Options for Europe – Part 97

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).

Part III – Options for Europe


Chapter 1 – Introduction



As the leaders left Maastricht there were ‘winners’ everywhere. The French thought they would finally get rid of the Bundesbank and create something they might have more control over. The Germans knew that by playing the European card they would look less scary and they also understood that the terms of the Treaty would just ensure the Bundesbank would morph into the European Central Bank at some point. There was a lot of optimism among the political classes. But support for the Delors Plan among ordinary citizens had been waning in the lead up to Maastricht, prompting Szasz (1999: 115) to say that the the signing was not “a moment too soon”. By 1991, the mini-growth surge that Europe had enjoyed during the EMU negotiation phase was well and truly over and a major recession was approaching. Germany was at the centre of the shifting fortunes. Its spending boom associated with re-unification had created favourable spill-overs across Europe but had driven the German inflation rate up to around 5 per cent. Any reasonable interpretation of this would have suggested that the inflation rate would soon fall again once the abnormal spending patterns ended. But the Bundesbank’s inflation impatience saw them hike interest rates and within a few quarters, Europe was in recession.

The Maastricht Treaty still had to be ratified by each of the individual signatory nations and the ratification process varied in the different nations. The politicians thought this would be a relatively quick matter and the Treaty could become operational on January 1, 1993. How wrong they were. The Danes voted first and the result was a disaster for the EMU proponents. The failed referendum meant that Denmark would, under the existing rules, have scuppered the Treaty coming into force. Szasz (1999: 166) said that “it was hard to imagine that one small country could prevent the Treaty from coming into force. The European Council responded soon after and proposed an ‘opt-out’ for Denmark, which among other concessions granted, allowed it to keep their own currency. A second Danish referendum barely passed but the problem in that corner of Europe was solved. France was next and Mitterand achieved the barest victory with 51.1 per cent in favour of the Treaty. Strong opposition manifested itself not only in countries where the governments had been more or less pushed along, like Britain and Denmark, but also in those where the governments had taken the lead, France and Germany”. In 1992 it was clear that the populations of the prospective EMU partners were less than enamoured with the idea. The ratification process did not generate the positive reinforcement of what the politicians had been up to since the Delors Plan was released in 1989. There was uncertainty, dissent and, in retrospect, a sense of foreboding of what was to come.

The negativity in the public arena towards the EMU that manifested during the flawed ratification process partly contributed to the next disaster in Europe – Black September 1992. The Summer of 1992 in Europe threatened to stop the transition to the EMU before it had really started. But like the current crisis in the Eurozone, the politicians and bureaucrats managed to construct the near meltdown of the EMS as a demonstration of why a single currency was needed rather than a reason to abandon their half-baked plan. Any reasonable interpretation, based on an understanding of what happened and why, would conclude the exact opposite – that a single currency would be very destructive for some, if not most, of the 12 nations that were in the process of surrendering their currency sovereignty to join the Economic and Monetary Union.

While austerity is a term that has entered the economic lexicon in the current crisis, the reality was that euro-zone nations entered the age of fiscal austerity and inflicted early pain on their citizens immediately after the Maastricht Treaty was signed as a result of the need to satisfy the so-called ‘convergence criteria’. The point of these conditions, in the minds of the Treaty signatories, was to ensure all participating nations would not threaten the hallowed ‘price stability’ objective after Stage II of the transition was completed. The Germans and the Dutch maintained the line that no signatory nation would automatically be allowed to adopt the common currency. There was clear suspicion that the Italians and the Greeks, at least, would not be able to meet the criteria by the time it was ready to ‘bite the bullet’ and enter, what they considered would be an irrevocable Stage III. The ‘convergence criteria’, which later were solidified into the SGP, were considered by the political and bureaucratic class in Europe to define an appropriate economic state. Significantly, they failed to mention anything about unemployment rates, poverty rates or notions of social inclusion. The whole discussion was about nations needing to make ‘sacrifices’ to ensure they satisfied the financial ratios, without any notion that unemployment should be at some acceptable level. Their tainted reasoning was based on the Monetarist theory that full employment would arise automatically if price stability was achieved. The evidence was contrary to this theory but the ideology ruled.

It was clear to everyone but the people that once capital flows were liberalised, the central banks would not be able to set individual interest rate regimes and simultaneously maintain their exchange rates within the allowable bands specified by the EMS. A nation that tried to run lower interest rates, as a means of stimulating their economy and reducing unemployment would face capital outflow and downward pressure on their exchange rate. Much of the stability of the EMS in the latter half of the 1980s was achieved by the Member Nations imposing capital controls to prevent violent speculative shifts in capital flows from undermining their exchange rates. Without the capacity to float their exchange rate and/or impose capital controls, the only other adjustment possibility was to impose fiscal austerity on the domestic economy, which entrenched the persistently high unemployment. The logic of the EMS and the convergence process was driven by this reality and the result was the obvious one – high unemployment rates and increasing discontent with the whole integration plan.

