‘All for one, one for all’

The FINANCIAL — The financial crisis has completely changed the eurozone’s winners and losers. Germany now looks remarkably fit while Italians are worse off today than they were in 1999. So does the euro have a fundamental design fault?

Its creation meant countries normally facing currency risk saw interest rates reduce dramatically towards German levels. And Germany, having suffered years of currency appreciation against European rivals, no longer had to worry about exchange-rate induced competitive losses. However, the additional revenues from its booming exports were invested in the bonds of Europe’s peripheral nations.

The absence of sovereign discipline allowed previously cautious governments, particularly France and Italy, to loosen fiscal policy without having to worry about financial instability risks. However, looser policy masked underlying structural weaknesses.

Europe’s problems were bubbling away below the surface long before the sub-prime crisis and the eurozone sovereign-debt crisis. For all the attempts to stitch together a single currency, there was never a proper attempt to embrace the fundamental philosophical insight of the Three Musketeers – “All for one, one for all”.

The “Whatever it takes” comments of Mario Draghi, the European Central Bank President, helped, but despite the avoidance of euro break-up and narrowing bond spreads, the threat of deflation is now even higher than during the sovereign crisis.
Before the eurozone, countries facing severe financial pressure would simply devalue. Once in a financial crisis, they were forced to adjust on their own through painful austerity and labour-market reform. But this ‘internal devaluation’ only passes the burden on to other economies.

Spain’s recent success, for example, has merely made life more difficult for Italy and France. Germany’s insistence that others deliver austerity has led only to weaker German exports, even though its exporters are more competitive than eurozone rivals.

Competitive internal devaluations have led to lower and lower inflation and now a growing threat of outright deflation. This places the whole eurozone in a parlous state.

The European Central Bank’s likely adoption of quantitative easing (QE) will not solve all of the eurozone’s problems. QE might lift asset prices further but the primary benefit is likely to come from its impact on the exchange rate and, hence, on the competitiveness of the eurozone as a whole. France and Italy might gain relative to non-member competitors but, within the eurozone – where their relative competitiveness is already very weak – they would be no better off.

A lasting eurozone solution ultimately needs more than just QE and a bit of labour-market restructuring. Unfortunately, there is still an absence of serious institutional reform. Without it, gaps in living standards between eurozone countries will widen exponentially.

Member nations need to recognise that monetary unions succeed only if there is appropriate burden sharing, either through democratically legitimate common fiscal institutions or between creditors and debtors – implying the need for occasional defaults or restructurings.

A principle of “All for one, one for all” quickly needs to be established and implemented. Far better, after all, to invoke the Three Musketeers than the Four Horsemen of the Apocalypse.