF and loans from the rest of the eurozone worth €110 billion -- or 46 percent of Greece’s 2010 GDP. Because the Greek crisis spread to other countries -- Portugal and Spain, in particular -- member states agreed to create a special European Financial Stability Fund to support any eurozone country that decides to undertake economic reform.

Yet there is already widespread skepticism about the IMF plan among some academics, investors, and speculators. Many fear that it is too harsh, imposes too many restrictions, and would ultimately be politically unsustainable. Their alternatives, however, are no better. Some have called for Greece to undertake an “orderly” debt restructuring, including devaluing bonds to alleviate the country’s debt burden. In its extreme form, this proposal also calls for the reinstatement of the drachma, because moving to the less valuable currency could restore Greece’s economic competitiveness.

In truth, however, these measures would not work and would be much harsher for the people of Greece than the IMF plan. Debt restructuring is never orderly. Undertaken now, it would hammer Greece’s domestic financial system and have serious repercussions for the rest of its economy. Greek access to eurozone capital markets would be impaired for years, stalling the public and private sectors. And if Greece did not fully repay the loans from other eurozone countries, it would suffer a major loss of political credibility.