How I learned to stop worrying (and love the euro)

Another old piece I’m copying over from Medium because I have posts in too many places. This is from May 2021, and could use an update and I promise I will do one soon.

This piece goes over many things I’ve said before in other places, tweets or threads, but I thought it worth doing for a couple of reasons. First, I liked the idea of having it all in place. Second, while the ideas in here have gone (and I speak here mostly in the context of US and UK market talk) from being fringe to mainstream, I still have the occasional argument about this. The tl;dr version of this piece is “The Eurozone’s problem is not the Euro, it’s the stability and growth pact.” As to the title, it is the other title of Dr. Strangelove; since my first public outing was a letter in the FT comparing Argentina’s currency board to a Doomsday Device, I figured it would work for a piece based on the idea that the Eurozone was not Argentina.

Almost exactly 11 years ago I changed my mind about the Euro, going from “this thing is never going to make it” to “it’ll survive.” My reaction in spring 2010 was driven by the belated realization that in agreeing to the EFSF, and Wolfgang Schaeuble’s suggestion of a European Monetary Fund — https://www.ft.com/content/2a205b88-2d41-11df-9c5b-00144feabdc0 — Germany was signaling that the survival of the Eurozone was a core national interest. I went from being someone who believed that Germany would jump ship to being someone who believed that Germany might make someone walk the plank but would never jump ship.

My opinions about the Euro until then had been driven largely by two factors. The first was the immense good fortune of having worked for and with a brilliant Euroskeptic early in my finance career (right after an abandoned attempt at a European history Ph.D). The second was having entered that career about two weeks before the devaluation of the Baht and the ripples outward of the Asian, Russian, Brazilian and Argentine crises. The combination had been enough to convince me that the Euro was nothing more than another exchange-rate peg that was doomed to disappear the way the others had.

But after my Europhilic conversion, based originally on a reevaluation of German political preferences, I began to think in greater detail about comparisons between the Euro-area and emerging markets. Around the taper tantrum in 2013/14, I compared the problems of fixed exchange rates with the possible travails of emerging market economies with a floating exchange rate and a completely open capital account. It struck me that the latter situation would also likely lead to increased overseas borrowing, dramatic nominal (rather than real) exchange rate overshoots, misallocation of investments to the non-tradeable sector, and asset-liability mismatches such that a weaker exchange would tighten rather than loosen domestic financial conditions, hitting the banking system. There’s a counterfactual argument to that effect here

But that argument also led to other questions — specifically, for all the comparisons of the Eurozone to exchange rate pegs, currency boards or gold standard type arrangements, were there differences in how the Euro functioned from its supposed parallels in other times and places? And here the comparisons with the countries forced off their USD-pegs by large reversals in capital flows stood out. In all these instances, the commitment to a peg operated in only one direction — — the Federal Reserve had no responsibility to absorb large capital outflows into USD in its balance sheet. However, because the Euro was not just a peg but a common currency area, the internal payment system Target 2 absorbed massive refluxes in intra-Eurozone capital flows at the height of the crisis.

But the operation of Target 2 was not sufficient to prevent bond markets from expressing the pressure that was prevented from appearing in currency markets. This then led to the next form of support from the ECB –Mario’s Draghi’s “Whatever It Takes” speech and the launch of OMT, which committed not just to prevent “unwarranted” expressions of currency risk from appearing in bond markets, but also to do so as a pari-passu creditor. The promise effectively reduced both the probability of default by proposing a backstop against market-driven runaway debt-dynamics and potential loss-given-default by doing away with the ECB’s status as senior creditor. OMT was never activated but QE began in 2014 and the pandemic has seen a further expansion of ECB support for national bond markets. One indication of the importance of this is how much lower bond yields are across the Eurozone (compared to 2009) despite large increases in government debt, particularly in the periphery.

The shortcomings of all these programs (the need for an ESM program in conjunction with OMT, issuer and issue limits in QE etc.) are obviously well known. Nevertheless, any comparison of the Eurozone with gold-standard or currency board type arrangements is in my view fundamentally misplaced. The ECB offers Eurozone members multiple programs of support that dwarf what emerging markets get from the Fed in a world where the world’s dominant invoice currency for commodities and cross-border borrowing remains the USD.

Instead, I would characterize the ECB’s role in the Eurozone as acquiescence in fiscal dominance for single national governments, but with such acquiescence conditional upon commitment by the government to the broad political and economic project of the EU. The level of such commitment is gauged by the ECB, key national governments (essentially Germany and France), the European Commission and is further tempered by consideration of the size, systemic importance and “oppositional” or “cooperative” character of the government in question.

