There is a strong case for Germany to make a definitive choice whether to accept eurobonds or to leave the euro
• The speech in full
The euro crisis has already transformed the European Union from a voluntary association of equal states into a creditor-debtor relationship from which there is no easy escape. The creditors stand to lose large sums should a member state exit the union, yet debtors are subjected to policies that deepen their depression, aggravate their debt burden and perpetuate their subordinate position. As a result, the crisis is now threatening to destroy the European Union. That would be a tragedy of historic proportions which can only be prevented with German leadership.
The causes of the crisis are so complicated that they boggle the mind. They cannot be properly understood without realising the crucial role that mistakes and misconceptions have played in creating them.The fatal flaw of the euro is that by creating an independent central bank, member countries have become indebted in a currency that they don't control. The risk of default relegates some member countries to the status of third world countries that became over-indebted in a foreign currency. This feature of the euro was ignored both by the authorities and market participants until the Greek crisis and it is still not properly understood today.
At first, both the authorities and market participants treated all government bonds as if they were riskless, creating a perverse incentive for banks to load up on the weaker bonds. When Greece revealed the extent of its deficit, financial markets discovered the risk of sovereign debt default and raised risk premiums not only on Greek bonds but on the bonds of all heavily indebted euro members with a vengeance. Since European banks were heavily loaded with exactly those bonds, this precipitated a twin sovereign debt and banking crisis.
Subsequently the so-called periphery countries were treated as if they were solely responsible for their misfortunes and the structural defects of the euro remained uncorrected. Germany and the other creditor countries did the minimum necessary to preserve the euro but they continued to apply the treaties that proved to be flawed and imposed new rules that prolonged and aggravated the recession. The pain and suffering is almost entirely self-inflicted by the eurozone. It has the quality of a nightmare.
The burden of responsibility falls mainly on Germany. The Bundesbank helped design the blueprint for the euro, whose defects put Germany into the driver's seat. This has created two problems. One is political, the other financial. It is the combination of the two that has rendered the situation so intractable.
The political problem is that Germany did not seek the dominant position into which it has been thrust and it is unwilling to accept the obligations and liabilities that go with it. Germany understandably doesn't want to be the "deep pocket" for the euro. So it extends just enough support to avoid default but nothing more, and as soon as the pressure from the financial markets abates it seeks to tighten the conditions on which the support is given.
The financial problem is that Germany is imposing the wrong policies on the eurozone. Austerity doesn't work. You cannot shrink the debt burden by shrinking the budget deficit. The debt burden is a ratio between the accumulated debt and the GDP, both expressed in nominal terms. And in conditions of inadequate demand, budget cuts cause a more than proportionate reduction in the GDP – in technical terms the so-called fiscal multiplier is greater than one. This means for every that for every million euro reduction in the budget deficit, the country's GDP falls by more than a million euros, leading to a rise in the ration of national debt to GDP.
The German public finds this difficult to understand. The fiscal and structural reforms undertaken by the Schröder government worked in 2006; why shouldn't they work for the eurozone a few years later? The answer is that austerity for a single country works by increasing its exports and reducing its imports. When everybody is doing the same thing it simply doesn't work: it is clearly impossible for all members of the eurozone to improve their balance of trade with one another.
In the bailout of Cyprus, Germany went too far. In order to minimise the cost of the bailout it insisted on bailing in bank depositors. This was premature. If it had happened after a banking union had been established and the banks recapitalised, it might have been a healthy reform. But it came at a time when the banking system was retreating into national silos and remained very vulnerable. What happened in Cyprus undermined the business model of European banks, which relies heavily on deposits. Until now the authorities went out of their way to protect depositors. Cyprus has changed that. Attention is focused on the impact of the rescue on Cyprus but the impact on the banking system is far more important. Banks will have to pay risk premiums that will fall more heavily on weaker banks and the banks of weaker countries. The insidious link between the cost of sovereign debt and bank debt will be reinforced and a banking union that would re-establish a more level playing field will be more difficult to attain.
Chancellor Merkel would have liked to put the euro crisis on ice at least until after the elections, but it is back in force. The German public may be unaware of this because Cyprus was a tremendous political victory for chancellor Merkel. No country will dare to challenge her will. Moreover, Germany itself remains relatively unaffected by the deepening depression that is enveloping the eurozone. I expect, however, that by the time of the elections Germany will also be in recession. That is because the monetary policy pursued by the eurozone is out of sync with the other major currencies. The others are engaged in quantitative easing. The Bank of Japan was the last holdout but it changed sides recently. A weaker yen coupled with the weakness in Europe is bound to affect Germany's exports.
The solution for all these problems of the eurozone can be summed up in one word: eurobonds. If countries that abide by the fiscal compact were allowed to convert their entire stock of government debt into eurobonds, the positive impact would be little short of the miraculous. The danger of default would disappear and so would the risk premiums. The balance sheets of the banks would receive an immediate boost and so would the budgets of the heavily indebted countries. Italy, for instance, would save up to 4% of its GDP. Its budget would move into surplus and fiscal stimulus would replace austerity. Its economy would grow and its debt ratio would fall. Most of the seemingly intractable problems would vanish into thin air. It would be truly like waking from a nightmare.
