Stephen King: The unfolding Greek drama will severely test the eurozone's unity of purpose

The risk is that the eurozone is condemned to years of grinding deflation which, in turn, will see Greek-style problems cropping up all over the place
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The Independent Online

In the mid-Nineties, I was one of many economists who thought the euro would only get off the ground if its membership was restricted to those countries which, year- in-year-out, had demonstrated their commitment to the rigours of Bundesbank-style price stability. I believed membership would only be for the select few.

Germany, France, Austria, the Netherlands, Luxembourg, Ireland and Belgium would be in, but the southern European countries would mostly be out. After all, these Mediterranean nations had lurched from one devaluation to the next within the exchange- rate mechanism of the European Monetary System. Moreover, some of them had been fiscally incontinent to a degree that suggested they had no real chance of meeting the so-called Maastricht convergence criteria, a set of rules designed to keep monetary and fiscal profligacy at bay.

Of course, I was wrong. I was thinking too much like an economist. I'd forgotten that the creation of the euro was a political, rather than an economic act. And so it was that the euro included all sorts of financially challenged reprobates – countries which had not been able to demonstrate the monastic commitment to economic orthodoxy which, over the years, had proved to be part of Germany's DNA.

Soon after its creation, other countries were allowed to sign up, further emphasising the euro's political backbone. These "second-wave" nations included Greece, Slovenia, Cyprus, Malta and Slovakia. In passing the entrance examination for convergence, it turns out that one of these countries was, to use the polite version, economical with the truth. Initially, the reprobates found euro membership extremely cosy. Interest rates collapsed to German levels because the euro seemed to promise a Teutonic monetary nirvana for all. Unfortunately, the reprobates forgot that interest rates were low for a reason. Germany had successfully kept its prices and wages under control for decades, and its cautious citizens had chosen to save, rather than spend, their money. Low interest rates were a consequence of good behaviour, not an incentive for bad behaviour.

For the reprobates, however, the opposite applied. Faced with exquisitely low interest rates, their discipline went out of the window. They had housing booms, big wage gains (at least relative to their limited productivity successes), and large increases in both private-sector and government borrowing. They lived the good life. All the while, they slowly lost competitiveness against the austere Germans.

Now the party's over. Countries can borrow a lot only if their creditors are happy to lend to them. During the euro's formative years, creditors took the view that all governments in the eurozone were equally safe (or unsafe). Interest rates on government bonds hardly varied from country to country.

That's all changing. Creditors are having second thoughts and beginning to wonder whether countries within the eurozone still have the capacity to repay their debts. Some countries are deemed riskier than others and are paying ever-higher interest rates to service their past borrowings. At the end of last week, Greece finally capitulated, accepting that, on its own, it was no longer able to keep its creditors happy (interest rates on Greek 10-year government bonds had soared to 8.7 per cent, whereas those in Germany were a mere 3.1 per cent). Greece will now be propped up by the IMF in conjunction with the European Union, in exchange for a period of particularly painful austerity.

The Greek crisis reveals an inherent weakness within the eurozone. Is the eurozone a collection of sovereign states all under the umbrella of a single monetary policy, in which case defaults and distress are in danger of becoming facts of life? Or is the eurozone a sovereign entity in its own right, a system in which nation states sacrifice their individual sovereign claims for the greater good of the single currency project as a whole? And who determines the greater good? These are important questions. Arguably, the eurozone is an attempt to resolve a key paradox at the heart of the global economy: we live in a world of massive cross-border capital flows but, at the same time, we have seen a huge proliferation of nation states over the last 100 years. In other words, we have both more and less globalisation. By pooling their economic interests together into a single currency, European nations thought they could overcome this paradox.

In effect, euro membership implied a diminution of national sovereignty – via the abolition of individual currencies – in exchange for superior economic outcomes for all. Far better to have a single currency than to have constant upheavals in a market of many currencies. As the Greek crisis has progressed, however, it has become ever more apparent that countries are still trying to retain their economic sovereignty in other ways. Some have been dangerously profligate in their fiscal decisions, as I've already noted. Others have resisted the domestic inflationary implications of euro membership, to the detriment of the system as a whole.

Germany most obviously falls within this latter camp. The last thing it wants to see is a rise in its own inflation rate above 2 per cent. Yet that's what should happen if the eurozone is to recover its earlier swagger. Most commentators agree that the reprobates have to improve their competitiveness within the eurozone. That either means their wages and prices have to fall compared with the "best in class" or, alternatively, that wages and prices for the best in class have to rise.

If, however, Germany – the best in class – prevents its wages and prices from rising too far (most obviously via a tightening of fiscal policy), wages and prices elsewhere will have to fall. And, as they do so, eurozone inflation on average will likely undershoot the European Central Bank's target band of 1.5 to 2 per cent . That, in turn, makes a nonsense of the idea that all countries have surrendered their national economic sovereignty for the greater good. The German piper is still calling the tune.

In doing so, the risk is that the eurozone is condemned to years of grinding deflation which, in turn, will see Greek-style problems cropping up all over the place. Germany would also be damaged. Its companies trade a lot with the rest of Europe, so the fabled German export machine would splutter a lot more frequently. Even worse, because Germans save a lot more than they invest domestically, they need to find foreign bolt-holes for their wealth. Over the last 10 years, the foreign assets of choice have included US mortgage-backed securities and Greek government bonds, neither of which has proved to be safe.

Germans may think they're being prudent, but their prudence merely encourages bad behaviour elsewhere in the world, including within the eurozone. To subvert a phrase, it's prudence without a purpose.

Stephen King's new book, 'Losing Control: The Emerging Threats to Western Prosperity', will be published by Yale University Press on 4 May.