Europe fears war, hopes for peace, and gets neither

Economic and monetary union remains unfinished

By David Marsh

Helmut Kohl, the former German chancellor, used to say that his landmark European project — economic and monetary union (EMU) — was a matter of war and peace. It would make European conflict impossible. Kohl got it partly right, partly wrong, for different reasons than those he anticipated.

Europe is enduring a long-running but profoundly unsettling ceasefire between debtors and creditors. Neither war nor peace is breaking out. As long as doubt persists on whether the euro truce will hold, so will the uncertainty overhanging the world economy. That encapsulates the mood of many participants at the annual meetings of the International Monetary Fund and the World Bank that ended at the weekend in Tokyo.

As one Asian central banker put it: “We will not have a disaster, but we will not have a solution.” A large fault line in EMU runs through Germany, which the IMF openly blames for not having alleviated far earlier the running sore and vicious circle of low EMU growth and persistent imbalances.

The European Central Bank, on the other hand, emerged from the meetings with reputation and credibility intact. An important point underlined by ECB President Mario Draghi, and backed up by key governing council members such as Austria central bank governor Ewald Nowotny, is that the ECB has to remain distant from the “will they, won’t they?” kerfuffle over whether the Spanish government will apply to European governments (and the IMF) for a new bailout program.

Conditionality is necessary so that errant-but-reforming states “do not take the money and run”, according to central banking insiders. But before the ECB can decide whether countries such as Spain can tap its so-far-unused OMT facility to buy allegedly unlimited quantities of state bonds, the conditionality has to be applied by lending governments, not the ECB.

In two important aspects, decision-makers from both emerging market and developed economies are in agreement.

First, euro-member states have made important strides in enacting fiscal and structural reforms and achieving productivity gains, as well as putting into place mutual-assistance credit mechanisms and laying the groundwork for better economic governance and financial surveillance. A senior Japanese policy-maker gives Europe “nine out of 10 for effort” in trying to rectify the mistakes of the first 10 euro years.

Mario Draghi, president of the European Central Bank

Second, and less optimistic: positive economic changes have been achieved largely at the cost of sharp increases in unemployment and a reduction in social welfare in the most-affected peripheral countries. This has damaged political and social cohesion and throws into doubt whether the edifice will remain sustainable.

One sign of a reduction in stress in Europe, highlighted by key euro officials in Tokyo, has been a fall in the Bundesbank’s claims on the ECB under the Target-2 interbank payments system. However, the 7.5% fall in September to just under 700 billion euro still leaves Germany’s Target balance 50% higher than at the start of 2012 — demonstrating how much the Bundesbank’s balance sheet is potentially at risk from euro area strains.

This is why it is vital for the euro’s future that recent signs of a reflow of capital into countries like Spain are maintained.

Asian central banks, major state funds, and other large institutional investors are still holding back from large-scale euro commitments, leaving short-term speculators as well as (potentially) official European creditors to shoulder the burden. As a leading Japanese investor puts it: “Once confidence [in the euro] is lost, it’s difficult to recover.”

Investors’ lack of euro enthusiasm increases the probability that in future further debt restructurings (at least for Greece), public-sector creditors will have to pay. That’s a time bomb ticking under already weakening public acceptance of the euro in Germany.

The magnitude of the European crisis has at least made everyone agree on EMU’s deep-seated flaws. In particular these concern the failure to implement convincing coordination of European states’ fiscal policies to accompany union in the monetary sphere, and the lack of adequate Europeanization of banking supervision and regulation.

In a new, compelling book on the origins of EMU, Professor Harold James of Princeton University, a member of the Official Monetary and Financial Institutions Forum Advisory Board, chronicles with scholarly precision how EMU’s founding fathers were aware of the need to embed monetary union into the right framework to correct the excesses that in fact have arisen — and how the edifice was only half-built.

James titles his work “Making the European Monetary Union” (rather than using the official phrase “economic and monetary union”) to denote how the job was unfinished. Using previously secret documentation made available from central banking archives, as well as his own colossal historical insights and experience, James provides a masterful overview of the process of building a common money. There is no doubt that, on the technical side, the experts were well aware of the design errors.

A near-constant atmosphere of living on a cliff-edge, and the global expectation that Europe should take steps to clear up its own now- tragically evident shortcomings, can spur progress. Yet achieving a form of political union in Europe that was impossible in much more benign circumstances before EMU started requires overcoming both already existing hurdles as well as new ones that have risen in the meantime.

In particular, a fundamental rebalancing is required between creditors and debtors, with both sides expressing indignation and antagonism at what they both see as unjustified sacrifices. This rebalancing is much more difficult to carry out when the cash sums involved have reached astronomical proportions.

So Europe fears war, hopes for peace, and gets neither. Not quite what Kohl had in mind.