Euro Crisis

Political motives swept economic logic aside

Harald Benink assumes that a few countries will leave the eurozone in exchange for debt relief

"The history of the euro has been dominated by political motives and, where convenient, economic reality has been ignored," says Harald Benink, Professor of Banking and Finance at Tilburg University. One consequence has been moral hazard, a phenomenon which undermines the disciplinary effect of the financial markets. "Greece was admitted to the eurozone because it was the cradle of European democracy. That is a specious argument."

Moral hazard afflicted the euro even before its introduction. "The interest rates in the countries that would take part in the common currency had started to converge before the euro even came into existence," continues Benink. "Investors had realized that lending to Portugal or Greece would hardly be more risky than lending to Germany or the Netherlands. As all these countries were going to form a monetary union, investors would always get their money back. That was the assumption." 

Whether or not it is justified, investor confidence of this kind can disrupt financial markets. Bondholders in 'normal' companies can tackle the management if they feel that unduly large risks are being taken. This is because bondholders have nothing to gain from risk-taking. Only shareholders would benefit from the extra profits. The response of the bondholders is therefore important. "They may, for example, require the management to keep larger capital buffers," says Benink. "Or they may demand a higher risk premium."  In this way, financial markets have a disciplinary effect.  

Blithely unconcerned
The incentive for providers of capital to keep a close watch on the degree of risk posed by their investments vanishes if they are able to rely on – explicit or implicit – guarantees.  "This is also true of the banking industry," explains Benink. "On the assumption that countries cannot permit their large banks to go bankrupt, investors blithely continue to fund these institutions. Nor do they feel the need to tackle the management on issues of policy. After all, investors will always get their money back if things go wrong, won't they?"

The analogy with the euro crisis is clear. The southern eurozone countries have been able to borrow unlimited funds at low interest rates because it was always assumed that the entire eurozone would guarantee the debts of a member state. Investors felt no need to warn about unbalanced budgets, although everyone could have foreseen that this would ultimately result in unsustainable debt burdens."

"The crisis only really broke out when it became apparent how Europe was dealing with the Greek problem," says Benink. "European unity was by no means great enough to send a convincing signal to the financial markets. It became apparent that the provision of general guarantees was out of the question. Instead, the member states embarked on protracted negotiations about who should contribute how much and when, and the private banks were also dragged in. This lack of unity and action made the crisis unnecessarily large: investors became nervous and fears of contagion spreading to other countries could not be dispelled."

East Germany
So does the euro still have a future? Benink believes it does if two past mistakes can be rectified. "In the run-up to the signing of the Maastricht Treaty in December 1991 the Netherlands, which then held the presidency of the European Union, tried to secure the adoption of much stricter agreements on the budgetary policy to be pursued within a monetary union. However, its efforts were doomed to failure: various  important member states were against it, and the Germans gave in as they did not wish to antagonize the French at a time when they themselves were engaged in the process of reunification with East Germany. But today, twenty years later, the eurozone still needs strict budgetary discipline."

The second mistake was to admit countries to the eurozone that did not belong in it. "As Italy was one of the six founding members of the EEC, it would not have been politically feasible to exclude it from participation in the first phase of the euro," comments Benink. "But from the perspective of economic logic this was a specious argument. The same was certainly also true of Greece. Admittedly, Greece had to wait a further two years, but even then it was still not really ready for the euro. But, as 'the cradle of European democracy', it was felt that it could not be omitted.  There you go!"

Eurozone holiday
The process of correcting these two mistakes has now been put in motion with proposals for treaty changes. Benink also believes that it might be a good thing for a few European countries to 'take a eurozone holiday', in other words to leave the zone temporarily. "Countries cannot be ejected from the eurozone against their will," he says, "but it is certainly not inconceivable that Greece in particular could take this step in exchange for substantial debt relief. Italy and Spain are in a very different situation: there is less doubt about the competitive strength of their economies. But the competitive position of the Greek economy is in a perilous state and can be revived only by a devaluation. This can be done either internally by slashing wages and prices or externally by introducing a new drachma. As I do not believe that an internal devaluation is feasible for the Greeks, the only alternative is external devaluation."