Prepare for a European Union Divided in Two/ How Germany can avoid a two-speed Europe

WSJ.com
March 21, 2011

Twenty-seven divided by two equals 17, with 10 left over. That's the new Euromath.

Sooner or later, the euro-zone financial crisis will be over. Greek, Irish, Portuguese and probably Spanish creditors will have neatly trimmed hair, the banks will have had to shore up their inadequate capital, German exporters will continue to cash the profits from the euro their southern partners have obligingly weakened, and the eurocracy will have found other reasons to meet. But Europe will not be the same.

It will be changed in two very important ways. First, the 27-nation European Union will have fractured into separate groups of 17 and 10. Second, the economies of the Gang of 17 will be centrally managed by a Franco-German coalition, while the nations among the 10 "leftovers" will fight a losing battle to effect the policies of the EU of which they are paid-up members. Peaceful coexistence between the 17 and the 10 is no sure thing.

The 17 euro-zone countries have made the direction in which they are heading very clear. The felt need to prevent defaults by its overly indebted members is leading to a more pervasive system of central economic management. The 17 are to have access to Germany's balance sheet, in return for which Germany is quite properly demanding a say in how they manage their economic affairs. Not only their budgets, but all the factors that affect their international competitiveness: methods of wage bargaining; the generosity of their welfare states, including the timing and terms of retirement; regulations concerning access to various occupations; and, most of all, tax rates.

It's not on for Greece to borrow money from the stronger euro-zone countries while operating loss-making, nationalized transport systems; or for euro-countries to index retirement benefits to wage rates rather than retail prices, with Germany the payer of last resort; or for one member to maintain corporate tax rates at half the level of the group average. It has become clear that a one-size-fits-all interest rate must be accompanied by more uniform fiscal and related economic policies. Joy unbounded in Paris as the long-sought French goal of a 17-nation euro-zone "economic government" comes closer to realization, marginalizing EU institutions.

The nations outside of the euro zone, the left-over 10, maintain their own national currencies, and retain control over their own interest rates. The value of their currencies can fluctuate, allowing depreciation if they are over-valued, and appreciation if inflation threatens. Their central banks can raise or lower interest rates in response to changing economic conditions. And to some extent they are free to follow the more liberal economic policies they prefer, rather than hew to the line set by the more anti-free-market euro-zone 17.

Those differences between the 17 and the 10 are creating a threat to the cohesion of the 27-member European Union. The euro-zone countries are developing rules for coordinated economic management without consulting the excluded group of 10. Next step: apply some of those rules to the 27-nation EU to prevent non-euro countries from gaining a competitive advantage over euro-zone members, as France and others complain Britain has done by allowing the pound to float, countenancing a less regulated labor market, and keeping regulation of financial services to an essential minimum.

The excluded 10 are well aware of their exclusion from meetings that set policies that will affect them. "It really rankles that they [Denmark and Sweden] can't get into important policy meetings," reports the Economist. Add Britain to the increasingly rankled as Brussels makes it more costly to employ part-time workers and weaves a new web of regulations around the U.K. financial services sector, and you have a core group that just might decide that exclusion from euro-zone summits makes membership in the EU less attractive. After all, majority voting allows the bloc of 17 to dominate rule-making in the EU.

France has a solution for the under-represented, non-euro countries: get rid of your national currencies adopt the euro, and get to have a say—a tiny one compared to Germany and ours, but a say nevertheless—in the rules being drafted to implement the new European-wide system of economic management. That has little appeal for many members of the excluded 10. Britain's economic reasons for refusing to buy a seat at the table by surrendering its own currency are rooted in basic differences from euro-zone countries—a more interest-rate sensitive economy, greater reliance on financial services, the need for a currency that adjusts to changing economic conditions. These remain as powerful a deterrent to membership as when they were first developed by then-Chancellor of the Exchequer Gordon Brown and the current shadow chancellor, Ed Balls.

Meanwhile, Sweden points out that its economy is the fastest growing in the EU, Danish voters believe they are not Ireland because the krone is not the euro, and euro members Greece and Ireland are wondering whether friends-in-need should have to pay usurious interest rates to their friends-in-deed.

