EU Monitor 82

July 1, 2011 Reports on European integration

The political economics of the euro

The altered nature of political relationships within the EU after the fall of the Berlin Wall had a profound impact on the project of establishing a common currency. If in the past, the creation of a common

currency had been seen as catalyst to create political union, which had been regarded as the ultimate guarantor of peace in Europe, it had now turned into an undertaking whose value was measured primarily in the economic advantages it was supposed to afford its members.
The history of past real or quasi monetary union of sovereign states suggests that the build-up of severe fiscal imbalances in parts of the union and the monetisation of these deficits have been the key reasons for failure. Mindful of the past experience, the fathers of EMU wanted

to shield the central bank from any pressures to monetise fiscal deficits and hold countries responsible for their financial behaviour.
The ECBs involvement in the funding of banks and governments whose solvency is in serious doubt has not been the only serious deviation from the intention of the Maastricht Treaty. With the budgetary

support to Greece, Ireland, and Portugal, EMU governments have arguably violated Article 125 of the EU Treaty forbidding the bail-out of financially distressed countries. As a result, the two key pillars on which EMU was built the principles of the central banks exclusive focus on the purchasing power of the common money and governments full liability for their financial decisions have crumbled. In order to return EMU to a stable, contractually founded base it seems necessary that governments either take a significant step forward towards a political union or restore the two original pillars of EMU.
With political union in our view very unlikely, the best option for a stable future of EMU would be a return to the basic principles of the Maastricht Treaty. Without political leadership from the top, this outcome is
Author Thomas Mayer +49 69 910-30800 tom.mayer@db.com Editor Barbara Bttcher Technical Assistant Angelika Greiner Deutsche Bank Research Frankfurt am Main Germany Internet: www.dbresearch.com E-mail: marketing.dbr@db.com Fax: +49 69 910-31877 Managing Director Thomas Mayer

likely to be driven by grass-root events (e.g., a rebellion of the backbenchers in the Greek or Berlin parliament against their leaders or a bank run in Greece). Given the recent momentum in the political debate, we would give such an outcome over the coming 6-12 months the highest probability. Alternatively, if the political elites remain in control and enforce the continuing execution of unviable adjustment programmes, we see a significant risk of an eventual break-up of EMU.

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There is no example in history of a lasting monetary union that was not linked to one State. Otmar Issing, former Chief Economist of the Bundesbank and the ECB, 1991. In the past, common currency regarded as a catalyst for political union The altered nature of political relationships within the EU after the fall of the Berlin Wall had a profound impact on the project of establishing a common currency. If in the past, the creation of a common currency had been seen as catalyst to create political union, which had been regarded as the ultimate guarantor of peace in Europe, it had now turned into an undertaking whose value was measured primarily in the economic advantages it was supposed to afford its members. Future historians may find it ironic that the threat of war disappeared before the process of European unification had found its fulfilment in political union, which had been seen as the key instrument to eliminate the possibility of war in Europe for all times. As a result, EMU, which originally should have been fortified by creating political union, was caught out on a limb. During the 1990s European leaders were warned that the creation of a monetary union without the prospect of a political union following in the not too distant future was risky business. They went ahead anyway. The history of past real or quasi monetary union of sovereign states suggests that the build-up of severe fiscal imbalances in parts of the union and the monetisation of these deficits have been the key reasons for failure. Mindful of the past experience, the fathers of EMU wanted to shield the central bank from any pressures to monetise fiscal deficits and hold countries responsible for their financial behaviour. To achieve the first objective, the ECB was prohibited to purchase government bonds in the primary market and given far reaching independence in the Maastricht Treaty that constituted EMU. To achieve the second objective, the Stability and Growth Pact was concluded with the aim to prevent governments from running up excessive fiscal deficits. In addition, the threat of default was expected to exert further disciplinary influence on the conduct of fiscal policy. The ECBs involvement in the funding of banks and governments whose solvency is in serious doubt has not been the only serious deviation from the intention of the Maastricht Treaty. With the budgetary support to Greece, Ireland, and Portugal, EMU governments have arguably violated Article 125 of the EU Treaty forbidding the bail-out of financially distressed countries. As a result, the two key pillars on which EMU was built the principles of the central banks exclusive focus on the purchasing power of the common money and governments full liability for their financial decisions have crumbled. In order to return EMU to a stable, contractually founded base it seems necessary that governments either take a significant step forward towards a political union or restore the two original pillars of EMU. With political union in our view very unlikely, the best option for a stable future of EMU would be a return to the basic principles of the Maastricht Treaty. Without political leadership from the top, this outcome must be driven by grass-root events (e.g., a rebellion of the backbenchers in the Greek or Berlin parliament against their leaders or a bank run in Greece). Given the recent momentum in the political debate, we would give such an outcome over the coming 6-12 months the highest probability. Alternatively, if the political elites remain in control and enforce the continuing execution of unviable adjustment programmes, we see a significant risk of an eventual break-up of EMU.

