Feature on the eurozone

In: Uncategorized

4 Nov 2014

This is the main text of my Fund Strategy cover story for November on the eurozone on the 25th anniversary of the collapse of the Berlin wall. I should emphasise that, given this is a piece for a financial magazine, I had to rein in my own opinions and quote experts from within the investment industry. The published text, including an additional box, can be read here.

 This month marks the 25th anniversary of one of the defining events of the past century. On 9 November 1989 protestors breached the Berlin Wall with sledgehammers and chisels. It marked the beginning of the end of a division of Berlin into a capitalist West and a socialist East. In less than a year, on 3 October 1990, Germany was reunited as a single nation under the auspices of West Germany. The old pro-Soviet state of East Germany was defunct.

The event was hugely significant not only for Germany but for Europe and indeed the entire world. Few people under the age of 40 are likely to remember that for over four decades a division between East and West scarred the continent. The states of eastern Europe – including Czechoslovakia, Hungary and Poland – were part of an Eastern bloc led by the Soviet Union. Trade, investment and indeed the movement of people between it and the Western bloc were heavily restricted.

Even less well understood is the economic impact of Germany’s subsequent reunification and the removal of the ‘iron curtain’ separating East from West. It is not possible to properly grasp the character of the European Union and the eurozone without seeing them in this context. Contemporary discussions of monetary policy or banking union, while they have their place, can never tell the whole story. The historical dimension is vital.

This article will therefore start by examining the impetus behind the creation of the EU with a particular focus on the eurozone. It will argue that the monetary bloc should be understood at least in part as a way of binding a united Germany into Europe. It will then examine what this has meant in terms of some of the key tensions within the eurozone: core versus periphery, Keynesianism versus anti-Keynesianism and integration versus populism. To conclude, it will consider the practical implications of these rifts.

The eurozone’s creation

It is easy to forget that the architecture of the eurozone was largely shaped by the perceived need to contain Germany. Although there were other factors at work – including maintaining competiveness with America and East Asia – the desire to curb the power of a newly reunited Germany was strong.

Indeed, official papers released in 2009 showed that two decades earlier Margaret Thatcher, then Britain’s prime minister, had forcefully opposed German unification. She took the view, common at the time, that a Germany combining its eastern and western parts would be too powerful. President François Mitterrand of France, who feared the consequences of having such a powerful neighbour, shared her view.

However, even these two leaders between them did not have the power to stop the impetus towards a united Germany. Instead, a consensus quickly emerged that Germany should be contained within a more integrated Europe. That way it could be part of a larger whole rather than a perceived threat to other European states.

As it happens, Germany was happy to go along with this arrangement. It exhibited no desire to pursue a unilateral path separate from the rest of the European Union. However, it was concerned that weaker and what it saw as more profligate European states could destabilise the new European institutions. For that reason it was always keen that the EU should have strict rules on fiscal policy as well as independent central banks.

This was the backdrop against which the EU’s 1992 Maastricht Treaty was signed. Before that the European Economic Community, as it was then, was focused on such matters as trade and agricultural policy. But under the newly created EU there was a drive for a far more thorough-going integration.

The new arrangements included convergence criteria covering such matters as inflation targets, government debt and fiscal deficits. Later in the decade these rules were extended under a framework known as the Stability and Growth pact. In 1999 the eurozone was established, a monetary union comprising the original 11 member states. Notes and coins denominated in ‘euros’ were introduced in 2002. There are currently 18 member states in the eurozone, including several countries of the former Eastern bloc. Lithuania is set to join in 2015.

Before continuing, it is worth remembering Britain’s place in this arrangement. Back in 1990 the plan was for it to adopt the euro in place of sterling. In October 1990, as a prelude to this, the pound joined the Exchange Rate Mechanism, in which several European currencies were tied to each other. However, in September 1992 the pound was forced to leave the mechanism after it came under attack from speculators. After that, successive governments decided that Britain should stay out of the currency union. The subsequent eurozone financial crisis that emerged in 2009 seemed to confirm the wisdom of this decision.

