Otmar Issing on the Fate of the Euro

Euro, fiscal policy, government debt financing, Otmar Issing, Stability and Growth Pact
"House of Cards," by Peter Roberts. CC BY 2.0 https://www.flickr.com/photos/peter_roberts/4457615801

house-of-cardsBack in July 2015 I reminded Alt-M  readers of a paper I presented at the 2012 Mont Pelerin Society meetings in Prague, as part of a session in which Otmar Issing, one of the euro's architects, also took part. As I remarked in that last post, although Mr. Issing "put a much more favorable spin on the euro's prospects for survival" than I did, I argued at the time that our apparent disagreement boiled down to the fact that while he chose to regard "the merest heartbeat from Frankfurt" as proof of the euro's vitality, I considered it "for all intents and purposes already brain-dead."

The gist of my argument was that the viability of the euro depended on strict enforcement of the 1997 Stability and Growth Pact. However, when both France and Germany were allowed to violate it in 2003, the pact ceased to be credible. "That change meant, in effect, that either the ECB's independence or the no bailout commitment or both would have to give way, as both have indeed done." That stage having been reached, I argued, the euro's eventual disintegration was all but certain.

I'm bringing this up yet again because Central Banking Journal recently published a remarkable (but, unfortunately, gated) interview with Mr. Issing in which he acknowledges that the euro is indeed falling apart. What's more, he agrees that the euro's fate was sealed when "Germany and France violated the pact in 2003, delivering a fatal blow to the pact from which it has never recovered."

The idea of installing a politically controlled mechanism of fiscal policy of member states via the Stability and Growth Pact has more or less failed. Market discipline is done away with by interventions by the ECB. So there is no fiscal control mechanism from markets or politics. This has all the elements to bring disaster for monetary union.

The euro's other, critical flaw, according to Issing, consisted of European authorities' decision to make the ECB responsible for banking supervision. Issing and other ECB economists strenuously opposed that step, having been

concerned about conflicts with monetary policy and interactions with politics when it comes to rescuing individual banks — as, ultimately, rescues involve taxpayer money, rather than central bank money. This brings the central bank unavoidably into contact and conflict with national fiscal policy.

"How," Issing and his colleagues wondered, "can you separate monetary policy from effort that supports the weak banks to ensure they survive?" How indeed! Once the Stability and Growth Pact was a dead letter, "[q]uite a few countries — behaved as though they could still devalue their currencies." Those countries' creditors in turn, European banks among them, had reason to expect the ECB to intervene in the bond markets to keep them from failing. Indeed, "nobody" really believed

that the 'no-bail-out' principle would be observed in a crisis. There was a belief the ECB would come in. And now of course, the ECB is heavily invested in these bonds whose spreads are artificially low, meaning an exit from QE policy is more difficult, as the consequences potentially could be disastrous.

Another problem with the design of the European Monetary Union, Issing observes, "was that once a member, you remain a member." In retrospect,

It would have been better to demonstrate a country could leave the euro and rejoin from a much stronger position later. Such an event would have clarified that being a member of the 'euro club' can only come by meeting the club's economic rules. But this opportunity was missed.

And now?   "Realistically," Issing says,

it will be a case of muddling through, struggling from one crisis to the next one. It is difficult to forecast how long this will continue, but it cannot go on endlessly.  Governments will pile up more debt — and then one day, the house of cards will collapse.