The euro in a delicate situation

Read our article in the Cayman Financial Review Magazine, eversion 

The present delicate situation of the euro, and the European Monetary Union, may be seen from different perspectives. An obvious one is from the point of view of the European economic and political unification process since 1945. An early highlight of this development is:

1. The Treaty of Rome

The Treaty of Rome of 25 March 1957 between Belgium, France, Germany, Italy, Luxembourg and the Netherlands on the foundation of the European Economic Community.
Part I, Article 2 of the Treaty of Rome describes its purpose as following:

“The Community shall have as its task, by establishing a common market and progressively approximating the economic policies of member states, to promote throughout the Community a harmonious development of economic activities, a continuous and balanced expansion, an increase in stability, an accelerated raising of the standard of living and closer relations between the States belonging to it.”

Recalling the food shortages and hunger after World War II, common agricultural policy was codified right from the beginning. The purpose was to increase agricultural production, to insure steady agricultural income, to supply consumers with sufficient food to reasonable prices and to stabilise agricultural markets.

This was successfully achieved during the first decennia by decoupling the European agricultural market from the rest of the world through tariffs and levies combined with a policy of guaranteed prices without output limitation.

The purchase guarantee for agricultural products of the European Community (EC) lead however to the accumulation of inventories (like “wine lakes” or “butter mountains”) that had a serious impact on the EC budget. Finally, the EC replaced price supports by direct payments (ie “transfer payments”), first in 1992 and later with Agenda 2000.

In addition, rural development was made the second pillar of the Common Agricultural Policy. These examples illustrate that the European Community was early on a “transfer union”. Anyway, intersecting transfer payments among the members of the European Community (nowadays 27 states) are a vital part of European cooperation.

They caused, however, serious problems after the breakdown of the Breton Woods agreement in 1972 and are one of the reasons for establishing a monetary union between presently 17 of the meanwhile 27 member states.

2. The European Monetary Union (EMU)

The European Monetary Union (EMU) is part of a rather more comprehensive Agreement Treaty on the European Union or Maastricht Agreement of July 1992 with the a revamped European Community as one of its three pillars1.

It has been several times revised and extended. The purpose of the revamped EC is more ambitious than of the EEC established by the Treaty of Rome. According to Title I, Article 2 of the consolidated version of the Treaty Establishing the European Community2.

“The Community shall have as its task, by establishing a common market and an economic and monetary union and by implementing common policies or activities referred to in Articles 3 and 4, to promote throughout the Community a harmonious, balanced and sustainable development of economic activities, a high level of employment and of social protection, equality between men and women, sustainable and non-inflationary growth, a high degree of competitiveness and convergence of economic performance, a high level of protection and improvement of the quality of the environment, the raising of the standard of living and quality of life, and economic and social cohesion and solidarity among member states.”

For the purpose set out above, Article 3 details 21 activities which the Community is obliged to observe, among them “… the strengthening of the competitiveness of Community industry;” which is, as we shall see, an important policy for the aspired monetary union.

For obvious reasons, not all EU member states are allowed to become EMU members right away. Only those who fulfilled certain requirements on their financial hygiene – the so-called Maastricht Criteria or convergence criteria3 – were accepted. These criteria were aimed at ensuring that prospective members were ready for monetary union.

In addition, the Treaty includes a number of provisions geared at the maintenance of price and fiscal stability among monetary union members. As for the latter, the treaty’s main concern is to prevent governments to kick over the traces.

The treaty does this, so to speak, by declaring fiscal instability illegal – enforced by penalty payments. In this context, a list of prohibitions and commandments stands out – like the no-bail-out clause (Article 125 of the Treaty on the Functioning of the European Union) or the agreement obligation to avoid excessive government deficits (Article 126 – substantiated in the Stability and Growth Pact) etc. The trouble is that the Maastricht criteria had never been taken too seriously – neither when accepting new members nor afterwards.

Even Germany failed to meet the requirements of the stability and growth pact. Regarding Maastricht, breach of contract seems to be seen as gentleman offence – first with some hand wringing and bad conscience, later as matter of course. Anyway, during the first years of EMU, financial markets (their rating agencies) appear to have been convinced in the Commission’s skills to eliminate market forces and run EMU administratively as it did before successfully (for a while) in the case of European agricultural policy.

Unfortunately, however, financial markets are more difficult to be sealed off from the rest of the world than markets for agricultural products, and more difficult to control. Another problem is that EMU must remain open to international financial markets, as long at least as EC governments wish to tap international capital markets as does their example, the USA. However, financial transactions rely on trust in counterparties’ compliance.

As not only game theorists know4, the history of previous behaviour of contractual parties matters. Given their previous behaviour, EMU governments will have a hard time to restore their lost reputation. Insofar, no quick and simple solution of the on-going euro crisis is in sight, and muddling through remains the most EMU can do.
Putting aside reputational problems, what are the basic problems of a (paper) money union between otherwise sovereign states?

3. Two basic problems plus one

Two basic problems are apparent: How to ensure stable prices (“sound money”) and how guarantee stable financial markets? Modern monetary theory has a clear answer to the first: by establishing an independent central bank that is legally bound to safeguard the purchasing power of money.

