Operation Self-Deceit

New Documents Shine Light on Euro Birth Defects

Newly revealed German government documents reveal that many in Helmut Kohl's Chancellery had deep doubts about a European common currency when it was introduced in 1998. First and foremost, experts pointed to Italy as being the euro's weak link. The early shortcomings have yet to be corrected.

By Sven Böll, Christian Reiermann, Michael Sauga and Klaus Wiegrefe

It was shortly before his departure to Brussels when the chancellor was overpowered by the sheer magnitude of the moment. Helmut Kohl said that the "weight of history" would become palpable on that weekend; the resolution to establish the monetary union, he said, was a reason for "joyful celebration."

Soon afterwards, on May 2, 1998, Kohl and his counterparts reached a momentous decision. Eleven countries were to become part of the new European currency, including Germany, France, the Benelux countries -- and Italy.

Now, 14 years later, the weight of history has indeed become extraordinary. But no one is in the mood to celebrate anymore. In fact, the mood was downright somber when current Chancellor Angela Merkel met with her Italian counterpart Mario Monti in Rome six weeks ago.

Even as the markets were already prematurely celebrating the end of the euro crisis, the chancellor warned: "Europe hasn't turned the corner yet." She also noted that new challenges would constantly emerge in the coming years. Her host conceded that his country had not even overcome the most critical phase yet, and that the fight to save the currency remained an "ongoing challenge."

It didn't take long for the two leaders' concerns to prove justified. The Spanish economy has continued its decline, interest rates for southern European government bonds are rising once again, and election results in both France and Greece have shown that citizens are tired of austerity programs. In short, no one can be certain that the monetary union will survive in the long term.

Many of the euro's problems can be traced to its birth defects. For political reasons, countries were included that weren't ready at the time. Furthermore, a common currency cannot survive on the long term if it is not backed by a political union. Even as the euro was being born, many experts warned that currency union members didn't belong together.

Pushing Ahead Regardless

But it wasn't just the experts. Documents from the Kohl administration, kept confidential until now, indicate that the euro's founding fathers were well aware of its deficits. And that they pushed ahead with the project regardless.

In response to a request by SPIEGEL, the German government has, for the first time, released hundreds of pages of documents from 1994 to 1998 on the introduction of the euro and the inclusion of Italy in the euro zone. They include reports from the German embassy in Rome, internal government memos and letters, and hand-written minutes of the chancellor's meetings.

The documents prove what was only assumed until now: Italy should never have been accepted into the common currency zone. The decision to invite Rome to join was based almost exclusively on political considerations at the expense of economic criteria. It also created a precedent for a much bigger mistake two years later, namely Greece's acceptance into the euro zone.

Instead of waiting until the economic requirements for a common currency were met, Kohl wanted to demonstrate that Germany, even after its reunification, remained profoundly European in its orientation. He even referred to the new currency as a "bit of a peace guarantee."

Of course, financial data doesn't play much of a role when it comes to war and peace. Italy became a perfect example of the steadfast belief of politicians that economic development would eventually conform to the visions of national leaders.

However, the Kohl administration cannot plead ignorance. In fact, the documents show that it was extremely well informed about the state of Italy's finances. Many austerity measures were merely window dressing -- either they were accounting tricks or were immediately dialed back when the political pressure subsided. It was a paradoxical situation. While Kohl pushed through the common currency against all resistance, his experts essentially confirmed the assessment of Gerhard Schröder, the center-left Social Democratic Party (SPD) candidate for the Chancellery at the time. Schröder called the euro a "sickly premature baby."

A Miraculous Cure

Operation "self-deception" began in December 1991, in an office building in the Dutch city of Maastricht, the capital of the southeastern province of Limburg. The European heads of state and government had come together to reach the decision of the century, namely to introduce the euro by 1999.

To ensure the stability of the new currency, strict accession criteria were agreed upon. Countries must have low rates of inflation, must have reduced new borrowing and must have their debt levels under control in order to be accepted. The European Commission and the European Monetary Institute (EMI) were to monitor developments, and European leaders were to reach the final decision in the spring of 1998.