It was quite clear that the economies of the prospective euro-zone nations were very different, especially in terms of export capacity and domestic cost structures. These differences had been exposed during the early years of the EMS and had led to several major currency realignments as nations found it impossible to maintain the agreed exchange rates. After the Basel-Nyborg agreement was signed in 1987, nations with weaker currencies were forced to push up their interest rates in order to attract capital inflow to reduce the downward pressure on their exchange rates. The cost was that the rising interest rates undermined domestic economic growth. The false sense of EMS stability that emerged in the late 1980s (that is, there were fewer realignments) didn’t reflect any major convergence between the economies in economic performance. The speculators formed the view that central banks were committed to this interest rate policy and would allow unemployment to rise. But the uncertainty started to build again as a result of the growing dissatisfaction with the Maastricht Treaty process, which came to a head during the ratification period.

It is also often overlooked that capital controls were still in place during this period of relative stability, which prevented some of the speculative movements that could destabilise a nation’s exchange rate. But Monetarist economsts hated capital controls and they were eventually eliminated as a policy choice for all nations. The passing of the Single European Act of 1986 meant that capital controls had to be largely abolished by July 1, 1990, which would eliminate one policy tool that governments had to maintain currency stability and this would become evident in 1992. The referendum failure in Denmark in June 1992 introduced instability and the European financial markets, temporarily lulled by all the Maastricht optimism, started to focus on the very disparate inflation rates and levels of international competitiveness across the prospective euro-zone nations. It was obvious that Italian and British competitiveness had been severely eroded by their higher inflation rates and that their currencies were substantially overvalued, particularly against the Deutsche Mark.

The politicians pushing for the EMU saw the dark clouds emerging in the international currency markets as a sign that they had to move more quickly to introduce the single currency and impose harsher fiscal rules on Member States. The Bundesbank didn’t help matters when it pushed up interest rates on July 16, 1992 because of its concern for rising inflation associated with the reunification. This had the effect of further reinforcing the view that the Mark was undervalued. The obvious happened. International currency speculators started selling the US dollar, the Italian lira and the British pound and shifted massive volumes of funds into the mark. The Bundesbank’s decisions were particularly problematic for Germany’s neighbours because they were facing the prospect of recession and unemployment was already high. The increased German interest rates forced them increase their own interest rates beyond the levels deemed prudent given their domestic circumstances. Monetary policy was locked into ensuring the exchange rates were stable and higher unemployment was the casualty. The increasing political backlash to the high unemployment raised further doubts in the financial markets as to the commitment by policy makers to maintaining the ‘no realignment’ policy.

The EMS was now on very shaky ground. The first cab off the rank was the Italian Lira, which came under increased speculative scrutiny in mid-1992. The Banca d’Italia resisted devaluation and by September 1992, short-term interest rates in Italy reached a growth-choking 15 per cent. Investors continued to move funds from Italy to Germany and the lira plunged in value. Italy finally was forced to devalue. The British pound was also under pressure and its unemployment was skyrocketing as a result of the high interest rates. The resentment against the Bundesbank’s high interest rate policy was also prominent among the other central bankers and finance ministers. On Wednesday, September 16, 1992 the Bank of England lost a massive quantity of its foreign reserves and pushed up interest rates to 12 per cent as it tried to defend the pound against the attack, initially instigated by George Soros’s Quantum Fund. Other investors were also selling the pound believing it would have to devalue. The capital outflow was unstoppable and the macroeconomic policy was out of control – the obsession with fighting inflation by tying the pound to the mark was leading to frenzied and totally inappropriate changes to domestic policy settings. The central bank proposed that it would hike rates to 15 per cent next day.

In the early evening the British Chancellor Norman Lamont stood outside the Treasury Building in London and announced that Britain has ‘suspended’ its membership of the ERM. The pound has floated ever since. Once the speculation eased, the pound had devalued around 13 per cent against the Deutsche mark and 18 per cent against the US dollar, which freed the Bank of England from following the Bundesbank interest rate policy and spurred growth. Inflation didn’t break out as many mainstream economists had predicted. For many ‘Black Wednesday’ became ‘White Wednesday’ – the day Britain regained its policy independence and distanced itself from the madness that was going on in Europe.

Next day, the Italian government announced it was withdrawing the lira from the ERM and Spain announced that the peseta would be devalued by 5 per cent. The rot had set in and the speculators relentlessly attacked most of the European currencies such that by the Summer of 1993, the crisis had resurfaced and Ireland, Portugal and Spain (for the second time within a few months) were forced to devalue. The 1992-93 crisis demonstrated that the system of fixed exchange rates or even tightly linked exchange rates between economies that were disparate in nature and performance would always fail if capital was mobile.