(Negative) historical experience should be prevented by ECB independence and the SGP

The two key pillars of EMU have crumbled

Political union very unlikely

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The political economics of the euro

No more about war and peace

Germany to be bound into a European structure Already towards the end of WWII, visionary French politicians, such as Jean Monnet and Robert Marjolin, concluded that a defeated Germany would have to be bound into a European structure in order to avoid a repeat of the experience after WWI. Then, the harsh conditions dictated in the Treaty of Versailles had led to deep-seated German resentment and had helped to pave the way to German revanchism and eventually to Nazi-Germany. To avoid this, the French politicians set the stage for the creation of the so-called European Coal and Steel community, where industries important for the conduct of war were brought under a European umbrella. But European integration was not supposed to end there. Ever closer economic integration was seen to drive forward political integration. The steps at the economic level included the move to the European Economic Community, the creation of the European Union and the Single European Market, and eventually the establishment of European Monetary Union (see Table p. 4 for a short history of European Integration). The close relationship between France and Germany as the engine for European integration was reflected in the close personal relationship between the political leaders of the two nations. President de Gaulle and Chancellor Adenauer started the tradition that was carried on, among others, by Valrie Giscard dEstaing and Helmut Schmidt, and Franois Mitterrand and Helmut Kohl. During the post-WWII period, this was not a relationship of two equal partners. There was a clear hierarchy: France was in the political lead and Germany followed, often backing the European project by its regained financial power. But the relationship benefited both partners: Germany was able to influence the international political debate by France speaking for it as well as for itself, and France could leverage up its political weight by German economic power. Moreover, the process of European integration was driven forward by the political elites in both countries, which had to pull along a more or less sceptical general public. Early on, the creation of a common currency was seen as of particular importance for European unification. Already in 1949, Jacques Rueff, a famous French economist and government adviser, had predicted that Europe will be created through its money, or it will not come into existence at all. The first attempt at creating a common European currency was made in 1970. The plan, designed by the Luxembourg Prime Minister Pierre Werner, envisaged the creation of a monetary union by 1980. The Werner Plan failed in the wake of the oil price shock of the early 1970s and the collapse of the Bretton Woods system of quasi-fixed exchange rates in 1973. However, this plan laid the ground for the creation of the European Monetary System in 1979, which established the preconditions for the eventual creation of Economic and Monetary Union in 1999.

France and Germany as engine for European integration

Various attempts to create a common currency in Europe

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The history of economic integration in Europe: Timeline of major events