As luck would have it, Italy fulfilled all requirements as the date approached -- surprisingly so, given that it had acquired a reputation for notoriously imbalanced budgets. But the country had undergone a miraculous cure -- on paper at least.

Officials at the German Chancellery in Bonn had their doubts. In February 1997, following a German-Italian summit, one official noted that the government in Rome had suddenly claimed, "to the great surprise of the Germans," that its budget deficit was smaller than indicated by the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD).

Shortly before the meeting, a senior German official had written in a memo that new posting rules for interest had alone resulted in a 0.26 percent decline in the Italian budget deficit.

A few months later Jürgen Stark, a state secretary in the German Finance Ministry, reported that the governments of Italy and Belgium had "exerted pressure on their central bank heads, contrary to the promised independence of the central banks." The top bankers were apparently supposed to ensure that the EMI's inspectors would "not take such a critical approach" to the debt levels of the two countries. In early 1998, the Italian treasury published such positive figures on the country's financial development that even a spokesman for the treasury described them as "astonishing."

Snail's Pace

In Maastricht, Kohl and other European leaders had agreed that the total debt of a euro candidate could be no more than 60 percent of its annual economic output, "unless the ratio is declining sufficiently and is rapidly approaching the reference value."

But Italy's debt level was twice that amount, and the country was only approaching the reference value at a snail's pace. Between 1994 and 1997, its debt ratio declined by all of three percentage points.

"A debt level of 120 percent meant that this convergence criterion could not be satisfied," says Stark today. "But the politically relevant question was: Can founding members of the European Economic Community be left out?"

Government experts had known the answer for a long time. "Until well into 1997, we at the Finance Ministry did not believe that Italy would be able to satisfy the convergence criteria," says Klaus Regling, at the time, the Director-General for European and International Financial Relations at the Finance Ministry. Currently, Regling is the chief executive of the temporary euro bailout fund, the European Financial Stability Facility (EFSF).

The skepticism is reflected in the documents. On Feb. 3, 1997, the German Finance Ministry noted that in Rome "important structural cost-saving measures were almost completely omitted, out of consideration for the social consensus." On April 22, speaker's notes for the chancellor stated that there was "almost no chance" that "Italy will fulfill the criteria." On June 5, the economics department of the Chancellery reported that Italy's growth outlook was "moderate" and that progress on consolidation was "overrated."

In 1998, the decisive year for the introduction of the euro, nothing about this assessment had changed. In preparation for a meeting with an Italian government delegation on Jan. 22, State Secretary Stark noted that the "longevity of solid public finances" was "not yet guaranteed."

'Not Without the Italians'

Horst Köhler wrote to the chancellor in mid-March. Formerly the German chief negotiator in the Maastricht Treaty negotiations, Köhler had moved on to become the president of the German Savings Bank Association. Enclosed with his letter was a study by the Hamburg Institute of International Economics, which concluded that Italy had not fulfilled the conditions "for permanent and sustainable deficit and debt reduction," and that it posed "a special risk" to the euro.

But Kohl rebuffed his former confidant. Of course the Europeans would have to continue their structural reforms, he replied, but he was confident that the governments would rise to the challenge "in the coming years."

At a European Union special summit in Brussels in early May 1998, Kohl felt the "weight of history" and, without further ado, provided his unreserved support. "Not without the Italians, please. That was the political motto," says Joachim Bitterlich, Kohl's foreign policy advisor.

The documents that have now been released suggest that the Kohl administration misled both the public and Germany's Federal Constitutional Court. Four professors had at the time filed a lawsuit against the introduction of the euro. The suit was "clearly without merit," the government told the court, arguing that it would only be justified in the event of a "substantial deviation" from the Maastricht criteria, and that such a deviation was "neither recognizable nor to be expected."