Core versus periphery

The first tension arguably embodied in the eurozone is that between the core and the periphery. It is widely held that tying together economies with widely different levels of competiveness is a recipe for trouble. For example, interest rates that are appropriate for one area of the eurozone might not be appropriate for another. Yet under the auspices of the European Central Bank (ECB) all countries have the same level of policy rates.

Similarly the fact that all eurozone members share the same currency removes an important mechanism for economic adjustment. Greece or Portugal, for instance, could not allow their currencies to depreciate in response to growing imbalances within the eurozone.

Of course, it is true that many states outside Europe, such as America, do themselves have regional variations in economic performance. But America has well-established structures that enable it to shift resources from one area to another if necessary. In contrast, the eurozone is made up of member states that still retail a substantial degree of autonomy. As a result, the economically stronger states can and sometimes do veto the transfer of resources to weaker economies.

Josef Joffe, the publisher-editor of Die Zeit, a German weekly newspaper, is one of many experts who have argued that such arrangements are flawed. He expressed scepticism about whether the monetary bloc could work in a 1997 article in the New York Review of Books entitled: “The euro: the engine that couldn’t”.

In a 2010 interview with Deutsche Welle, Germany’s external broadcaster, he argued that his earlier case had been vindicated. “It didn’t take a PhD in economics to know that you can’t have a monetary union without political union. I used the image of taking 10 train engines and coupling them together. The idea is that they didn’t have a lead locomotive. Each of these engines had to move at the same speed at the same time; otherwise the train would derail … and that has exactly come to pass.”

Philippe Legrain, an economic adviser to Manuel Barroso when he was president of the European Commission, has argued a contrary view. In European Spring: Why Our Economies and Politics are in a Mess he says the competitiveness story did not hold for Greece, Ireland or Spain. The imbalances that emerged in the eurozone were in his view largely the result of bad cross-border lending by banks rather than variations in national competiveness.

Fund managers tend to be pragmatic on such matters. Although many acknowledge the structural weaknesses of the eurozone they tend to argue that these can be resolved or are outweighed by the advantages.

Andrew Milligan, the head of global strategy at Standard Life Investments, says the policy framework proved even worse than many had feared when it was established. “Having monetary union without having strong fiscal union and strong banking union clearly led to the Greek crisis of a few years ago,” he says. However, he emphasises that creating an integrated economic bloc is a long slow process. A key challenge is to put structures in place, such as banking union, to allow it to work more efficiently.

David Moss, the manager of the F&C European Equity fund, sees both positive and negative sides to the eurozone’s institutional arrangements. “Pre-crisis interest rates were largely set for Germany and France,” he says. “For the likes of Spain and Ireland interest rates were set at far too low a level. If they were set at a domestic basis they would have been far higher.”

On the positive side, says Moss, the support of the ECB and the whole euro system helped resolve the problems. He also points out that doing business across the eurozone was “immeasurably easier” with a single currency. For one thing, it saved a lot on hedging costs.

“Whether we can disentangle the positives and the negatives I don’t know,” he says. He speculates that if member states had abided by the Maastricht criteria many of the subsequent problems would not have emerged.

Keynesians versus anti-Keynesians

Although there are often vociferous debates within the eurozone’s elite, the competing views tend to fit into one or the other of two camps. On one side are the anti-Keynesians or what are sometimes called ordoliberals. These are most often German, although the viewpoint is represented in other member states such as Finland. On the other side are the Keynesians, who tend not to be German, although there are exceptions.

The ordoliberals emphasise the importance of having rules to keep inflation on a tight rein and curb public spending. They are also suspicious of anything that could be seen to compromise the ECB’s independence. For example, two senior German representatives, Axel Weber and Jürgen Stark, resigned from the ECB in protest against its bond purchase programme. Similarly, Germany’s powerful constitutional court is wary of any ECB actions that seem to be beyond its mandate.

