The euro is mature, but still has growing pains

How did we get here?

It was with confetti and there was dancing on the table, but a party it was not. When the left-wing activist Josephine Witt jumped on the table in front of a bewildered Mario Draghi in 2015 – shouting “Put an end to the dictatorship of the ECB” – she probably signed up for the most bizarre protest against the European Central Bank’s policies, but by no means the only one.

Witt summarised her motivations afterwards: central bankers are technocrats, there is no democratic legitimacy and citizens have no control over what happens in the economy.

On the other hand, there is criticism from conservative quarters. The ECB is not technocratic enough, it pays too much attention to the wishes of politicians and it fails to live up to its raison d’être: guaranteeing price stability.

It illustrates the split into which the policymakers behind the euro have landed, a consequence of construction errors that go back 30 years to 9 December 1991. That is when the foundations were laid for the euro, which was launched eight years later. For eight years, almost everything went well. There was praise. The shared currency made international travel and payments a lot easier and cheaper. Entrepreneurs happy, citizens happy, politicians happy.

But the eurozone did not enjoy a carefree decade. In 2008 the financial crisis broke out, followed by the euro crisis. Suddenly, it turned out that the currency union also had a lot of drawbacks. The northern European countries had to contribute to keeping Greece, Portugal and Ireland afloat because the credibility of the euro was at stake. Once scrambled, it is impossible to get the eggs back out of the omelette. That was supposed to be the message to the financial markets.

Yet it is far from an even omelette. The nineteen eurozone countries have their own labour markets, pension systems, government policies and different administrative cultures. Implementing a single monetary policy for all of this is proving to be problematic. For some it is too strict, for others too flexible. Germany and the Netherlands, for example, have been complaining for years that interest rates must be raised because higher inflation is eating away at the purchasing power of savings. No, keep it low, or preferably even lower, is what southern Europe is asking, which is carrying towering government debts.

Reforms are necessary, everyone has realised that. But which reforms? One group believes in creating a fully-fledged political union with structural solidarity between euro countries. Give the ECB more powers, that’s enough, it says elsewhere. Frankfurt can then help realise the transition to a sustainable economy, and work in a more tailor-made way for individual countries. Still, others see only one good reform: call it a day. Back to the guilder, the franc, the mark, the lira. How could we have come this far in the last 30 years, and how far will it still go?

How it started

Why did the euro come about in the first place? There have been ideas about a single European currency since the 1970s, but first, a wall has to come down before progress can be made. Germany reunited in 1990, making it demographically and economically a lot larger than the other European countries.

The French, in particular, are afraid of a repeat of the past and demand that Germany anchor itself in Europe. We need a European Union in order to keep a potentially dangerous Germany in Europe under control,’ declares Chancellor Helmut Kohl. Germany is promising to enter a monetary union, and thus to give up its rock-solid mark for the shared euro.

The Netherlands is to be seen as one of the founding fathers of the euro, although this comes with a diplomatic setback. In 1991, as president of the European Community, the Netherlands proposed the establishment of a European Political Union, whereas in previous decades it had fought tooth and nail against it.

It is a step forward: better that Brussels should have more say, than the Berlin-Paris axis. The Dutch plan only gets support from Belgium and is therefore directly thrown in the bin. The Netherlands was a goner,’ explains Foreign Affairs Minister Hans van den Broek later.

In order to wipe out the loss of face, the Netherlands is working on the Maastricht Treaty, which the 12 EC Member States will sign on 9 December and which also lays the foundations for Economic and Monetary Union (EMU). Not everyone is allowed to join just like that. Candidate countries have to fulfil a number of conditions. The national debt may not exceed 60% of the gross domestic product (GDP) and the budget deficit must be less than 3%. Furthermore, inflation has to be kept under control.

Major obstacles, as is evident from the evaluation in 1997. Only four countries meet all the conditions and only two still want to join: Luxembourg and France. Denmark and the United Kingdom pass. Fortunately for the Netherlands, which by then had a debt ratio of 72%, it soon became clear that political considerations also counted when assessing a country’s candidacy for the eurozone. As a result, all aspirants receive a green light, except for Greece.

