Philipp Bagus is a professor of economics at King Juan Carlos University in Madrid. He is also assistant editor of the journal Procesos de Mercado: Revista Europea de Economía Política. His main research areas are monetary theory and business cycle theory. He has published articles in numerous academic journals and other scholarly outlets. Bagus is author of The Tragedy of the Euro and, with David Howden, of Deep Freeze: Iceland’s Economic Collapse.
In your book, The Tragedy of the Euro, you argue that the euro project actually started out as a liberal/Christian notion and was then “captured” by the socialist, centrist, “big government” viewpoint. What happened?
It is quite clear that from the beginning of the European Union the advocates of two different ideals strove to impose their preferred form on the European project, and the euro is key to understanding how this struggle has played out. As I say in the book, the founding fathers of the European Union, Robert Schuman from France, Konrad Adenauer from Germany, and Italy’s Alcide De Gasperi, were all German-speaking Catholics and Christian Democrats. Their ideals were the classical cultural values of Europeans and Christianity, which see sovereign European states as being the defenders of private property rights and the creators of a free market economy in a Europe of open borders. The natural boundaries of Europe, in the liberal vision, were the limits of Christian Europe.
This liberal vision’s greatest achievement was the Treaty of Rome in 1957. The Treaty underlined four basic liberties for Europe: the free circulation of goods, the free offering of services, free movement of finance, and freedom of movement for European citizens. These essential rights had been achieved in Europe during the 19th century, but they were then swept aside by the age of nationalism and socialism that ended with the Second World War.
This idea of freedom is extremely powerful as a limit on “big government” philosophies. Citizens who find themselves in a socialist state that is determined to redistribute wealth through “progressive” taxation in order to build a massive welfare state would be able to vote with their feet by moving to a state with a lower tax burden. All you need to achieve this is freedom of movement for goods, people, services, and finance, together with a respect for private property.
In this vision there is not only no need to create a European superstate, such a concept is in fact antithetical to the vision. The classical liberal point of view needs many competing political systems, as had been the case in Europe for centuries. Competition on all levels is essential to the vision. It leads to coherence as product standards, factor prices (factors being all the elements, including labor, needed to create products and services) and especially wage rates, tend to converge.
Capital moves to where wages are low, bidding them up; workers on the other hand move to where wage rates are high, bidding them down. You have the basis for efficient, competitive economies, while political competition ensures the most important European value: liberty.
Self-evidently, the “superstate” approach is very much in favor of “big government,” since such a state works to establish a homogeneous set of conditions within its borders. There is nowhere to move to that is different, so the citizens are “captured” and freedom of movement is rendered meaningless. Having different national tax sovereignties is the best protection against the tyranny of “big government.”
Politicians who aim for big government have to have policies that appeal to the largest possible base of voters. It is natural and logical therefore for them to offer “redistributive” taxation strategies which promise a socialist “nirvana” of free housing, free education, free healthcare, and early and large pensions to all. This policy garners votes and puts socialist politicians in power, but what this strategy lacks is a way to pay for the socialist vision of a vast welfare state. As we will see, this point has returned to haunt the euro and may well be instrumental in its eventual demise. The current plight of Greece sketches out the possible fate of all.
The time-honored way for politicians—and kings and emperors before them—to pay for unaffordable policies is to produce money. The idea, or rather, the myth, of controlled inflation is therefore deeply embedded in the socialist vision (“control” is illusory since booms and busts are endemic to an inflationary stance, as Austrian business cycle theory demonstrates).
You have argued that the creation of the euro can be seen as an attempt by high-spending, high-inflation countries to get away from the tyranny of the Deutsche Bundesbank. Can you explain this?
Much of the story of the creation of the euro revolves around such high-spending, high-inflationary states—with France the paramount example—struggling to get rid of the limiting power of Germany’s Bundesbank. In postwar Europe the Bundesbank—which, for historical reasons (the two periods of hyperinflation endured by Germans in the 20th century) was fixated on stable prices—became the yardstick against which all European economies were measured. It is not that the Bundesbank was not itself inflationary; rather, that it inflated at a lower rate than countries with more overtly socialist governments found desirable.
The inflationary excesses of such countries were highly visible when set against the “stability” of the Deutschmark. The exchange rates against the Deutschmark, especially of the southern European countries which used their central banks most generously to finance deficits, served as a standard of comparison. Their currencies would devalue very visibly against the Deutschmark as they attempted to inflate away their deficits. The euro was a way of ending the embarrassing comparisons and devaluations.
