COVER STORY

Too Late for the Euro?

A decade into its ambitious currency experiment, the Eurozone is in trouble. Business school professor David Beim, a financial-markets expert and former investment banker, says the euro's hour of reckoning is at hand.

Published Winter 2011-12
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Columbia: What happens when those bonds mature?

Beim: Some day quite soon, a stressed government like Italy or Spain will attempt to sell new bonds to repay maturing bonds, and the market will be unwilling to buy them. Then either it will face default on the maturing bonds or the ECB will have to be the buyer of last resort. The ECB has tried mightily to avoid being in this position, but I think it will face this choice soon. And to avoid a sovereign default, with all its unknown consequences, I think they will succumb.

Columbia: Why is it so terrible for the ECB to buy government bonds?

Beim: Because the ECB can pay for them only by printing money. What we call “money” is the promissory note of a central bank. Look at a dollar bill and you will see the words “Federal Reserve Note” across the top. A central bank, like any company, has assets on one side of its balance sheet and liabilities and capital on the other. If it takes on new assets, it needs to issue new liabilities, i.e., create new money. This is like turning on the printing presses to finance the stressed governments of Europe.

 

Columbia: Would that cause massive inflation?

Beim: I see no other possible outcome unless the Eurozone dramatically reverses course. This does not mean that prices would immediately start rising in Europe. There is currently a lot of economic slack all over the industrialized world. But the system would shift in a fundamental way, and the flood of new euros, once started, would be very hard to stop. 

Furthermore, the quality of the euros would be undermined. The quality of any money depends on the quality of the assets in the central bank that issues it. Ideally, many would like a central bank to hold gold against its issuance of money, but there is not enough gold in the world to do this. The Federal Reserve does the next best thing and holds treasury bonds against its issuance of dollars. This is the closest thing we have to a risk-free asset, so the dollar has retained its popularity. But the ECB’s assets are far from risk-free, and if it becomes the lender of last resort to stressed governments, its asset quality will deteriorate rapidly, and people’s trust in the euro will soon fall. You don’t want your currency to be backed by doubtful assets.

 

Columbia: How long could the system go on in that case?

Beim: Not very long. I would guess that this scenario would lead fairly soon to the withdrawal of one or more northern countries from the euro. It probably wouldn’t be Germany at first, because they are working so hard to be good citizens in this drama, but it could easily start with the Netherlands or Finland.

 

Columbia: Shortly before the December summit, the Organisation for Economic Co-operation and Development (OECD) warned of a worldwide recession if the euro crisis were not resolved. 

Beim: The OECD is right. The flood of government bonds has overwhelmed the Eurozone banks and crowded out bank lending to the private sector, which has fallen precipitously in the past few years. The austerity imposed by the debt crisis further represses the economies. In fact, some economists will soon be saying that the massive printing of euros is desirable to fight recession, a kind of super quantitative easing.

But the real answer, I believe, is to admit that the primary source of these problems is the euro itself. Locking together the currencies of countries as different as Germany and Greece is a mistake, and predictably leads to payments imbalances. The same happened to Argentina, which locked its currency to the dollar in the 1990s and soon fell into a current-account imbalance, rising public deficits, debt escalating without limit, and a bruising economic recession induced by austerity. It ended when the peso was re-established and inflation resumed. That experiment lasted ten years. 

 

Columbia: The euro turned ten on January 1.

Beim: And it is showing the same pattern of current-account imbalance, rising public deficits, debt escalating without limit, and a bruising economic recession induced by austerity. Many intelligent and dedicated people have worked extremely hard to create and defend the euro. But the project is deeply flawed. It includes too many countries too unlike one another. It has no governance system to resolve its many stresses. And the central bank at the center of the system is about to swallow lots of bad assets and pay for them with newly printed money. This would be an ironic end for a currency that was designed to take printing presses away from national governments. 

It is painful and difficult to reverse a course that so many governments have so thoroughly committed themselves to. Nevertheless, the question of exit is now being discussed in public for the first time. An orderly exit needs to be planned for, or a disorderly exit will soon occur. Europe should begin this reversal by creating a pathway for exit, beginning with Greece. The euro was a bold and creative project, but the time to rethink it has arrived.

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