The countries that have joined the euro area together have been sharing the euro since 1999, starting on paper. It was not until 2002 that the eurozone residents actually got their hands on the coins and notes. Then the advantages become apparent. Before the introduction of the euro, those who travelled with 1,000 D-Mark through the nineteen euro-countries and had that amount exchanged for the local currency in each country, eventually returned with 735 D-Mark. And then, apart from the 2% exchange commission, you had not spent anything.

The euro is also advantageous for entrepreneurs. Before the euro, for example, they always had to keep an eye on whether the currency used to pay foreign customers was not depreciating too much. That would be seriously detrimental. To avoid negative exchange rate effects, they, therefore, hedge their currency risk, but that is far from free. In 1990, the European Commission calculated that the cost of this is equivalent to 0.07% to 0.08% of the GDP of the European Community, which then consists of twelve countries.

The number of countries adopting the euro has been growing over the years. The Baltic States, which joined the EU in 2004, are embracing the single currency, as are Slovakia, Slovenia and the island states of Cyprus and Malta. Croatia and Bulgaria want to say goodbye to their own currencies soon. But euro adoption is a curse in Poland, Hungary, the Czech Republic and Romania. They are in no hurry whatsoever.

Nor are they the only sceptics. According to the European treaties, the ultimate goal of all EU member states is to adopt the euro, but the ‘old’ member states Sweden and Denmark never went for it. The Danes even negotiated an opt-out. Although the Danish krone is in name only an independent currency, in practice it is linked to the euro and cannot, therefore, gain or lose value against the single currency.

Who actually defends the young euro? It has been the European Central Bank since 1999, with Dutchman Wim Duisenberg as its first top executive. The main task of the ECB is to guarantee price stability.

It does this mainly by making it cheaper or more expensive for citizens, companies and governments to borrow money. Sounds simple, but it is actually quite complex.

Communicating clearly about monetary policy is a gift anyhow, as former chief economist Peter Praet once painfully illustrated.

1 January 2002 is the real date: Europeans in twelve countries will be able to pay with euro banknotes for the first time. 

There is a simple reason why the currency is called “euro” and not “ECU” (the name of its temporary predecessor). The ECU was the name of an old French currency, and the Germans do not want to hear about it. The design of the banknotes is also a matter of negotiation. Images of European figures such as Jean Monnet or Paul-Henri Spaak proved too French or too Belgian.

The first cracks

The first years of the euro were relatively smooth. But then a storm arose. It is about the very essence of doing business, and more specifically of borrowing money: trust. A bank makes money available on the assumption that the borrower can repay the loan. Usually, the bank asks a prospective debtor all the questions he or she needs to know.

About collateral, about assets, about past profits that are no guarantee for the future. About prospects. But apart from hard data, there is also trust. Or not. Trust is something intangible that can suddenly disappear. This became apparent in 2007 at the start of the credit crisis, which will develop into the euro crisis.

The problem arises in the United States. There, banks have packaged packages of mortgages into financial products. Without exception, these are given a solid rating by credit rating agencies. Only, with these packages, the phenomenon of the swimming pool puddle kicks in.

It works like this: if a hundred people go to the swimming pool and one person says he peed in it, nobody wants to go swimming any more. Translated into the credit crisis: the packages of mortgages also turn out to contain rubbish. But nobody knows how much.

This has an evaporating effect on confidence. Nobody dares to say with certainty what the value of the packages of mortgages is, and so banks do not know how financially sound investors and other banks are. So they no longer lend money to those parties.

The biggest banking crash was that of the US investment bank Lehman Brothers in 2008. But European banks are also in trouble. Financial institutions need billions in support. Member States are setting up enormous support schemes for banks. 

In the eurozone, the banking crisis is a multi-headed monster. In a country like Spain, the banks have not made risky foreign investments, but are addicted to bricks. They have given far too much money to the property sector. The same is true in Ireland.

But one country has come to symbolise the euro crisis: Greece. In the autumn of 2009, it turned out that Athens had been fiddling with its budget figures. The financial markets, which had always thought that a eurozone country could count on being rescued by other eurozone countries, were startled when the question arose whether the rest of the world really wanted to help Athens. Greek interest rates explode.