Really? Following a meeting between the chancellor, Finance Minister Theo Waigel and Bundesbank President Hans Tietmeyer, on the case before the Federal Constitutional Court, the head of the economics division at the Chancellery, Sighart Nehring, noted in mid-March 1998 that "enormous risks" were associated with Italy's "high debt levels." The debt structure, Nehring added, was "unfavorable" and outlays would increase considerably if interest rates rose by only a small amount.

A Love for Italy

But the memo had no repercussions. The chancellor, it would seem, wasn't terribly interested in the details. There was a "built-in flexibility" among politicians when it came to the Maastricht criteria," says Dieter Kastrup, German ambassador to Italy at the time.

Italy, after all, was a founding member of the EU, and the Italians had never behaved as poorly in Brussels as the French did under President Charles de Gaulle or the British under Prime Minister Margaret Thatcher. And, finally, hadn't Goethe too waxed lyrical about Italy? "We all shared a certain love for Italy," says Bitterlich.

Officials in Bonn were pinning their hopes on two men who had set out to clean house in Italy: Prime Minister Romano Prodi, a quiet professor from Bologna, and his ascetic minister for the budget and economic planning, Carlo Ciampi, who had been governor of the Italian central bank for many years.

The two technocrats had come into power after the old Italian party system had foundered in a maelstrom of corruption and Mafia connections. Prodi and his center-left alliance "Ulivo" ("Olive Tree") won the election in 1996.

Kohl had doted on the short, liberal professor from the start. Ciampi, who had attended a Jesuit school in Tuscany, also enjoyed a good reputation with the Germans. "Without Ciampi, Italy would never have managed to be on board at the beginning of the monetary union," says former Finance Minister Waigel.

The country was drifting "toward financial bankruptcy" at the time, writes historian Hans Woller. The red tape involved in establishing a company took more than 60 days to complete. Italians couldn't buy newspapers at noon, because they could only be sold at kiosks, which were closed for lunch. Retirees outnumbered the working population, and many of the 1.5 million people officially classified as severely disabled were in the best of health.

Tricks and Luck

Ciampi and Prodi were relatively successful compared to their predecessors. Through reforms and cost-cutting measures, they were able to reduce new borrowing and bring down inflation. But the country had bigger problems than that, and the government was fully aware of them. Indeed, the Italians twice suggested postponing the launch of the euro in 1997. But the Germans rejected the idea. It was "a taboo," says Kohl's former advisor Bitterlich, pointing out that the Germans were pinning their hopes on Ciampi. "Everyone felt that he was Italy's guarantor, in a certain sense, and that he would fix things."

It is also clear, of course, that Kohl was determined to wrap up the monetary union before the 1998 parliamentary election. His re-election was in jeopardy, and his challenger, Social Democrat Schröder, was a known euro skeptic.

In the end, the Italians formally fulfilled the Maastricht criteria with a combination of tricks and fortunate circumstances. The country benefited from historically low interest rates, and Ciampi proved to be a creative financial juggler. He introduced, for example, a "Europe tax" and carried out a clever accounting trick, which involved selling national gold reserves to the central bank and imposing a tax on the profits. The budget deficit shrank accordingly. Even though EU statisticians ultimately did not acknowledge this trickery, it symbolized the fundamental Italian problem: The budget was not structurally balanced, but in fact had benefited from special effects.

This not did not escape the notice of Chancellery officials. In a memo dated Jan. 19, 1998, Bitterlich pointed out that the deficit reduction was based primarily on the special Europe tax and on market interest rates that had fallen considerably in comparison to rates in other countries. A few weeks later, representatives of the Dutch government contacted the Chancellery and requested a "confidential meeting." The general secretary of the Dutch prime minister and a state secretary from the finance ministry wanted to put pressure on Rome. "Without additional measures on the part of Italy to provide credible proof of the longevity of the consolidation, Italy's acceptance into the euro zone is currently unacceptable," the Dutch officials argued.

