Will the Euro Survive?

Liaquat Ahamed
Liaquat Ahamed
Liaquat Ahamed Investment manager and author of Pulitzer-winning best seller "Lords of Finance: The Bankers Who Broke the World"

August 20, 2012

Editor’s Note: Liaquat Ahamed delivered this speech on the future of the euro at the 2012 Sun Valley Writers’ Conference. Ahamed, who is a Trustee of the Brookings Institution, won the 2010 Pulitzer Prize for History for Lords of Finance: the Bankers Who Broke the World (Penguin, 2009). Brookings President Strobe Talbott asked Mr. Ahamed to share his speech on the Brookings web site.

Europe is today at a critical juncture in its history. In the fourth year of a giant financial crisis that never quite seems to get resolved and keeps spiraling on, hundreds of billions of dollars of capital is fleeing the weaker countries. It is tearing the banking systems apart. It has driven several governments close to insolvency and default. The economy has reeled back into recession for the second time in three years. People are now talking about a lost decade. More worrying, some parts of the continent are in an actual deep depression. Unemployment in the so-called economic periphery of Europe—Greece, Portugal, Ireland, and Spain—has risen above 20%. In some parts youth unemployment is as high as 50%. These are Great Depression sort of numbers.

Not surprisingly this is bringing political turmoil. In the last year, 11 of the 17 eurozone governments have been rejected in the polls or fallen prematurely. Extremist parties, especially nationalist ones, are on the rise. Support for the euro in both the weak countries and the strong countries is eroding.

What is particularly scary is how impotent the authorities seem to be. Massive centrifugal financial forces are ripping through the eurozone. And yet, whatever the authorities try seems to have no impact. In the last two years, the leaders of the euro countries have held 19 summits; they have created a bailout fund of close to one trillion euros; the Greek debt has been restructured not once but twice, and a third makeover seems to be on the cards; the European Central Bank has sought to support the government bond market in various ways and pumped in three trillion euros into the banking system. Most recently they have agreed to use the centralized bailout fund to recapitalize the Spanish and Irish banking systems.

And yet nothing they have thrown at the problem has worked; indeed matters seem to be getting worse.

What is fascinating is that in commentary from this side of the Atlantic the overwhelming consensus is that the eurozone, as it is currently constituted, cannot survive. Whereas most Europeans—apart obviously from the British who are a breed apart—believe fervently that the euro will hold. When you point this out, Europeans will typically reply that this is because Americans don’t fully appreciate the political dimension of the single currency. To most Europeans monetary union is much more than just an economic arrangement. It is a reflection of a much deeper political commitment to an integrated Europe that has motivated the continent’s statesmen since the Second World War. And until you appreciate that, Europeans insist, you will never fully be able to understand what is going in Europe.

This paper tries to address three questions. First what led to the creation of the euro in the first place? Second how did it get into the mess that it is in today? And third, why has it been so difficult for the Europeans to dig themselves out of the hole they are in? It deals less with the pure economics of the situation, and more with the politics of the euro—and in particular the role and position of Germany.


The idea of a unified Europe has been around for a long time. As far back as the18th century, one finds George Washington writing to the Marquis de La Fayette that “one day, on the model of the United States of America, a United States of Europe will come into being.” And already by the middle of the 19th century, visionaries like Victor Hugo had begun dreaming of a single European currency.

But it was only after the Second World War when the nations of Europe saw themselves squeezed between the two great superpowers, that the idea got any real traction. The right alignment of geopolitical forces was clearly a big factor behind the European idea. But essentially it was a small group of French and German statesmen who really gave life to the idea.

The initial architect was Jean Monnet. Born in 1888, he was the son of a cognac merchant and entered his father’s business at 16. He happened to stumble into international economics during the First World War when he was drafted to work on the challenge of getting Britain and France to cooperate economically. For the next twenty years he alternated between two quite improbable careers, on the one hand selling cognac, which sounds like a very pleasant and relaxing way of life, and on the other a high-flying career as an international financier and civil servant, including, by the way, a stint in his early thirties as the deputy secretary general of the League of Nations.

