There is now a real danger that the euro crisis may end up destroying the European Union
By George Soros
My objective in coming here today is to discuss the euro crisis. In light of the latest developments, I think you will all agree that the crisis is far from resolved. It has already caused tremendous damage both financially and politically and taken an extensive human toll as well. The crisis has also transformed the European Union into something radically different from what was originally intended. The EU was meant to be a voluntary association of equal states but the crisis has turned it into a hierarchy with Germany and other creditors in charge and the heavily indebted countries relegated to second-class status. While in theory Germany cannot dictate policy, in practice no policy can be proposed without obtaining Germany's permission first. To make matters worse, the austerity policy promoted by Germany has the effect of prolonging the crisis and perpetuating the subordination of debtor countries.
This has created political tensions as demonstrated by the political stalemate in Italy. Italy now has a majority opposed to the euro and the trend is likely to grow. There is now a real danger that the euro crisis may end up destroying the European Union. A disorderly disintegration would leave Europe worse off than it was when the bold experiment of creating a European Union was begun. That would be a tragedy of historic proportions. But It can be prevented only by Germany with Germany's leadership. Germany did not seek to occupy a dominant position and has been reluctant to accept the responsibilities and liabilities that go with it. That is one of the reasons why the current situation has arisen. But willingly or not, Germany is in the driver's seat and that is what brings me here.
How did Europe get into such a mess? And how can it escape from it? These are the two questions I want to address. The answer to the first question is extremely complicated because the euro crisis is extremely complex. It has both a political and a financial dimension. And the financial dimension can be divided into at least three components: a sovereign debt crisis and a banking crisis, as well as divergences in competitiveness. The various aspects are interconnected, making the problems so complicated that they boggle the mind. In my view the euro crisis cannot be properly understood without realising the crucial role that mistakes and misconceptions have played in creating it. The crisis is almost entirely self-inflicted. It has the quality of a nightmare.
By contrast, the answer to the second question is extremely simple. Once we have gained a proper understanding of the problems the solution practically suggests itself.
I shall argue that Germany bears a large share of the responsibility for the policy errors that have created the crisis. But I want to make it clear in advance that I am not blaming Germany. Whoever was in charge would have made similar mistakes. I can say from personal experience that nobody could have understood the situation in all its complexity at the time it unfolded.
I realize that I risk antagonising you by putting the responsibility on Germany. But only Germany can put things right. I am a great believer in the European Union and I don't want to see it destroyed. I also care about the immense and unnecessary human suffering that the euro crisis is causing and I want to do whatever I can to mitigate it. My interpretation of the euro crisis is very different from the views prevailing in Germany. I hope that by offering you a different perspective I may get you to reconsider your position before more damage is done. That is my goal in coming here.
The European Union was a bold project that fired many people's imagination, including mine. I regarded the European Union as the embodiment of an open society – a voluntary association of equal states who surrendered part of their sovereignty for the common good. The European Union had five large member states and a number of small ones and they all subscribed to the principles of democracy, individual freedom, human rights and the rule of law. No nation or nationality occupied a dominant position.
The process of integration was spearheaded by a small group of far sighted statesmen who recognised that perfection was unattainable and practiced what Karl Popper called piecemeal social engineering. They set themselves limited objectives and firm timelines and then mobilised the political will for a small step forward, knowing full well that when they achieved it, its inadequacy would become apparent and require a further step. The process fed on its own success, very much like a boom-bust sequence in financial markets. That is how the Coal and Steel Community was gradually transformed into the European Union, step by step.
France and Germany used to be in the forefront of the effort. When the Soviet empire started to disintegrate, Germany's leaders realized that reunification was possible only in the context of a more united Europe and they were prepared to make considerable sacrifices to achieve it. When it came to bargaining, they were willing to contribute a little more and take a little less than the others, thereby facilitating agreement. At that time, German statesmen used to say that Germany has no independent foreign policy, only a European one. This led to a dramatic acceleration of the process. It culminated with the reunification of Germany in 1990 and the signing of the Maastricht treaty in 1992. That was followed by a period of consolidation which lasted until the financial crisis of 2007-8.
Unfortunately, the Maastricht treaty was fundamentally flawed. The architects of the euro recognised that it was an incomplete construct: a currency union without a political union. The architects had reason to believe, however, that when the need arose, the political will to take the next step forward could be mobilized. After all, that was how the process of integration had worked until then.
