The euro: a man-made disaster

In the early 1990s, while eastern Europe was emerging from the man-made disaster of communism, in western Europe the seeds of a new man-made disaster were being sown.

The euro - the European Union's common currency - was designed to draw the countries of Europe together. In practice, it is now driving them apart.

The Maastricht Treaty signed in 1992 by the member states of the European Union (EU) paved the way for the introduction of the euro as the sole legal tender in most EU countries in 1999 (currently the eurozone includes 17 of the EU's 27 members). The project was controversial from the start. Not because it was political in inspiration: it was always understood that the common currency was a major instrument to pursue the goal of 'ever closer union' to which the EU (then the 'European Economic Community') had committed itself in 1958, in its foundation Treaty of Rome, and which had acquired special significance after Germany's national unification in 1991 and its emergence as by far the weightiest EU member.

The doubts arose from the euro's lack of secure institutional underpinning.

True, the EU's so-called Stability and Growth Pact required members of the eurozone to achieve

• an annual total public sector budget deficit no higher than 3 percent of GDP; and
• a national debt lower than 60 per cent of GDP or approaching that value.

On the other hand, the European Central Bank (ECB), set up to administer the euro and to determine the single policy interest rate throughout the eurozone, was not to act as 'lender of last resort' in the way that national central banks do: it could not decisively bail out eurozone governments that threatened to go bankrupt.

Given the present crisis of the eurozone, it is deeply ironic that this institutional weakness should have mainly reflected Germany's well-founded fears that its price stability and sound public finances would be compromised by the inflationary tendencies in the eurozone's less competitive members in southern Europe: an ECB empowered to guarantee the bonds of all eurozone governments might ignite inflation and generate 'moral hazard', that is, it could encourage less competitive economies to become addicted to regular fiscal transfers from the more successful ones (like Germany).

The standard response to these fears was that the single currency would encourage 'convergence' among the eurozone's economies as they imported via the euro the benefits of Germany's monetary and fiscal discipline. This was a superficially plausible argument for public consumption. But for such convergence to happen, at the very least the Stability and Growth Pact would have had to be rigorously enforced.

In practice, it was a dead letter more or less from the start. In the 1990s some countries were allowed into the eurozone with national debts well in excess of 60 per cent of GDP, and showing very ambiguous signs of 'approaching' that limit. Worse, when in the early 2000s France and Germany ran budget deficits above the limit of 3 per cent of GDP, they quickly changed the rules to avoid the fines they would otherwise have been obliged to pay. This gave the green light to other eurozone members to go their own ways.

The eurozone interest rate, which the ECB set primarily with reference to the needs of the German economy, was too low for most of the others, encouraging various forms of delinquency. Some countries - such as Greece, Belgium and Italy - simply ignored the official limits on budget deficits or national debt while avoiding the structural reforms their economies needed. Of those countries that did retain some control over their public finances, some - notably Spain and Ireland - experienced property boom-bust cycles and banking crises. All countries had to forgo both the benefits and the disciplines of exchange-rate flexibility. Monetary union has thus in practice presided over a divergence rather than a convergence of the eurozone economies.

Faced with the near-bankruptcy of some eurozone members, the EU has organised bailouts, but not - so far - primarily through the European Central Bank. The ECB has helped individual governments by buying their bonds, but it has avoided any 'lender of last resort' guarantee of national debts of the kind that could restore confidence and growth to the eurozone.

Germany shows no sign of relaxing its opposition to such a move. But it's hard to see where else the necessary money will come from, short of a major intervention by the International Monetary Fund, which cannot be relied on (the EU has approached several sovereign wealth funds around the world but they show little interest). As a result many commentators are concluding that the eurozone is doomed unless the Germans change their mind or the ECB unilaterally goes ahead anyway with unlimited purchases of bonds of distressed governments.

In the longer term, monetary union would also have to be underpinned by fiscal union to ensure compliance with something like the original Stability and Growth Pact that was so cynically allowed to fall into disuse. Even then, no 'convergence' of eurozone economies could be guaranteed. After all, the economic division between the north and the south of Italy remains deeply entrenched a century and a half after national unification. As well, the formerly communist eastern provinces of Germany remain stubbornly in recession 20 years after they were united with the rest of the country, at huge and continuing expense. It's no wonder the Germans are so fearful of what they are being increasingly pressured into doing to prove their 'European' credentials.

The only alternative path forward was unexpectedly voiced at the G20 meeting in early November 2011, where the French president and the German Chancellor publicly entertained the possibility of Greece leaving the eurozone. It's hard to exaggerate the symbolic significance of that admission. For the first time since the EU came into being, the leaders of its two central members have contemplated a retreat from the 'ever closer union' that was supposed to ensure that the big European countries never went to war again. But what would the departure of an over-indebted country from the eurozone entail? Economic commentators disagree on the likely total size of the domestic and international costs.

One such potential cost would be an increase in the country's national debt as it was redenominated in the fast-depreciating restored national currency. However, the country could avoid that cost if it defaulted on its debts, as Russia, Argentina and Iceland have done in recent years. The experience of those countries suggests that default can be followed quite quickly by economic recovery, whereas a chronically high level of national debt (as in Japan) induces prolonged stagnation. Of course, to secure their long-term prosperity such countries would still have to undertake radical domestic economic reform.

At the time of writing events are moving fast and it is unclear whether the eurozone can survive the contagion ignited by the Greek crisis.

Many commentators believe that the eurozone will eventually have to shrink to encompass Germany, France and a few small neighbouring countries whose economies have genuinely converged. But it is already very clear that the euro was a step too far in the quest for 'ever closer union' because the eurozone can be sustained only by measures that breach the limits of democratic legitimacy, and so introduce tensions among eurozone members.

This was starkly evident at the G20 meeting when the European leaders threatened to expel Greece from the eurozone should the Greek people reject the terms of the latest EU bailout in a proposed referendum (whereupon the Greek government cancelled the referendum).

How has it come to this? Since the Roman empire collapsed in the fifth century, Europe has undergone several cycles of centralisation and disintegration. The EU is the first attempt to unite Europe by peaceful means. But although it was formally ratified by democratic institutions, its inspiration was overtly elitist. Its founders, who feared and distrusted the European nationalisms that had led to two world wars, sought to replace them with a popular allegiance to Europe. They have failed.

National allegiances persist: west Germans willingly subsidise their fellow Germans in the eastern provinces but resent being expected to subsidise other Europeans indefinitely. Yet such sentiments are nowadays far from dangerous. Europeans have abandoned the disastrous national rivalries of the past; and they need no Europe-wide institutions to enable them to cooperate peacefully through trade, investment, migration and tourism. A form of European monetary union could have emerged spontaneously from currency competition: a country that envied the Germans their strong Deutschmark could have made it legal tender alongside the national currency, so that any 'Deutschmarkzone' that evolved would necessarily be stable. But if the eurozone persists under the existing supranational arrangements, it may well provoke a political reaction that revives the national conflicts that the EU was designed to avoid.