After the Second World War, he came up with a scheme that became known as the Schuman Plan. France was then the biggest steelmaker in Europe, but had no coal to speak of. Germany on the other hand had the largest coalfields in Europe. He proposed that France and Germany pool their resources in coal and steel. In this way Germany would be guaranteed a market for its coal, and France would be guaranteed a permanent supply of raw materials.

When he first advanced the idea, Monnet saw it as a defensive measure. In the immediate post-war period the French were not surprisingly deeply mistrustful of the Germans. But, ever practical, Monnet believed that a partnership with Germany would protect the French steel industry and thus restore prosperity to Northern France.

There was also an idealistic dimension. The hope was that the two countries, which had over the previous 80 years fought three terrible wars, would in the process learn to work with each other.

The European Coal and Steel Community did not in fact achieve very much in economic terms. But it provided the key psychological impetus for cooperation between the key nations of Europe and in 1958, under the Treaty of Rome, six of them committed themselves to creating a free trade zone.

Monnet was no Utopian. He understood that it was no easy matter to forge an economic federation out of a bunch of countries, all with different languages and customs and laws, many of which had been repeatedly at war with each other over the centuries. So his approach was to start small and then step-by-step to chip away at the obstacles to trade.

Monnet may have been the economic architect of the Common Market. But the credit for the political vision that an economic bond between the countries of the continent would not only bring prosperity but also peace in its wake belonged to two statesmen—Konrad Adenauer, the first chancellor of postwar Germany and General Charles de Gaulle of France.

Adenauer had been mayor of Cologne between 1917 and 1933. Dismissed after Hitler took power, he spent the years of Nazi rule as a private citizen, in and out of jail, including after the failed assassination attempt against Hitler in 1944. In 1949, at the age of 73, he became West Germany’s first chancellor, a position he held for the next 14 years. When he finally retired in 1963 at the age of 87, he was the world’s oldest elected leader.

As a Catholic from the Rhineland, the area of Germany both physically and culturally closest to France, he was deeply suspicious of the sort of Prussian militarism that had caused Germany so many of its problems and was acutely sensitive to the German responsibility for two world wars. As chancellor he decided not to oppose the indefinite division of Germany that occurred after the war, but instead to accept it and focus all his efforts on rehabilitating Germany in the eyes of the rest of Europe.

In 1958 he met Charles de Gaulle, and was totally captivated. De Gaulle was a larger-than-life figure. He had this wonderfully overblown view about the destiny of France and was infamous for his grandiose rhetoric —over the top statements like “France cannot be France without greatness.” He had also developed a rather epic view of himself, seeing himself was one of those handful of French heroes, people like Joan of Arc, Napoleon Bonaparte, or Clemenceau, called to greatness to save their country at a moment of national weakness.

For all de Gaulle’s grandiosity and bluster, he was actually quite a realist. He had been deeply marked by the constant military defeats to which France had been subject and recognized that on its own France would be condemned to be a second-rate power. But at the head of Europe it would have to be accepted as part of the first tier.

“Europe is the means by which France can once again become what she has not been since Waterloo: first in the world,” he declared.

For his part Adenauer saw the Common Market as a way for Germany to earn its way back into the community of nations. In the early 1950s, Germany was still occupied by foreign troops and still viewed as a problem country. Adenauer realized that by joining up with France and ceding some degree of sovereignty to Europe, Germany could restore its own legitimacy as a nation. He was also fully aware that German leadership within Europe was at that stage unthinkable. So he agreed to take a back seat and allow France to be in the driver’s seat. What made that acceptable was his admiration for de Gaulle.

That Franco-German partnership, with France behind the wheel and Germany providing the economic motor, was to provide the formula for the next 35 years.

In its first two decades, the European Common Market was an enormous economic success. Trade between the European countries increased fourfold, much of the impetus coming from the West German economic miracle. As a consequence countries within the community grew at double the rate of the countries like Britain, which did not join.