British Chancellor Lamont clearly blamed the Germans for the crisis and the President of the Bundesbank, Helmut Schlesinger in particular. The Bundesbank had made it clear to the German government that if it thought that it would undermine its anti-inflation approach by selling Deutsche marks in order to purchase weaker currencies as part of its intervention obligations under the EMS, it would simply renege and let the other nation lose reserves and enter crisis. The two positions: high interest rates in Germany and reduced rates elsewhere to fight recession, on the one hand; and maintenance of the agreed exchange rate settings, on the other, were incompatible. These incompatibilities would reveal themselves in different ways once the common currency had been adopted with nations forced into austerity because Germany would not stimulate its own domestic economy.

The 1992-93 crisis was resolved by the political decision to widened the allowable fluctuation range for all currencies to plus or minus 15 per cent (a 30 per cent overall allowable fluctuation), which made a mockery of the claim that the EMS was maintaining currency stability. The EMS was heading in the same direction as the Bretton Woods system, which collapsed for similar reasons in August 1971. The problem was not ‘laxity’ or excessive fiscal stimulus, but the fact that a ‘fixed’ exchange rate system such as the EMS (and its predecessor the Bretton Woods system) was incommensurate with the economic and political reality. Nations cannot absorb high unemployment for lengthy periods without major consequences such as social instability and increased political extremism. The Germans, above all, should have learned that lesson.

The related debate about the EMU and so-called Optimal Currency Areas (OCA) that occured in the early 1990s should have also warned the political leaders to take a step back from their common currency desires. This issue is dealt with in detail in Chapter X. While playing “no serious role in the drafting of the Maastricht Treaty” (Wyplosz, 2006: 211), the long-standing concept of an OCA, which emerged in the 1960s, became an organising framework for the debate over the viability of the proposed EMU. OCA theory purports to define the conditions under which several independent countries will be better off by forming a monetary union (sharing a currency) or, alternatively, fixing their exchange rates. Optimality, in this context, refers to the collection of geographic units (in the case of the EMU, Member States) that would most effectively enter a monetary union. Too few ‘geographical areas’ or too many will deliver a sub- or non-optimal arrangement. The conditions that are required to justify the formation of a monetary union as an OCA were clearly absent in the case of the euro-zone nations.

In the lead up to Maastricht, the European Commission largely ignored the OCA literature. The Maastricht Treaty was more about process towards the adoption of the single currency and the requisite institutional changes that would be required to accommodate this process. Why was the relevant existing economic framework (OCA) ignored? The European Commission (1990: 46) concluded that the OCA literature provides a “rather limited framework whose adequacy for today’s analysis is questionable”. The reasons for their scepticism was based on their rejection of the Keynesian view that fiscal policy provides an effective means of stabilising economies hit with private spending fluctuations. An application of the OCA theory was highly inconvenient to the proponents of the EMU, who had rejected, on ideological grounds, a key component – the necessity to have capacity for fiscal policy to redress regional unemployment arising from asymmetric spending fluctuations. De Grauwe (2006) reinforced the view that the EMU cheer squad was ideologically selective in their use of the prevailing knowledge. The theory of OCA was Keynesian and to be rejected by the Monetarists as a matter of course. The millions that have been unemployed since 2008 are testament to the fallacy of the Monetarist presumptions.

Despite its complexity and the various interpretations that have been made of OCA theory, a fundamental prediction that emerges from the theory is that, in the face of a serious slump in spending which is not uniformly spread across a group of nations, unemployment will rise significantly in some Member States if they have foregone their currency sovereignty and entered a monetary union. That is a simple prediction and easily assessed. The data tells us that this prediction has come to fruition.

Apart from the 1992-93 currency crisis, the other key features of the next period leading up to the introduction of the common currency (Stage III) were the final sign off on the SGP and the farcical convergence process leading to decision about which nations would be included. In 1994, German Finance Minister Theo Waigel responded to the growing public alarm in Germany about the EMU by publicly naming the European nations that he considered were taking the Maastricht convergence criteria seriously (Germany and Luxembourg) and those that he believed were flagrantly abusing them (Greece, Italy, Portugal and Spain).The pressure on the German government to do something about the public concern intensified during 1995. Waigel told the German Bundestag in November 1995 during the Federal Budget debate, that each country proposing to go to Stage III would have to strictly comply with the Maastricht criteria. No ifs, no buts. At that point he proposed what he called the ‘Stability Pact’ for Europe, which required governments to limit total fiscal deficits to 3 per cent of GDP (in unfavourable periods) and to below 1 per cent of GDP in normal periods. These rules would have constituted very harsh constraints on the capacity of government to maintain full employment. Waigel formalised this proposal into a Memorandum circulated among Finance Ministers in November 1995. Growth was not a feature of the initial version, nor its successor, despite the inclusion in the title.

Waigel was not only attempting to impose harsher rules but also working outside of the normal European Commission institutions. As part of his proposed ‘Stability Pact’, he wanted to secure an intergovernmental agreement to set up the ‘European Stability Council’ which would manage the surveillance and compliance processes of the Pact. It would impose harsh penalties on nations that breached the rules. The Ecofin Ministers, driven by resistance from France, Italy and Spain rejected the plan and required that the Pact remain within the operation of the Maastricht Treaty. France, in particular, was adamant that the Stability Pact had been contrived by German technocrats. After some bitter exchanges at various European Council meeetings throughout 1995 and 1996, France forced the term ‘Growth’ to be inserted into the Pact and so Waigel’s ‘Stability Pact’ and was able to gain other concessions relating to the reference values and the application of the fiscal rules. By 1997, the haggling was over and the European Council agreed on the form that the SGP. The SGP was formally adopted in 1997.

