Getting to Yes (Again) with Germany

GENEVA – Europe’s slow-motion sovereign-debt crisis may appear unique, but it is not. Just a few decades ago, Europe had the Exchange Rate Mechanism, which collapsed during a crisis very much akin to the one afflicting Europe today. Will the outcome this time be different? The ERM was an arrangement that pegged most European currencies’ exchange-rate movements within limited bands. But ERM members’ monetary policies remained home-grown, which, no surprise, occasionally led to fiscal imbalances. When capital markets smelled a problem among ERM members, they invariably shorted the most vulnerable currency and pushed that country’s authorities to devalue. Authorities resisted, blamed speculators, and then, usually over a frantic few days, gave in. Markets also tested the resolve of policymakers in otherwise sound ERM countries, particularly when there were big strikes or important elections. In those cases, even a government with the proper economic fundamentals and its financial house in order could still run into trouble. European Central Bank President Jean-Claude Trichet is well aware of this: in the early 1990’s, he confronted such a crisis as Governor of the Bank of France. Some contemporary observers of the ERM thought that there was an easy fix for these troubles. If the central bank of the country that printed its “strong currency” (Germany) had been willing to provide unlimited support to a “weak currency,” things would have been sorted out. Germany’s Bundesbank, it was suggested, would stand ready to buy “unlimited quantities” of lire or francs, so no one would dare to short either currency. The notion of “unlimited quantities” was important: speculators would force officials to exhaust limited quantities, with the purchasing authority (the Bundesbank) eventually bearing the loss. Monetary support would lead to fiscal transfers, making limited interventions a non-starter. With unlimited support, by contrast, every single speculator could be quashed, and no loss would be borne (since intervention to support a weak currency would succeed). The only problem was that both the Bundesbank and the German government always fiercely resisted such an arrangement, on the grounds that it could lead to the printing of unlimited quantities of Deutschmarks, and thus stoke inflation. Instead, Europe developed the euro, which solved the problem of speculative attacks and monetary credibility by replacing individual currencies with a new one. It was impossible to short the lira or the franc because there were no more lire or francs. But Italy and France had to give something in return for this security: the ECB was made independent of all eurozone governments. Yet the current debt crisis has resurrected the old problem, with debt now filling the role that currencies played under the ERM. Some eurozone countries borrowed excessively and have been punished by the markets, perhaps deservedly so, while others, in the resulting climate of anxiety, have become targets for speculators. On July 21, eurozone leaders agreed to make “more extensive” use of the new European Financial Stability Facility (EFSF) by permitting it to purchase endangered eurozone countries’ debt in secondary markets. But the EFSF’s “more extensive interventions” recalls the “unlimited quantities” of foreign-exchange intervention proposed to rescue the ERM. If “more extensive” means piecemeal limited commitments that will eventually be exhausted, the scheme runs the risk of creating losses (just as the Bundesbank would have suffered losses had it engaged in limited defense of weak ERM currencies). To rule this out, “unlimited interventions” would be needed. But with whose resources, and under whose authority? This explains the growing excitement about issuing “Eurobonds.” The conversion of all eurozone national bonds into obligations jointly recognized by all eurozone governments is a replica of the solution to the ERM’s breakdown, which consisted in abandoning national currencies in favor of the euro. This would cost Germany control over the quality of its credit, just as the replacement of the Bundesbank by the ECB implied Germany’s loss of control over the quality of its currency (though it was given a large role in designing the ECB). What is missing in today’s proposals is the equivalent of the ECB’s independence, which ensured Germany’s participation in the euro. It is no coincidence that one of the leading opponents – the ECB’s first chief economist, Otmar Issing – of the “unlimited interventions” policy under the ERM recently rebuked both the “extended-EFSF” and Eurobonds. The current proposals, Issing argues, are “undemocratic.” The concessions needed to ensure German participation are likely to be enormous. With markets’ ability to monitor dubious borrowers, the guarantees will probably have to be institutional, constitutional, and political – probably formal control over European fiscal policy by a body at least as credible as the ECB, which would mean a dramatic reduction in the power of national parliaments. Such radical changes would require the consent of all eurozone countries. And the Bundestag (not Standard and Poor’s) would have to be happy. Anything short of this is bound to fail. Marc Flandreau, is Professor of International Economics and International History at the Graduate Institute of International and Development Studies, Geneva. Copyright: Project Syndicate, 2011.www.project-syndicate.org