While the European Community was remarkably successful in achieving free trade in goods and to a lesser degree services, its experience with money and currency was much more checkered.

In the early 1970s Europe was hit by a series of shocks including the oil price rise and the collapse of the Bretton Woods system of fixed exchange rates. For a variety of reasons, Germany was able to handle those economic shocks much better than the other members of the Common Market and it emerged as the unquestioned economic powerhouse of Europe.

With the anchor of the dollar gone and fearing the sort of instability that had led to the currency and trade wars of the 1930s, European countries decided to tie themselves to the deutschmark, the German currency. In effect the mark would replace the dollar within Europe. The driving force behind this arrangement, which came to be known as the European Monetary System, was again a Franco-German duo, Valery Giscard d’Estaing of France and Helmut Schmidt of Germany.

Their careers ran in parallel. They both came to power in May 1974, within 11 days of each other, and held office for almost the same length of time, 8 years in one case and 7 years. Each had been his country’s finance minister before becoming the head of government and both of them understood money.

Despite their different backgrounds—Schmidt came from a humble middle class family of teachers from Hamburg, while Giscard had somewhat aristocrat pretentions—they had very similar personalities, difficult men who did not suffer fools gladly.

The main push for the European Monetary System again came from the French. Throughout the late 19th and the first half of the 20th century, even though Germany had been the industrial giant of Europe, France had actually been the dominant country financially. For example, Paris had always been much more of an international financial center than Berlin and France had always had much larger gold reserves than Germany. By the 1960s all that had changed. France was now financially in second place within Europe. Giscard decided that the way to reestablish his country’s credibility in financial matters was to piggy-back off the German currency.

Schmidt’s motivation was almost the opposite. He was worried that German banks and insurance companies were becoming so dominant within Europe that a reaction was bound to occur. He conceived of the European Monetary System as a way to make German economic might less obviously visible.

Over time, however, the French became increasingly dissatisfied with the European Monetary System. By tying the franc to the deutschmark, France did get the benefits of German monetary stability. But it also meant that all decisions about interest rates in France were taken by a bunch of Germans in Frankfurt. And so the French began to push for full monetary union, run by a full European central bank, believing that monetary union would allow France to have its cake and eat it too—to get all the benefits of a German-style hard currency but with a seat at the table.

At this stage French and German attitudes began to diverge. Both sides embraced the need for a step-by-step approach, which has always been the hallmark of the European way of handling such issues. But at each juncture, France always seemed to want to take bigger steps than Germany. The Germans, supported by the Dutch and most central bankers, kept arguing that Europe was not yet ready for a single currency. The structure of the economies had to converge first. Once these fundamentals were in sync, then countries could think of fixing exchange rates and moving to monetary union. Whereas the French, supported by the Belgians and the bureaucrats in Brussels, believed that it was possible and necessary to force the pace somewhat. Take bolder steps, they argued, even if these seemed at the time premature. That would force changes in economic policy and bring about convergence faster.

By the late 1980s this difference had led to a stalemate. It all came to a head in 1989 when the Berlin Wall came down.


Which brings us to the third great partnership between a German and a French leader, that between Helmut Kohl and Francois Mitterrand. Coming to power and in the early 1980s, both would end up as the longest serving leaders of their respective countries since 1870—Mitterrand for 14 years, Kohl for 16.

By virtue of the generation that they were born in, both were acutely aware of the intertwined and tragic histories of their two countries. Kohl had been born in 1930 in the Rhineland, close to the French border. He would take foreign visitors into the garden of his home there and show them the countryside around, and talk very emotionally about how the soil was soaked with the blood of French and German soldiers.

Mitterrand had been similarly marked by the war. Born in 1916, the year of the Battle of Verdun, he spent 18 months after the Fall of France in 1940 in a German prison of war camp. After twice trying to escape but being recaptured, he succeeded on his third attempt. But he often spoke about his experiences as a German prisoner of war.