Its design meant that it would neither provide stability nor growth in any sustainable way. The emphasis in the MacDougall Report (1977) on the need for a significant European-level fiscal function (of at least 5 per cent of total European GDP) to ensure the union could meet asymmetric spending declines was lost in the final SGP. The Delors alternative, subsequently reflected in the Maastricht Treaty (1991) was to impose tight controls on the national fiscal positions in the blind hope that these constraints would allow the European Central Bank to maintain price stability, which in the Monetarist dogma would maximise real economic growth. The Delors Committee claimed that all the so-called stabilisation functions would be done at the Member State level using the so-called ‘automatic stabilisers’ that are built into national government fiscal positions (or ‘budgets’). So when private spending fell and economic activity declined, the lost taxation revenue would push the fiscal deficits of the national governments up and this would provide some stabilisation to total spending.

The SGP rules assumed that even the worst ‘cyclical’ impacts would, on average, keep the reported deficits below the 3 per cent threshold. The swings in fiscal positions that were evidenced as the 2008 crisis unfolded and taxation revenue collapsed indicate that the SGP was poorly crafted to say the least. But there was a further denial embedded in the fiscal rules as to the proper function of government deficits The aim of fiscal policy – that is, discretionary government spending and tax decisions – is to achieve the government’s macroeconomic policy goals, which include full employment. The responsible goal of fiscal policy is not to achieve some dictated fiscal ratios. Fiscal policy positions can only be reasonably assessed in the context of the macroeconomic policy goals. Attempting to assess the fiscal outcome strictly in terms of some prior fiscal rule (such as a deficit of 3 per cent of GDP) independent of the actual economic context is likely to lead to flawed policy choices.

Total economic activity (output and employment) is determined by how much spending there is in the economy. There will be a particular level of national output at any point in time, which would be sufficient to generate enough jobs that will satisfy the preferences of workers for work. In other words, there will be a particular level of total sales (total spending) that will justify the firms producing this level of output and offering sufficient jobs to exhaust the supply of labour. Once the private sector has made its spending (and saving decisions) in any particular period, the national government has a choice. It can use its fiscal capacity to ensure that total spending in the economy is equal to the full employment level. The fiscal deficits required to achieve this aim might be large (well beyond 3 per cent of GDP) or small, depending on how strong private and net export spending is. The alternative choice the government can make it to maintain some slack in the economy with persistently high unemployment and underemployment in an effort to maintain a lower fiscal deficit than would be associated with maintaining full employment. Economists call this strategy one of ‘fiscal drag’ which refers to the policy choice dragging the economy below its full employment output level. This type of fiscal stance ultimately undermines the confidence of the private sector and cause firms to reduce production and income. The automatic stabilisers then drive the fiscal outcome towards increasing deficits and stagnation sets in. Fiscal sustainability is thus about governments ensuring there are no ‘spending gaps’ so that the levels of economic activity are consistent with full employment. Once the link between full employment and the conduct of fiscal policy is abandoned, we are effectively admitting that we do not want government to take responsibility of full employment (and the equity advantages that accompany that end). That is the position that the euro-zone took on once it accepted the SGP as its guiding framework.

The SGP also biased governments towards so-called ‘pro-cyclical’ policy changes, which are anathema of sound fiscal policy practice. The economy cycles between booms (strong growth) and busts (weak growth or recession). Discretionary fiscal policy changes should be ‘counter-cyclical’ that is move in the opposite direction to the economic cycle, because the role of government is to ensure economic activity remains at levels consistent with full employment. So when the private sector spending growth slows, which would push the economy into a slump with lower output growth and falling employment, the correct response of government is to introduce a fiscal stimulus – to inject spending into the economy to make up for the deficiency caused by the slowdown in private spending. The worst thing a government can do as private spending falls off and the economy moves towards or into recession is to cut its own spending and/or increase taxes in an attempt to reduce its deficit. The withdrawal of the public spending contribution to total sales would only make the recession worse and further undermine the confidence of the private sector. This sort of response is called a ‘pro-cyclical’ policy change and clearly is not consistent with responsible policy practice.

Enforcement of the SGP rules compel governments to impose austerity at a time when private spending is weak and unable to support growth. This is madness. As the recent experience has so emphatically demonstrated, imposing fiscal austerity on a nation in recession is self-defeating because the attempts to cut the discretionary component of the deficit, further undermines the tax base and drives the automatic stabilisers into further deficit as economic growth deteriorates. An unemployed person pays no taxes!