Germany's Growing Debt

Kohl, fearing for his most important project since German reunification, refused. He told the Dutch officials that the government in Paris had warned him that France would withdraw from the agreement if Italy were excluded.

The Germans were in a weak negotiating position. When it came to fiscal discipline, they were overbearing in their approach to the rest of Europe, and yet Germany's own budget figures were anything but exemplary. The country's sovereign debt level was slightly above the critical 60 percent mark. Even worse, in contrast to almost all of the other countries that wanted to be included in the first round of the monetary union, Germany's total debt was not decreasing, as the treaty required, but in fact was growing.

The Chancellery was aware of the problem. "In contrast to Belgium and Italy, the German debt level has risen since 1994," they wrote in a March 24, 1998 memo to Kohl and Chief of Staff Friedrich Bohl. The consequences were unpleasant. "In our view, there is a legal problem in Germany's case, because the Maastricht Treaty only provides for an exception if the debt level is declining," the memo continues.

Kohl and Waigel claimed mitigating circumstances. Without German reunification, they argued, the debt ratio would only be 45 percent. The excuse was "met with understanding" by both the European Commission and the partner countries, the officials noted with relief.

Still, the situation made it difficult for Germany to play judge, particularly given the lack of formal proof that Italy was in violation. In the spring of 1998, the statistical office of the European Union certified that the Italians had satisfied the deficit criteria of the Maastricht Treaty. This meant that there was "no longer any reason to bar the Italians accession to the euro," as Waigel recalls. After this hurdle had been removed for the Italians, "they had a sort of legal claim to be allowed to be part of the euro from the very beginning," Waigel's former top official Regling says today.

Italy Turns Away from Austerity

Many knew that the figures were sugarcoated, and that they hardly represented real debt reduction. But no one dared draw the consequences. Kohl trusted Ciampi's reassuring claims that the Italians would continue to pursue the "cammino virtuoso" ("virtuous path") they had embarked upon and would "be unrelenting in efforts to clean up the budget." The government in Rome predicted that its debt level would sink to 60 percent of GDP by no later than 2010.

Things didn't turn out that way. As early as April 1998 -- that is, prior to the official decision on which countries would be part of the euro -- there were growing indications that Prodi's coalition partners, the neo-communists, were just waiting to return to their old habits. On April 3, the German embassy in Rome warned that this risk should "not be ignored."

Three months later, when Italy had secured its participation in the euro, the problem came to a head. On July 10, 1998, Ambassador Kastrup expressed his concern to officials in Bonn that Italy was overcome by "stagnation" and "exhaustion," and that the government there was taking "a break of sorts after its extraordinary effort to satisfy the Maastricht criteria."

The break became the status quo. In early August, the Italian Finance Ministry admitted that the budget deficit had been higher in the first seven months than in the same period the previous year -- a period which had been critical to Italy's acceptance into the euro club.

Stephan Freiherr von Stenglin, the financial attaché at the German embassy in Rome, still hadn't completely lost faith in Rome's willingness to cut costs. "Failing to reach this year's deficit target will likely do considerable damage to the credibility of the Italian consolidation policy," Stenglin wrote. At the Chancellery, a large exclamation mark was written in the margin next to this sentence.

'A Qualitative Shift'

In the mean time, however, the most intense phase of the general election campaign had begun. The battle between Kohl and his challenger Schröder focused on domestic policy, and not the euro.

This didn't change after the election, either, no matter how many alarming messages Financial Attaché Stenglin sent to Bonn. On Oct. 1, he submitted a blunt analysis of the Italian fiscal policy, which he hid behind the harmless subject line "Italian Government Approves Draft for the 1999 Budget." Stenglin, who had been sent to Rome from his position at the Bundesbank, saw that the development in Italy was moving completely in the wrong direction. The Italian government's draft budget, he reported to Bonn, signified a "qualitative shift in budget policy."