They had contrasting personalities. With his jovial manner and provincial accent, Kohl liked to give the impression of being a good-hearted country bumpkin. He was constantly being underestimated and mocked in the press for his lack of sophistication. Mitterrand by contrast was the epitome of sophistication, an aloof intellectual who kept his cards close to his chest and developed a reputation for cunningness and opportunism.

Despite this and despite the fact that they did not share a common language—all their conversations had to pass through interpreters—they struck up a great friendship. There is, for example, a very poignant photo of the two of them holding hands at a memorial ceremony for the war dead of Verdun.

The fall of the Berlin Wall in November 1989 at first created a deep rift in their partnership. When it happened Kohl decided to grab history by the horns and, without consulting any of his allies, developed a plan for German reunification, which he then presented to the world. Mitterrand since 1981 had been predicting that the Soviet Union would fall apart and that Germany would be reunified. Nevertheless when it happened, it occurred so fast that he was taken completely by surprise. On learning about Kohl’s fait accompli, he supposedly threw a temper tantrum lasting several hours.

Over the next month there ensued a flurry of negotiations between the two leaders. Fearful that a united Germany would go off on its own and upset the European balance of nations, Mitterrand kept threatening to veto German reunification. Finally in order to get the French to accede, Kohl offered monetary union as a quid pro quo, arguing that this would guarantee that a united Germany would be irrevocably bound to the rest of Europe. And so the bargain was struck: the single currency in return for German reunification.

Monetary union was therefore a fundamentally flawed project from the start, pushed for all the wrong reasons. Neither Kohl nor Mitterrand had any clue about finance and allowed political considerations to trump economics.

From an economic point of view monetary union had two big flaws. First, such an arrangement only really makes sense in a large continental-size area like Europe if workers can move freely from areas of high unemployment to those where jobs are plentiful. That is essentially why monetary union in the U.S. works pretty well. Americans think nothing of moving from state to state. So, for example, when a housing bubble bursts in, say, Nevada, unemployment there may shoot up for a while—but, over time, workers will move out of the state looking for job opportunities elsewhere. By contrast, in Europe, workers are much more tethered to their local economies by linguistic and cultural ties. As a consequence pockets of deep unemployment can persist for years and even decades.

The second problem is that, in a single currency area, credit conditions are by definition roughly the same for all regions, which only makes sense if the member economies are at roughly comparable stages of development. Otherwise the one-size-fits-all credit policy can cause all sorts of problems, which in Europe it did.

The economic flaws were important. But even more significant for today’s situation was the fact that from the start the single currency was never popular with the man in the street in Germany. The deutschemark was a symbol of Germany’s postwar economic success and the public feared that abandoning it would sap German economic might. And it did not help that the Bundesbank, the German central bank, made no secret of being vehemently against the single currency. In fact most of the economic establishment was against the idea. In early 1998, as the deadline for the single currency approached, 155 German professors of economics signed a letter proposing that the whole scheme be put on the back burner.

On this side of the Atlantic, most economists, on both the left—people like Paul Krugman—and on the right—people like Marty Feldstein—were also deeply skeptical of the idea. But these criticisms were dismissed, especially in France, as self-serving rationalizations by Americans fearful that the euro would compete with the dollar as the world’s main reserve currency and thus undermine U.S. economic dominance.


For all these sour predictions, the first few years of the euro were surprisingly trouble-free. Public finances in southern Europe were actually quite disciplined. Italy managed to cut its budget deficits, and though some creative accounting was involved, progress was very real. In places like Spain and Ireland, massive inflows of capital set off a boom, which allowed the government to pay down its debt to remarkably low levels. The big exception was, of course, Greece—but we did not know the extent of the problems at the time because it was systematically cooking its books.

The real problem was not in the public finances but in the one-size-fits-all monetary policy, which kept interest rates in the Southern Tier far too low during the good years. This in turn created a credit and real estate bubble in places like Ireland and Spain. Another effect of this boom was to drive up wages. So in the first decade of the euro, while the Germans agonized about how uncompetitive they had become, and went furiously to work restructuring their economy and restraining wages, the southern European countries were letting it rip. During the 2000s, labor costs in Germany rose 20%, in Italy by 40%, and in Spain they rose 60%.

