Europe’s Unfinished Currency – by Thomas Mayer

Read the article in the Cayman Financial Review Magazine 

In his “Europe’s Unfinished Currency”, Thomas Mayer gives us a highly readable account of the political origins of the European Union and its currency and its current weaknesses and promise.

Mayer was chief economist of Deutsche Bank Group at the height of the euro crisis and writes with a clear-eyed understanding of his topic. He sets out clearly the alternative approaches to addressing the euro’s weaknesses – greater EU sovereignty over member countries’ financial affairs, or greater market discipline of the behaviour of largely sovereign member states – and sides with the latter. In this regard, Mayer offers the model established by the United States of earlier years when quasi-sovereign state governments were allowed to default on their debt creating significant market discipline of state and municipal borrowing.

In many respects World War II was the outcome of the unrealistically harsh treatment of Germany in the Treaty of Versailles after World War I. France in particular was determined not to repeat this mistake after WW II. Integrating and tying Germany to the rest of Europe became the driving passion of political elites in France and Germany.

The European project, which was from the beginning a political project, built up step by step around the theme of economic integration – the free movement of goods, capital and people within Europe, the so called European internal or “common” market. Mayer argues that the fall of the Berlin Wall in 1989 and end of the Cold War “fundamentally changed the nature of European integration”. (page 29)

After Germany paid the price demanded by the West for its reunification – giving up the German mark for the euro – the political rational for European integration lost its driving force. The earlier political imperatives of passing national sovereignty over budgetary matters to European level bodies no longer existed. The proposals of the Delors report on Economic and Monetary Union “represented a much deeper infringement on national sovereignty than eventually agreed in the Maastricht Treaty and the Stability and Growth Pact”. (page 34) Thus the architecture of the monetary union was incomplete and defective.

Mayer provides a fascinating history of monetary unions, distilling what worked and what didn’t. “The incentive for a state to issue more money than its partners creates the risk of a competitive debasement of the common currency and hence makes currency unions of sovereign states inherently unstable. To avoid this problem, the issuance of money must be centralized.” (73)

The most recent demonstration of this truth was the collapse of the use of the Russian rouble throughout the newly independent republics of the former Soviet Union (FSU). This inherent instability was resolved in the FSU by each newly independent country issuing its own currency. “But how” Mayer continues, “can fiscal discipline be enforced among largely sovereign public entities?” Either integration needs to proceed with some fiscal sovereignty shifting to the EU, or the default of states on their debts needs to be made credible in order to establish market discipline of excessive borrowing.

The former, Mayer argues, is not going to happen so the EU had better develop the latter. Eurobonds, which remove any country risk premium from the cost of borrowing for individual countries, would require EU level control over country borrowing and is an example of the former direction. The Greek default is an example of the latter, market, direction.

A common currency for Europe requires some measure of the Mundell Optimal Currency Area conditions (capital and labour mobility and price flexibility) and the euro was expected to prod the emergence of those conditions. While Germany reformed its labour markets and welfare system early on, suffering the initial costs and reaping the longer run gains, Southern European countries did not, living off the cheap credit the euro afforded. While commending the ECB for performing well early in the crisis to address bank liquidity problems, Mayer is critical of its subsequent filling in for the lack of proper EU mechanisms for dealing with the crises: “While the ECB’s initial liquidity support was indeed in line with best practice in central banking, the same cannot be said of the subsequent actions.” (page 104)

Mayer provides an excellent account of the arguments for and against the two approaches and of the history as the euro crisis unfolded. “In the eyes of the critics, the two key pillars on which EMU was built – the central bank’s exclusive focus on the purchasing power of the common money and the governments’ full liability for their financial decisions – had been destroyed by the way the euro crisis had been managed. … The criticism and loss of trust could probably have been avoided had emergency procedures been clearly defined for the times of financial crises and incorporated into EMU’s legal framework.” (page 114-5)

“Clearly, the Greek experience suggests that what some consider the solution to the problem – fiscal transfers and joint liability for sovereign debt – was actually its source.” (page 141)

Strengthening the market discipline needed for Mayer’s preferred approach, “would require the economies of EMU member countries be made fit to live with a hard budget constraint”. (page 143)

His recommendations for doing so include an EU level bank regulator, insurer and resolution authority and an explicit lender of last resort authority for the ECB to lend directly to member governments in the case of illiquidity only and tied to IMF like adjustment conditionality. He cautions that: “In view of the risks associated with assuming the role of lender of last resort, the central bank ought to perform this role in close cooperation with a fiscal authority.” (page 153)

Thus he would permit the European Stability Mechanism (ESM) to borrow from the ECB. “Sovereign default in EMU has to become possible, which requires that its fallout on the financial sector can be managed.” (page 215).

You are not likely to find a more readable account of the development of the EMU, nor one with sounder advice for saving it.