The SGP also increased the vulnerability of national governments to the private bond markets. Prior to the 1990s, governments and central banks worked together to ensure that the fiscal plans of the government would always have sufficient funds, even though, as we will discuss in a later chapter, the governments unnecessarily continued to issue debt to the private bond markets to match their deficits. The reference to the lack of necessity in this case refers to the collapse of the Bretton Woods system which freed currency-issuing governments from the need to issue any debt at all. The convention of issuing debt was continued because the dominant conservatism among economists saw it as a means of pressuring governments to run smaller deficits than might be required. Shifts in public debt ratios are always a sensitive issue in the public arena, even though most of the financial commentators and the public in general do not understand the meaning or relevance of the data that is paraded on financial reports and the like on a daily basis as if it is important.

During this period, central banks in many European nations regularly purchased government debt directly from the treasuries if they felt accessing private funds in the bond markets would not be in the interests of the government. This practice was outlawed under the Maastricht Treaty. The upshot was that once the euro-zone came into operation, all Member States had to seek loans from the private bond markets to cover any fiscal deficits. The bond markets thus were elevated in importance within the euro-zone and could not only dictate the cost of public borrowing but also had the capacity to withdraw funds altogether and force a euro-zone nation into insolvency.

For nations that issue their own currency, the bond markets are impotent and know that the corresponding central bank can always set the terms (interest rates) that public debt is issued. Governments in these cases only have to pay what the bond markets demand if the government concedes to the false authority of the markets. Otherwise, the government is fully in charge of the bond issuance process and the markets become compliant recipients of corporate welfare in the form of a guaranteed (risk-free) annuity (with interest) in exchange for non-interest bearing bank reserves. The bond markets know that there is no default risk on bonds that are issued in the currency that the central bank creates.

The bond markets clearly understand though, that the euro-zone nations face insolvency risk. In the absence of any ECB support, these nations are reliant on the terms set by the bond markets for any debt they issue. The excessive deficit procedure built into the SGP acts as an alarm bell for the bond markets because it unnecessarily invokes a sense of crisis when the real crisis is the loss of employment and output. The responsible response is to support total spending with larger deficits, which almost certainly exceed the SGP threshold. In creating this sense of crisis, the solvency risk of the nations is highlighted. By forcing all the fiscal adjustment onto the Member States and then restricting their capacity to meet an economic crisis, the EMU ensures that recessions will be deeper than they should be and that peripheral crises, such as the refusal of bond markets to lend to governments at reasonable rates, will become more likely.

The SGP was designed to place binding constraints on the capacity of national governments to use their spending and taxation capacities to fulfil their legitimate responsibilities. The constraints effectively limit the capacity of these governments to respond to crises and the result has been that millions of workers in Europe have unnecessarily lost their jobs as the Troika has bullied governments into adopting ‘pro-cyclical’ policy changes, which are the anathema of sound fiscal practice. It is now widely recognised that the fiscal rules that are central to the SGP are highly arbitrary without any solid theoretical foundation or internal consistency (see Mitchell, Muysken and Van Veen, 2006). The rationale of controlling government debt and budget deficits were consistent with the rising neo-liberal orthodoxy that promoted inflation control as the macroeconomic policy priority and asserted the primacy of monetary policy (a narrow conception notwithstanding) over fiscal policy. Fiscal policy was forced by this inflation first ideology to become a passive actor on the macroeconomic stage. It is often said that the European economies are sclerotic, which is usually taken to mean that their labour markets are overly protected and their welfare systems are overly generous. However, the real European sclerosis is found in the inflexible macroeconomic policy regime that the Euro countries chose to contrive. The rigid monetary arrangements conducted by the undemocratic ECB and the irrational fiscal constraints that are required if the SGP is to be adhered to, render the nation states within the Eurozone incapable of achieving low levels of unemployment and increasing income growth. The SGP promotes neither stability or growth.

The nations only finally achieved entry to the common currency through a series of smokescreens, accounting tricks, and denial, which we might call the ‘Convergence Farce’. The convergence criteria specified under Article 109j(1) of the Maastricht Treaty were clear despite being ill-founded. It was clear that many nations were never going to meet all the required criteria. The excessive deficit criterion was clearly tripping a number of nations up, including Germany. In 1997, France, Germany and Spain had deficits above the 3 per cent and could not really appeal to the special circumstances clauses as a way out. Further, the public debt ratios in Germany and Spain were above the 60 per cent threshold and had been increasing since 1995. By contrast, although Italy’s public debt ratio was well in excess of the criteria, it had been falling. Further, Belgium was in this category too and presented Germany with a major tactical headache – it could not isolate Italy without pleading some special case for Belgium, which of-course, it attempted without success.