Importantly, although from the outside the new European Central Bank (ECB) would look like a copy of the Bundesbank, from the inside it could be put under political pressure and transformed over time into a central bank more like the Latin central banks. Key here is the fact that voting rights mean that southern Europe actually has control of the ECB. The council of the ECB is composed of the directors of the ECB and the presidents of the national central banks. All have the same vote. Hard-currency countries with low rates of monetary inflation, such as Germany, the Netherlands, Luxembourg, and Belgium, hold the minority of votes against countries such as Italy, Portugal, Greece, Spain, and France. These countries had strong labor unions and high debts, making them prone to wage inflation and inflation generally.
One of the great advantages of the euro to these countries is that its inflation could be conducted without any direct evidence of an appreciating Deutschmark. Under a euro regime, when prices started to rise it would be relatively easy to blame it on externalities. Fiscal mismanagement in Spain or Greece would, initially at least, be much harder to spot.
Giscard d’Estaing, founder of a lobbying group for the euro, explicitly stated in June 1992 that the ECB would finally put an end to the monetary supremacy of Germany, and added that the ECB should be used for macroeconomic growth policies—in other words, inflation. In a similar way Jacques Attali, advisor to François Mitterand, acknowledged that the Maastricht Treaty was just a complicated contract whose purpose was to get rid of the Deutschmark.
The result of the introduction of the euro was the expectation of a more stable currency for southern European countries. As a result, inflationary expectations fell in those countries. When inflation expectations rise, people reduce their cash holdings and buy today as they expect goods to be more expensive tomorrow. When inflationary expectations fall, that pressure to spend evaporates and spending falls marginally, leading to lower price inflation. This was a positive benefit for southern Europe, and these countries began to benefit as soon as it became clear that the euro would be introduced. This in turn helped them to fulfill the Maastricht euro entry criterion of low inflation rates.
Another great benefit the southern European countries enjoyed in the run-up to the euro was that investors became much more willing to buy government bonds issued by these countries. The expectation was that these bonds, which were still denominated in lira, peseta, escudo, and drachma, would be repaid in the more stable euro. As a result of the attractiveness of this proposition to investors, the rates of interest paid by southern European countries for their bonds fell. This in turn helped some of these countries to reduce their debt and helped them to meet the Maastricht entry criteria. Italy, for example, paid around €110 billion in interest on its debts in 1996. By 1999 its interest payments had fallen to €79 billion. The risk premium element of their debts fell, and the partial transfer of the prestige of the Bundesbank to the ECB made the euro a more acceptable currency than southern European national currencies.
If the southern European countries were winners in this process, it looks as if the Germans were set to be net losers. What was the attraction for them?
Germans, of course, feared that the euro would be less stable than the Deutschmark, spurring inflationary expectations. It was plain to all that the German government was in fact using the Bundesbank’s monetary prestige to the benefit of the inflationary member states and to the detriment of the general German population. So the question we have to answer next is, why did the German ruling classes agree to the demise of the Bundesbank? Some polls show that up to 70% of Germans wanted to keep the Deutschmark, so why did the politicians override the will of the majority? The most feasible explanation is that giving up the Mark was seen by Germany’s political class as the price of achieving reunification in 1990, after the fall of the Berlin Wall.
The negotiators at the time included the two Germanies and the winning allies, namely the United Kingdom, the United States, France, and the Soviet Union. You have to remember that Germany was still subject to domination, since no peace treaty was signed with Germany after World War II. The allies continued to have special control rights after the Potsdam Agreement of August 1945 right up until the Two Plus Four Agreement of 1991. All four occupying powers—Russia in East Germany, the United States, France, and the United Kingdom in West Germany, were atomic powers with vastly superior military forces to Germany. This despite the fact that Germany is the most populated nation in Europe, is the strongest economically, and is located in the strategic heart of Europe.
The French and British governments in particular feared the power of a unified Germany, which they saw as potentially moving to dominate Europe. For more than a decade prior to unification the Bundesbank had repeatedly forced other nations to curtail their printing presses and their inflationary ways, or to realign their foreign exchange rates. There have been a number of press articles (for example, “Mitterand forderte Euro als Gegenleistung für die Einheit” in Spiegel Online, September 25, 2010) which show that the French President, François Mitterrand, demanded the single currency as a condition for his agreement to unification.
