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Toward a More Perfect (European) Union

Friday, May 21, 2010

German authorities probably saw monetary union as a stepping-stone toward tighter political union. Building a $1 trillion bailout reserve, requiring more coordination of fiscal policies, furthers that end.

In a financial crisis, policy makers improvise, and in the process set all manner of precedents. In deciding to create a fund of €750 billion (about $1 trillion), European authorities are likely hurtling toward creating a more perfect political union, whether they realize it now or not. It is just as unlikely that the citizens of those 16 separate nations on the Continent appreciate the forces put into motion by their leaders.

The initiating problem was a misperception by investors that provided an opportunity for politicians. Bond buyers apparently assumed that monetary union implied fiscal union. That is, because Greece issued debt denominated in euros, the story runs, all Europe would ultimately stand behind repayment. There was nothing in the Maastricht Treaty about such support. Indeed, the weak discipline that was supposed to be imparted by the treaty had been dealt with “flexibly” as the need arose, leaving local fiscal authorities considerable leeway to follow their own course.

Politicians rarely have an internal discipline—it has to be imposed from the outside. Moderating mechanisms include voter anger, peer pressure, and financial markets. As for financial markets, interest rate spreads (or the excess of a risky yield over a safe one) are supposed to be the temperature gauge to know if the fiscal engine is overheating. But the perception of support cooled the reading on the thermometer. This liberated politicians from the shackles of market discipline.

It is unlikely that the citizens of the 16 separate nations on the Continent appreciate the forces put into motion by their leaders.

As a consequence, the Greek government could continue to issue debt at interest rates not much above its sounder brethren in Europe. Interest rate spreads of Greek over German bonds were quite narrow after the 2001 accession to the monetary union and until last year, even as the level of outstanding Greek obligations soared past national income and ongoing fiscal deficits required ever-growing issuance.

Market confidence wavered this year, in part because the Greek fiscal process veered further away from any plausibly sustainable track. Essentially, widening debt spreads were a gauntlet investors threw down before European officials: Which was right, the treaty's narrow definition of monetary union or their own expectation of a pan-European safety net?

With the announcement of a willingness to commit €750 billion to fight strains in the financial markets of euro-zone countries, it is painfully evident that investors won. The initiating misperception of markets morphed into the new reality.

Why would authorities of fiscally prudent countries provide such massive support to other sovereigns that did not share that discipline? There are three possibilities, and evaluating them requires walking down memory lane of the missteps of U.S. officials in dealing with our own financial crisis.

European authorities know the fundamental source of the problem: themselves.

First, European Union officials might believe that the strains roiling markets owe to a lack of confidence. The theory runs that an overwhelming show of support would soothe jittery investors' nerves, thereby eliminating the need for intervention. If so, they would be sharing the same delusion as U.S. Treasury Secretary Hank Paulson in the summer of 2008 when he mistook the solvency problems of Fannie Mae and Freddie Mac as merely temporary illiquidity. The government-sponsored enterprises were as fundamentally off track then as the Greek government today.

Second, the cost of bailing out governments has to be weighed against the alternative. A Greek default would create a gravitational downward pull on Portugal, Spain, and Ireland. This would batter the balance sheets of many large European financial institutions. (As one among many ironies, those banks probably loaded up on Greek debt because the European Central Bank overvalued it as collateral when banks wanted to borrow in their monetary operations.) It may be the case that the bailout package for sovereigns is in fact an indirection: Large governments are indirectly supporting their national financial champions by supporting the prices of some of the assets they hold.

In that sense, the fund could be viewed as “Son of TARP.” On one level, Europeans have an advantage over Federal Reserve Chairman Ben Bernanke and Treasury Secretaries Tim Geithner and Hank Paulson in 2008. The assets they are protecting are uncomplicated and only issued by at most 16 sovereign governments. And European authorities know the fundamental source of the problem: themselves. On another level, though, sovereign governments can be much more intransigent. Inconveniently for Brussels, those elected officials might have a lingering sense of responsibility to those who elected them.

Third, the bill might be seen as worth the price of purchase. Euro-skeptics, a common breed in the United Kingdom and the United States, have long suspected that monetary union was imposed on Germany by France two decades ago in return for the unification of East and West. If so, German authorities would naturally see the euro as the flawed descendant of the beloved deutschemark and have little tolerance for failure. This would create a centrifugal force that would cast out threats to the system at the first whiff of stress.

To Euroskeptics, the official response to the crisis formalizes transfers from the frozen thrifty north to the sunny spendthrift south.

An alternative explanation now seems much more likely in light of the massive support package. Back in the 1990s, German authorities probably saw monetary union as a stepping-stone toward tighter political union—they had a vision at least as grand as the French. Building a big bailout reserve, in that it will by necessity require more coordination of fiscal policies, furthers that end.

Euroskeptics, including the new resident of 10 Downing Street in London, Prime Minister David Cameron, must be bewildered. To them, the official response to the crisis formalizes transfers from the frozen thrifty north to the sunny spendthrift south. But that might have been the point. German authorities might have been as reluctant to move in the direction of government control at a time of financial stress as, say, the Obama administration in passing stimulus legislation and taking control of the auto industry.

The strongest indicator of the German pursuit of a Greater Europe might be in the minutiae. The European Central Bank is buying euro-zone government and private bonds "to ensure depth and liquidity" in markets, and the U.S. Federal Reserve has reopened swap lines with other central banks to make sure they had ample access to dollars. European Central Bank officials, no doubt reluctantly, had to recognize their role as inevitable. At a time of crisis, the central bank is the only game in town. A central bank is flexible and it is an off-balance-sheet entity.

A willingness to gun the engines of monetary policy runs counter to three-quarters of a century of German history. German officials—at least those currently in power—appear willing to put much at risk to further a longer-term goal.

Vincent Reinhart is a resident scholar at the American Enterprise Institute.

FURTHER READING: Among Reinhart’s other financial tracking for THE AMERICAN, he has evaluated “The Deflation Club,” asserted that “Geithner and Bernanke Are Wrong about Fed Power,” described “Bernanke’s Confidence Game,” “The Crack-up” of financial reform proposals, and “When the Fed Was Boring.” He has suggested what to do concerning how “Europe Fiddles While Greece Burns,” made “The Case for Simpler Financial Regulation,” and explained “The Right Role for the Fed.”

Image by Rob Green/Bergman Group.

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