An Interview with Brian Milner

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July 29, 2011

Was the current European crisis caused by a “lack of stability culture” or by the flawed architecture of the single-currency system?

Brian Milner: Both, really. The competitive gap between the wealthier euro-zone members and Greece, Portugal, and probably Ireland was far too wide to be bridged by the flexibility of a single currency and the capacity to borrow vastly larger sums at much lower interest rates. But the euro zone has always been a political construct, not one based on coherent fiscal or economic policies. The idea was that the poorer countries would move closer to the German model, and that increased labour mobility and access to bigger markets and cheaper capital would boost competitiveness by lowering production costs. But, as many experts warned, Greeks really didn’t want to leave their sunny climate for jobs in northern factories; and the Germans, French, and Dutch didn’t want them anyway.

Also, as we know, the flood of capital that washed into Greece, Portugal, Spain, and Ireland was not directed at making their economies more competitive.

Numerous analysts, including Milton Friedman, warned that without a fiscal union to go along with the monetary one, the whole house of cards would be in jeopardy at the first sign of major financial distress. And they turned out to be right.The Maastricht treaty laid out certain rules for qualification – notably, setting limits on deficit and debt to GDP ratios. I have interviewed one of the architects of the treaty, who said the provision was put in place because no one trusted the Italians. As it happened, Greece and Portugal fudged their numbers even more, claiming much lower ratios than actually existed. But the European Commission had no mechanism for auditing the finances of individual countries.

So the architecture was flawed from the beginning. Not only were there no means by which to hold violators of the deficit rule to account, there were also no penalties prescribed, nor were there any rules allowing members to be booted out for any reason. If the political goal is a Europe-wide political union, starting with trade and economic policies and then monetary union, you’re not going to make it easy for members, weak or strong, to leave whenever they feel like it.

Based on your answer to (1), are the weak members of the EU community to blame? Or do the stronger members deserve blame as well?

BM: Rather than taking advantage of the optimal borrowing conditions and strong currency that prevailed between 2001 and 2007 to get their fiscal houses in order, and instead of adopting industrial and labour strategies that would make their economies more competitive within Europe, Greece et al. chose to embark on disastrous policies of heavy spending, much of it in the public sector. Ireland and Spain ended up with unsustainable housing bubbles. Greece ended up with a bloated bureaucracy, the richest public-pension scheme in Europe, and so much red tape that it strangled private-sector growth.

But we can’t hold the stronger members blameless. The Germans, who fear inflation above all else because of their experience during the 1920s, effectively control the European Central Bank, whose tight monetary policies made life considerably harder for the weaker economies. Also, the first countries to formally violate the deficit ratios were Germany and France, so they could hardly throw stones at the smaller members or seek to enforce tougher rules.

Will the euro survive the crisis?

BM: The euro has proven far more resilient and popular than skeptics imagined back in 1999. But its chances of long-term survival in the absence of some sort of sturdy fiscal union seem bleak. One possibility is a breakup into two separate zones, one grouping the stronger economies and the other accounting for the rest. Sort of like the former French African colonies that kept a version of the French franc. But I don’t see that as very likely, either. In the shorter term, no one is leaving or getting thrown out. If the Greeks abandoned the euro for a vastly cheaper drachma, their debts, denominated in euro, would soar dramatically. And even a massive devaluation won’t make their feeble economy much more competitive.

The Germans may hate the idea, but the best way to safeguard the euro over the next few years is to make hefty transfer payments from the wealthier members to the weaker states. Fiscal transfers combined with more debt relief offer the best solution.

Would the breakup of the “one-currency-fits-all” model represent a “Lehman moment,” triggering another slump? And, on a related point, how tied up are U.K. banks in the crisis?

BM: It certainly wouldn’t be pretty, but a large chunk of Europe is already in a slump. Whether the risks spread through the global financial system, and, in turn, spill over into the economy, depends on how well foreign banks have managed to insulate themselves from the risks of default in the weaker countries, as well as on the levels of exposure through derivatives deals. Most of the major banks, including the British ones, have been writing down their dodgier assets and reducing exposure. And few banks hold much in the way of credit default swaps on Greek or other sovereign debt. As for the Brits, I know they did some hefty lending on the continent, and I don’t have the numbers off hand. But their exposure is below that of the German and French banks and the ECB itself.

But I would note that the global financial system and global markets are at least as closely intertwined today as they were in 2008 when officials who paid no heed to the potential global repercussions pulled the plug on Lehman. And I think a failure of the euro would have similarly far-reaching consequences.

How far are France and Germany willing to go to save the euro? What is their breaking point? Is it possible that Germany will, as Niall Ferguson alleged, kill Europe?

BM: As I said, if German and French taxpayers want no part of huge, and potentially endless, transfer payments (and who would?), there will be limits on what they’re prepared to do. As long as the poor members are willing to accept severe austerity measures and lower standards of living, France and Germany (and the Netherlands, Luxembourg, and probably Finland) will keep propping up the system – mainly because the alternative would be far worse. The Germans, especially, have benefited enormously from the euro thanks to their economic efficiency and high productivity. And the euro’s recent decline has been a huge boost to export earnings. The goal is to get through the next couple of years with more bailouts, get treaty changes that enforce tougher rules on fiscal management, and hope that their economies recover enough to enable Greece, Portugal, and Ireland to stabilize their finances. But even a default would not kill the euro. But if vastly larger Spain or Italy were to end up needing help, that would be a different story entirely. There isn’t enough money or taxation capacity in the EU to save them.