Horst Teltschik, chief foreign policy advisor to Chancellor Helmut Kohl, told journalists that “the German Federal Government was now in a position that it had to accept practically any French initiative for Europe (Vaubel, 2010, p. 83). Hans Albin Larsson (2004, p. 163) points out that “The European Monetary Union [EMU, the precursor to the euro] became an opportunity for the French to get a share of German economic power. For the German Federal Chancellor Kohl, the EMU was an instrument to make the other EC member states accept the German reunion and consequently a larger and stronger Germany in the heart of Europe.”
The ECB was modeled on the Bundesbank, but you suggest that it was flawed from the start. Why?
A key idea here is the “tragedy of the commons” in banking. This is a term coined by the American ecologist Garrett Hardin. First you need to grasp the idea of externalized costs. These are costs that an agent can shift to others because of poorly defined property rights. If a factory can dump waste in a private lake, it externalizes that cost to someone else. In a “tragedy of the commons” multiple agents can externalize costs. Take shoals of fish in the ocean. A fisherman benefits by fishing the shoal but reduces its size for others. Where there are multiple fishermen, they will all seek to grab as many fish as they can before the resource runs out. Hanging back does not conserve the fish since someone else will net them. In a tragedy of the commons, a resource is totally consumed because there is no defined framework for controlling access or allocating rights.
The idea can be applied to our modern banking system, where any bank can produce fiduciary media (i.e. unbacked demand deposits) by expanding its loan-making. Traditional legal principles of deposit contracts are not respected, because the bank lends out demand deposits and earns interest. The temptation to expand credit is almost irresistible. The more credits that get put into circulation, the more prices go up, so everyone in society bears the costs induced by the expansion of bank credit. There are complexities here that have to do with the relationship between banks, but let us assume that they all agree to expand credit simultaneously. That allows them to remain solvent, to retain their reserves in relation to one another, and to make huge profits.
Where you have a central bank, it takes over the business of coordinating credit expansion, which allows banks the freedom to expand at will—subject only to two factors. These are: the control of the central bank, which may set limits to credit expansion; and the fear of hyperinflation.
In our fishing example, the ungoverned exploitation of the common resource can be managed through the introduction of monitored fish quotas; similarly, central banks can choose to monitor and regulate the credit expansion of banks. This happens through the requirement to hold minimum reserves, control of interest rates, and so on. Now we have the introduction of the euro, which brings in a third layer to go along with the central bank as monopolistic money producer, and a fractional reserve banking system. The institutional set-up of the euro in the EMU is such that all governments can use the ECB to finance their deficits.
The ECB does this by buying government bonds directly (this policy was started only recently, in May 2010) or, which amounts to the same thing, by accepting them as collateral for new loans to the banking system. The process works like this. When governments in the EMU run deficits, they issue bonds. A substantial portion of these bonds are bought by that nation’s banks. They are happy to buy their own government’s bonds, because they know that the ECB will accept these bonds as collateral and will then give new money as cheap loans to the banks. What do the banks buy their government bonds with in the first place? They buy them with the new money they have created.
This is a merry-go-round. The governments finance their deficits with new money created by banks, and the banks receive new base money from the ECB by pledging the bonds as collateral. There are brakes on this process, which explains why the euro is still with us and has not yet imploded. There is the not insignificant risk that banks, even local banks, might not want to purchase the bonds of a highly indebted government, or that the ECB will not be accommodative in the production of base money.
This risk is reduced in the eurozone by the fact that the whole project is widely seen as a political project aimed at tighter European integration. The default of a member state and its exit from the euro would be seen as not only a failure of the euro, but also as a failure of the socialist version of the European Union.
We have now reached the point where the implicit guarantee that stronger states would support the weaker and not allow the euro project to fail has transformed into an explicit guarantee. We have the €110 billion bailout fund from the eurozone and the IMF and a pledge of a further €750 billion from EU member states. In addition, from May 2010 the ECB began buying government bonds outright from banks.
What we have here, then, is the tragedy of the euro, which is on a par with the tragedy of the commons. The tragedy is the incentive that governments have to incur higher deficits, and then to issue government bonds that make the whole euro group take on the cost burden of those higher deficits. The costs show up as a diminution of the purchasing power of the euro. The perverse incentive for politicians is easy to state: why pay for higher expenditure by making yourself unpopular through raising taxation? Instead, simply issue bonds that will be purchased by the creation of new money. Ultimately the process drives up prices in the whole of the EMU, but local politicians escape blame since their role in driving up prices is not clearly visible to the public.
In this way the costs of extravagant government are externalized in the EMU. Add in the fact that, in democracies, politicians tend to focus on the next election rather than the long-term effects of their policies, and you have the making of a total disaster. The EMU is, ultimately, a self-destroying mechanism.