Soros on the Euro Crisis

How Germany can avoid a two-speed Europe

By George Soros  

The “euro crisis” is generally seen as a currency crisis, but it is also a sovereign debt and, even more, a banking crisis. The situation is complex. The complexity has bred confusion, and this has political consequences. Europe’s various member states have formed widely different views and their policies reflect their views rather than their true national interests. The clash of perceptions carries the seeds of serious political conflicts. 

The solution that is about to be put in place will, in effect, be dictated by Germany, without whose sovereign credit no solution is possible. France tries to influence the outcome but in the end must yield to Germany because its triple A rating is dependent on being closely allied with Germany. 

Germany blames the crisis on the countries that have lost competitiveness and run up their debts, and so puts all the burden of adjustment on debtor countries. This is a biased view, which ignores the fact that this is not only a sovereign debt crisis but also a currency and banking crisis – and Germany bears a major share of responsibility for those crises. 

When the euro was introduced it was expected to create convergence but it brought divergence instead. The European Central Bank treated the sovereign debt of all member countries as riskless and accepted them at its discount window on equal terms. Banks that were obliged to hold riskless assets to meet their liquidity requirements were induced to load up on the sovereign debt of the weaker countries to earn a few extra basis points. This lowered interest rates in Portugal, Ireland, Greece, Italy and Spain and generated housing bubbles – at the same time as Germany had to tighten its belt to cope with the costs of reunification. The result was a divergence in competitiveness, and a banking crisis that affected German banks more strongly than most of the others. Truth be told, Germany has been bailing out the heavily indebted countries as a way of protecting its own banking system. 

The arrangements imposed by Germany protect the banking system by treating outstanding sovereign debt as sacrosanct; they also put all the burden of adjustment on the debtor countries. The arrangements are reminiscent of the international banking crisis of 1982, when the international financial institutions lent the debtor countries enough money to service their debts until the banks could build up sufficient reserves to exchange their bad debts for Brady bonds in 1989. That caused a “lost decade” for Latin America. Indeed, the current arrangements penalise the debtor countries even more than in the 1980s because they will have to pay hefty risk premiums after 2013. 

There is something inconsistent in bailing out the banking system once again and then bailing in the holders of sovereign debt after 2013 by introducing collective action clauses. As a result, the European Union will suffer something worse than a lost decade; it will endure a chronic divergence in which the surplus countries forge ahead and the deficit countries are dragged down by the burden of accumulated debt. The competitiveness requirements will be imposed on an uneven playing field, putting deficit countries into an untenable position. Even Spain, which entered the euro crisis with a lower debt ratio than Germany, could be dragged down.

Berlin is imposing these arrangements under pressure from German public opinion, but the German public has not been told the truth and so is confused. The solution to the euro crisis to be put in place this week will set in stone a two-speed Europe. This will generate resentments that will endanger the EU’s political cohesion. 

Two fundamental modifications are required. First, the European financial stability facility must rescue the banking system as well as member states. This will allow the restructuring of sovereign debt without precipitating a banking crisis. The size of the rescue package could stay the same because any amount used for recapitalising or liquidating banks would reduce the amount lent to sovereign states. Bringing the banks under European supervision rather than leaving them in the hands of national authorities would help restore confidence in the banking system. 

Second, to create an even playing field, the risk premium on the borrowing costs of countries that abide by the rules will have to be removed. That could be accomplished by converting most sovereign debt into eurobonds; countries would then have to issue their own bonds with collective action clauses and pay the risk premium only on the amounts exceeding the Maastricht criteria. The first step could and should be taken immediately at Thursday’s summit; the second will have to wait. The German public is a long way from accepting it; yet it is needed to re-establish a level playing field. This has to be made clear to give deficit countries hope they can escape from their deficit predicament if they work hard enough at it.

© 2009 GeorgeSoros.com