Dancing on the Euro volcano

The euro is celebrating its 26th birthday this year, but there is little cause for celebration. On the contrary, Europe’s common currency finds itself in a precarious situation reminiscent of a dormant volcano — seemingly stable, but with magma building up beneath the surface. When the euro was launched, it seemed like a masterpiece of European vision. A common currency without common finances — what could possibly go wrong? A lot, as it turns out. The architects of the euro understood the risks, but left crucial elements unfinished. They made no provisions for sovereign default and created no crisis management. It was like building a car without airbags because you never expect to crash. In 2003, barely five years after its launch, France and Germany — the two largest economies — were already breaking the debt and deficit rules. Without consequences. That was the start of a dangerous downward spiral of moral hazard.

The ECB as saviour

During the financial crisis of 2008 and the debt crisis of 2010, the European Central Bank was forced to take on the role of firefighter. Mario Draghi’s famous words, ‘whatever it takes,’ saved the eurozone at the time, but also set a dangerous precedent.

The ECB bought up government bonds on a massive scale, lent money to banks to buy more government bonds, and turned a blind eye to countries financing their balance of payments through the TARGET2 system. These rescue measures worked in the short term, but reinforced the underlying problem. Countries had fewer incentives to get their finances in order. Banks stuffed themselves even fuller with government bonds because they knew the ECB would always be there to bail them out. It was like helping a gambling addict by taking on his debts — it solves the immediate problem, but makes the underlying addiction worse.

Today, Europe is still in dire straits. Overregulation and bureaucracy are stifling innovation and growth. Government debt has risen dramatically. The ECB is stuck with huge portfolios of government bonds. Banks remain full of government bonds, which means that any government debt crisis automatically becomes a banking crisis. Worst of all, Europe is awash with moral hazard. Governments have little incentive to govern wisely, reduce debt or implement growth-oriented reforms. Investors no longer need to scrutinise sovereign risks because the ECB will intervene regardless.

The divergent nature of the eurozone

The next crisis will put European sovereign debt to the test. This crisis will quickly become too big even for the ECB to handle without chaotic defaults, financial meltdown or sharp inflation. We have already seen the signs during the inflation wave of 2021–2022, when the ECB continued to push ahead with bond purchases while prices rose.

The dramatic story of Italy versus Sweden perfectly illustrates how destructive the euro can be. Both countries had similar economic fundamentals when the euro was launched. Since then, Sweden’s economy has grown by 43%, while Italy’s has shrunk — one of the few developed countries in the world to have suffered such a fate.

But the comparison between Italy and Germany within the eurozone is even more shocking. Until 1998, both countries operated according to normal economic laws: as Germany became more productive, the lira devalued to compensate for the difference. By 1995, one German mark bought 1,300 lire, compared to 275 in 1975. This adjustment mechanism disappeared abruptly with the launch of the euro in 1998. Without an exchange rate adjustment, a structural divergence began. German companies received higher returns on invested capital, and Italian companies received lower. The Germanification of the European Union had begun.

France versus Germany shows the same pattern. This divergence is not temporary but structural — as long as the euro exists, France cannot devalue to restore its competitive position. The result is rising unemployment and an increasingly weak international position. Compare the Netherlands with Switzerland: before the introduction of the euro, their levels of prosperity were more or less comparable, but now they are incomparably different.

Italy is trapped in a monetary straitjacket. But because it uses the euro, it cannot devalue and remains stuck with positive interest rates that are too high for the Italian economy. The result is a vicious circle: lower profits lead to less investment, falling productivity, higher unemployment and lower tax revenues. Italy has fallen into a debt trap three times since 2000, with public debt exploding from around 100% to over 150% of GDP.

The problem is that the natural correction mechanisms no longer work. In a normal economy, capital and exchange rates would adjust to equalise returns. But the euro has made this adjustment impossible, causing economies to diverge structurally instead of converging. In physics, diverging systems always explode, while converging systems do not. The broader problem is that even northern European countries such as Germany may have fallen victim to the euro system. Twenty years of ECB market manipulation have led to capital misallocation and structurally lower returns. There are no winners — only losers.

Time for real reforms

Europe still has a chance, but only if it implements fundamental reforms. First, a European fiscal institution must be established that can provide rapid support with conditions, so that the ECB no longer has to play the political role of saviour. State bankruptcy must remain an option; otherwise, such an institution will have no bargaining power.

Second, banks and regulators must treat sovereign debt for what it is: risky. Banks must reduce their government debt holdings and diversify their portfolios further. Third, the ECB must reduce its government bond portfolio and stop constantly suppressing risk diversification between countries. Finally, Europe needs growth. Without economic dynamism, it remains a weak house of cards.

Europe faces a choice. It can continue on its current path of crisis management and symptom control, or it can finally implement the fundamental reforms needed for a sustainable monetary union. The irony is that since 2000, Western central bankers have decided that they know better than the markets. There is no legal mechanism for withdrawal. Countries can unilaterally terminate treaties, but doing so would likely lead to chaos and civil unrest. Markets desperately want to believe that the euro can work. Politicians and central bankers have broken every rule and every treaty to keep the Union afloat. It is reminiscent of the Soviet Union in its final years, with Macron in the role of Gorbachev.

The irony is that the euro was intended to make Europe stronger. But without fundamental reforms, it is now the weakest link. No transfer of funds from north to south will solve this as long as countries such as Italy remain trapped in a monetary system that does not fit their economic reality. The question is not whether there will be another crisis, but whether Europe is ready for it. At the moment, the answer is no.