As a consequence by 2008, the economies of southern Europe had become seriously uncompetitive and were really only being kept afloat by flows of money from French and German banks: money that would prove to be very fickle.

When the crisis hit in 2008, both the U.S. and the Europeans were determined not to make the same mistakes as the Japanese when faced with similar troubles back in 1990. So on both sides of the Atlantic interest rates were cut to the bone, though the Fed was a little quicker off the mark than the European Central Bank. Bank balance sheets were cleaned up and banks were recapitalized. Again the U.S. authorities acted with greater dispatch and more aggressively than the Europeans. And finally governments on both sides of the Atlantic attempted to jump-start their economies by allowing budget deficits to expand. In Europe this process was much more automatic because the social safety net there is more extensive than here. In the U.S., it took a big fight in Congress to put the same stimulus in place.

If the Europeans essentially followed the same playbook as we did, why then are they in such worse shape?

The financial crisis has uncovered the fundamental structural flaw of the euro system. In a downturn European economic policy operates in a completely perverse way. It actually works to make the weakest parts of the eurozone even weaker. The problem is that power is vested with the member states. As a consequence the economic response to a downturn has to occur largely at the national level.

Take Ireland for example. The cost of bailing out the Irish banks was about E70 billion. In the scheme of things this is not a lot of money. But Ireland is a small place: 4 million people with an economy the size about the size of Connecticut. Because the Irish taxpayers had to foot the whole bill, it ended up amounting to some 40% of their GDP, something like 70,000 euros per household. In relative terms it was the second largest bank bailout in history, only exceeded by what happened in Iceland. Had American taxpayers to bear a comparable burden, the cost here would have been $6 trillion. And not only did the Irish taxpayers have to come up with money for the banks, they also had to lay out had for their own unemployment insurance, all at a time when their tax revenues had collapsed.

To understand the effect of this, try the following mental exercise. Just suppose the cost of cleaning up the Nevada housing bubble, all those bad mortgages, and resulting bank losses, and unemployment checks had been left entirely in the hands of Nevada taxpayers. How do you think Nevada would have fared?

Like the U.S., where the epicenter of the housing bubble was concentrated in a few sunbelt states—Nevada, Florida, Arizona, California—the European economic disaster was similarly concentrated in a few countries, Portugal, Ireland, Spain, and Greece. Now, the U.S. economic woes are by no means over. But compared to Europe, we are in much better shape. And what has helped the U.S. is that its response to the downturn was largely federal, paid for through the federal budget. Neither Nevada nor Florida nor California nor any of the states that were badly hit had to cope with the crisis on their own. All the states chipped in. And the astounding thing is that it all happened quite automatically.

The political machinery kicked into gear and we had New Yorkers and Midwesterners paying for the mistakes of Floridian homeowners or bailing out a bank based in North Carolina or financing unemployment checks in Michigan. We did not have lots of op-eds decrying the inherent fecklessness of people in Reno or Miami Beach. We did not have demonstrations in the street. And we did not need 19 different summits of state governors to figure out how the burden should be shared.


That brings me to my final battery of questions: How does Europe get out of this hole and will the euro survive?

Unfortunately I have no idea. No one has. It depends on too many imponderables: on how much economic pain the politicians of southern Europe are willing to impose on their electorates, on how much money the Germans can be persuaded to put on the table, and what they calculate the costs of a breakup to be.

But as you can tell from the tone of my remarks, I am pessimistic. The dilemma is that there is almost nothing that Spain, Ireland, Portugal, and even in some respects Greece, can do by themselves that will get them out of the hole they are in. All of them are caught in a vicious downward spiral where the only action available to them, which is to curb borrowing by taxes or cutting government expenditure, will deepen their recession, throw more people out of jobs, increase the bad debts of their already fragile banking systems and possibly even worsen their budgetary situations.

The solution to the euro problem will therefore have to come from some action at a European-wide level. And that will be largely decided in Frankfurt and Berlin.

There are three big hurdles that I see.