But the euro had many other defects, of which neither the architects nor the member states were fully aware. For instance, the Maastricht Treaty took it for granted that only the public sector could produce chronic deficits because the private sector would always correct its own excesses. The financial crisis of 2007-8 proved that wrong. The financial crisis also revealed a near fatal defect in the construction of the euro: by creating an independent central bank, member countries became indebted in a currency they did not control. This exposed them to the risk of default.
Developed countries have no reason to default; they can always print money. Their currency may depreciate in value, but the risk of default is practically nonexistent. By contrast, less developed countries that have to borrow in a foreign currency run the risk of default. To make matters worse, financial markets can actually drive such countries into default through bear raids. The risk of default relegated some member countries to the status of a third world country that became over-indebted in a foreign currency.
Prior to the financial crisis of 2007-8 both the authorities and the financial markets ignored this feature of the euro. When the euro was introduced, government bonds were treated as riskless. The regulators allowed commercial banks to buy unlimited amounts of government bonds without setting aside any equity capital, and the European Central Bank accepted all government bonds at its discount window on equal terms. This created a perverse incentive for commercial banks to accumulate the bonds of the weaker member countries, which paid higher rates, in order to earn a few extra basis points. As a result interest rate differentials between the various government bonds practically disappeared.
The convergence of interest rates caused a divergence in economic performance. The so-called periphery countries, Spain and Ireland foremost among them, enjoyed real estate, investment and consumption booms that made them less competitive, while Germany, weighed down by the cost of reunification, engaged in far-reaching labour market and other structural reforms that made it more competitive.
In the week following the bankruptcy of Lehman Brothers, the global financial markets literally ceased to function and had to be put on artificial life support. This required substituting sovereign credit (in the form of central bank guarantees and budget deficits) for the credit of the financial institutions whose standing was impaired. The emphasis placed on sovereign credit revealed the hitherto ignored feature of the euro, namely that by creating an independent central bank the euro member countries signed away part of their sovereign status.
That would have been the moment to take the next step toward fiscal as well as monetary union but the political will was lacking. Germany, weighed down by the costs of reunification, was no longer in the forefront of integration. Chancellor Merkel read public opinion correctly when she declared that each country should look after its own financial institutions instead of the European Union doing it collectively. That was a step backwards. In retrospect it was the beginning of a process of disintegration.
It took financial markets more than a year to realize the implications of chancellor Merkel's declaration, demonstrating that they too operate with far-from-perfect knowledge. Only at the end of 2009, when the extent of the Greek deficit was revealed, did the financial markets realize that a member country could actually default. But then the markets raised the risk premiums on the weaker countries with a vengeance. This rendered commercial banks whose balance sheets were loaded with those bonds potentially insolvent and that created both a sovereign debt and a banking crisis. The two are linked together like Siamese twins.
There is a close parallel between the euro crisis and the international banking crisis of 1982. Then the IMF and the international banking authorities saved the international banking system by lending just enough money to the heavily indebted countries to enable them to avoid default but at the cost of pushing them into a lasting depression. Latin America suffered a lost decade.
Today Germany is playing the same role as the IMF did then. The setting differs, but the effect is the same. The creditors are in effect shifting the whole burden of adjustment on to the debtor countries and avoiding their own responsibility for the imbalances. Interestingly, the terms "center" and "periphery" have crept into usage almost unnoticed, although in political terms it is obviously inappropriate to describe Italy and Spain as the periphery of the European Union. In effect, however, the euro had turned their government bonds into bonds of third world countries that carry the risk of default. This fact was ignored by the authorities and it is still not properly recognised. In retrospect, that was the root cause of the euro crisis.
Just as in the 1980s, all the blame and burden fell on the "periphery" and the responsibility of the "center" has never been properly acknowledged. The periphery countries are criticized for their lack of fiscal discipline and work ethic, but there is more to it than that. Admittedly the periphery countries need to make structural reforms, just as Germany did after reunification. But to deny that the euro itself has some structural problems that need to be corrected is to ignore the root cause of the euro crisis. Yet that is what is happening.
In this context the German word "Schuld" plays a key role. As you know it means both debt and responsibility or guilt. This has made it natural or "selbstverständlich" for German public opinion to blame the heavily indebted countries for their misfortune. The fact that Greece blatantly broke the rules has helped to support this attitude. But other countries like Spain and Ireland had played by the rules; indeed Spain used to be held up as a paragon of virtue. Clearly, the faults are systemic and the misfortunes of the heavily indebted countries are largely caused by the rules that govern the euro. That is the point I would like to drive home today.
In my opinion, the "Schuld" or responsibility of the "center" is even greater today than it was in the banking crisis of 1982. It may have been politically acceptable in 1982 to inflict austerity on the less developed countries in order to save the international financial system; but doing the same within the eurozone today cannot be reconciled with the European Union as a voluntary association of equal states. There is an unresolved conflict between what is dictated by financial necessity and what is politically acceptable. That is the point the recent Italian elections should have driven home.
The burden of responsibility falls mainly on Germany. The Bundesbank helped design the blueprint for the euro whose defects put Germany into the driver's seat. This has created two problems. One is political, the other financial. It is the combination of the two that has rendered the situation so intractable.
The political problem is that Germany did not seek the dominant position into which it has been thrust and it is unwilling to accept the obligations and liabilities that go with it. Germany understandably doesn't want to be the "deep pocket" for the euro. So it extends just enough support to avoid default but nothing more, and as soon as the pressure from the financial markets abates it seeks to tighten the conditions on which the support is given.
The financial problem is that Germany is imposing the wrong policies on the eurozone. Austerity doesn't work. You cannot shrink the debt burden by shrinking the budget deficit. The debt burden is a ratio between the accumulated debt and the GDP, both expressed in nominal terms. And in conditions of inadequate demand, budget cuts cause a more than proportionate reduction in the GDP — in technical terms the so-called fiscal multiplier is greater than one.
The German public finds this difficult to understand. The fiscal and structural reforms undertaken by the Schroeder government worked in 2006; why shouldn't they work for the eurozone a few years later? The answer is that austerity works by increasing exports and reducing imports. When everybody is doing the same thing it simply doesn't work.
The euro crisis reached a climax last summer. Financial markets started to anticipate a possible breakup and risk premiums reached unsustainable levels. As a last resort, chancellor Merkel endorsed the president of the European Central Bank, Mario Draghi, against her own nominee, Jens Weidmann. Draghi rose to the occasion. He declared that the ECB would do "whatever it takes" to protect the euro and backed it up by introducing the so-called Open Market Transactions. Financial markets were reassured and embarked on a powerful relief rally. But the jubilation was premature. As soon as the pressure from the financial markets abated, Germany started to whittle down the promises it had made at the height of the crisis.
In the bailout of Cyprus, Germany went too far. In order to minimize the cost of the bailout it insisted on bailing in bank depositors. This was premature. If it had happened after a banking union had been established and the banks recapitalised, it might have been a healthy development. But it came at a time when the banking system was retreating into national silos and remained very vulnerable. What happened in Cyprus undermined the business model of European banks, which relies heavily on deposits. Until now the authorities went out of their way to protect depositors. Cyprus has changed that. Attention is focused on the impact of the rescue on Cyprus but the impact on the banking system is far more important. Banks will have to pay risk premiums that will fall more heavily on weaker banks and the banks of weaker countries. The insidious link between the cost of sovereign debt and bank debt will be reinforced. The playing field will become even more uneven than before.
Chancellor Merkel would have liked to put the euro crisis on ice at least until after the elections, but it is back in force. The German public may be unaware of this because Cyprus was a tremendous political victory for Chancellor Merkel. No country will dare to challenge her will. Moreover, Germany itself remains relatively unaffected by the deepening depression that is enveloping the eurozone. I expect, however, that by the time of the elections Germany will also be in recession. That is because the monetary policy pursued by the eurozone is out of sync with the other major currencies. The others are engaged in quantitative easing. The Bank of Japan was the last holdout but it changed sides recently. A weaker yen coupled with the weakness in Europe is bound to affect Germany's exports.
If my analysis is correct, a simple solution suggests itself. It can be summed up in one word: eurobonds.
Eurobonds are the joint and several obligations of all member states. If countries that abide by the fiscal compact were allowed to convert their entire existing stock of government debt into eurobonds, the positive impact would be little short of the miraculous. The danger of default would disappear and so would the risk premiums. The balance sheets of the banks would receive an immediate boost and so would the budgets of the heavily indebted countries because it would cost them less to service their existing stock of government debt. Italy, for instance, would save up to 4% of its GDP. Its budget would move into surplus and instead of austerity, the government could apply fiscal stimulus. The economy would grow and the debt ratio would fall. Most of the seemingly intractable problems would vanish into thin air. Only the divergences in competitiveness would remain unresolved. Individual countries would still need structural reforms, but the main structural defect of the euro would be cured. It would be truly like waking from a nightmare.
