07 September 2012

George Soros: The tragedy of the European Union and how to resolve it

Germany must decide whether to become a benevolent hegemon or leave the euro. The first alternative would be by far the best. What would that entail? Simply put, it would require two new objectives that are at variance with current policies:

1. Establishing a more or less level playing field between debtor and creditor countries, which would mean that they would be able to refinance their government debt on more or less equal terms.
2. Aiming at nominal growth of up to 5 per cent so that Europe can grow its way out of its excessive debt burden. This will necessitate a higher level of inflation than the Bundesbank is likely to countenance. It may also require a treaty change and a change in the German constitution.

Both these objectives are attainable, but only after considerable progress toward a political union. The political decisions taken in the next year or so will determine the future of the European Union. The steps taken by the ECB on September 6 could be a prelude to the creation of a two-tier Europe; alternatively they could lead to the formation of a closer political union in which Germany accepts the obligations that its leadership position brings with it.

A two-tier eurozone would eventually destroy the European Union because the disenfranchised would sooner or later withdraw from it. If a political union is not attainable the next best thing would be an orderly separation between creditor and debtor countries. If the members of the euro cannot live together without pushing their union into a lasting depression, they would be better off separating by mutual consent.

In an amicable breakup of the euro it matters a great deal which party leaves, because all the accumulated debts are denominated in a common currency. If a debtor country leaves, its debt increases in value in line with the depreciation of its currency. The country concerned could become competitive; but it would be forced to default on its debt and that would cause incalculable financial disruptions. The common market and the European Union may be able to cope with the default of a small country such as Greece, especially when it is so widely anticipated, but it could not survive the departure of a larger country like Spain or Italy. Even a Greek default may prove fatal. It would encourage capital flight and embolden financial markets to mount bear raids against other countries, so the euro may well break up as the Exchange Rate Mechanism did in 1992.

By contrast, if Germany were to exit and leave the common currency in the hands of the debtor countries, the euro would fall and the accumulated debt woulddepreciate in line with the currency. Practically all the currently intractable problems would dissolve. The debtor countries would regain competitiveness; their debt would diminish in real terms and, with the ECB in their control, the threat of default would evaporate. Without Germany, the euro area would have no difficulty in carrying out the U-turn for which it would otherwise need Chancellor Merkel’s consent.

A German exit would be a disruptive but manageable onetime event, instead of the chaotic and protracted domino effect of one debtor country after another being forced out of the euro by speculation and capital flight. There would be no valid lawsuits from aggrieved bond holders. Even the real estate problems would become more manageable. With a significant exchange rate differential, Germans would be flocking to buy Spanish and Irish real estate. After the initial disruptions the euro area would swing from depression to growth.

The first step would be to establish a European Fiscal Authority (EFA) that would be authorised to make important economic decisions on behalf of Member States. This is the missing ingredient that is needed to make the euro a fully-fledged currency with a genuine lender of last resort. The fiscal authority acting in partnership with the central bank could do what the ECB cannot do on its own. The mandate of the ECB is to maintain the stability of the currency; it is expressly prohibited from financing government deficits. But there is nothing prohibiting the Member States from establishing a fiscal authority. It is Germany’s fear of becoming the deep pocket for Europe that stands in the way.

The EFA would automatically take charge of the EFSF and the ESM. The great advantage of having an EFA is that it would be able to make decisions on a day-to-day basis, like the ECB. Another advantage of the EFA is that it would reestablish the proper distinction between fiscal and monetary responsibilities. 

The second step would be to use the EFA to establish a more level playing field than the ECB will be able to offer on its own on September 6. I have proposed that the EFA should establish a Debt Reduction Fund—a modified form of the European Debt Redemption Pact proposed by Chancellor Merkel’s own Council of Economic Advisers and endorsed by the Social Democrats and Greens. The Debt Reduction Fund would acquire national debts in excess of 60 per cent of GDP on condition that the countries concerned undertook structural reforms approved by the EFA. The debt would not be canceled but held by the fund. If a debtor country fails to abide by the conditions to which it has agreed the fund would impose an appropriate penalty. As required by the Fiscal Compact, the debtor country would be required to reduce its excess debt by 5 per cent a year after a moratorium of five years. That is why Europe must aim at nominal growth of up to 5 per cent.

That leaves the second objective: an effective growth policy aiming at nominal growth of up to 5 per cent. That is needed to enable the heavily indebted countries to meet the requirements of the Fiscal Compact without falling into a deflationary debt trap. There is no way this objective can be achieved as long as Germany abides by the Bundesbank’s asymmetric interpretation of monetary stability. Germany would have to accept inflation in excess of 2 per cent for a limited period of time if it wants to stay in the euro without destroying the European Union.

Currently, the German economy is doing relatively well and the political situation is also relatively stable; the crisis is only a distant noise coming from abroad. Only something shocking would shake Germany out of its preconceived ideas and force it to face the consequences of its current policies. That is what a movement offering a workable alternative to German domination could accomplish. In short, the current situation is like a nightmare that can be escaped only by waking up Germany and making it aware of the misconceptions that are currently guiding its policies. We can hope Germany, when put to the choice, will choose to exercise benevolent leadership rather than to suffer the losses connected with leaving the euro.

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