The travails of the euro are never-ending; they have given the media endless footage. But all the coverage is either microfactual or depressive; one seldom sees a good analysis of the problem. One of the few people who have thought about the collapse of the euro is George Soros. He is worried, and thinks that the situation can be saved only by Germany — a message he has tried repeatedly to deliver. In June he gave an interview to Der Spiegel to convey the message; on September 10 he went and gave a speech in Berlin.
Many Germans are beginning to doubt that it is in their interest to stay in the European Union. They feel that south European countries would be unable to service their debts and that Germany would have to take them over. That would make them debtors to Germany, but the debt would be worthless since they would not be able to service it. So Germans think that the cost of staying in the EU would be high for Germany.
Soros pointed out that the cost of breakup would also be high. Already, citizens of southern Europe, fearing the breakup, have been transferring funds out of their own countries into safe countries, especially Germany. When they do so, their banks have to transfer the funds to German banks. Suppose a Greek citizen sends Deutsche Bank a cheque on his account in Piraeus Bank. Deutsche Bank sends the cheque to Bundesbank, the German central bank, and asks for a credit in its own account. Bundesbank sends it to the Bank of Greece, which debits Piraeus Bank’s account with itself. The transfer makes Bank of Greece a debtor to Bundesbank. According to Soros, other central banks will owe Bundesbank a trillion euros by the end of this year.
As long as the euro survives, those central banks can borrow from the market, or the European Central Bank, or the European Financial Stabilization Mechanism, and pay those trillion euros. If the euro collapses, they will not be able to borrow, and will then not be able to pay their debts to Bundesbank, which will be left with bad debts.
Besides, the south European countries will introduce their own currencies, which will immediately depreciate against the euro. That will improve the competitiveness of southern Europe, and worsen that of Germany. German exports will fall, and imports will rise. So whether on capital or on current account, the collapse of the euro will be bad for Germany.
Soros did not quite put it that way, but as the government debt of south European countries has risen, so have the interest rates they have to pay to finance their fiscal deficits. The high interest rates accelerate the build-up of their deficits. The deficits represent that much government demand for goods and services; it competes with private demand for consumption and investment. The bigger the deficits they run, the worse it is for the growth of their economies. One can see this happening in India; the greed of the Congress for votes led to massive populist expenditure, financed with rising fiscal deficits, and that contributed to the collapse of a great investment boom and decline in growth. P. Chidambaram and Pranab Mukherjee are not the only shortsighted politicians in the world; they are competing with European finance ministers.
The solution Soros proposes is that the EU should set up a fiscal authority — what we call a finance ministry. The authority would set up a debt reduction fund. It would issue treasury bills, and with the money, buy up Spanish and Italian debt provided they accept certain conditions. But not Greek debt; Greece would be thrown to the dogs, to show the other Europeans what can happen to countries that do not cooperate with Brussels.
I do not see what is fiscal about Soros’s fiscal authority, for he does not envisage its having powers of taxation. If it cannot tax, it is not necessary; the European Central Bank can borrow from the market and refinance south European debt. So I do not think Soros is proposing anything different from what is on the ground just now; and I do not think it will work.
In September, Soros got a bit further with his euro analysis. According to him, when countries joined the euro system, they ceded their right to issue currency. By doing so, they made themselves susceptible to sovereign default, for any country that can issue currency can pay off its debt by printing money and hence can never default. But European regulators did not recognize or realize this. They allowed banks to invest in the debt of all European governments as if it was all equally risk-free. But there were differences in risk; south European countries had relatively higher debt-gross domestic product ratios, and when growth disappeared, they became more susceptible to default. The market sensed that, and raised interest rates on their debt. But since regulators treated the debt of all EU member countries as equally risky, banks preferred to buy the debt of south European countries, which paid higher interest. Those countries were happy to borrow and spend rather than tax their citizens. But that only raised their debt further. This set the stage for their sovereign debt default.
After the Lehman crisis in 2008, Angela Merkel declared that the responsibility for rescuing systemically important banks would lie with national governments and central banks, and not with European institutions. That meant that if governments went bankrupt, the banks of their countries would no longer have any insurance against default: it set the stage for the simultaneous bankruptcy of both fiscal and banking systems. The European Union recognized the bankruptcy of countries, starting from Greece, and lent them vast amounts of money; but it has no mechanism for rescuing, repairing or closing down banks. In the early stages, as governments went bankrupt, the EU got banks that held the governments’ debt to take part of the losses. But this will become increasingly difficult as banks’ capital adequacy declines. Spain recently took 100 billion euros from Brussels to rescue its banks; this will become more common.
But if Soros is to be believed, there is an even more serious problem. Euroland has no interbank settlement system. Banks settle their mutual debts through their respective central banks, but there is no clearing between central banks; they just accumulate debits and credits. At the end of July, other central banks owed Bundesbank 727 billion euros.
Soros suggests a way out. He proposes that the European Debt Reduction Fund should exchange all member governments’ debt over 60 per cent of GDP for 1 per cent 10-year bonds on three conditions: that they should do agreed structural reforms, achieve a primary surplus of 2 per cent immediately, and begin to repay 5 per cent of debt every year after 5 years. That will become practicable if, meanwhile, Euroland begins to grow — Soros dreams of 5 per cent growth.
For Soros’s plan to become a reality, it has to be accepted by Germany. He has been campaigning in Germany, with no result till now. Economic rationality has no chance against political hubris.