Stephen King: Eurozone states will need an act of union to save the single currency

Outlook: The European Central Bank could expand its balance sheet to purchase government bonds shunned by private sector investors
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The Independent Online

For some, it's almost time to pop open the champagne. Those who thought the euro was, from the beginning, a madcap idea are already saying: "I told you so".

With protesters marching in Dublin – the capital of a nation which, until now, has been admirably stoical in the face of mounting austerity – and with the cost of borrowing rapidly rising in Portugal and Spain, it's easy enough to believe that the death throes of the euro are upon us. But are countries really on the verge of going their separate ways, with the re-introduction of marks, francs, pesetas and punts? Or, instead, can a solution be found that will deal with the euro's obvious weaknesses?

The euro's difficulties stem from a fundamental paradox, namely the combination of a single currency with many nation states. Plenty of monetary unions work perfectly well, but only because they also tend to be associated with political union.

If the Scottish Nationalists had their way, they'd probably take Scotland out of the sterling area (although – rather perversely – some of them would immediately plonk Scotland into the euro instead). For now, however, the 1707 Act of Union serves its purpose. Scottish bank notes may still exist but it's the Bank of England which pulls the monetary strings on either side of the border. And the Old Lady can do so with relative ease because England and Scotland are fiscally joined at the hip. Even with the creation of a Scottish Parliament, taxes are still raised across the UK as a whole. And when the UK government borrows from the world's capital markets - through the issuance of gilts – its borrowing is backed by both English and Scottish (not to mention Welsh and Northern Irish) taxpayers.

When it comes to fiscal sustainability, no one worries about the Scottish deficit, the English national debt, or the Welsh cost of borrowing: in the UK's case, it's all for one and one for all.

In the eurozone, however, it's a completely different affair. Creditors lend to the individual Irish, Greek, Spanish, Portuguese and German governments in much the same way that, in the event of a disunited Kingdom, they might have to lend individually to England, Scotland, Wales and Northern Ireland. How would creditors treat the individual members of the UK? Would they regard each of them as equally safe? Would they instead take the view that some countries were riskier than others? Would Scotland pay a higher rate of interest on its borrowings from international capital markets than, say, Wales?

For much of the euro's existence so far, investors rather naively believed that each of the member states within the single currency were more or less equally safe. True, German bond yields were a tiny bit lower than the bond yields of other countries but, to all intents and purposes, investors treated the government debt of one member state as being roughly the same as government debt issued by other member states. It's not difficult to see why. Before the euro's formation, investors dabbling in Spanish or Italian government debt regularly got their fingers burnt as a result of all-too frequent currency devaluations. The formation of the euro removed the currency risk once and for all. Investors flocked to buy high-yielding bonds in the so-called "peripheral" nations safe in the knowledge that they would no longer be victims of currency collapse.

This was a major mistake. Currency declines are a neat way to shift the burden of adjustment from domestic debtors to foreign creditors. Before the formation of the euro, German investors were wary of buying peseta-denominated Spanish bonds because, in the event of a peseta devaluation, those bonds would now be worth less to a Deutschmark-based investor. To guard against this risk of "virtual default", the Spanish government had to pay an interest rate much higher than that paid by the German high priests of monetary conservatism.

The single currency removed the risk of "virtual default" because countries within the eurozone no longer had their own currencies. But it was always wrong to assume that the removal of the risk of "virtual default" also removed the risk of outright default. Indeed, by getting rid of the "virtual default" option, the risk of outright default actually rose. And the sudden realisation of this new reality lies at the heart of the crisis now doing so much damage to the euro. The United Kingdom deals with this problem through the use of a political arrangement which allows for incomes in one part of the Union automatically to be transferred to another part. And because it's a transfer, not a loan, there is no sense in which one part of the Union can default to another, one reason why we don't spend our waking hours worrying about the individual fiscal arithmetic in, say, Scotland or Wales. But when it comes to the eurozone, investors do worry about these matters. They worry about the size of Irish government debt or Greek tax receipts precisely because the financial arrangements which govern the UK's cross-border fiscal arrangements don't exist within the eurozone.

But why are investors worrying now when they weren't worrying before? Obviously, the economic crisis has done its damage, leaving nations with revenue shortages and huge budget deficits. But there's more. Ireland's recent difficulties are linked to the uncertainties within the Irish banking system.

And this, in turn, takes us all the way back to the onset of the global financial crisis a couple of years ago, when trust in the financial system completely collapsed. We are now seeing a similar loss of trust, but this time the problem relates to the possible exposure of individual governments to losses within their banking systems which, as with Ireland's experience, have the capacity to turn the fiscal arithmetic upside down.

Whereas, in the early stages of the crisis, government debt was seen to be safe – at least compared with asset backed securities, collateralised debt obligations and all the other weird and not-so-wonderful products of the financial industry – that safety is no longer guaranteed. The eurozone's problems have less to do with fiscal mismanagement and more with the unknown fiscal implications of hidden – or merely suspected – losses within banking systems.

This is not a problem easily solvable by individual nations nor, indeed, by fiscal authorities alone. Trust has to be restored. One way to do this is to find a buyer of last resort for government paper which, for investors, has become tarnished. In Europe's case, that's the European Central Bank. It could expand its balance sheet to purchase government bonds shunned by private sector investors.

Another is to create a new treaty that would, once and for all, make clear how countries will, in the future, fiscally support each other. It could even be an Act of Union for the eurozone. It wouldn't need to go as far as 1707, but it would have to recognise that some shocks are the responsibility of all eurozone countries. Until and unless that simple truth is properly recognised, investors will continue to look at the euro with a mixture of uncertainty and caution.

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