Keynesians, in contrast, tend to be more relaxed about both fiscal and monetary matters. In times of economic difficulty they argue that deficit financing is appropriate. They are also much more ready to support unconventional monetary measures than the ordoliberals.

Of course, the real world tends to be messier than these neat labels suggest. For instance, the Germans have broken the eurozone’s fiscal deficit target on several occasions. However, breaking the rules themselves and allowing others to do so are different matters. Germany’s big fear is that it will become the paymaster for what it regards as spendthrift eurozone states. The typical ordoliberal view is that excessive public spending by southern European states was the root cause of the crisis.

Germany’s view matters because it has the largest and strongest European economy. Although it tends not to play a proactive role it is willing to block moves that it sees as detrimental to its interests. Jens Weidmann, the president of Germany’s central bank and an ECB board member, is a tough critic of Mario Draghi, the ECB president.

The outcome of these conflicting views within the elite is a process of muddle through that never fully satisfies either side. Although both generally favour further economic integration, they have different visions of what it means. The ordoliberals oppose any measures that they see as too lax while the Keynesians are frustrated by what they regard as the rigidity of their opponents.

Integration versus populism

While eurozone’s leaders are split between ordoliberals and Keynesians, there is another important fissure to take into account. Much of the region’s population is wary of the EU, and in some cases it is actively hostile. This tension has manifested itself in different ways over the years. In 2005 the French and Dutch electorates refused to ratify an EU constitution. Britain’s Labour government had promised a similar referendum on the matter but decided not to proceed. In the event the proposed constitution was abandoned, but the EU’s 2007 Lisbon treaty included many of its provisions. In 2008 the Irish electorate rejected the adoption of the Lisbon treaty but this decision was overturned in a second referendum in 2009.

More recently, eurosceptic parties have gained significant support in many European countries. These include Britain’s United Kingdom Independence Party (Ukip), France’s Front National and Italy’s Five Star Movement. Even Germany with its Alternative für Deutschland (Alternative for Germany) now has a significant eurosceptic force.

Eurosceptic parties vary enormously in character. Some consider themselves on the left and others define themselves as conservative. Some, such as Greece’s Golden Dawn, are openly fascist, while mild-mannered technocrats lead others. What they all have in common is that they have become repositories for popular resentment against the EU in particular and established politicians in general.


The existence of all these tensions helps explain why the eurozone’s economic policy never seems decisive. There is a constant process of negotiation that never entirely satisfies either side or suits all countries. Muddling through is even more prevalent than in American or British policy circles.

Most recently the policy mix has been described in terms of ‘Draghinomics’. This is the combination of monetary easing, short-term fiscal stimulus and structural reform advocated by the ECB president. But even if these elements are accepted in principle, the devil, as always, will be in the detail. There is enormous room to debate the type of monetary easing, the extent of fiscal stimulus and the appropriate structural reforms.

It is particularly notable that an unelected technocrat, Mario Draghi, is taking the lead on such matters. A similar economic package in Japan, dubbed ‘Abenomics’, was introduced by the prime minister. But the eurozone’s politicians often prefer to leave key initiatives to senior officials.

The progress of banking union will be another key process to watch. In June 2012 the eurozone’s leaders agreed to have a centralised set of rules for banks in the region. The first element of this arrangement, the Single Supervisory Mechanism, is coming into force this month. Under it the ECB will directly supervise the largest institutions while it will have ultimate responsibility for all banks. In 2016 the other main plank of banking union, a Single Resolution Mechanism, is due to become fully operational. It will determine how banks that get into difficulties will be restructured.

Whatever tensions exist within the eurozone its leaders are united in their determination to keep it together. As Stephen Macklow-Smith, a portfolio manager within the European Equity Group at JP Morgan Asset Management, says: “The strength of will to keep this [eurozone] show on the road is way higher than anyone in the US or the UK thinks.” The Anglo-Saxon world has “underestimated the glue that holds the whole thing together”.

Whatever flaws the eurozone may have, it is here to stay for the foreseeable future.





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