For EMU the statutory provisions of the European Central Bank do this excellently. However, regarding the stability of financial markets the state of the art is less satisfying5. What we know for sure is how to achieve and guarantee stable public finances – a task whose realisation lies in the responsibility and reputation of national parliaments (for EMU presently 17 legislatures).

The Maastricht criteria tend to go in the right direction, but differences in national interests may disturb compliance and lead to strategic breaches of contract. As Milton Friedman (1953, 199) put it:

“Why should a country do so [cooperate] when the failure of any other country to cooperate or to behave ‘properly’ would destroy the whole structure and permit it to transmit its difficulties to its neighbours?”

The problem is that members of an international currency union are taking each other hostage – whether they want to or not – which invites strategic behaviour. Friedman continues therefore that really effective (and credible) “coordination” requires

“[…] either that nations adopt a common commodity monetary standard like gold and agree to submit unwaveringly to its discipline or that some international body control the supply of money in each country [which does the ECB], which in turn implies [central] control over at least interest-rate policy and budgetary policy”.

But the latter demands an “effective federal government democratically elected and responsible to the electorate”. (Friedman) To achieve this would be hardly a quick fix of the present crisis.
The third basic problem is the question of how to deal with the wide gap of competitiveness of EU member states6?

The problem is that in a monetary union, firms of low and high productivity nations are mercilessly forced to compete with each other at eye level – a fact leading to persistent current account surpluses of Austria, Germany and the Netherlands. Eastern Germans where traumatised by this experience after reunification with West Germany. Much patience and understanding was needed for East Germans to swallow this price of freedom – and for West Germans to be willing to pay the bill.

One can hardly expect the same patience and understanding among, say, suffering Greeks7 and grudgingly paying Northern Europeans. One cannot expect either that EU members who do not belong to the eurozone, like Romania or Bulgaria, will silently watch any special treatment of their southern eurozone neighbours.

As a sad fact, the Maastricht criteria (and its ambiguous covering agreement) disregard this problem even though it was talk of the town in Germany while the Maastricht agreement had been drafted and redrafted8. The Euro Plus Pact, advocated only in February 2011 by the French and German governments, suggests a step in the right direction9. 

4. Some basic answers

The present activities of EMU members to stabilise the euro may work for some time – and may be the most we can expect for the years to come.

Yet what about a more fundamental repair? One possible answer would be to have the world return to some kind of new Bretton Woods Agreement, ie to a world of fixed exchange rates and foreign exchange control. Yet in spite of much ado about the financial crisis of 2007-08, a return to foreign exchange control doesn’t seem to fit in with our times10.

It seems advisable to return to the popular main task of the European Union, the perfection of European unification, and to ask the Community to focus itself on working off the long list of common policies and activities under Title I, Articles 3 and 4 of the consolidated version of the Treaty Establishing the European Community. The European Monetary Union is only a small part of the Maastricht Agreement. Neither would its reform nor its collapse endanger the implementation of a European political and economic union.

To the contrary, pushing through EMU or some form of it might do more harm than good. Seen in this light, it seems advisable to relieve the Commission from its task to try to reach for all members an “irrevocable fixing of exchange rates leading to the introduction of a single currency” (Art 4, par 2 of the Treaty on European Union). This provision smacks of hubris or “Utopian social engineering”11.

Nothing against human design, if it allows for an appropriate dose of “peace meal social engineering”12.

Why not permit EMU members to leave the monetary union if they wish to? Why not give the Community the right to dismiss conspicuously misbehaving members? Under more market oriented, decentralised decision-making conditions, EMU may be perfectly able to reorganise itself effectively.

The author thanks Wouter Coussins for critical comments.


  1. The other two are the European Coal and Steel Community and the European Atomic Energy Community.
  2. See European Union (2006).
  3. The four main criteria regard their present inflation rates (no more than 1.5 percentage points above those of member states with the most stable currency), their annual government deficits (no more than 3 per cent of GDP), government debt to GDP ratios (must not exceed 60 per cent at the end of the preceding fiscal year), their previous exchange policy of the previous two years, and their long-term interest rates (no more than 2 percentage points above those of member states with the most stable currency). (See the Protocol on the convergence criteria referred to in Article 109j of the Treaty establishing the European Community
  4. No 21 annexed to Art 121 of the Treaty of Amsterdam amending the Treaty on the European Union etc of 2 Oct 1997).
  5. Eg Telser (1980).At least since the international farewell to gold, de facto since 1914.
  6. Labour productivity ranges in 2010 between 41.3 [Bulgaria] and 187.0 [Luxembourg] – where 100 denotes the average labour productivity of all 27 EU member states together. (See Eurostat – Tables, Graphs and Maps Interface [TGM] 26. 07. 12).
  7. Whose labour productivity was about 60 per cent of Germany’s labour productivity between 2000 and 2010 (see Eurostat – Tables, Graphs and Maps Interface [TGM] 26. 07. 12).
  8. Karl-Otto Pöhl, outgoing president of the Deutsche Bundesbank, had mentioned it in public (see Richter 1991, 94).
  9. Lane (2012) in his otherwise excellent article on the European sovereign debt crisis disregards the problem of competitiveness completely.
  10. Yet see Hal S. Scott on „The Global (Not Euro-Zone) Crisis“ (Aug. 15 2012) considering some kind of „Bretton Woods II“ agreement.
  12. Popper (1957, 67).
  13. Ibid.