“The Tragedy of the European Union”

Thank you all for coming. My purpose in coming to Berlin is to put before you a lasting solution to the seemingly intractable problems connected with the euro. That sounds like mission impossible. After all, the problems have been with us for a number of years and they have been growing worse rather than getting resolved. We have been drifting from crisis to crisis and both the economic and the political situation keeps deteriorating.  It has been a thoroughly debilitating process accompanied by a lot human suffering, not here in Germany, but in the so-called “periphery” countries, and generating a lot of hostility and resentment both at the core and in the periphery.  We reached a point where the survival of the euro could no longer be taken for granted and there is a real danger that the euro will destroy the European Union itself exactly because of its division into a core and periphery. The euro crisis has turned into a veritable nightmare.

But nightmares can be escaped. You can wake up and realize that all the seemingly insoluble problems were creatures of your own imagination. That is the message I have come to deliver.

Let me say a few words about myself. You may know me as a successful hedgefund manager, now retired, who knows a thing or two about financial markets.  But I am also a fervent believer of the European Union as an embodiment of the ideal of an open society and I don’t want the euro to destroy it. I have a network of open society foundations which are active in various parts of the world and I can testify from personal experience that the world needs a strong and prosperous Europe devoted to the principles of open society.

The traumatic experience of my life was the German occupation of Hungary in 1944. I survived it because my father taught me at a early age that it’s better to confront harsh reality than to passively submit to it.  I realize that in my analysis I’m quite critical of German policies, but please don’t take it amiss. I am equally critical of others, including the financial markets. As an erstwhile disciple of Karl Popper I have developed a philosophy based on the recognition that our understanding of the world in which we live is inherently imperfect and our misconceptions play an important role in shaping the course of history. It just happens that as the largest and most successful creditor country, Germany is in the driver’s seat and whether you like it or not, your policies largely determine the outcome of the current crisis.

The policy of fiscal retrenchment in the midst of rising unemployment is pro-cyclical and pushing Europe into a deeper and longer depression. That is no longer a forecast; it is an observation. The German public doesn’t yet feel it and doesn’t quite believe it. But it is all too real in the periphery and it will reach Germany in the next six months or so. My message is that the looming depression is largely self inflicted and the nightmare can be escaped.  It won’t be easy.  The euro crisis is extremely complex and complex problems don’t have easy solutions.

I won’t repeat my analysis because you can read it at Spiegel online. I’ll just highlight the key points and then I will bring my argument up to date in light of the impending decision by the constitutional court.

The European Union was meant to be the embodiment of an open society – a voluntary association of equal states that surrendered part of their sovereignty for the common good. The euro crisis is now turning the European Union into something fundamentally different. The member countries are divided into two classes – creditors and debtors – with the creditors in charge. As the strongest creditor country, Germany is emerging as the hegemon. Debtor countries have to pay substantial risk premiums for financing their government debt and this is reflected in their cost of money throughout the economy. To make matters worse they are pushed into countercyclical policies by Germany.

This is not the result of some evil plot but a lack of coherent policy making. The Bundesbank remains committed to an outmoded monetary doctrine that is deeply rooted in Germany’s traumatic experience with inflation. The Bundesbank recognizes only inflation as a threat to stability and ignores deflation, which is the real threat today. Therefore, Germany insists on imposing austerity on debtor countries. This can easily become counterproductive because a reduction in GDP automatically increases the debt ratio and that can outweigh the benefits of structural reforms.

This point has not been understood in Germany until now. Structural reforms worked for Germany a few years ago, why shouldn’t it work for Europe now? The answer is that it was countercyclical when the rest of Europe enjoyed a real estate and consumption boom, so that Germany could enjoy an export led recovery. But it is pro-cyclical now so that Europe is pushed into a depression.

The division of Europe into creditor and debtor countries has brought some unintended and unexpected benefits for creditors. They enjoy a competitive advantage and they fare better than the debtors. This creates a real danger that the two-tier Europe will become permanent. Both human and financial resources are attracted to the center and the periphery will become permanently depressed. Germany will even enjoy some relief from its demographic problems by the immigration of well educated people from the Iberian Peninsula and Italy instead of less qualified “Gastarbeiter” from Turkey or Ukraine.

Although this was unintended some German politicians have started to figure out the advantages it has conferred on Germany and this has begun to influence their policy decisions. As time passes, there will be increasing grounds for blaming Germany for the policies it is imposing on Europe, while the German public will feel unjustly blamed. This is truly a tragedy of historic significance. As in ancient Greek tragedies, misconceptions and the sheer lack of understanding have unintended but fateful consequences. In the long run a eurozone permanently divided between debtors and creditors is politically unacceptable. The debtors are bound to revolt sooner or later. If and when the euro breaks up in disarray it will also destroy the common market and the European Union. Europe will be worse off than it was when the effort to unite it began, because of a legacy of mutual mistrust and hostility. The later it happens, the worse the ultimate outcome. That is such a dismal prospect that it must be prevented if at all possible. It is time to consider alternatives that would have been inconceivable until recently. The euro must not be allowed to destroy the European Union.

That puts Germany before a difficult choice: either lead the eurozone out of the looming depression towards a political union with genuine burden sharing or leave the euro to the debtor countries. They would find it surprisingly easy to grow their way out of their over indebtedness if Germany did not stand in the way.

Since all the accumulated debt is denominated in euro it makes all the difference who remains in charge of the euro. If Germany left, the euro would depreciate. The debtor countries would regain their competitiveness; their debt would diminish in real terms and, with the ECB in their control, the threat of default would evaporate. The creditor countries, by contrast, would encounter stiff competition in their home markets from the euro area and incur losses on their claims and investments denominated in euro. The extent of their losses would depend on the extent of the depreciation; therefore creditor countries would have an interest in keeping the depreciation within bounds. After the initial dislocation and shock the eventual outcome would fulfill John Maynard Keynes’ dream of an international currency system in which both creditors and debtors share responsibility for maintaining stability. And Europe would escape from the looming depression.

The same result could be achieved, with far less cost to Germany, if Germany chose to behave as a benevolent hegemon. I am happy to note that the political debate in Germany has shifted in favor of saving the euro. Both the decision of the June summit to create a banking union and the bond buying program announced by the ECB on September 6^th were major steps in the right direction. Both were made possible by the support of Chancellor Angela Merkel. Only two other steps would be needed to achieve a lasting solution to the euro crisis. First, activate the Debt Reduction Fund recommended by the Chancellor’s Council of Economic Advisors and endorsed by the Social Democrats and the Greens. That would help create a level playing field. Second, stop imposing pro-cyclical austerity measures for the duration of the recession. That would save Europe from depression. We are tantalizingly close to a lasting solution.

It is up to Germany now to decide which alternative it chooses. If the German public were willing to accept the additional liabilities that the remaining two steps would entail it would be by far the best for all concerned if Germany stayed in the euro. If not, it would be best if Germany and other like-mined creditor countries withdrew from the euro in a negotiated separation.

The impending decision of the constitutional court may well prohibit Germany from taking on the additional obligations and delegations of power that remaining two steps would involve. In that case, Germany would have to hold a referendum to decide whether to lead or leave.

Either decision would be better than to allow the euro to destroy the European Union. Those who claim that the bond buying program of the ECB has solved the problem are giving the public a sleeping pill and ensure the continuation of the nightmare.