A giant hangover

Why E.U. collapse is more likely than the fall of the euro

By Niall Ferguson

European politics has become a giant Jenga game. Since June 2010 governments have fallen in the Netherlands, Slovakia, Belgium, Ireland, Finland, Portugal, Slovenia, Greece and Italy.

The question is not: Who will be next? That’s easy. (Spain’s Socialist government will be pulverized in this weekend’s elections.) The real question is: When will the Jenga tower topple?

Many people assume that the tipping point will come when one country — most likely Greece — leaves or is ejected from Europe’s monetary union. But the scenario that worries Eurocrats is different. They fear that a country could leave the European Union itself.

This is by no means an irrational anxiety. Under E.U. law, it would be much easier for Britain to leave the European Union than for Greece to leave the euro zone.

Thus the process of European integration has reached a richly ironic point: The breakdown of the European Union is now more likely than the collapse of the single currency that was supposed to bind it together.

This is not surprising. In March 2000, Larry Kotlikoff and I wrote in Foreign Affairs, “History offers few examples of successful adjustments on the scale necessary in certain European countries today. What it does offer are several examples of monetary unions disintegrating when fiscal strains became incompatible with the unpleasant arithmetic of a single currency.” The euro, we predicted, “could degenerate — not overnight, but within the next decade.”

Our timing was not bad. The degeneration of the single currency began in 2010, though the crisis has certainly intensified in recent months.

We specified “degeneration” to highlight the generational imbalances arising from Europe’s combination of aging populations and over-generous welfare systems. Even if there had been no financial crisis emanating from the U.S. subprime mortgage crisis that began in 2007, the European monetary system would still have degenerated as public debts soared.

But we also struggled to see how, once assembled, the euro zone could be dismantled. The costs of exit would be prohibitive for a small peripheral country such as Greece, which would overnight lose access to any source of external credit. And a Greek departure would raise the probability of others leaving, causing contagion throughout Southern Europe.

Finally, if all the weaker brethren were to leave the monetary union except Germany, Austria, the Netherlands and Finland, the strengthening of the euro would cause significant pain to the exporters of those countries. In short, almost nobody would gain from a breakup of the euro zone.

This is why I am not among the growing throng of pundits predicting the degeneration of the euro — a number of whom argued with equal self-confidence a dozen years ago that the euro would be a great success.

Anyone who closely followed events of the 1990s had a clear idea of what a monetary union with the Federal Republic of Germany would entail: short-term spending power but long-term unemployment mitigated by handouts.

Some doubt that German taxpayers will be as ready to pay doles to Lesbos and Livorno as they were to pay doles to Leipzig. But if the alternative is a breakup of the euro zone, they will do it. Chancellor Angela Merkel made that clear Monday when she urged her Christian Democrats to accept “not less Europe but more. . . . That means creating a Europe that ensures that the euro has a future. Our responsibility no longer stops at our countries’ borders.”

Those betting on a euro breakup believe that the inflation-phobic Germans will never permit large-scale bond purchases by the European Central Bank — the policy known in the United States as quantitative easing. But this needs to happen to bail out not only the Mediterranean governments but also insolvent banks — including German banks — throughout the euro zone.

In short, the European monetary union survives, albeit with a gloomy future of higher unemployment for southern Europe and higher taxes for the North.

But the fate of the European Union itself will be very different. The creation of the single currency — obeying the law of unintended consequences — set in motion a powerful process of European disintegration. The fact that not all 27 E.U. members joined the monetary union was its first manifestation. Today we have a two-tier system, with 17 member-states sharing the euro, but 10 other states — notably Britain — retaining their own currencies.

The result is that key decisions today — particularly those about the scale of transfers from core nations to the periphery — are being made by the 17, not the 27. But the 10 non-euro members may still find themselves on the hook to help fund whatever combination of bailout, haircut and bank recapitalization the 17 decide on. They may also face more stringent financial regulation or a financial transaction tax, ideas that are much more popular in Berlin than in London.

This is an unsustainable imbalance. If the euro countries are intent on going down the road to federalism — and they don’t have a better alternative — the non-euro countries will face a stark choice: giving up monetary sovereignty or accepting the role of second-class citizens within the E.U.

Under these circumstances, the logic of continued British membership in the E.U. looks less and less persuasive. British public opinion has long been deeply Euro-skeptic. If it came to a referendum, as many Conservatives would like, Britons might well vote to leave the E.U. And under Article 50 of the Treaty of European Union, withdrawal would simply need to be approved by a qualified majority of E.U. members.

In the great game of European Jenga, most people expect the French government of Nicolas Sarkozy will fall next year. But the thing that could cause the European Union to topple, or at least shrink in size, would be the outright withdrawal of Britain. And that has started to look quite possible.