1951 1957 European Coal and Steel Community 1.) Preferential Zone Treaties of Rome: European Economic Community EEC 2.) Free Trade Area European Atomic Energy Community EURATOM European Coal and Steel Community ECSC European Free Trade Area: Founding members were the Outer seven: Austria, Denmark, Norway, Portugal, Sweden, Switzerland, UK Merger Treaty: ECSC, EURATOM and EEC merged into European Community EC 3.) Customs Union Exchange Rate Mechanism (ERM): European Currency Snake Northern Enlargement 1: Accession of Denmark, UK and Ireland European Monetary System (EMS), including ECU as a basket currency Southern Enlargement 1: Accession of Greece Southern Enlargement 2: Accession of Spain and Portugal Schengen Treaty signed. Schengen area came into existence 10 years later in 1995 Single European Act First major Treaty revision since 1957 Agreement on full removal of all tariff and non tariff barriers in the European Single Market until 1992 European Economic Area: EFTA plus EU-12 minus Switzerland Maastricht Treaty: 4.) Common Market; Treaty Reform three pillars: EC (supranational) Common Foreign and Security Policy (CFSP, intergovernmental) Justice and Home Affairs (JHA, intergovernmental) Agreement on 3 stages to EMU: 1. 1990: Free capital movement 2. 1994: Convergence of macro policies 3. 1999: Launch of the euro Northern Enlargement 2: Finland, Sweden, Austria Broad Economic Policy Guidelines as a means for economic policy coordination. 5.) Economic Union. Stability and Growth Pact Amsterdam Treaty More power for European Parliament, strengthening the rights of citizens Third Stage of EMU: European Central Bank, Launch of the euro as accounting unit 6.) Currency Union Treaty of Nice: Amendment of majority rules in the Council. Strengthening the principle of qualified majority, weighing population Eastern Enlargement 1: Cyprus, Czech Republic, Estonia, Hungaria, Latvia, Lithuania, Malta, Poland, Slovak Republic, Slovenia Eastern Enlargement 2: Romania, Bulgaria Lisbon Treaty: Institutional reforms, more qualified majority voting, closer economic coordination between EMU member states, EU becomes legal personality Euro Crisis: EMU countries agree on support programmes for Greece (2 May) and other EMU countries (9 May). Founding of EFSM and EFSF Signing of ESM Treaty.

1960 (1965) 1967 1972 1973 1979 1981 1985 1985 (1986) 1987

(1993) 1994 (1992) 1993

1995 1996 1997 (1997) 1999 1999 (2001) 2003 2004 2007 2009 2010 2011

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1989 changed the nature of European integration

Germany started to behave like any other normal EU member state ...

... with progress towards closer union becoming more cumbersome

The fall of the Berlin Wall in 1989 was not only a watershed event for the world but also fundamentally changed the nature of European integration. On the one hand, this historical event induced Germany to give up its beloved D-Mark, the symbol for its postWWII achievements, in favour of a common currency. This was the price President Mitterrand demanded from Chancellor Kohl for Frances backing of German unification. On the other hand, it fundamentally changed Germanys relationship to France and its other European partners. Having regained its full national sovereignty through unification and having been freed from the military threat emanating from the former Soviet Union, Germany began to lose its political deference to France and its other European partners and to behave like any other normal EU member state. Normal behaviour in the EU consisted more often than not in the pursuit of national interests within without much regard for the common good of European unity. As long as Germany was willing to protect the union by footing the bill for such behaviour, common European projects could be implemented relatively smoothly. When Germany closed its checkbook, progress towards ever closer union became more cumbersome. The change in the political relationship was also reflected in the change in personal relationships between the French and German political leaders. The relationships between Jacques Chirac and Gerhard Schrder, and even more so that between Nicolas Sarkozy and Angela Merkel, became less cordial and more businesslike. If the pre-unification pairs of French-German leaders saw European unification as a question of war and peace, the post-unification leaders looked at it more from the perspective of what political and economic advantage was in it for their countries. Most importantly, the desire to crown European unification by creating a political union that had long been an inspiration for economic integration disappeared into thin air. The altered nature of political relationships within the EU had a profound impact on the project of establishing a common currency. If in the past, the creation of a common currency had been seen as catalyst to create political union, which had been regarded as the ultimate guarantor of peace in Europe, it had now turned into an undertaking whose value was measured primarily in the economic advantages it was supposed to afford its members. Future historians may find it ironic that the threat of war disappeared before the process of European unification had found its fulfilment in political union, which had been seen as the key instrument to eliminate the possibility of war in Europe for all times. As a result, EMU, which originally should have been fortified by creating political union, was caught out on a limb. During the 1990s European leaders were warned that the creation of a monetary union without the prospect of a political union following in the not too distant future was risky business. They went ahead anyway.