First the German diagnosis of the problem is totally at odds with what most of the others think. Without going into abstruse economic debates, the Germans basically believe that the problem arose because of failures in the way each of the southern European countries managed its economy. So they insist that the solution is for the southern Europeans to get their own house in order. Angela Merkel supposedly likes to quote Goethe: “If everyone just sweeps outside their door, the whole city will be clean.” It is a view that owes as much to moral philosophy, in particular the Lutheran stress on the virtues of self-sufficiency, than to any economic theory.

The opposing view is that the Europe is in trouble primarily because of systemic failures in the way the eurozone operated. Thus the solution lies in some form of collective European action.

As with almost all economic debates, there is some truth to both sides. The Germans are right that the southern European economies have been badly mismanaged. Greece had an egregiously corrupt government. Italy squandered an opportunity to reform itself. Others like Ireland and Spain were unlucky, short-sighted and foolhardy.

But those who argue that the euro had some fundamental systemic flaws that enabled all this bad behavior on the part of governments and banks are also right.

Because the Germans have such a different interpretation of the problem, they end up being the spoiler. Every serious proposal advanced to deal with the systemic issues—some form of burden-sharing through eurobonds, a European bailout fund for banks, more active use of the ECB to stabilize government bond markets, more aggressive monetary policy by the central bank—ends up being vetoed by an intransigent Germany. As a result, aside from its small group of allies, Finland, Austria and the Netherlands, Germany is becoming increasingly isolated in the European corridors of power.

The second problem is the conflict about money: who pays and how much. There is a very simple tradeoff. Southern Europe will only be able to grow if it can restore its competitiveness by some very painful and deep cuts in wages. The more money that Germany puts on the table, the less the required cut in the standard of living of the average Spanish or Italian worker. The Germans have a nightmare that they will end up in the sort of position that northern Italy is in, which has been transferring money to southern Italy ever since the unification of Italy 150 years ago.

The third problem, which is the biggest problem as far as I am concerned, is the erosion of commitment within Germany to the euro. As I have tried to describe in this talk, for the last 60 years German leaders, from Adenauer to Kohl, men who had lived through the Second World War and its aftermath, saw in the European project a way for Germany to atone for its sins and rehabilitate itself in the eyes of the rest of Europe. That is why they allowed themselves to be bounced by the French into a single currency that they did not really believe in. That generation of leaders is now gone. The new generation of Angela Merkel and Wolfgang Schauble grew up in a postwar Germany that is proud of German economic achievements and sees little reason to keep apologizing for the actions of its grandparents.


In 1953 the novelist Thomas Mann gave a speech to an audience of students in Hamburg. The central challenge confronting the country, he told them, was the deep mistrust of German intentions in the rest of Europe. As a result their goal should be to strive not for “a German Europe but a European Germany.” And thus, during the following fifty years the Germans assiduously avoided any hint that they sought continental primacy. They always tried to keep a low profile in Europe, to avoid the leadership position, leaving that role to France. And by the way the French were always happy to oblige.

Here is the great irony of the current situation. In the seventy years before Thomas Mann spoke, the main threat to European stability had indeed come from German attempts to dominate Europe. The continent now faces the opposite problem. The only hope for stability is actually for the Germans to step up to the plate and take on the mantle of leadership within Europe, with all the burdens and responsibilities that go with it. Frankly that goes against all the instincts of the generation that has grown up in post war Germany.

Economists do not have a great reputation for their forecasting ability. Understandably so. After all they seemed to have missed every single major crisis that we have had over the last four decades. This is one exception. In 1997 the American economist Marty Feldstein wrote an incredibly prescient piece in Foreign Affairs in which he argued that the single currency, far from cementing the European Union, would, in his words, “lead to conflicts over economic policies … that could reinforce long-standing animosities based on history, nationality, and religion.” He has proved to be right.

This crisis has thrown open a new faultline across Europe, between Germany and all the other major countries, especially France, Italy, and Spain. It is a conflict that is destined to remain with us for decades to come and will define the future of the continent.