07 October 2011

Charles Grant: Resuscitating the euro

Over the past few weeks, however, the chances of the euro holding together may have grown. This is because Angela Merkel, the German chancellor, has said she wants a new treaty to enforce closer co-ordination of economic policy making.

In general, new treaties are a bad idea. They take years to negotiate and cannot take effect unless ratified by every Member State through a parliamentary vote or referendum. There is always the risk that one country or another will block a new agreement. But on this occasion, the news that the Germans want a new treaty is welcome. This is because the new treaty only makes sense as part of a grand bargain. Merkel will be able to say to the German people that, thanks to the new treaty, tough new rules will keep profligate southern Europeans under firm discipline. In return, she will say, Germany should be ready to support more generous bailout mechanisms. The new treaty would probably be for the 17 eurozone countries, rather than the 27, so that eurosceptical Britain — in the EU but not the euro — would have no opportunity to block it.

In order to reassure the markets and bring down borrowing costs, Germany needs to indicate support for one of three options.

• First, the European Central Bank (ECB) could step up purchases of government bonds.
• Second, the EU could set up a scheme for “eurobonds,” with euro members raising money collectively to ease the cost of borrowing for those with too much debt.
• The third and most plausible option is to boost the firepower of the EFSF, possibly through mechanisms that would link it to the ECB. A war chest of around €2 trillion likely would convince the markets that the EU is serious about keeping Spain and Italy in the eurozone.

But more financial assistance is only part of what is required to save the euro. Much of the debt owed by Greece, Portugal and perhaps others will have to be written off, and that in turn will require a massive recapitalisation of European banks (by €200-300 billion, IMF figures suggest). And, crucially, the problem countries need to adopt intelligent policies. They need to keep public spending under control and introduce structural economic reforms that will facilitate growth (such as opening up closed professions and labour markets).

EU governments should create an orderly exit mechanism for Greece or any other country that may wish to leave. The more that EU governments plan in advance, for example by agreeing to a legal framework and financial aid for departing countries, the less disruptive any departure would be. The biggest argument against Greece leaving is the fear of contagion spreading through panicky financial markets. But the EU would be able to ring-fence Greece from other problem countries if it pledged sufficient financial support and if these countries adopted credible policies.

In the long run, a stable euro requires more balanced trade and growth among its members. The financial markets worry not only about the southern countries’ budget deficits but also their inability to grow. The Germanic medicine that the EU has imposed on Greece and Portugal — austerity and structural reform — was necessary but not sufficient. Unaccompanied by measures to promote growth, it has led to shrinking economies and government debt rising as a percentage of GDP.

Another long-term problem is peoples’ growing hostility to the EU in general and to the euro in particular. Even if EU leaders can, belatedly, agree on the right policies to save the euro, public opinion may prevent them from carrying out those policies. In one country, a national parliament may veto a bailout; in another, a referendum on the new treaty could be lost.

Whether the euro endures depends on many factors, including the quality of European leadership. Nowhere is this more important than in Germany. Merkel will never be a visionary, but she is a practical problem-solver. Churchill famously said that "the Americans can always be counted on to do the right thing...after they have exhausted all other possibilities". Those who fear the consequences of Europe’s euro crisis are counting on the same being true of the Germans.

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© Charles Grant