The American colonies went to war to break away from Britain, and fought under the banner, "Taxation without representation is tyranny." The excluded 10 will have to decide just how long they want to tolerate marginalization before deciding that regulation without representation is equally tyrannical.

—Irwin Stelzer is the director of economic-policy studies at the Hudson Institute in Washington.

===========================================================================

FT.com

How Germany can avoid a two-speed Europe

By George Soros
Published: March 21 2011 13:49 | Last updated: March 21 2011 13:49

The so-called euro crisis is more than a currency crisis; it is also a sovereign debt and, even more, a banking crisis. The situation is extremely complex. This complexity has bred confusion and the confusion has political consequences. So Europe faces not only an economic and financial but also a political crisis. The various member states have formed widely different views and their policies reflect their views rather than their true national interests. The clash of perceptions carries the seeds of serious political conflicts.

The solution that is about to be put in place will be effectively dictated by Germany, without whose sovereign credit no solution is possible. France tries to influence the outcome but in the end must yield to Germany because its triple A rating is dependent on being closely allied with Germany.

Germany blames the crisis on the countries that have lost competitiveness and run up their debts. Consequently, Germany puts all the burden of adjustment on the debtor countries. This is a highly biased view that ignores the fact that this is not only a sovereign debt crisis but also a currency and banking crisis – and Germany bears a major share of responsibility for those crises.

When the euro was introduced it was expected to create convergence but it brought about divergence instead. The European Central Bank treated the sovereign debt of all member countries as essentially riskless and accepted them at its discount window on equal terms. Banks that were obliged to hold riskless assets to meet their liquidity requirements were induced to load up on the sovereign debt of the weaker countries in order to earn a few extra basis points. This lowered interest rates in Portugal, Ireland, Greece, Italy and Spain and generated housing bubbles – at the same time as Germany had to tighten its belt to cope with the costs of reunification. The result was a divergence in competitiveness and a banking crisis that affected German banks more strongly than most of the others. Truth be told, Germany has been bailing out the heavily indebted countries as a way of protecting its own banking system.

The arrangements imposed by Germany protect the banking system by treating the currently outstanding sovereign debt as sacrosanct; they also put all the burden of adjustment on the debtor countries. These arrangements are reminiscent of the international banking crisis of 1982, when the international financial institutions lent the debtor countries enough money to service their debts until the banks could build up sufficient reserves to exchange their bad debts for Brady bonds in 1989. That caused a “lost decade” for Latin America. Indeed, the current arrangements penalise the debtor countries even more than in the 1980s because they will have to pay hefty risk premiums after 2013.

There is something inconsistent in bailing out the banking system once again and then bailing in the holders of sovereign debt after 2013 by introducing collective action clauses. As a result, the European Union will suffer something worse than a lost decade; it will endure a chronic divergence in which the surplus countries forge ahead and the deficit countries are dragged down by the burden of their accumulated debt. The competitiveness requirements will be imposed on an uneven playing field, putting the deficit countries into an untenable position. Even Spain, which entered the euro crisis with a lower debt ratio than Germany, could be dragged down.

Berlin is imposing these arrangements under severe pressure from German public opinion, but the German public has not been told the truth and is therefore confused. The solution to the euro crisis to be put in place at the end of March will set in stone a two-speed Europe. This will generate resentments that will endanger the EU’s political cohesion.

Two fundamental modifications are required. First, the European Financial Stability Facility must rescue the banking system as well as member states. This will allow the restructuring of sovereign debt without precipitating a banking crisis. The size of the rescue package could remain the same because any amount used for recapitalising or liquidating banks would reduce the amount lent to sovereign states. Bringing the banking system under European supervision rather than leaving it in the hands of national authorities would be a fundamental improvement that would help restore confidence.

Second, to create an even playing field, the risk premium on the borrowing costs of countries that abide by the rules will have to be removed. That could be accomplished by converting the bulk of the sovereign debt into eurobonds; individual countries would then have to issue their own bonds with collective action clauses and pay the risk premium only on the amounts that exceed the Maastricht criteria. The first step could and should be taken immediately at the European summit on Thursday; the second will have to wait. The German public is a long way from accepting it; yet it is needed in order to re-establish a level playing field. This has to be made clear in order to give the deficit countries hope that they can escape from their deficit predicament if they work hard enough at it.


As for Mr. Soros: