Politics Will Determine the Fate of the Euro

It has always been clear to me the European Monetary Union (EMU) and the single currency were poorly designed as both a political system and as a common currency area. Roland Vaubel, of the University of Mannheim, is a distinguished economist who has followed the euro from birth, and his podcast tells the story eloquently.

For example, I never really understood what would have motivated Germany to be interested in a common currency, given its strong economy, currency and its clear understanding of the weaknesses in the euro's design.  It goes back to the Franco-German relationship, which has always been one of mutual suspicion and grudging acceptance, at best. 

German Chancellor Helmut Kohl was extremely interested in common European Union foreign and defense policies, and he felt strongly that a European defense policy had to have a nuclear component.  France, of course, was especially loath to give Germany access to a common nuclear capability. Kohl was willing to talk about a common currency in exchange for his larger interest in a common EU foreign policy and defense structure. So began the bargaining.

When the Berlin Wall fell in the autumn of 1989, the former Federal Republic of Germany had reunification thrust upon it.  President G.H.W. Bush was an early supporter of unification.  France and the United Kingdom were publicly cool and privately opposed.  According to Professor Vaubel, French President Mitterand got his euro in exchange for lending his support to German reunification. 

There is a well established body of economic research, begun by Professors Peter Kenen, Charles Kindleberger and Robert Mundell, on the "optimum currency area."  The original eleven members of the economic and monetary union (EMU) in no way fit the criteria for an optimum currency area.  Everybody knew this from the outset, but rules were put into place which were consistent with such an area. These rules were flouted openly to admit the weaker members.  These flaws have come become manifest in the secular budget deficits, inefficient labor market productivity, and high public debt to GDP ratios.

The original charade with eleven members has been expanded, in violation of the system's own rules, to seventeen members.

Before the formation of the euro, French monetary policy had to react to and align with German monetary policy, something which rankled French political sensibility. 

The German government hoped, according to Professor Vaubel, to maintain control over the euro by having veto power over the European Central Bank board's decisions, and the earliest supervisory board was stocked with supporters of a "hard currency."

The Maastricht Treaty of 1991, at the behest of France, specified that a European monetary union would be established by 1999.  This and some other subtle changes were apparently not appreciated by German negotiators until it was too late.

The Stability and Fiscal Pact of 1996 represented another German attempt to put some discipline into the dismal fiscal performance of euro currency zone members by establishing limits for the ratio of sovereign debt to GDP of euro zone members.  The three percent limit was quickly violated by most of the members.

The EMU attempted to emulate the U.S. Federal Reserve by establishing a 2 percent inflation target for union members.  This target has not been consistently achieved, and now inflation is running at three percent with economies heading into recessions. 

Germany is the largest shareholder of the European Stability Mechanism, which has 80 billion euros in contributed capital and 620 billion euros in callable capital.  Exposures to large losses from this facility will be political poison for the current German government, which faces Federal elections in September 2013. 

According to Professor Vaubel, two-thirds of the German electorate have consistently opposed bailouts for Greece and other weak euro periphery members.  So, no matter how badly the Chancellor is painted in the European press, it seems unlikely that any decisive breaks from her basic position will be translated into real, additional financial commitments before the 2013 election.