Common currency increasingly measured in its economic advantages

A history of failures
Fiscal problems at the roots of historical monetary unions failures Historical experience suggested that the creation of a monetary union without political union would be a highly risky undertaking. Two previous efforts at creating a monetary union of sovereign states in Europe both failed. In 1865, France, Belgium, Italy, Switzerland and Greece created the so-called Latin Currency Union. This union lasted until 1914, when financial pressures in some countries induced them to monetise government deficits. As a result of the de-basement of the currency, the union then broke apart. In 1872, several northern European countries created the

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Scandinavian Monetary Union. This project at least survived WWI. But in 1924 it also broke apart as some countries started to monetise their fiscal deficits. In both cases, the union unravelled when severe fiscal problems in part of the union led to a monetary funding of government deficits. History of fixed exchange rate systems not encouraging either The history of fixed exchange rate systems a weaker form of a currency union was also not encouraging. During WWI, the gold standard was suspended as countries used the money printing press to finance the war effort. Following the return to the gold standard after WWI, severe balance of payments imbalances emerged during the 1920s. France and the US both accumulated large gold reserves while the UK and Germany saw their reserves melt away. The problem was especially acute in Germany, which had to rely on short-term borrowing in the international capital market to fund its balance of payments deficit. When the short-term capital market seized up in the wake of the 1929 stock market crash, Germany experienced a financial crisis that led to a series of bank failures and deepened the Great Depression. After WWII, the western powers replaced the pre-war gold standard with a fixed, but adjustable exchange rate system, the so-called Bretton-Woods system, where the US dollar performed the role of the monetary anchor. To avoid balance of payments crises that could bring down the system, an institution, the International Monetary Fund, was created and charged with monitoring economic performance, and in the case of balance of payments deficits, designing and funding adjustment programmes. However, when in the late 1960s the US administration colluded with its central bank to provide monetary financing of fiscal deficits, an international excess supply of US dollars built up that led to the demise of the monetary anchor and in 1973 the break-up of the Bretton Woods System. The history of past real or quasi monetary unions of sovereign states suggests that the build-up of severe fiscal imbalances in parts of the union and the monetisation of these deficits have been the key reasons for failure. Mindful of the past experience, the fathers of EMU wanted to shield the central bank from any pressures to monetise fiscal deficits and hold countries responsible for their financial behaviour. To achieve the first objective, the ECB was prohibited to purchase government bonds in the primary market and given far reaching independence in the Maastricht Treaty that constituted EMU. To achieve the second objective, the Stability and Growth Pact was concluded with the aim to prevent governments from running up excessive fiscal deficits. In addition, the threat of default was expected to exert further disciplinary influence on the conduct of fiscal policy.

Break-up of the Bretton-Woods system

Monetising fiscal deficits and bad fiscal behaviour weak spots for monetary unions

Crumbling foundations
Contractual basis of EMU has severely eroded in the course of the financial crisis Since the beginning of the financial crisis the contractual basis of EMU has severely eroded. It all began with swift liquidity support by the ECB for a gummed up money market in August 2007, when the news broke that euro-denominated European money market funds had exposure to the US sub-prime mortgage market. For quite some time afterwards, ECB President Trichet liked to proudly refer to this operation as proof that the ECB was capable of doing the right thing in a critical moment without delay. However, while the ECBs initial liquidity support was indeed in line with best practice in central banking, the same cannot be said of the subsequent events. As time passed and the full scale of the financial crisis became visible, governments should have stepped in and wound down insolvent
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banks. However, while governments indeed prevented the worst by recapitalising or resolving the weakest institutions, they failed to inject sufficient equity into the banking system to return all surviving institutions to financial health. As a result, a significant number of weak banks for which the name addicted banks was coined remained cut off from market funding and hence dependent on ECB support for the funding of their assets. Since the ECB was not able to force the governments to recapitalise or close the addicted banks, they were drawn into the open-ended support of insolvent financial institutions. ECB not only sustained individual banks but banking systems Circumstances worsened when market funding for over-indebted countries dried up towards the end of 2009. Now, the banks of these countries, which had a high and rising exposure to their govern1 ments debt, turned collectively into addicted banks. The ECB was 2 no longer sustaining individual banks, but entire banking systems. Given these governments weak finances (and the absence of a European deposit insurance and bank resolution regime), the ECB could end supporting these banks only at the cost of their collective failure. When in May last year the funding problems of the Greek government led to fears of bankruptcy of a number of EMU states and a collapse of the euro, EMU member governments decided on the creation of a EUR 750 bn funding mechanism for states cut off from market funding. Since it took some time to prepare the institutional set-up of this mechanism, the ECB was enlisted to intervene and stabilise the bond markets of financially troubled countries. As a result, the ECB acquired some EUR 75 bn of bonds of the governments of Greece, Ireland, and Portugal, all countries presently pursuing adjustment programmes backed by the EU and IMF. To the direct financial exposure of the ECB to these countries comes the indirect exposure in the form of loans to banks in these countries that are collateralised with government bonds of the same countries or securities closely correlated with the latter (e.g. mortgage backed securities). Thus, the ECB has strayed far from its prime mandate to secure the purchasing power of the common currency and taken on the funding of governments and banks whose solvency is highly doubtful. In propping up banks and governments that have lost access to market funding for a longer period of time, the ECB has also provided balance of payments funding for euro area member countries. As we explained in our GEP from June 8, national central banks within the Eurosystem through the interbank payment system Target2 finance payment imbalances, arising when the current and capital account fails to balance. Thus, the Bundesbank has accumulated a claim against the target system in the amount of EUR 321 bn by the end of the first quarter of this year while the Bank of Greece has a liability in the amount of EUR 83 bn. The