Germany, in particular, didn’t believe Italy would meet the requirements by the specfied date. Ultimately, German agreed to Italy’s entry purely on political grounds. It would not be the first time the agreed ‘rules’ would be bent to satisfy pragamtic considerations. The German news Magazine, Der Spiegel characterised the convergence exercise as “Operation ‘self-deception'” (Der Spiegel, 2012, Part 1). They report that the German officials and government were aware of the accounting tricks that Italy was engaging (gold sales and special ‘taxes’) to bring the deficit down below the Maastricht thresholds. In early 1997, the Italians announced that they had reached the 3 per cent deficit criterion, defying other known measures of their fiscal position provided by the IMF and the OECD. But Italy was not the only nation ‘cooking the books’! As 1997 dawned, it was clear that Germany itself might not meet the deficit and public debt thresholds laid out in the convergence criteria. There was a fierce internal battle within German politics, which accused Waigel of lying to the public about the state of the nation’s finances.

Externally, the German government’s problem was obvious. As the ‘enforcer’ within Europe, was adamant that countries should not be allowed to take part in the euro unless they met the convergence criteria exactly. Waigel came out with some extraordinary statements as part of the a strategy to prevent the Germans losing face and control of the whole march to the EMU. At once stage he denied that he had ever mentioned the 60 per cent public debt limit. Which was a lie. The slippage continued further though. At an informal Ecofin meeting in 1997, Waigel demonstrated the hypocrisy still dominates decision making in Europe and colours the debate relating to the options for the euro-zone by he said that “I have never nailed myself on the cross of 3 percent. When I said in the past ‘3 percent means 3 percent’ I did not necessarily mean 3.0 percent” (Palmer, 1997). Germany suddenly was proposing flexibility. It was clear that while Germany hated the idea of Italy joining the EMU, it was so weakened by its own inability to meet the criteria and facing a difficult federal election in 1998, that it would do what it took to push through to Stage III. Further, while Waigel was publicly railing against France, Italy, and Spain for manipulating their public accounts in order to meet the convergence criteria, he privately crafted his own plan to ‘cook the books’, which looked very similar to those same creative accounting plans deployed by France and Italy. After a public spat with the Bundesbank, who claimed the plan would compromise their independence, the Government was forced to scrap the plan and bear the public humiliation associated losing out to the bank.

It was clear though, that the final decision on who would enter the EMU would be political and the convergence criteria were really a smokescreen, a sort of delusional security blanket designed to placate the German public and the conservatives elsewhere that the process was disciplined and sustainable. There was no economic logic anyway, just a set of arbitrary numbers grabbed out of the air, which were then backfilled with a series of spurious ‘economic’ reports which claimed to prove the legitimacy of these numbers as ‘economic knowledge’. They were never that – they were always just ideological statements about the Monetarist disdain for government activity in what should be for them, a self-regulating free market devoid of worker protections, with as small a government sector as is required for external defense. All of this meant that the convergence criteria had to be watered down. In effect, they all agreed to fudge the books and bend the rules they had set for themselves, because the rules themselves were impossible to meet while still maintaining anything like politically acceptable unemployment rates. The politicians demonstrated a spectacular capacity to bend their own rules. That trait continues into the current crisis.

While the convergence process was farcical at best, it remained the case the nations could only ‘gild the lily’ so far, not withstanding the amazing scam that Goldman Sachs helped the Greeks perpetrate in 2001, which facilitated that nation’s entry to the 12. In other words, the exercise while fraudulent, still caused considerable self-inflicted damage as the nations imposed fiscal austerity and growth rates fell sharply. The descent into prolonged low growth was the precursor of the much greater problems that would come when the external events exposed the design flaws of the monetary system later in the decade.

The early days of the EMU, coincided with an extraordinary period in economic history, where economic policy makers adopted a sort of smug, self-congratulatory triumphalism, which, in part, would lead them to make policy choices that would eventually multiply the risks inherent in the flawed design of the monetary union. This is the ‘business cycle is dead’ era, we referred to earlier. The world entered a period known as the ‘Washington Consensus’, which refers to the liberalisation policy agenda broadly pursued by Washington-based institutions such as the IMF, the World Bank and the economic agencies of the US government, the Federal Reserve Board, and the think tanks (Williamson, 1990). The policy agenda was dominated by free market fundamentalism, fiscal austerity, broad-based deregulation of financial and labour markets, privatisation. This underlying neo-liberal narrative dominated policy making in the 1990s as the EMU was being crafted, and was justified by the unfounded assertion that if private markets were left free of regulation and central banks were allowed to concentrate on price stability unfettered by the political process, then economies would be able to maintain long periods of stable output and employment growth.

