Europe stands at a crossroads. Does it want centralization or liberty? It is the euro’s future that will decide the issue.
The path of the euro is marked by the currency’s inherent misconstruction. The institutional setup of the euro is deeply awed because several independent governments can use one central banking system to finance their expenditures.
When a country such as Greece spends more than it receives in tax revenues, its government can simply print government bonds. This government bonds can be bought by banks, which in turn pledge these bonds as collateral at the ECB in order to get new reserves. With these new reserves the banks can expand credits and, therefore, increase the money supply. Due to the indirect monetization of the government deficit the purchasing power of the euro tends to fall, and not only in Greece, the deficit country, but all over the eurozone. Part of the costs of the Greek deficit and government spending has been externalized on foreigners, namely the users of the euro. This setup is very attractive for politicians. They can buy votes by boosting government spending and impose part of the costs on foreigners, which do not vote in national elections.
The Highest Deficit Tends to Win Out
Greece is not the only country that can use this indirect monetization mechanism to enrich itself, any eurozone government can. In this beggar-thy-neighbor race the government with the highest deficit comes out as a winner. Imagine that Germany runs a deficit of 3 percent of the GDP and the rest of the eurozone has a deficit of 10 percent of GDP. When, due to the monetization, prices rise in the eurozone at about 8%, real German government spending may actually fall despite the government’s deficit. Thus, a government can only profit from the euro’s redistribution if it has a higher deficit than the average of the eurozone. The situation resembles the tragedy of the commons, where the commonly owned and overexploited resource is the purchasing power of the euro.
The dynamics of the setup are perverse and self-destructive. The problem was well known to the originators of the euro. Therefore, they imposed a quota on the use of the monetization mechanism. The Stability and Growth Pact set a limit for government deficits at 3 % of GDP. Unfortunately, the monetization quotas were only a voluntary promise by the eurozone governments. No one could charge governments for noncompliance at independent courts. There were no automatic penalties for infringements and the infringers themselves decided if there were to be consequences, which unsurprisingly never did materialize. As a consequence, government expenditures and deficits rose especially in southern members of the eurozone. Unsustainable state finances led to the European sovereign debt crisis. Even with the Stability and Growth Pact amounting to a failure, the perverse incentives of the euro are largely intact. There are basically three ways to solve the misconstruction of the euro.
Greece is not the only country that can use indirect monetization mechanism to enrich itself. In this beggar-thy-neighbor race the government with the highest deficit comes out as a winner.
The Fiscal Compact Aims at Balanced Budgets
First, the problem may be solved by a breakup of the eurozone. One of the more oversized states unwilling to reform and to follow the conditions that come with a bailout may be eager to devalue and therefore to leave the eurozone. Greece was close to follow this path in 2015. Movements that want to leave the euro have gained support in other countries such as Italy and France.
Alternatively, a country on the losing side of the euro-redistribution could leave the eurozone. In fact, parts of the German Euroskeptic party Alternative for Germany (AfD) want to reintroduce the D-Mark and have gained some support.
Unsustainable state finances led to the European sovereign debt crisis. Even with the Stability and Growth Pact amounting to a failure, the perverse incentives of the euro are largely intact.
Second, the eurozone could be reformed to effectively limit or stop entirely the indirect monetization of deficits. Indeed, the former has been the policy of the German government. In exchange for its support for the permanent bailout fund ESM, the German government demanded the implementation of the European Fiscal Compact, which is an attempt to tighten the Stability and Growth Pact.
The European Fiscal Compact aims at structurally balanced budgets. Only in a recession may the government deficits touch the 3 % of GDP limit. Yet, these deficits must be compensated by surpluses in times of economic expansion. In normal times, deficits should not exceed 0.5% of GDP (if government debts stand below 60% of GDP, a 1% deficit is acceptable).
Less Profligate Governments Transfer Funds to the More Profligate
Moreover, the European Fiscal Compact introduces a debt brake. If government debts are higher than 60% of GDP, the excess is to be reduced by 5% per year. If, for instance, a government has its debts at 100% of GDP, it has to reduce its debts by 2% (5% of 40%). Unfortunately, the European Fiscal Compact seems to suffer the same fate as the Stability and Growth Pact. By and large, the European Fiscal Compact is ignored. Even though we see economic growth in many southern countries, they do not run budget surpluses. They also fail to comply with the debt break in cutting their overall debt burden.
The European Fiscal Compact suffers from the same shortcomings as the Stability and Growth Pact. When political interests stand against compliance with the European Fiscal Compact, the treaty becomes a toothless bit of paper unable to effectively limit the tragedy of the euro. The next recession (at the latest) will bring to the floor the failure of the European Fiscal Compact.
When political interests stand against compliance with the European Fiscal Compact, the treaty becomes a toothless bit of paper unable to effectively limit the tragedy of the euro.
More direct limitations to the euro redistribution through the monetization of government deficits can, of course, be put in effect. The simplest solution would be to prohibit the ECB to buy government bonds or accept them as collateral in its refinancing operations. There is, however, no political will to follow this path today. Currently, a reform effectively solving the misconstruction of the euro is not imminent. This leaves us with the last option for the future of the euro.