ECB has strayed far from its prime mandate to secure the purchasing power of the euro

Large imbalances within Target2

Banks were pushed into raising their government bond holdings when other investors withdrew. They could finance their bond purchases by using the acquired bonds as collateral for borrowing from the ECB. When the rating of Greece fell below the limit for eligible collaterals, the ECB waived the limit for Greece. The notion that there should be something like a national banking system within EMU is a fallacy. In a currency union banks should operate across regions with a view to diversifying both investment and funding risk. However, a true euro area banking sector has not emerged so far. Hence, banks in individual countries have remained heavily exposed to country-specific risk with the result that a sovereign debt problem in an EMU member country is directly leading to a banking problem in this country. 7

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emergence of these large imbalances within Target2 reflects the markets distrust in the financial viability of certain EMU countries. Budgetary support arguably violated bail-out clause in the EU Treaty The erosion of the ECBs mandate has not been the only serious deviation from the intention of the Maastricht Treaty. With the budgetary support to Greece, Ireland, and Portugal, EMU governments have arguably violated Article 125 of the EU Treaty 3 forbidding the bail-out of financially distressed countries. As a result, the two key pillars on which EMU was built the principles of the central banks exclusive focus on the purchasing power of the common money and governments full liability for their financial decisions have crumbled. In order to return EMU to a stable, contractually founded base it seems necessary that governments either take a significant step forward towards a political union or restore the two original pillars of EMU. EU officials would of course reject our above reasoning on the ground that it is impossible for an EMU country to become insolvent. Hence, all that is needed is that these countries stick to their adjustment programmes. If the market does not believe in the success of these programmes, then the public sector should take over the funding until success of the programmes becomes visible. This argument implies that the political planners have the better foresight of both the future economic and political developments. No doubt, markets can be wrong for an extended period of time, as the recent experience of the inflation of the credit bubble has shown. But markets correct eventually, something that cannot be said for political planners. This is why economic history has shown markets to be far superior in making economic decisions compared to political planners.

Markets are far superior in making economic decisions compared to political planners

Forward or backward?
Call for a more comprehensive political union logical ... Already in 1991, Bundesbank President Hans Tietmeyer warned that a European currency will lead to member-nations transferring their sovereignty over financial and wage policies as well as monetary affairs, and concluded that it is an illusion to think that States can hold on to their autonomy over taxation policies. His warning was echoed in the Bundesbanks Annual Report of 1995, which admonished politicians: As a monetary union represents a lasting commitment to integration which encroaches on the core area of national sovereignty, EMU participants must also be prepared to take further steps towards a more comprehensive political union. Hence, it is only logical that ECB President Trichet, when he received the 2011 Karlspreis on June 2 in Aachen, proposed the creation of a ministry of finance of the Union that would exert direct responsibilities in at least three domains: first, the surveillance of both fiscal policies and competitiveness policies, as well as the direct responsibilities mentioned earlier as regards countries in a second stage inside the euro area; second, all the typical responsibilities of the executive branches as regards the unions integrated financial sector, so as to accompany the full integration of financial services; and third, the representation of the union confederation in international financial institutions. His
3

