The Euro’s endless horror

According to an old German saying, an end with horror is better than a horror without an end. Judging by the Eurozone’s disappointing economic performance over the past 20 years, this saying might provide a useful way to frame the fundamental policy choice now facing European economic policymakers in a post-coronavirus world.  

Will European economic policymakers perpetuate the horror of the Eurozone’s poor long-run economic performance by allowing the European Central Bank (ECB) to keep the Euro afloat by further substantially expanding its already bloated balance sheet? Or, in the interest of enhancing the Eurozone’s long-term economic performance, will they allow the Euro to unravel despite the immediate economic horror that the Euro’s unraveling would surely entail?

It would be a gross understatement to say that since its 1999 launch, the Euro has failed to deliver on its promise. Far from promoting European economic prosperity and narrowing the economic gap between the Eurozone’s southern and northern member countries, over the past 20 years the Eurozone’s overall economic growth rate has been mediocre at best, while the economic gap between the Eurozone’s core and peripheral countries has only widened. 

At the heart of the Eurozone’s disappointing economic performance is the original policy mistake of tying in a monetary union a strong economic performer such as Germany and weak productivity performers such as Italy and Greece. It also did not help matters that following the 2008-2009 Great Recession, Germany insisted on imposing fiscal austerity on the Eurozone’s economic periphery at a time of considerable economic weakness.  

The disparate productivity performance between Germany and the Eurozone’s economic periphery resulted in a progressive loss in the periphery’s international competitiveness. Stuck in a Euro straitjacket, the periphery could no longer correct lost international competitiveness with currency depreciation. 

The economic fallout expected from the coronavirus pandemic is now bound to exacerbate the Eurozone’s existing internal economic and political tensions. In a cruel twist of fate, it would seem that the Eurozone countries whose economies are least suited to withstand the pandemic’s severe economic body blow are precisely the ones that have been hardest hit by the pandemic. According to the IMF, whereas the German economy is forecast to contract by close to 8 percent in 2020, the heavily indebted Italian and Spanish economies are both forecast to decline by almost 13 percent. 

The very troubling economic outlook for Italy, an economy some 10 times the size of that of Greece, is illustrative of the ECB’s daunting challenge to hold the Euro together. As a result of the pandemic, it’s clear that Italy’s public finances are no longer sustainable, while its banking system looks well on its way to a major crisis. 

Since the start of the coronavirus pandemic, markets have become increasingly reluctant to buy Italian government bonds as doubts have grown about the sustainability of that country’s public finances and the solvency of its banks. In response, the ECB has considerably expanded its quantitative easing program and it has bought a very much larger proportion of Italian government bonds than Italy’s share in the ECB’s capital structure.   

A principal challenge to the ECB’s prospective efforts to keep Italy afloat is more than likely to come from the German Constitutional Court and from the German political system. This is especially the case considering the very large size of the bailout that Italy might need to be kept afloat. It is also the case considering the likely strong Italian political resistance to any notion of conditions being attached to any ECB or European bailout.

In May 2020, the German Constitutional Court raised serious questions about whether the ECB’s past quantitative easing program had taken it beyond its legal authority. More recently, the ECB has been flagrantly deviating from its capital key in buying member country government bonds. In particular, it has in effect been buying Italian government bonds in the secondary market in an amount equivalent to that country’s gross government borrowing needs. This makes it difficult to see how at some stage the German Constitutional Court is not going to rule that the ECB is in violation of the Lisbon Treaty, which explicitly prohibits the ECB from engaging in the monetary financing of a member country’s government deficit.  

In the past, when confronted with an existential Euro crisis, the Europeans have been adept at finding a way to waive rules that had earlier seemed to be ironclad. One must hope that they again find a way to do so in the current Italian context. The last thing that a coronavirus-weakened European economy now needs is the horror of Italy crashing out of the Euro.  

Unfortunately, however, one cannot rule out the possibility that at some stage the German legal and political system might tire of bailing out the likes of Italy. Instead they might come around to the view that an end with horror is after all preferable to a horror without an end.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.