Ferguson, Niall, Newsweek
The Greek debt crisis could be the beginning of the end of Europe's answer to the dollar.
Crisis--from the Greek "krisis"--is one of many English words we owe to the ancient Athenians. Now their modern descendants are reminding us what it really means.
Just when it seemed safe to start using the word "recovery," a Greek crisis threatened to choke off the global rebound, and to terminate the very existence of the world's second-biggest currency. So serious was the situation that it took a European version of the 2008 TARP bailout of the U.S. banks to save the euro. In an unprecedented move, the European Union joined forces with the International Monetary Fund to pledge up to [euro]750 billion for Greece and other euro countries with spiraling fiscal deficits. If fully implemented, it will be the mother of all bailouts--and one of the biggest admissions of error in modern financial history. The design of the European currency has been fatally flawed from the outset. It just took the Greek crisis to expose it.
The euro seemed like such a good idea 10 years ago. Europe had already achieved remarkable levels of integration as a trading bloc. Monetary union offered all kinds of alluring benefits. It would end forever the exchange-rate volatility that had bedeviled the continent since the breakdown of the Bretton Woods system of fixed rates in the 1970s. No more annoying and costly currency conversions for travelers and businesses. And greater price transparency would improve the flow of intra-European trade.
A single European currency also seemed to offer a sweet deal. Countries with excessive public debt would get German-style low inflation and interest rates. And the Germans could quietly hope that the euro would be a little weaker than their own super-strong Deutsche mark. Best of all, it would create an alternative reserve currency to challenge the mighty U.S. dollar.
Still, when European Commission president Jacques Delors first proposed monetary union, it seemed a wildly ambitious project. Even when it was formally adopted, many economists--myself included--remained skeptical. It was far from clear that the 11 countries that initially joined up constituted an "optimal currency area." A single monetary policy would likely amplify, rather than diminish, the fundamental differentials between highly productive Germany and the less efficient periphery.
But the worst defect in the design of the Economic and Monetary Union (EMU), we argued, was that it united Europe's currencies but left its fiscal policies completely uncoordinated. There were, to be sure, "convergence criteria," which specified that a country could join only if its deficit was less than 3 percent of gross domestic product and its public debt was less than 60 percent. But even when these were turned into a permanent set of fiscal rules in the Stability and Growth Pact, there was no obvious way to enforce them.
The design of the EMU illustrates a profoundly important truth about human institutions. Just because you don't create a formal procedure for something you would rather didn't happen, that doesn't mean it won't happen. This was one of the reasons Britain decided not to join the single currency. A confidential Bank of England paper that circulated in 1998 speculated about what would happen if a country--referred to only as "Country I"--ran much larger deficits than were allowed. The result, the bank warned, would be a colossal mess.
Why? Because the new European Central Bank (ECB) was prohibited from bailing out a country with such an excess deficit by lending money directly to the government. Yet, at the same time, there was no mechanism for Country I to exit the monetary union. Make that "Country G."
For nearly nine years after Greece became the 12th EMU member on Jan. 1, 2001, the Cassandras appeared to have gotten it wrong. The euro was a triumphant success. Long-term interest rates converged. …