Third, a fiscal union favored by many European politicians could substitute part of the destructive monetary redistribution with a more controllable fiscal redistribution. In this fiscal union, the less profligate governments (north) transfer funds to the more profligate governments (south) in order to maintain their overregulated and overexpanded welfare states. At the end of this dynamic stands a European superstate that controls and limits effectively the tragedy of the euro by redistributing funds between nations and homogenizing the exploitation of the purchasing power of the euro. The centrally managed redistribution can be used to sustain and equalize living standards and welfare systems throughout the eurozone.
The European Superstate Is the Logical End of the Setup of the Euro
As we see in this last option, the construction of the euro already contains the seeds for centralization. The euro causes overspending, higher deficits, and sovereign debt crises. These crises can be used to introduce new central institutions or expand existing ones to manage the situation. The European superstate is a logical end of the setup of the euro. We have already seen several steps to this effect with the introduction of the permanent bailout fund ESM that effectively redistributes funds from the more responsible to the less responsible governments. Another step in that direction has been the enormous expansion of the power of the ECB. Also the banking union socializes risks across nations and redistributes savings. When Greek banks get into trouble because there is a haircut on Greek government bonds, they can tap the single resolution fund of the banking union, which is funded by banks of the whole eurozone. As a result, savings from other nations can be used to cover losses caused by excessive Greek government welfare spending.
More recently, in December 2017, the European Commission set up its “Roadmap for deepening Europe’s Economic and Monetary Union.” It contains several steps toward further centralization. The ESM is to be transformed into a European Monetary Fund. It could be used in case of asymmetric shocks and as a backstop for the banking union, thereby amplifying the redistributive range of the ESM. While the ESM is under international law, which implies a veto power for the signing countries, the European Monetary Fund would be a Union body. One could only exit the European Monetary Fund by leaving the European Union altogether. Decisions could be made with a qualified majority. The roadmap also calls for a European minister of economy and finance, adding to the centralization of decision-making.
The euro causes overspending, higher deficits, and sovereign debt crises. These crises can be used to introduce new central institutions or expand existing ones to manage the situation.
The Struggle between a Liberal and a Socialist Vision for Europe
Moreover, French President Emanuel Macron has made additional proposals. He envisions a budget for the eurozone and defends a harmonization of tax policies such as an EU-wide corporate tax rate.
None of these developments come as a surprise. Since the beginning of the European integration after World War II, there has been a struggle between two visions for Europe: the classical liberal one and the socialist one.
The classical liberal vision considers freedom to be the most important European value. In this vision, independent and free states compete with each other, upholding liberty. In order to preserve freedom one does not need a European superstate. Quite the opposite, a European superstate is seen as a threat to individual liberty. The introduction of the four freedoms—free movement of goods, capital, services, and labor—was a great success for the classical liberal vision.
The socialist vision for Europe envisions the EU as an empire that plays an important role in world politics and competes with other big players such as Russia, China, or the United States. Europe is a fortress: interventionist to the inside and protectionist to the outside.
As we see, both visions are incompatible. France and Mediterranean countries have inclined more towards the socialist vision, while northern countries have been more favorable to the classical liberal vision. The euro has pushed Europe more towards a socialist vision of a European superstate.
Harmonization Is in Fact a Cartelization of Policies
The socialist vision of a superstate is extremely dangerous for the future of Europe. What its proponents call harmonization is in fact a cartelization of policies. It ends fiscal and regulatory competition. Once policies are harmonized, the tendency will be for taxes to increase and regulations to become more burdensome, because the competition, which serves as a check on the desire of politicians to increase state power, is deactivated—at least within Europe.
One should not forget that it is competition between political entities that limits government power and enables freedom. Indeed, it is the competition of small states that has made Europe unique and extremely successful. In the Middle Ages, Europe contained thousands of small political entities that lowered the costs of voting-by-feet. Individuals and companies could escape oppression and high taxes at a relatively low cost. States could not become too oppressive because they would lose citizens and companies en masse. Competition forced states to become freer.
Liberty was allowed to flourish in Europe, leading to great economic, cultural, and technological advances that propelled Europe to be the most advanced and powerful region in the world. In contrast, empires that existed in China or India fell behind, as citizens could not escape their despots. From a historical perspective, an empire or superstate would be rather un-European. Without intra-European competition, taxes and state power would rise. As the size and power of the European superstate would increase, individual liberty—the basis for prosperity and progress—would recede.
Europe Stands at a Crossroads
Those who cherish individual liberty should vehemently oppose all attempts at further centralization. Champions of liberty should roll back the steps of the last years toward a European superstate. The ESM must be abolished and the banking union must end. Most importantly, people must realize that it is the misconstruction of the euro that has pushed Europe down the road of the socialist vision. A European superstate can only be avoided if the misconstruction of the euro is corrected. The most straightforward solution is to prohibit that the ECB buys government bonds or accepts them as collateral. Only then the indirect monetization of government deficits with its redistributive effects will end. A link to gold would further strengthen the currency and make it more immune against political manipulations.
The socialist vision for Europe envisions the EU as an empire that plays an important role in world politics and competes with other big players such as Russia, China, or the United States. Europe is a fortress.
If the reform of the euro fails, as a last resort, there remains the option to exit or break up the eurozone. The breakup of the eurozone would hurt in the short run, but it would reinstitute monetary competition in Europe and prevent the rise of a European superstate. Europe stands at a crossroads. Does it want centralization or liberty? It is the euro’s future that will decide the issue.
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