In the 1990s, when European monetary union was a plan but not a reality, I would explain to students that the effect was to replace currency risk by credit risk. With exchange rates free to float, loose monetary and fiscal policies would lead sooner or later to a fall in the exchange rate. That expectation implied higher interest rates. Currency markets would limit the scope for bad economic policies.
Monetary union meant sovereign governments could no longer print money. That change put them in the same position as any other borrower: and substantially increased the likelihood of default. Like businesses or households, governments would find that profligacy made loans more and more costly and difficult to obtain. Credit markets would limit the scope for bad economic policies.
This was how decentralised budgeting worked in the US. The federal government does not guarantee the solvency of the states, which can and do go bust – and, as several economic historians have pointed out, have done so without damage to the federal government’s credit. Last year, California’s issue of 30-year Build America bonds was set to yield 325 basis points above comparable US Treasuries – and no one suggested that this divergence put the US single currency in danger. Within the eurozone, interest rate spreads would be set differently, and might be narrower or wider.
The account I gave these students was profoundly misleading. Interest rates across the eurozone quickly converged. By 2007, European countries with much worse economic situations than California could borrow at rates no more than 20 or 30 basis points higher than Germany. The graph of interest rate spreads across Europe is one of the most widely used in economic presentations. But the significance of that graph is not the vicissitudes since 2007, but the convergence and stability that preceded it.
Why were interest rate spreads in Europe so small? Many participants simply did not care about default possibilities. If there was any interest rate differential at all between eurozone countries, a profitable carry trade was to be long the weaker country and short the stronger one, to finance Greek assets with German liabilities. In a banking book, such a position necessarily yielded regular profits until an actual event of default took place, which would certainly not happen within the next few months. And modern bankers rarely have longer time horizons than a few months.
But markets also doubted whether default would happen. They correctly judged that the European Union’s institutions would use financial irresponsibility in one part of the EU, not to reiterate the independence of individual states, but to emphasise the interdependence between them. When New York crassly mismanaged its financial affairs, the president’s response was famously paraphrased as “Ford to City: drop dead!” When Greece was guilty of similar mismanagement the reaction of the ECB and the European Commission was “how can we help?”.
The crisis in Greece – and Ireland and Portugal and perhaps elsewhere – is a crisis for Europe as a whole. Not because that is the nature of a single currency, but because Europe has consciously chosen to make it one. From its inception, the guiding philosophy of the EU was that if you took every opportunity to promote the mechanisms of integration, political and economic reality would eventually catch up. That was the vision of Robert Schumann and Jean Monnet, and their strategy was successful beyond their dreams.
But such a policy was always risky, because if institutions did not match aspirations then the resulting strains would jeopardise not just future progress but the gains already made. The fate of those who push their luck until it runs out is one of the most familiar stories of business, politics and finance – and is the fate of Europe today. Perhaps we could instead learn some lessons from across the Atlantic. The US has, on the whole successfully, combined an affirmation of states’ rights with a powerful federal government, and has maintained a stable currency union since – well, 1865.