To avoid any misunderstanding, I am proposing the conversion of the existing stock of government bonds into eurobonds, not the redemption scheme put forward by chancellor's council of economic advisors.
This is how my proposal would work. The eurozone would establish a fiscal authority that would be in charge of issuing eurobonds. Its board would be composed of the finance ministers with an independent chairman elected by the board. Voting would be weighted by the GDP of each country. Countries that are in violation of the fiscal compact would not be allowed to vote. Countries that are in compliance would be allowed, but not required to convert their national debt into eurobonds.
The fiscal compact provides adequate safeguards against the risk involved in a joint and several obligation. In accordance with the fiscal compact they member countries would be allowed to issue new bonds and bills only to replace maturing ones, but nothing more; after five years the debt outstanding would gradually be reduced to 60% of GDP. If a country fell out of compliance, the fiscal authority it would be penalised it by restricting the amount of eurobonds it would be allowed to issue; it would have to borrow the balance in its own name and pay heavy risk premiums.
Germany is opposed to eurobonds on the grounds that once they are introduced there can be no assurance that the so-called periphery countries would not break the rules once again. I believe these fears are misplaced. Losing the privilege of issuing eurobonds and having to pay stiff risk premiums would be a powerful inducement to stay in compliance. Indeed the penalty would be so painful that the rules would have to call for small doses in order not to aggravate the offending country's financial position too abruptly. At the same time a the fiscal authority in charge would exercise stricter controls and disobedience would be punished by further reductions in the amount of eurobonds allowed to be issued. No government could resist such pressure.
There are also widespread fears that eurobonds would ruin Germany's credit rating. eurobonds are often compared with the Marshall Plan. The argument goes that the Marshall Plan cost only a few percentage points of America's GDP while eurobonds would cost a multiple of Germany's GDP. That argument is comparing apples with oranges. The Marshall Plan was an actual expenditure while eurobonds would involve a guarantee that will never be called upon. The cost to Germany of agreeing to eurobonds has been greatly exaggerated.
Guarantees have a peculiar character: the more convincing they are, the less they are likely to be invoked. The US never had to pay off the debt it incurred when it converted the debt of individual states into Federal obligations. Germany has been willing to do only the minimum; that is why it had to keep escalating its commitments and is incurring actual losses. The fiscal compact, backed up by a well functioning fiscal authority would practically eliminate the risk of default. eurobonds would compare favorably with the bonds of US, UK and Japan in the financial markets. Admittedly, Germany would have to pay more on its own debt than it does today but the exceptionally low yields on Bunds is a symptom of the disease plaguing the periphery. The indirect benefit Germany would derive from the recovery of the periphery would far outweigh the additional cost incurred on its own national debt.
To be sure, eurobonds are not a panacea. First of all, the fiscal compact itself is an ill-designed instrument. The introduction of eurobonds would give the eurozone a boost but that may not be enough. In that case some additional fiscal and or monetary stimulus would be needed. But it would be a luxury to have such a problem.
Second, the European Union also needs a banking union and eventually a political union. The Cyprus rescue made these needs more acute by calling into question the business model of European banks that relies heavily on large deposits. But the introduction of eurobonds would be a step in the right direction. Germany accepting eurobonds would totally change the political atmosphere and pave the way to the additional steps.
The most profound deficiency The main limitation of eurobonds is that they would not eliminate the divergences in competitiveness. Individual countries would still need to undertake structural reforms. Those that fail to do so would turn into permanent pockets of poverty and dependency similar to the ones that persist in many rich countries. They would survive on limited support from European Structural Funds and remittances. But Germany accepting eurobonds would totally change the political atmosphere and facilitate the structural reforms that are also needed. Reforms work better when trading partners are prosperous than in conditions of widespread decline. Eurobonds offer a promising environment to structural reforms that are also needed.
The fact remains that the large majority of the German public is adamantly opposed to eurobonds. Since chancellor Merkel vetoed eurobonds, the arguments I have put forward here have not even been considered. People don't realize that agreeing to eurobonds would be much less costly than doing only the minimum to preserve the euro. That is how misconceptions can become engrained in public opinion.
It is up to Germany to decide whether it is willing to authorise eurobonds or not. But it has no right to prevent the heavily indebted countries from escaping their misery by banding together and issuing eurobonds. In other words, if Germany is opposed to eurobonds it should consider leaving the euro and letting the others introduce them.