Clearly, the Washington consensus dove-tailed closely with the policy mentality in Europe that had created the EMU and the growing ‘sense of success’ that emerged in the early days of the union. In July 2003, the European Commission published the so-called Sapir Report, which was the product of an expert panel chosen to review the entire system of EU economic policies” (Sapir et al, 2003: i). The panel was chock-full of conservative, free-market oriented economists. The 183-page Sapir Report was very influential and is full of neo-liberal success rhetoric (see Mitchell and Muysken, 2006 for a critique). The Report claimed that the remaining policy challenges were at the microeconomic level – to free up more markets and reduce welfare budgets – the echo of the Washington consensus. At the time that Sapir and his colleagues were busily praising the EMU, economic growth was slowing and unemployment remained persistently high. It was rather surprising that the on-going macroeconomic losses that arise from the persistent unemployment, not to mention the massive social and personal costs, were not considered by European Commission politicians to be the most compelling policy problem that should command their highest priority. It appeared that the politicians and policy-makers, aided and abetted by the so-called ‘experts’ they wheeled in from time to time to produce these self-reinforcing reports, had the totally opposite construction of events. Unemployment was seen, at best, as an unfortunate and ephemeral consequence of policies that are required to maintain low inflation economies and are largely attributed to either rigidities (overly generous welfare and other regulations and out-of-touch unions) or to individual choice. This construction provided the political cover for governments in Europe (and elsewhere) to abandon the goal of full employment and replace it with the diminished goal of full employability. The Sapir Report represented what is now known as the ‘Brussels-Frankfurt consensus’.

The Washington consensus and the Brussels-Frankfurt consensus dovetailed perfectly and the whole world became besotted by the austerity culture and the urgency of deregulation. The pre-conditions for the global crisis that would come a few years later were being laid, but the creators were blind to their actions, such was their enthusiasm for the agenda and their capacity for Groupthink. These pre-conditions included the burgeoning property booms in Ireland and Spain and the growing export surpluses in Germany. They would would soon combine with the flawed design of the EMU to amplify the negative consequences of the collapse of the housing market in the US and push the euro-zone to the brink of collapse. Such was the magnitude of the threat to the monetary union that the Euro cabal was forced to break its own ban on bailouts, despite their continued denials to the contrary. It also forced the ECB to break their taboo on funding government deficits when they bought billions of Euros worth of public bonds and maintained the solvency of several EMU national governments. While they denied they were doing that and resorted to opaque explanations about ‘managing liquidity requirements’ the fact is they were ‘funding’ deficits and everyone knew it. And, despite all the protestations of economists of the Sapir-mould, deflation not inflation emerged as the problem as unemployment skyrocketed.

Another notable development in the euro-zone prior to the crisis was the way Germany gamed its currency partners. Before the EMU, the Bundesbank had regularly kept the Deutsche mark undervalued to ensure the German export sector remained competitive. Upon entering the EMU, the Germans lost control of their exchange rate and hence they had to manipulate other ‘cost’ variables to retain their international competitiveness. Gerhard Schröder also was under immense political pressure to do something about the high unemployment in the East after reunification. The Germans understood that without the capacity to manipulate its exchange rate it would have to maintain international competitiveness using so-called ‘internal devaluation’ strategies. Gerhard Schröder’s ‘Agenda 2010′ announced in 2003, which aimed to attack income support systems and ensure that Germany’s export competitiveness endured. The so-called ‘Hartz reforms’ were a major plank in Schröder’s Agenda 2010 strategy and the aim was clear, unemployment benefits had to be cut and job protections had to go. The recommendations were fully endorsed by the Schröder government and introduced between 2003 and 2005. The changes were far reaching in terms of the labour market policy and included the privatisation of public employment agencies, the acceleration of the casualisation of the jobs. New types of employment were introduced, the ‘mini-job’ and the ‘midi-job’, which were paid low wages and provided no job security. There was a sharp fall in regular employment as a result and real wages growth in Germany ground to a halt, thus undermining the capacity of the German economy to grow on the back of private domestic spending.

German capitalists harvested a profit bonanza as their share of nation income grew substantially as a result of the suppression of real wages growth in Germany. The lower costs also maintained Germany’s export competitiveness and the large export surpluses provided capital with the funds to loan out to other nations. The suppression of consumption growth in Germany and the reliance on capital exports to the ‘south’ to maintain growth was very damaging to the peripheral member states. That sort of unilateralism was not sensible in a monetary union. The dramatic suppression of domestic costs and domestic spending in the early days of the EMU by Germany, not only meant that the Germans would ultimately undermine the welfare of the other EMU nations, but also meant that the living standards of German workers were being driven down in the process.

To some extent the German government understood the logic of the flawed design of the EMU more fully than the other nations. They knew the monetary system encouraged a race to the bottom and exploited the ‘solidarity’ of its workers to game the other nations. The huge export surpluses provided the funds which led to the German banks accelerating their lending to other nations, in particular Spain and Italy, and less so Ireland. The common monetary policy meant that interest rates fell in the peripheral nations because rates were essentially set to reflect conditions in Germany rather than elsewhere. The lower interest rates encouraged this massive lending spree, which then in Spain and Ireland, among other nations, found its way into the construction and housing boom. Much of the debt was private. The accusations that would emerge as the crisis hit that the PIIGS were ‘spending beyond their means’ and gorging on debt were rather thin when you realise that Germany’s growth strategy required the PIIGS to borrow heavily. For every dollar loaned there has to be a lender.

