The End of the Euro

By Niall Ferguson

Just when it seemed safe to start using the word "recovery," a Greek crisis is threatening the world economy, and the very existence of the world's second-biggest currency.

The euro seemed like such a good idea just 10 years ago. Europe had already achieved remarkable levels of integration as a trading bloc, to say nothing of its consolidation as a legal community. 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 trade. European countries with problems of 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.

Monetary union had geopolitical appeal, too. In the wake of German reunification, the French worried that Europe was heading for a new kind of domination by its biggest member state. Getting the Germans to pool monetary sovereignty would increase the power of the other members over a potential Fourth Reich. And, 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 as the third pillar of the European Union in the Maastricht Treaty of 1992, 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 EMU, we argued, was that it was uniting Europe's currencies but leaving 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 they could be enforced.

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 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. This rigidity was one reason Harvard economist Martin Feldstein foresaw the single currency leading not to greater harmony in Europe, but to conflict.

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. True, the fiscal rules were not tightly enforced—indeed, none of the member states really satisfied the convergence criteria when the euro was launched in 1999—but the trends were healthy. Deficits shrank. And although there was less convergence of inflation rates and economic performance than had been hoped for, there seemed little cause for concern. Not only Europeans but the whole world took to the euro. Between 1999 and 2003, international banks issued more bonds priced in euros than in dollars. The countries that had stayed out began to wonder if they'd missed not just the bus but a luxury coach.

Then, in October 2009, a newly elected Greek government fessed up. Greece's budget deficit was in fact a whopping 12.7 percent of GDP, as opposed to the 6 percent reported by the old government, and more than three times the 3.7 percent promised to the European Commission at the beginning of 2009. It also turned out that the ECB was indirectly funding more than a third of Greek government borrowing via its emergency lending to Greek banks (giving the lie to the supposed "no bailouts" rule). The news set off precisely the kind of chain reaction the Euro-skeptics had always feared. Lenders had always charged higher interest on Greek bonds than German bonds, even in the euro's golden years, but that spread suddenly blew out from about 1 percent to above 5, and then 10. The country went into a fiscal death spiral as rising interest rates made the deficit even larger (it's now up to 13.6 percent) by increasing the costs of debt service. In desperation, the Greeks turned to their fellow Europeans for assistance. That might have been relatively cheap back in January, but the German government hesitated. In the midst of a global financial crisis and a German recession, and with regional elections fast approaching, German voters were in no mood to bail out foreigners who had been fiddling with their fiscal figures. But the longer the Germans dithered, the higher the cost of a Greek bailout rose.

Finally, at the end of April, a deal was hammered out whereby the Greeks received €110 billion, of which €30 billion came from the International Monetary Fund, and the rest from the other euro-zone countries. In return, the government in Athens committed to strict fiscal retrenchment, pledging to reduce the deficit to 3 percent by 2014 with a mixture of spending cuts and tax hikes.

Problem solved? Unfortunately not. This Greek tragedy has several more acts to come.

The first will be a Greek default. It's simply not credible that the government will be able to deliver such severe fiscal tightening at a time of deep recession. Even if everything were to go according to plan, the debt would peak at 150 percent of GDP, with a crippling 7.5 percent of GDP going on interest payments. Greece manifestly lacks the political will to do this. Prediction: the government of George Papandreou will fall and its successor will inflict a 30 percent "haircut" on holders of Greek bonds.

The next act will be even more dramatic. For what makes the crisis in tiny Greece so serious is the contagion effect—the realization among investors that if this can happen to Greek bonds, it can happen to other bonds, too. A scan of the data reveals two other euro-zone countries with bloated debts (Italy and Belgium) and another two with Greek-style overreliance on foreign lending (Portugal and Spain).

Last week the rating agency Moody's placed Portugal's long-term government bond Aa2 rating on review for a possible downgrade. And as Spain sold five-year bonds paying 3.5 percent—compared with a yield of 2.8 percent two months ago—rumors swirled that Madrid was seeking a bailout even bigger than Greece's.

Nor is this the only way the Greek crisis can spread like a virus throughout the European economy. Their balance sheets stuffed full of dodgy government bonds, the Greek banks are heading into Lehman Brothers territory. For neighboring countries like Bulgaria and Romania, which rely heavily on Greek banks for funding, that spells a credit crunch.

Even more alarming is the exposure of other EU banks to Greek debt, which totals $193 billion, according to the Bank for International Settlements. Factor in the risk of copycat crises in Portugal and Spain, and you begin to see the outlines of a disastrous Europewide banking crisis. The only way out of that will be further compromises by the ECB about the paper it accepts as collateral. Already last week it waived its rules, continuing to hold Greek bonds, despite their junk status. If this continues, there is only one way for the euro to go, and that's down.

Keep this in perspective. When the euro was launched back in January 1999, it was worth less than $1.20, and for most of its first three years it was down below parity with the dollar. So its recent slide from close to $1.60 before the global financial crisis to $1.27 last week is far from unprecedented. But the way this crisis is unfolding, further declines seem likely. It will surely be at least a year before investors wake up to the fact that the fiscal predicament of the United States is actually worse than that of the euro zone.

The difference is, of course, that the United States has a federal system, while the euro zone does not. In America, Texas automatically bails out Michigan via the redistribution of income and corporation tax receipts. What the Greek crisis has belatedly revealed is that such fiscal centralization is the necessary corollary of a monetary union.

Europe now faces a much bigger decision than whether to bail out Greece. The real choice is between becoming a fully fledged United States of Europe, or remaining little more than a modern-day Holy Roman Empire, a gimcrack hodgepodge of "variable geometry" that will sooner or later fall apart.

Ferguson is Laurence A. Tisch professor of history at Harvard University and William Ziegler professor at Harvard Business School. He is the author of The Ascent of Money: A Financial History of the World (Penguin Press).