Meanwhile, for all the loud complaints in the US about the need for the Eurozone to arrive at its “Hamilton Moment”, i.e., a true fiscal burden-sharing through the creation of joint and several liabilities, even before the EU’s pandemic bonds, the Eurozone had already engaged in a monetary Hamilton moment with the launch of ECB QE in 2014. Once the ECB began to purchase government debt as assets and created ECB liabilities, the fiscal liabilities of single national governments were converted to joint-and-several liabilities of the central bank. What the US accomplished by means of a central fiscal authority, the Eurozone has accomplished via the role played by its central monetary authority in government bond markets that are of size (in aggregate) comparable to the US.

Of course, the most important reason for this backdoor monetary route to deeper integration is because the politics of direct fiscal integration have proven problematic, though there are signs that the constraints are easing. But even if the politics of fiscal union have been difficult, the story of the Eurozone since the onset of the crisis in late 2009/early 2010 has been a serial overcoming of taboos, particularly on the monetary front — from the completely unanticipated scale of expansion of Target 2 balances, to SMP, to OMT coming alongside the ECB’s renunciation of senior creditor status, to negative interest rates, QE, TLTRO and tiered rates, PEPP etc. One oddity for me has always been that to the extent that the taboos seemed to be grounded in an alleged German fear of hyperinflation, the monetary taboos have proven easier to break until now than fiscal ones. But this most likely a reflection of the relative opacity of the operation of monetary backstops and their location in the hands of unelected personnel. Be that as it may, these expedients nevertheless had to be implicitly “countersigned” by key elected authorities, in Germany above all. And the important lesson here is that while the argument that the Euro was/is a political project rather than an economic one has been deployed by Euroskeptics as a reason for its projected failure, it is precisely that the fact the Euro is a political rather than an economic project that has kept it alive through extraordinary and once unthinkable interventions every time it was given up for dead.

Having compared the Eurozone with the situation of some EMs in an extended-USD zone, it is also worth noting that just as the Eurozone has spent the last decade moving towards a more “full-service central bank” model, it has long been enmeshed in the EU, which provides a more “full-service” model of integration beyond monetary matters. As EU members, Eurozone members also benefit from structural adjustment funds; an institutional anchor that may be perceived as important by foreign investors; freedom of movement of FDI, goods, labor (all good IMO) and portfolio capital (which might anyway replicate many aspects of membership in a single-currency area). I believe that all this makes the EU a vastly superior mode of integration into the global economy than seen in the case of Latin America e.g. over the last 50 years.

One frequently hears the argument that entry the single currency has dissipated some of the gains of economic integration via the EU, which might be the case (with Italy in this instance a stronger case than Spain or France). However, exiting a currency union is likely a different matter than never having entered it. This is particularly so because legal structures really seem only to permit an exit from the EU (via Article 50), rather than from just the Eurozone while remaining in the EU. And as long as a country is in the EU, it is to be subject to the Treaties to which it is a signatory — while I am not a lawyer (still less one of EU public law), I think there is a case (“irrevocable conversion” e.g.) that a member of the EU that has entered the Eurozone has consented to transfer its monetary sovereignty to an EU institution. This would suggest that any effort at a unilateral exit while remaining a member of the EU would be a legally fraught exercise before the ECJ not just with respect to other governments and the ECB, but also wrt a country’s own citizens (or any external creditors of its citizens). Now that the ECB has become a “full-service” central bank anchoring bond yields in the periphery; the EU itself has become expanded its own countercyclical fiscal response; and the Commission has become much more permissive in allowing national governments to do the same, the cost-benefit analysis of exit looks very different from how it might looked have in 2011.

Does this mean all is well? Obviously not. The 2010s have clearly been a lost decade for the Eurozone periphery, with terrible human costs. But the answer to this is not to exit the Eurozone and lose the shelter and support provided by the ECB, a level of support that is extremely unlikely to be matched in terms of market credibility were it to be provided by a post-exit successor NCB. Rather it is to use the umbrella provided by a full-service ECB to expand the ability of both the Union as a collective and of single Eurozone members to engage in proactive fiscal policy for the purposes of both countercyclical stimulus and the enhancement of structural growth trends. Pandemic-related joint issuance; the behavior of the Commission as it handles Excessive Deficit Procedures; and the recent remarks by ESM head Klaus Regling on abandoning the 60% Maastricht debt limit (which in turn guides recommendations on the trend primary surplus path) all suggest that there is movement afoot here as well, albeit at the Eurozone’s customary pace. But it still moves. Another salutary move would be to continue to push for banking union via a multipronged exercise that delivers regulatory and legal harmonization; cross-border mergers to denationalize the asset and liability base of large banks (thus rendering them less susceptible to asymmetric shocks); and the creation of a supplementary pan-European safe asset; These are all steps that would help the complicated bargains around derisking and mutualization required for banking union. Perhaps the recent failings of one of the national regulators most hostile to such an outcome might make for incremental progress on this front.

In sum, all available political capital among friends of Europe should be expended not on undoing the single currency, but in loosening the fiscal strictures at the EU and national levels that accompanied its birth. Or More Europe Is Better Europe. And that’s how things seem to be moving.