Two-tier EU a realistic, dangerous possibility

With Germany in charge, Europe is being split between creditors and debtors, writes George Soros

EUROPE has been in a financial crisis since 2007. When the bankruptcy of Lehman Brothers endangered the credit of financial institutions, private credit was replaced by the credit of the state, revealing an unrecognised flaw in the euro.

By transferring their right to print money to the ECB, member countries exposed themselves to the risk of default, like Third World nations heavily indebted in a foreign currency. Commercial banks loaded with weaker countries’ government bonds became potentially insolvent.

There is a parallel between the ongoing euro crisis and the international banking crisis of 1982. Back then, the IMF saved the global banking system by lending just enough money to heavily indebted countries; default was avoided, but at the cost of a lasting depression. Latin America suffered a lost decade.

Germany is playing the same role today as the IMF did then. The setting differs, but the effect is the same. Creditors are shifting the entire burden of adjustment on to the debtor countries and avoiding their own responsibility.

The euro crisis is dividing member countries into two classes — creditors and debtors — with the creditors in charge. As the strongest creditor country, Germany has emerged as the hegemon. Debtor countries pay substantial risk premiums for financing their government debt. This is reflected in their cost of financing in general. To make matters worse, the Bundesbank remains committed to an outmoded monetary doctrine rooted in Germany’s traumatic experience with inflation.

As a result, it recognises only inflation as a threat to stability, and ignores deflation, which is the real threat today. Moreover, Germany’s insistence on austerity for debtor countries can easily become counter-productive by increasing the debt ratio as GDP falls.

There is a real danger that a two-tier Europe will become permanent. Both human and financial resources will be attracted to the centre, leaving the periphery permanently depressed. But the periphery is seething with discontent.

Germany, as the largest creditor country, is in charge, but refuses to take on additional liabilities; as a result, every opportunity to resolve the crisis has been missed. Since a break-up of the euro would cause immense damage, Germany always does the minimum necessary to hold it together.

Most recently, German Chancellor Angela Merkel has backed ECB president Mario Draghi, leaving Bundesbank president Jens Weidmann isolated. This will enable the ECB to put a lid on the borrowing costs of countries that submit to an austerity programme under the supervision of the troika. That will save the euro, but it is also a step towards the permanent division of Europe into debtors and creditors.

The debtors are bound to reject a two-tier Europe sooner or later. If the euro breaks up, the common market and the EU will be destroyed, leaving Europe worse off than it was when the effort to unite it began. The later the break-up, the worse the ultimate outcome.

In my judgment, the best course of action is to persuade Germany to choose between either leading the creation of a political union with genuine burden-sharing, or leaving the euro.

Since all of the accumulated debt is denominated in euro, it makes all the difference who remains in charge of the monetary union. If Germany left, the euro would depreciate. Debtor countries would regain competitiveness; their debt would diminish in real terms; and, with the ECB under their control, the threat of default would disappear and borrowing costs would fall to levels comparable to the UK.

The creditor countries, by contrast, would incur losses on their claims and investments denominated in euro and encounter stiffer competition at home from other eurozone members. The extent of the losses would depend on the extent of the depreciation, giving them an interest in keeping the depreciation within bounds.

After initial dislocations, the eventual outcome would fulfil John Maynard Keynes’ dream of an international currency system in which both creditors and debtors share responsibility for maintaining stability. And Europe would avert the looming depression.

The same result could be achieved, with less cost to Germany, if Germany chose to behave as a benevolent hegemon. That would mean implementing the proposed European banking union; establishing a more or less level playing field between debtor and creditor countries by establishing a debt reduction fund; and eventually converting all debt into eurobonds; and aiming at nominal GDP growth of up to 5%, so that Europe could grow its way out of excessive indebtedness.

Whether Germany decides to lead or leave, either alternative would be better than creating an unsustainable two-tier Europe.

* George Soros is chairman of Soros Fund Management and of the Open Society Institute.

Copyright: Project Syndicate, 2012.

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