With some modification, the fiscal compact would provide adequate safeguards against the risks involved in a joint and several obligation. It would allow member countries to issue new eurobonds only to replace maturing ones, but nothing more; after five years the outstanding debt would be gradually reduced to 60% of GDP. Non-compliant countries would be penalised by restricting the amount of eurobonds they are allowed to issue, forcing them to borrow the balance in their own name and pay heavy risk premiums – a powerful inducement to adhere to the fiscal compact's terms.
Eurobonds would not ruin Germany's credit rating. On the contrary, they would favorably compare with the bonds of the United States, the United Kingdom, and Japan.
Eurobonds are not a panacea. First of all, the fiscal compact itself needs some modifications to ensure that the penalties are automatic, prompt and not too severe to be credible. Second, the boost derived from eurobonds may not be sufficient, necessitating additional stimulus but it would be a luxury to have such a problem. Third, the European Union also needs a banking union and eventually a political union. The Cyprus rescue made these needs more acute by calling into question the business model of European banks that relies heavily on large deposits. The main limitation of eurobonds is that they would not eliminate the divergences in competiveness. But Germany accepting eurobonds would totally change the political atmosphere and facilitate structural reforms. Unfortunately Germany is adamantly opposed to eurobonds. Since chancellor Merkel vetoed them, the arguments put forward here have not even been considered. People don't realise that agreeing to eurobonds would be much less costly than doing only the minimum to preserve the euro.
It is up to Germany to decide whether it is willing to authorise eurobonds or not. But it has no right to prevent the heavily indebted countries from escaping their misery by banding together and issuing eurobonds. In other words, if Germany is opposed to eurobonds it should consider leaving the euro and letting the others introduce them.
This exercise would yield a surprising result: eurobonds issued by a eurozone that excludes Germany and other like-minded countries would still compare favourably with those of the US, UK and Japan.
Let me explain why. SSince all the accumulated debt is denominated in euros, it makes all the difference which country remains in charge of the euro. If Germany left, the euro would depreciate. The debtor countries would regain their competitiveness. Their debt would diminish in real terms and, if they issued eurobonds, the threat of default would disappear. Their debt would suddenly become sustainable. Most of the burden of adjustment would fall on the countries that left the euro. Their exports would become less competitive and they would encounter stiff competition from the euro area in their home markets.
By contrast, if Italy left, its euro-denominated debt burden would become unsustainable and would have to be restructured. This would plunge the global financial system into a meltdown, which may well prove beyond the capacity of the monetary authorities to contain. The collapse of the euro would likely lead to the disorderly disintegration of the European Union and Europe would be left worse off than it had been when it embarked on the noble experiment of creating a European Union. So, if anyone must leave it should be Germany, not Italy.
There is a strong case for Germany to make a definitive choice whether to accept eurobonds or to leave the euro. The trouble is that Germany has not been put to the choice, and it has another alternative at its disposal: it can continue along the current course, always doing the minimum to preserve the euro, but nothing more. That is not the best alternative even for Germany, except perhaps in the very near term. Nevertheless, that is chancellor Merkel's preferred choice, at least until after the elections.
In sum, I contend that Europe would be infinitely better off if Germany made a definite choice between accepting eurobonds or leaving the euro. That holds true whether Germany chose eurobonds or exit; and it holds true not only for Europe but also for Germany, except perhaps in the very near term. Which of the two alternatives is better for Germany is less clear-cut. Only the German electorate is qualified to decide.
If a referendum were called today the eurosceptics would win hands down. But more intensive consideration could change people's mind. They would discover that authorising eurobonds would actually benefit Germany and the cost of leaving the euro has been greatly understated.
I have made some surprising assertions; notably how well eurobonds could work even without Germany. My pro-European friends simply cannot believe it. They can't imagine a euro without Germany. I think they are conflating the euro with the European Union. The two are not identical. The European Union is the goal and the euro is a means to an end. Therefore the euro ought not to be allowed to destroy the European Union.
But I may be too rational in my analysis. The European Union is conflated with the euro not only in popular narratives but also in law. Consequently the European Union may not survive Germany leaving the euro. In that case the German public needs to be persuaded to abandon some of its most ingrained prejudices and misconceptions and accept eurobonds.
I should like to emphasise how important the European Union is not only for Europe, but for the world. The EU was meant to be the embodiment of the principles of open society. That means that perfect knowledge is unattainable. Nobody is free of prejudices and misconceptions; nobody should be blamed for having made mistakes. The blame begins only when a mistake or misconception is identified but not corrected. That is when the principles on which the European Union was built are betrayed. It is in that spirit that Germany should agree to eurobonds and save the European Union.
• George Soros is chairman of Soros Fund Management and of the Open Society Foundations.
Copyright: Project Syndicate, 2013.
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