It didn’t take long for the flaws in the SGP to be revealed. After years of negotiating the Pact and its excessive deficit procedures (EDP) in particular, trouble emerged for the monetary union almost immediately. Given the poorly conceived nature of the SGP it was no surprise that it would fail its first test. What was surprising was the way the politicians and bureaucrats behaved in the face of what any reasonable assessment would consider to be extraordinary hypocrisy. Germany was one of the first nations to transgress the rules along with France. What followed was astounding, especially in the context of the machinations during the current crisis, where Germany has played it tough with its smaller, more fragile EMU partners. By early 2002, German economic growth was fairly subdued with a further slowdown likely. On January 30, 2002, the European Commission, acting under the EDP rules, gave Germany an early excessive deficits warning under the SGP rules and demanded a balanced budget position be met as soon as possible despite understanding that if the German economy slowed any further, the deficit would rise further. A similar narrative was followed for France. Sure enough, the mindless fiscal austerity that Germany adopted within the recession-biases of the SGP caused its economy to slow further. Millions lost their jobs as a result, while others increasingly found their jobs becoming more precarious and their wage prospects suppressed. If there was ever a time for reflection on how damaging the EMU structure could be, then this period should have been it.

In early 2003, the European Commission declared Germany to be in breach of the SGP excessive deficit rules. The German authorities could have cut its net spending more severely but unemployment was rising quickly. From outside the twisted neo-liberal logic of the SGP, the downturn was already looking serious (if not severe) but the SGP defined the threshold of severity as a decline in real GDP of more than 0.75 per cent in any year. That figure was like all the rest, totally arbitrary but meant that millions could lose their jobs, yet the downturn would not be considered severe. Even the Italian Romano Prodi, who was European Commission President at the time announced that the rigidity of the SGP was ‘stupid’. Germany was being caught in the trap it had set for Italy, Greece and other ‘suspect’ nations. The European Commission demanded that Germany cutting its net spending and retrenching its labour market protections and welfare system. The European Council went one step further by demanding that Germany cut its deficit by 1 per cent of GDP within four months, an impossible and dangerous request. A large fiscal contraction of this speed, if successful, would have guaranteed that the German economy would enter recession. Further, given the loss of tax revenue associated with this decline, there was no guarantee that the deficit would fall. As the German economy contracted in 2003 and the fiscal balance rose to 4.2 per cent of GDP up from 3.8 per cent in 2002, the European Commission upped the ante and announced it would pursue Germany for ‘non-compliance’ under the SGP.

A parallel process had been going on with respect to France. The French government was publicly hostile to the process. The problem was that the fiscal rules embedded in the SGP were ‘written in marble’ despite this protestation from the French Minister for Economic Affairs, Finance and Industry, Francis Mer in June 2003. The nations had all signed up to a discipline that they found was not possible to maintain and still meet their responsibilities to maintain growth and reduce unemployment. French President Jacques Chirac tried to persuade the Ecofin ministers to relax the fiscal rules to allow some room for growth but was met with hostility. At that point, Germany knew it had the ally it needed to ignore the Commission and manipulate the Council when it came to the crunch later in 2003. Both Germany and France spent the next months arguing that more flexibility was needed in the application of the SGP

On November 18, 2003, the Commission recommended to the Council that the response of both the French and German governments to their earlier demands be considered inadequate under the terms of the Treaty and that further action under the EDP be triggered and a much tighter frame be required for resolution. The stakes were now high. The Commission wanted both France and Germany to be sanctioned for their obdurate behaviour with respect to the rules. The Ecofin Council subsequently considered the Commission’s Recommendations and under the system of a ‘qualified majority’, which is a weighted voting system such that the larger nations by population are given more weight (votes) in the process, voted to reject it in relation to both France and Germany. The Council and Commission were now in open conflict and the latter sought a legal ruling in the European Court of Justice. The resulting decision in June 2004, was a small victory for the Commission because the ruling clearly indicated that the EMU partners could not unilaterally ignore the rules that they had formally agreed to. But the ‘law breakers’ got away with it because the impasse led to a renegotiation of the SGP and no sanction against France or Germany.

Not long after, the GFC struck Europe with all its might. The severity of the crisis reflects the poorly crafted monetary system that the euro-zone nations created. Neo-liberal economists played a key role in the European demise both before the crisis in influencing the design of the EMU and in influencing the policy response that followed the crisis. In the first sense, they ensured the EMU would not be able to withstand a major collapse in private spending. In the second sense, they ensured that the recession would be much longer than it should have been and millions would lose their jobs.

France, which had pushed for the economic and monetary union, thinking it would be a way to increase French influence in Europe and erode the dominance of Germany, discovered that the result was exactly the opposite. Germany, always the reluctant player in the discussions about monetary union, ended up being the dominant force in the eventual design of the EMU. However, it has come to resent the consequences of that flawed design. Neither nation achieved their initial aims or aspirations. The result is for all to see – a disaster. Part III of the book examines in detail what options exist to get out of this disaster.


Additional references

This list will be progressively compiled.


(c) Copyright 2014 Bill Mitchell. All Rights Reserved.

This Post Has One Comment

Leave a Reply

Your email address will not be published. Required fields are marked *

Back To Top