The euro countries rescued Greece by giving it loans. In the process, they also saved their banks, which had money outstanding in Athens. In exchange, the Greeks have to economise, and drastically. Greek pensions are being axed, Athens has to sell all its silverware to raise money and civil servants are losing their salaries.

The ECB has been watching from the sidelines for quite some time during the crisis. Monetary dogma dictates that a central bank must be a lender of last resort, and must therefore come to the rescue when the need is greatest. But the ECB is young, and does such a thing fit into its mandate?

Only when the banking crisis has turned into a country crisis – does ECB President Jean-Claude Trichet step in. When the eurozone set up its first emergency fund in May 2010, he lent a helping hand.

On the night of the crisis, 9-10 May, Trichet waited for the eurozone countries to agree on the emergency fund and then gave the order to buy up loans from eurozone countries in need. In this way the ECB will reduce the interest these countries have to pay for new capital.

But Trichet’s relationship with politics remains difficult. When, in the autumn of 2010, he emotionally objected to a Franco-German deal at an EU summit, made during a walk on the beach by German Chancellor Angela Merkel and French President Nicolas Sarkozy in the Normandy resort of Deauville, he was given a negative response.

This deal stipulates that investors must contribute to future rescues of euro countries. The ECB President is certain that this will lead to the crisis flaring up again.

Other countries share Trichet’s concerns. Greek finance minister George Papaconstantinou calls the Franco-German collusion ‘a disaster’. Now that investors know for sure that they will have to pay back their claims later, they demand an even higher fee for providing credit.

Few are listening to Greece at the moment. But when Trichet speaks, things are usually different. Sarkozy, however, bars the bank president from speaking at the EU summit in the autumn of 2010. Where was Trichet in 2009 when the eurozone was in danger of collapsing?

The ECB chief will not say. He left his plate untouched at the dinner of EU heads of government in Brussels, resigned and left the heads of government to stew in their own juices. The ECB cannot be expected to perform monetary stunts under his leadership.

Saviour in need

The ECB should be as similar as possible to the German Bundesbank (‘BuBa’), Germany once demanded. Strictly independent, with a mandate strictly focused on controlling inflation. No tomfoolery and no debauched, devaluing behaviour that southern euro zone central banks have often indulged in.

Suspicion in Berlin and Germany’s financial heartland, Frankfurt, is therefore high when an Italian stands in for Jean-Claude Trichet as President of the ECB at the end of 2011. An Italian? That can’t mean much.

But when German media lift Draghi’s lid, they are reassured. The former top Italian official, central banker and former Goldman Sachs employee could also have been called Von Drachenstein, they believe, from Draghi’s monetary views. Sensationalist newspaper Bild, therefore, depicts the Italian central banker with a Pickelhaube, a Prussian helmet. Draghi even receives one.

It is a gift that Bild will later regret. First, Draghi crowned himself king of the EMU, saying in a speech in July 2012 that the ECB would do ‘everything in its power’ to save the currency. ‘And believe me, that will be enough.’

Markets believe Draghi: the EMU storm is subsiding, and even rumblings about a new rescue package for Greece are not leading to new thunderclouds. However, grumblings around the ECB headquarters in Frankfurt are gradually growing.

To meet the ECB’s inflation target, the central bank is going to pump more and more money into the financial system through bond purchases in an attempt to prevent a damaging deflationary spiral.

That is the official story. The unofficial story is that the ECB, with its buying policy, is also pushing down the interest rates of southern euro countries, thus making their national debt more sustainable. Savers in northern Europe feel they have to pay for the south.

The ECB is thereby failing spectacularly to achieve its target – an inflation rate of around 2%. And that while the policy interest rate is even below zero. This means that savers have to pay to keep their money in a bank, the world upside down. Few banks dare to actually introduce negative interest rates. In Germany, however, it is happening for the first time, but only for very wealthy customers.

At the end of Draghi’s term, Bild wants his Pickelhaube back, which Draghi refuses. Once given, remains given, he says. German confidence in the ECB is completely gone. Money can be printed, trust cannot’, as the German publicist Hans Magnus Enzensberger once put it in an interview.