The German Constitutional Court on July 5 will hold its first hearing of a complaint by several German private citizens against the German governments financial support for Greece. Should the Court (in a ruling expected for later this year) find that the support violated the no-bail-out clause of the EU Treaty, the German government would have to stop its participation in the current support programmes and, in the case of Greece, demand its money back. However, such an outcome is unlikely. More likely, the Court will require greater involvement of German parliament in all EU matters that affect the German government budget. July 1, 2011

The political economics of the euro

... but this logic might be not valid any more

reasoning is fully in line with the past logic of driving forward European integration through a sequence of steps in the economic and monetary domain that eventually result in political union. But is this logic still valid today? We believe the answer to the above question is no. As we explained earlier, the European method of the political and business elites driving integration forward and pulling their reluctant citizens along lost its power when the fall of the Berlin Wall removed the threat of war from the European region. A clear signal that the peoples of Europe are not in favour of political union was given by the rejection of the Lisbon Treaty in public referendums in two core European states, France and the Netherlands. The Lisbon Treaty represented a rather small step towards political union (and could therefore be implemented nonetheless when it was stripped of those parts referring to closer political union). Compared to this, the permanent relinquishment of budgetary sovereignty (as suggested by Trichet) would be a major leap forward and probably be rejected in the vast majority of EMU member states when put to a referendum (or even a vote in parliament).

EMU can only be stabilised by going back to its key building principles

But if a leap forward to a much closer political union is against the wish of the peoples of Europe, EMU can only be stabilised when we go back to its key building principles. This would require that the ECB stops lending to banks and states that are most likely insolvent and returns to its main task of preserving the purchasing power of money. It would also require that the principle of member states full financial liability is restored, even when this requires allowing them to default on their debt (whereby the external effects of such a default could be minimised along the lines we have extensively discussed since the break of the Greek crisis). Although Otmar Issing, the Bundesbanks and the ECBs former chief economist, warned already in 1991 that there is no example in history of a lasting monetary union that was not linked to one States, we still believe that EMU can be stabilised if the ECB returned to its core 4 task and governments were held liable for their financial decisions.

A lack of leadership
Few signs that Europes political leaders are able to restore the foundations of EMU ... Unfortunately, there are few signs that Europes political leaders are able to restore the foundations of EMU in the way explained in the previous section. Without determined joint leadership by France and Germany, it is very difficult to take important decisions in European affairs. However, the French and German leaders are pulled in different directions. In Germany (and some smaller northern EMU member states), a deep-seated aversion by the electorate to put taxpayers money at risk in the support of likely insolvent EMU member states is exerting severe pressure on the political leaders to provide assistance only under strict conditions and enforce the financial participation of private sector participants in this assistance. In France (and some other mostly southern European countries) there is a much greater willingness by the electorate to support financially troubled countries, perhaps because these countries are perceived to be more similar to the own home country of the
4

... with compromises on EU level eroding credibility at home

In a recent article, Philip Stevens argued that the euro crisis marked the end of post-WWII European pooling of sovereignty and the return of the doctrine of state sovereignty established in the peace of Westphalia in 1648 (see Financial Times from June 24, 2011). We do not think that this will necessarily be the case. Rather, we find it more likely that euro area states in the future will continue to share sovereignty, based on the principles of subsidiarity, clearly defined responsibilities, and full financial liability (see T. Mayer and S. Richter; A second (reverse) Westphalian Peace for Europe, June 2011. 9

