The European single currency system spirals further out of control

The European Central Bank (ECB), which formulates eurozone monetary policy, recently announced plans to impose negative interest rates on deposits held by banks at the ECB. It also extended up to 400 billion euros in cheap loans to these banks in order to boost private-sector lending in the eurozone. Most of the analyses thus far, ever focused on the immediate economic indicators, viewed the ECB’s decision as a response to the threat of deflation, which continues to haunt the bloc. However, it is important to view the bank’s decision against the backdrop of local and European elections last month.

In the European parliamentary elections in May, voters chose a motley crew of Euroskeptic parties, including far-right groups such as France’s Front National and the Danish People’s Party and far-left parties like Greece’s Syriza and Sinn Féin in Ireland. The success of parties from across the political spectrum left many European observers confused.

European Union officials, or Eurocrats, as they are derogatively known, have completely lost control over the systems of governance they built in the decades since World War II. In the words of economist John Maynard Keynes, the Eurocrats have “blundered in the control of a delicate machine, the working of which they do not understand.” The roots of this problem are economic.

For starters, the European monetary union project, formulated in the late 1980s and early 1990s, was deeply naive. It was driven by a noxious ideology that held modern capitalist economies are self-balancing systems that do not need outside intervention to achieve economic growth and stability; balancing government budgets is enough. On the contrary, capitalist economies are inherently unstable, and attempts to balance government budgets as an end in itself exacerbate this instability.

Yet the Eurocrats formalized their misguided ideology with a series of ironclad rules and draconian laws. Two key laws stand out: The first mandates that governments not run deficits larger than 3 percent of their gross domestic product; the second prevents the ECB from lending to governments threatened with insolvency in the bond market. The financial collapse of 2008 made it clear that these laws prevented a timely response to the crisis. First, the ECB could not step in to stabilize the bond markets immediately, leading to a sovereign debt crisis. Second, it forced governments experiencing deficits of more than 10 percent to try to achieve the 3 percent target instead of responding to the recession. Even when it eventually stepped in to stabilize the bond markets, the ECB continued to push the 3 percent rule, throwing Europe into an economic austerity limbo.

Many of the right-wing parties that were elected last month chastise the Eurocrats for being unable to follow their own rules. Meanwhile, the left-wing parties see the rules as the root of the problem. But the two groups agree that the European system of governance is broken, perhaps even beyond repair.

European officials are now on a damage control mission without explicitly breaking the rules. The ECB’s negative interest rates and lending programs are part of their ongoing rule-bending endeavors. But as with the monetary union project, these too will not work. Similar measures have been tried elsewhere, most notably in Japan. In response to crippling deflation, Japan experimented with ultraloose monetary policy for more than a decade, but the policy failed to pull Tokyo out of economic stagnation. Similarly, the central bank acting alone will not rescue European economies from deep depression.

ECB officials and their advisers know that lower interest rates alone won’t be enough to stave off recession, but they are bound by oath not to violate the monetary union’s principles. The rules that Eurocrats drew up in the early 1990s now play a normative role in European political discourse, and even a minor violation is seen as a political sin. For example, allowing countries in recession to engage in fiscal stimulus would generate political backlash from members that are not experiencing an economic slump.

The eurozone is in an economic quagmire. The only way out of this mess is either by lifting austerity programs and instituting a massive deficit-spending program or by breaking the monetary union into separate currency zones. But it is unlikely that either of these routes will be taken. The newly elected Euroskeptic parties are divided on the way forward: Some favor ending austerity measures, while others want to split the eurozone. Both prospects are equally terrifying for the Eurocrats. 

Buoyed by its recent electoral gains, the European anti-austerity left is experiencing a major resurgence. “The surge in support for Sinn Féin and far-left parties, allied with peoples’ rejection of austerity, has bred a quiet confidence amongst those on the Irish left,” said Cillian Doyle, a member of the People Before Profit alliance, which stood in local elections in Dublin, commenting on the general feeling in his country. “The enduring success of Syriza in Greece continues to act as an inspiration not only to the Irish left but to the European left more generally.”

Doyle said the left would push hard to ensure that elected officials would not compromise on economic policy. There is no doubt that Europe’s right wing will cling to its mantra of anti-immigration and anti-peripheral sentiment.

What the future holds for the eurozone is anyone’s guess. But the rise of the far left in Greece offers some clues. In the 2012 elections, Syriza, until then a fringe radical left-wing party, became the second largest in the Greek parliament. It won by a substantial margin in the European parliamentary elections last month. Greece’s next elections are scheduled for 2016 but may come sooner, given that country’s volatile political situation, and it looks all but certain that Syriza will win them.

Syriza wants to keep the eurozone intact while pushing back hard against the austerity measures currently imposed on Greece and other countries. If political parties from other countries use Syriza as a battering ram to hammer away at the Eurocrats, the gathering momentum against austerity might come down harder and faster than expected. The question then becomes, Will the European monetary system remain flexible enough to weather such a shock, or will it completely fall apart?

A final alternative is to pursue a compromise solution known as tax-backed bonds, which allows peripheral countries to stabilize their interest rates without assistance from the central bank. During the financial crisis, investors were afraid that countries such as Ireland and Greece would not be able to raise sufficient tax revenues to pay back their creditors. In Japan, the United States and United Kingdom, this is not an issue because the central bank can print money anytime to pay back creditors. Under tax-backed bonds, if a country in the eurozone is unable to repay its creditors, lenders can use the bonds to make tax payments (or sell them to citizens who could use the bonds to pay taxes). The backing of the bonds with tax ensures they are always money good.

But ultimately, this solution won’t work if countries such as Greece do not reform their broken tax-collection systems. Otherwise, there is no way to assure investors that there will always be sufficient demand for the bonds in the face of nonpayment. To the best of my knowledge, Syriza is aware of the policy tool. Whether the party has what it takes to change the course of the debate remains to be seen. The issue is a political one. If Greece uses tax-backed bonds, it will effectively be asserting its political independence vis-à-vis the Eurocrats. When Ireland was faced with a similar choice in 2012, it backed down, utilizing a hardly believable legalistic argument. But all eyes should be on Greece’s next elections.