The Future of the Euro

Footing the bill for malinvestments will shape the future of the euro

by Philipp Bagus

The problems of the eurozone are ultimately malinvestments. In Greece these days the struggle continues about who will ultimately foot the bill for these investments. During the early 2000s an expansionary monetary policy lowered interest rates artificially. Entrepreneurs financed investment projects that only looked profitable due to the low interest rates but were not sustained by real savings. Housing bubbles and consumption booms developed in the periphery.

In 2007 the bubbles began to burst. Housing prices started to stagnate and even to fall. Homeowners and builders started to default on their loans. As banks had financed and invested into these malinvestments, they suffered losses. After the collapse of the investment bank Lehman Brothers interbank lending collapsed and governments intervened. They bailed out banks and, thereby, assumed the losses of the banking system resulting from the malinvestments.

As malinvestments were socialized, public debts soared in the eurozone. Furthermore, tax revenues collapsed due to the crisis. At the same time, governments started to subsidize industrial sectors and unemployment.

Moreover, even before the crisis, governments had accumulated malinvestments due to their excessive welfare spending. Two causes had incentivized social spending in the periphery. The first cause is low interest rates. These low interest rates were caused by an expansionary monetary policy by the European Central Bank (ECB) and the single currency in itself. The euro came with an implicit bailout guarantee. Market participants expected stronger governments to bail out weaker ones in order to save the political project of the euro if worse came to worst. The interest rates that the Italian, Spanish, Portuguese, and Greek governments had to pay came down drastically when these countries were admitted into the euro. The low interest rates gave these countries leeway for deficit spending.

The second cause is that the euro is a tragedy of the commons.

In the eurozone, several independent governments can use one central banking system to finance their deficits. The costs of these deficits can be partially externalized in the form of higher prices on foreigners. Take the following example: The Greek government spends more than it receives in taxes. For the difference, the Greek government prints bonds. The banking system buys these bonds because banks can use them as collateral for new loans from the ECB. When the banks pledge the Greek government bonds as collateral with the ECB, they receive new central-bank money. Banks can then use these new reserves to expand credit. The money supply increases, and prices rise. The deficit is thereby indirectly monetized, and the users of the currency pay.

Prices rise not only in Greece but all over the eurozone. In this way a part of the costs of the deficit is externalized to foreigners. Not only the Greek government but all governments can externalize the costs of their deficits in this way, resulting in perverse incentives. If you have higher deficits than other eurozone countries, you can externalize the costs of deficits on other countries. The higher the deficit is in relation to the deficits of the other eurozone members, the better.

There is a monetary redistribution from the fiscally sounder to the unsound governments. These incentives were known from the beginning of the euro. The idea was to restrict these incentives to deficits below 3 percent of GDP via the Stability and Growth Pact (SGP). Yet, the SGP was a total failure. In spite of numerous infringements, no sanction was ever imposed. The main problem is that governments are their own judges. Until now they have always decided that no penalty was necessary.

Today government debts in several eurozone countries are so high that they will never be paid back. Governments are unable or unwilling to do so. If they increase tax rates, their economy will collapse and deficits may actually increase. If they reduce expenditures, there may be social unrest. In either case, they would lose influence and votes. Because these debts will not be paid back, they represent malinvestments.

Malinvestments mean that scarce resources of society have already been squandered; real wealth has been lost by welfare spending and bailing out bubble industries. But it is still not clear who will pay the main burden of the losses caused by unsustainable welfare states and the bailout of industries.

Up to the beginning of the sovereign-debt crisis, the bill was being paid through the internal monetary redistribution entailed in the setup of the euro system. Main net contributors were citizens in fiscally sounder countries such as Germany that were implicitly guaranteeing for the spending sprees in the periphery. The bailouts of Greece, Ireland, and Portugal have made these wealth transfers more visible. The incentives of rescuing irresponsible government are now obvious to everyone. Germans do not want to pay the peripheral bills anymore.

The question of who will be paying the bill for these malinvestments has arisen anew with the sovereign-debt crisis. The answer to this question decides the future of the euro. There exist several possibilities in theory.

A.  Governments in the periphery pay themselves for their irresponsible behavior. They reduce expenditures and privatize public property. In this way they will lose influence and probably votes.

B.  Governments in the core (Germany, Finland, the Netherlands, Austria, maybe France) pay and sell their public property.

C.  Taxpayers in the periphery pay via a higher tax burden.

D.  Taxpayers in the core countries could pay. This could be done through a fiscal union. In a transfer union richer and more solid countries continuously transfer funds to the poorer countries. Alternatively, the transfers could be done through Eurobonds. In this variety peripheral countries issue Eurobonds guaranteed by all eurozone governments. Taxpayers in the core pay indirectly through higher interest rates on their public debts. The EFSF, the European Financial Stability Facility, is another variety of this option. The difference is that in the EFSF core countries have more control over the issuance of bonds to bail out peripheral governments and there are still different interest rates for different countries.

E.  Money users of the eurozone countries pay through price inflation. The ECB monetizes government debts. The ECB may do this in several ways. It could buy more peripheral government bonds. It could continue to accept peripheral bonds as collateral. It could also help to finance the EFSF or Eurobonds indirectly by monetizing more public debts of the core.

F.   The financial system pays. Overindebted governments default on their loans. Because the financial system has financed the excessive government spending and is interconnected, a banking crisis would be the result.

The periphery and the French government prefer a combination of options D and E, a fiscal union and monetization. The ECB prefers a fiscal union. The German government, however, opposes both options, as they fear inflation and their angry voters, who are tired of bailing out the periphery. Germany wants a reformed SGP with automatic penalties and more control of excessive government spending. Germany has also defended the position that private investors (banks) should assume at least part of the losses. In other words, Germany stands for a combination of option A, C, and F: governments and taxpayers in the periphery as well as banks assume their losses.

The future of the euro and the EU depends on who will finally win. If France and the periphery get their way, there will be a fiscal union and more centralization. The euro will be a political and weak currency.

If Germany wins and there is a reformed SGP, the euro will be a strong currency in the long run.

Yet, there exists also the possibility that the losing side will be so unhappy that the eurozone disintegrates. In the case of a German victory, more austerity measures and a reduction of the living standard may lead to unsustainable social unrest in Greece. Greece may then leave the eurozone and devalue its new currency to continue its spending spree. This could trigger a chain reaction with other countries exiting the eurozone and cause a banking crisis.

In the case of a Germany defeat, there will be more centralization in Europe and possibly double-digit inflation rates in the future. Then a German "tea party" opposed to the wealth transfer into the periphery may arise. Germany may then leave the euro, also triggering a disintegration of the eurozone and a banking crisis.

But who is likely to win? In principle Germany has the better cards because it is paying and it could just threaten to stop guaranteeing for the periphery. However, there may be even better arguments for the other side to win. France was on the winning side of WWII and has more geopolitical power than Germany. The French government and her allies managed already to get rid of the hated Deutsch Mark. Germany has been paying other countries since WWII due to a combination of guilt complexes and implicit threats of isolation. As geopolitical conditions have not changed radically, it is likely that Germany will keep paying in the future and that the euro will be a weak currency.