Draghi’s successor, ex-IMF top woman Christine Lagarde, also former finance minister of France, is not making things any better. It will become even easier to buy even more Italian debt paper. In Northern Europe, this could lead to the question ‘for whom does the ECB work?

Critics say that because of all the monetary stimulus, the ECB’s balance sheet has now grown into a runaway fungus that takes possession of a loaf of bread. If you look at a graph of that balance sheet, you think you see a corona explosion.

1999-2008 A global financial crisis begins when the US investment bank Lehman Brothers collapses on 15 September 2008. The ECB’s peaceful beginnings are definitely over. The bank has to pull out all the stops to support the economy. It lowers interest rates and completely opens the money supply to banks.

2008-2012 In May 2010, the ECB started buying government bonds for the first time, in order to reduce the financing costs of troubled eurozone countries. This purchase programme is controversial, temporary and half-hearted. In the meantime, Europe’s politicians are cobbling together various emergency funds to provide cheap loans to impoverished eurozone countries. But financial markets doubt whether they have enough money in cash.

2012-2015 In July 2012, ECB President Mario Draghi removes all doubt: the ECB is prepared to buy government bonds en masse to convince investors that the euro is here to stay. The credibility of that statement is such that this ‘bazooka’ does not need to fire a shot. Interest rates on peripheral government paper will fall by themselves.

2015-2020 In March 2015, the ECB will launch a new buy-back programme, and this time the money press will indeed be running. According to Draghi, buying up debt paper should avert ‘disastrous deflation’. A fall in the general price level could send an economy into a downward spiral of falling prices and lower wages, and thus into a deep recession.

2020-present The coronavirus spreads from Asia to Europe, infecting the whole economy. The ECB wants to keep interest rates low in order not to endanger lending in the eurozone. A special pandemic-buying programme is set up, for which the central bank allocates €1850bn. For that money, every eurozone citizen can eat a Big Mac every day for almost ten years. Or get one Citroën C4 (list price €23,150) for free,

Meanwhile, European governments are already allowed to offload a third of their debt to Frankfurt. In Germany, few positive words are heard about the monetary authority and criticism of the ECB is permeated with nostalgia for the old ‘BuBa’, whose President Jens Weidmann does not hide his dissatisfaction with the accommodating policy in the here and now.

But nostalgics often suffer from selective memory. Before the ECB, not every German walked away with die gute alte (the good old)  BuBa. Let the Bundesbank cut interest rates to support the economy, said the German Finance Minister Oskar Lafontaine in 1998, less than a year before the ECB was set up.

Where to go from here?

The eurozone has learned lessons from the crisis, but that does not mean the lessons have been fully applied. If the EMU is a chair, at least one leg is missing and there are questions about what kind of load the frame can take.

First the missing leg. EMU still lacks a European deposit guarantee scheme that would protect savers’ deposits to a serious level when banks are in danger of crashing. Although there are national regulations, the question remains whether each Member State can deploy enough financial ammunition to prevent a bank run. Political wrangling between North and South stands in the way of an agreement on this saver protection.

The same clash occurs in the discussion about the ‘frame’ of the EMU, the rules of the Stability and Growth Pact (SGP). The pact dictates that a budget deficit may not exceed 3% of GDP, and the national debt may not exceed 60%. The EU overrode both rules during the corona-pandemic. But many economists found them hardly workable anyway, and their enforcement by the European Commission arbitrary. The EU executive never applied sanctions from the SGP and looked away when France and the other Member States got a grip on the agreements.

Member States are fed up with the SGP straitjacket. They believe, for instance, that investments should no longer be included in the calculation of the budget deficit. Greece even states that defence expenditure should remain outside of the pact. And Germany is willing to discuss a revision, but also thinks that rules are rules and that this is the case for a reason.

For the ECB, in recent years the most important player in the EMU, there are two other challenges. How should the bank deal with crypto-currencies? Should it develop such a currency itself in order to stop other crypto currencies in their tracks? And how will the monetary authority credibly reconcile its policy goals with its philosophy on sustainability?

These are open questions. The EMU has been in existence for 30 years, but it is still a work in progress.