This exercise would yield a surprising result: eurobonds issued by a eurozone that excludes Germany would still compare favorably with those of the US, UK and Japan. The net debt of these three countries as a proportion of their GDP is actually higher than that of the eurozone excluding Germany.
This surprising result can be explained by comparing the consequences of Germany leaving the euro to a heavily indebted country, like Italy, leaving.
Since all the accumulated debt is denominated in euros, it makes all the difference which country remains in charge of the euro. If Germany left, the euro would depreciate. The debtor countries would regain their competitiveness. Their debt would diminish in real terms and, if they issued eurobonds, the threat of default would disappear. Their debt would suddenly become sustainable. Most of the burden of adjustment would fall on the countries that left the euro. Their exports would become less competitive and they would encounter stiff competition from the euro area in their home markets. They would also incur losses on their claims and investments denominated in euro. The extent of their losses would depend on the extent of the depreciation; therefore they would have an interest in keeping the depreciation within bounds. After initial dislocations, the eventual outcome would fulfill John Maynard Keynes' dream of an international currency system in which both creditors and debtors share responsibility for maintaining stability. And Europe would escape the looming depression.
By contrast, if Italy left, its euro-denominated debt burden would become unsustainable and it would have to be restructured. This would plunge the rest of Europe and the rest of the world into a financial meltdown, which may well prove beyond the capacity of the monetary authorities to contain. The collapse of the euro would likely lead to the disorderly disintegration of the European Union and Europe would be left worse off than it had been when it embarked on the noble experiment of creating a European Union.
Obviously, it would be better for Germany to leave than Italy and equally obviously, it would be better for Germany to agree to eurobonds than to leave the Euro. The trouble is that Germany has not been put to the choice, and it has another alternative at its disposal: it can continue along the current course, always doing the minimum to preserve the euro, but nothing more.
If my analysis is correct that is not the best alternative even for Germany, except in the very near term. The situation is deteriorating and eventually it is bound to become unsustainable. The longer it takes, the greater the damage. Nevertheless, that is Germany's preferred choice, at least until after the elections.
There is a strong case for Germany to make a definitive choice whether to agree to eurobonds or to leave the euro. That is the case I came here to argue.
I reflected long and hard whether I should present my case now or wait until after the elections. In the end I decided to go ahead, based on two considerations. One is that events have their own dynamics and the crisis is likely to become more acute even before the elections. The Cyprus rescue proved me right. The other is that my interpretation of events is so radically different from the one that prevails in Germany that it will take time for it to sink in and the sooner I start the better.
Let me sum up my argument. I contend that Europe would be better off if Germany decided between eurobonds and exit than if it continued on its current course of doing the minimum to hold the euro together. That holds true whether Germany agreed to eurobonds or decided to leave the euro; and it holds true not only for Europe but also for Germany, except in the very near term.
Which of the two alternatives is better for Germany is less clear-cut. Only the German electorate is qualified to decide. If a referendum were called today the eurosceptics would win hands down. But more intensive consideration could change people's mind. They would discover that the cost to Germany of authorising eurobonds has been greatly exaggerated and the cost of leaving the euro understated.
To state my own views, my first preference is eurobonds; my second is Germany leaving the euro. Either choice is infinitely better than not making a choice and perpetuating the crisis. Worst of all would be for a debtor country, like Italy, to leave the euro because it would lead to the disorderly dissolution of the European Union.
I have made some surprising assertions; notably how well eurobonds could work even without Germany. My pro-European friends simply cannot believe it. They can't imagine a euro without Germany. I think they are conflating the euro with the European Union. The two are not identical. The European Union is the goal and the euro is a means to an end. Therefore the euro ought not to be allowed to destroy the European Union.
But I may be too rational in my analysis. The European Union is conflated with the euro not only in popular narratives but also in law. Consequently the European Union may not survive Germany leaving the euro. In that case we must all do what we can to persuade the German public to abandon some of its most ingrained prejudices and misconceptions and accept eurobonds.
I should like to end by emphasising how important the European Union is not only for Europe, but for the world. The EU was meant to be the embodiment of the principles of open society. That means that perfect knowledge is unattainable. Nobody is free of prejudices and misconceptions; nobody should be blamed for having made mistakes. The blame or Schuld begins only when a mistake or misconception is identified but not corrected. That is when the principles on which the European Union was built are betrayed. It is in that spirit that Germany should agree to eurobonds and save the European Union.
• George Soros is chairman of Soros Fund Management and of the Open Society Foundations.
