Introducing the Latin Euro

This is not the end of the crisis but rather the next stage

By SIMON JOHNSON and PETER BOONE

The verdict is now in. Traditional German values lost and the Latin perspective won. Germany fought hard over many years to include “no bailout” clauses in the Maastricht Treaty (the founding document of the euro currency area) and to limit the rights of the European Central Bank to lend directly to national governments.

But last week, the bank’s governing council – over German objections – authorized the purchase of unlimited quantities of short-term national debts and effectively erased any traditional Germanic restrictions on its operations.

The finding this week by the German Constitutional Court that intra-European financial rescue funds are consistent with German law is just icing on this cake, as far as those who support bailouts are concerned.

With this critical defeat at the E.C.B., Germany is forced to concede two points. First, without the possibility of large-scale central-bank purchases of government debt for countries such as Spain and Italy, the euro area was set to collapse.

And second, that “one nation, one vote” really does rule at the E.C.B.; Germany has around one-quarter of the population of the euro area (81 million of a total of around 333 million), but only 1 vote of 17 on the bank’s governing council – and apparently no veto.

The balance of power and decision-making has shifted toward the troubled periphery of Europe. The “soft money” wing of the euro area is in the ascendancy.

This is not the end of the crisis but rather the next stage. The fact that the European Central Bank is willing to purchase unlimited debt from highly indebted nations should not make anyone jump for joy. The previous rule forbidding this was in place for good reason; the German government did not want investors to feel they could lend freely to any euro-area nation and then be bailed out by Germany.

Now investors know they can be bailed out by Germans, both directly through fiscal transfers and through credit provided by the European Central Bank. How does that affect the incentives of borrowers to be careful?

Prime Minister Mariano Rajoy of Spain has now opened the next front in the intra-European credit struggle. Despite the announcement of E.C.B. support, Mr. Rajoy remains elusive regarding whether he would seek the money.

His main concern is that the E.C.B. is insisting that the International Monetary Fund, along with the European Union commission and perhaps the central bank itself, negotiate an austerity program with any nation that needs funds. Such an austerity program is the “conditionality” that the E.C.B. had to assert would exist in order to justify the large bailouts they are promising.

So the battleground moves from whether the European Central Bank can bail out nations to whether austerity programs should be required for bailouts. The peripheral countries will fight this issue tooth and nail, and they will win.

Unemployment in Spain is now around 24.6 percent; in Greece it is 24.4 percent (with unemployment for those 14 to 24 at 55 percent). Both Portugal and Ireland have made progress with their austerity programs, but they are not growing, and their debts remain very large (gross general government debt is projected by the I.M.F.’s Fiscal Monitor to be 115 percent of gross domestic product next year in Portugal and 118 percent of G.D.P. in Ireland).

The current Italian government is well regarded, but large political battles loom, and it is also burdened with big debts (to reach 124 percent of G.D.P. in 2013).

At the same time, European countries outside the euro – including Britain, Sweden, Poland and Norway – are all seen as faring much better.

The Germans will be increasingly drawn toward one plausible conclusion: perhaps the euro area is simply the wrong system. If tough austerity programs do not wrest nations free from high unemployment and overindebtedness, then how are they to get back on the path to growth?

If a one-time devaluation could help release nations from their troubles rather more quickly, perhaps Germany should instead acknowledge – or insist – that the single currency is a failed exchange-rate regime.

The European Central Bank is now fighting for its survival as an organization. Its president, Mario Draghi, and his colleagues have stretched the rule book in order to open the money spigots to purchase troubled nations’ debts. The leaders of troubled nations will fight hard to get all they can with as few promises in return as possible. Elected officials must do this, or they will lose elections.

Europe has strong institutions, including good property rights and vibrant democracy. An independent central bank was long seen as an important manifestation of such institutions. But powerful interests have shifted toward wanting easy credit above all else. And the more the E.C.B. provides such credit, the more powerful those voices on the periphery will become.

We’ve seen such a dynamic operate time and again around the world. When strong regional governments are fighting for resources against national governments, there is a tendency for regions to accumulate large debts, then demand new bailouts at the national level. These battles often end in runaway inflation, messy defaults or both (think Argentina many times or Russia in the 1990s).

The European Central Bank has handed the euro zone’s peripheral governments a great victory at the expense of those who hoped to keep the euro area a solvent, “hard currency” zone through disciplined public finance.

It may be difficult to imagine that wealthy European nations could follow the tragic path to inflation and defaults seen for so long in Latin America. Yet with each “step forward” in this euro crisis, Europe moves further along that same route.