According to Stenglin, the budget showed the lowest cost-cutting figures since the beginning of the consolidation course in the early 1990s. Additional tax revenues, he noted, would no longer be used solely to reduce the deficit, but also to pay for new spending, particularly on social programs. The government, Stenglin wrote, could not avoid giving the impression that it was "more interested in a departure from the strict consolidation course of recent years than in doing everything possible to set aside doubts concerning the sustainability of Italy's public finances."

When Prodi was replaced a short time later by former Communist Massimo d'Alema, the situation deteriorated even further. D'Alema proposed financing a European economic stimulus program through euro bonds and not factoring the associated expenditures into the national deficits.

The new SPD-Green Party coalition government in Germany, led by Schröder, rejected the proposal. Nevertheless, the new approach had taken hold in Rome, as Stenglin wrote in a cable to Bonn on Nov. 18. He noted that members of the Italian government were demanding that the budget consolidation be spread out, the stability pact be interpreted more flexibly and Italy be freed "from the shackles of the Maastricht Treaty."

The Maelstrom of Crisis

A few weeks before the launch of the common European currency, Stenglin's assessment of the situation took on a dramatic undertone, when he wrote: "The question arises as to whether a country with an extremely high debt ratio doesn't risk gambling away the success of its consolidation efforts to date, thereby harming not only itself, but also the monetary union." It was a prophetic remark. In the fall of 2011, when the country was pulled into the maelstrom of the crisis, the debt ratio had risen above 120 percent of GDP once again.

Kurt Biedenkopf, a member of the center-right Christian Democratic Union (CDU), predicted the dilemma in which the monetary union finds itself today even before the introduction of the euro. At the time, Biedenkopf was governor of the eastern state of Saxony -- and was the only German governor to vote against the monetary union in the Bundesrat, the legislative body that represents the German states. "Europe wasn't ready for that epochal step," says Biedenkopf today, noting that the individual countries differed too widely in terms of economic performance. "Most politicians in Germany thought that the euro would function even without common institutions and without financial transfers. That was naïve."

Meanwhile, European leaders are trying to correct the defects of the founding phase of the euro. Austerity and reform measures are being implemented in large parts of Europe, and all countries support the idea of joint responsibility for the currency. Nevertheless, the new euro architecture doesn't differ all that much from the old one.

When the euro was first designed, the government in Bonn believed that it was sufficient to stipulate stringent debt criteria in an agreement and to rely on its members to responsibly implement the necessary structural reforms. Today, Europe's new fiscal pact is intended to teach the member states solid budget management and foster a willingness to bring about reform. In other words, the original procedure, which was unable to survive its first stress test, has only been slightly modified. There is still no central institution that could forcibly impose the necessary discipline. Offenders will still pass judgment on other offenders within the circle of European heads of government.

No Solution Yet

The government files from the founding phase of the monetary union reveal that this construct cannot function. The message the documents convey is that political opportunism will ultimately prevail. A monetary union amounts to more than shifting several billion euros back and forth. It is also a community of fate. Shared money requires shared policy and, in the end, shared institutions.

The euro is now in its 14th year, and after two years of ongoing crisis, there is a growing realization in Berlin and other capitals that the status quo cannot continue. All reform efforts still resemble small steps to nowhere, and yet politicians are beginning to think in terms of broader categories as they cope with the crisis. The new fiscal pact is not providing a quick solution yet, and as a result European politicians are developing new visions while old taboos are falling.

While the southern countries and France are coming to terms with a debt brake based on the German model, the German government no longer has any objections to an economic government within the euro zone, a French idea to which Germany was once staunchly opposed. Finance Minister Wolfgang Schäuble, for his part, is considering upgrading the EU finance commissioner to a kind of European finance minister, who would monitor the budgets of euro-zone member states and would also have the power to intervene, if necessary.

All of these measures boil down to individual countries relinquishing more authority and the central government in Brussels acquiring more power in return.

If the members of the monetary union quickly make up for what they neglected before embarking on the euro adventure, the project of the century can still succeed. But the longer then necessary reforms are delayed, the more costly the journey becomes for everyone.