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5

respective electorates. Endowed with different political mandates from home, the French President and German Chancellor are bound to strike compromises at the European level that satisfy no one (take, e.g., the compromise to push for a voluntary roll-over of 6 maturing Greek debt by the private sector). Over time, weak compromises at the European level erode the leaders credibility at home and pave the way to an eventual political defeat at home. Political problems in an insolvent state ... A similar problem arises for the political leader of an insolvent country who pursues a doomed adjustment strategy to stave off default. With success of the adjustment strategy proving elusive, the credibility of the leader declines until he is ousted by his political opponents. Alternatively, if the leader is able to retain political support in parliament, the confidence of the population in him may plummet, inducing people to fear personal bankruptcy in the wake of state and bank bankruptcy, and start a run on the banks. When the hands of the political leaders are forced by a loss of political support in parliament or bank runs by the public, it would be extremely important to have the proverbial Plan B ready to stave 7 off a financial disaster. As we have explained repeatedly, such a Plan B would consist of an assisted debt restructuring of the insolvent country along the lines shown by the Brady Plan for emerging market countries in the early 1990s, coupled with a bank re-capitalisation, bank resolution and deposit insurance scheme funded at the European level (especially for banks in the insolvent country). Since at least a part of the institutional framework for the implementation of such a Plan B exists in the form of the EFSF, it should not be difficult to implement it fast when needed. However, whether in the case of an emergency European leaders will be capable to make the necessary decisions quickly will remain to be seen.

... require the proverbial Plan B ...

... along the lines shown by the Brady Plan

Uncertain future for EMU

Grass-roof events might force return to the original Maastricht contract Take the example of couple that had entered into a contract keeping their wealth separate when they married. What will happen, when one partner has broken the contract and the other partner has been forced to provide financial assistance to bail him out? The couple could of course change the contract and pool its wealth from here on. But the odds for this to happen under such circumstances do not seem to be very high. The couple could go back to the original contract and accept separate financial liability. To make this credible, the partner responsible for the breach of contract would have to accept an end of further financial support from the other partner, even if this implied personal bankruptcy. This would perhaps ensure a better long-term basis for the marriage, but the financially weaker
5

In economic terms, we could perhaps rationalise the support by France and other southern European countries for the troubled countries with their desire to retain their status as the issuer of risk free assets. Following a default of an EMU country, markets are likely to trade only German debt as risk free and to regard all other sovereign debt as credit. Fear to create another financial crisis by triggering a default rating of the agencies or a credit event leading to the payout of credit insurance is another factor preventing clear decisions. As policy makers are taken hostage by the financial markets, their decisions become weak and inadequate for a solution of the problem. However, it is unclear whether they gain anything by kicking the can down the road. Economic fundamentals in other endangered countries will not change fast and derivates positions will not disappear overnight. Hence, all what leaders are likely to achieve by delaying an eventually inevitable event is damage to their credibility and hence ability to lead. See, for instance, Debt reduction without (a messy) default by Daniel Gros and Thomas Mayer, CEPS Commentary, 23 June 2011. July 1, 2011

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The political economics of the euro

partner may not be willing to accept the pain of going through an insolvency procedure. This leaves the option of continuing the marriage without any contract. An immediate divorce would be avoided, but the loss of trust and growing suspicions would probably induce divorce in due course. If political elites continue to enforce unviable adjustment programmes ... The purpose of giving the above example is of course to argue that EMU is in a similar dilemma. With political union in our view very unlikely, the best option for a stable future of EMU would be a return to the original marriage contract, the Maastricht Treaty. Without political leadership from the top, this outcome must be driven by grass-root events (e.g., a rebellion of the backbenchers in the Greek or Berlin parliament against their leaders or a bank run in Greece). Given the recent momentum in the political debate, we would give such an outcome over the coming 6-12 months the highest probability. Alternatively, if the political elites remain in control and enforce the continuing execution of unviable adjustment programmes, we see a significant risk of an eventual break-up of 8 EMU. Thomas Mayer (+49 69 910-30800, tom.mayer@db.com)

... there is a significant risk of an eventual break-up of EMU

Any scenario of a break-up of EMU is of course highly speculative. If it ever occurred, we would find it more likely to happen through the emergence of a parallel currency than official currency reform. For example, it the Greek government were suddenly cut-off from outside financial support, they could pay their bills with IOUs that could assume currency character and trade against the euro. Or, if the ECB presided over excessive money creation and a rise of inflation, German financial institutions could for example issue a gold-backed private currency that could evolve into a rival to a de-based euro. 11

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