Is This the End of the EMU?

L. Randall Wray | November 14, 2011

(cross posted at EconoMonitor)

For more than a decade, I’ve been arguing that the EMU was designed to fail. It was based on the pious hope that markets would not notice that member states had abandoned their currencies when they adopted the euro, thereby surrendering fiscal and monetary policy to the center. The problem was that while the center was quite happy to centralize monetary policy through the august auspices of the Bundesbank (with the ECB playing the role of the hapless dummy whose strings were pulled in Germany), the center never wanted to offer fiscal policy capable of funding essential spending. (See also Nouriel Roubini’s Eurozone Crisis: Here Are the Options, Now Choose and  Marshall Auerback’s piece: The Road to Serfdom.)

Member states became much like US states, but with two key differences. First, while US states can and do rely on fiscal transfers from Washington—which controls a budget equal to more than a fifth of US GDP—EMU member states got an underfunded European Parliament with a total budget of less than 1% of Europe’s GDP. This meant that member states were responsible for dealing not only with the routine expenditures on social welfare (health care, retirement, poverty relief) but also had to rise to the challenge of economic and financial crises.

The second difference is that Maastricht criteria were far too lax—permitting outrageously high budget deficits and government debt ratios.

What? Before readers accuse me of going over to the neoliberal side, let me explain. Most of the critics on the left had always argued that the Maastricht criteria were too tight—prohibiting member states from adding enough aggregate demand to keep their economies humming along at full employment. OK, it is true that government spending was chronically too low across Europe as evidenced by chronically high unemployment and rotten growth in most places. But since these states were essentially spending and borrowing a foreign currency—the euro—the Maastricht criteria permitted deficits and debts that were inappropriate.

Let us take a look at US states. All but two have balanced budget requirements—written into state constitutions—and all of them are disciplined by markets to submit balanced budgets. When a state finishes the year with a deficit, it faces a credit downgrade by our good friends the credit ratings agencies. (Yes, the same folks who thought that bundles of trash mortgages ought to be rated AAA—but that is not the topic today.) That would cause interest rates paid by states on their bonds to rise, raising budget deficits and fueling a vicious cycle of downgrades, rate hikes and burgeoning deficits. So a mixture of austerity, default on debt, and Federal government fiscal transfers keeps US state budget deficits low.

(Yes, I know that right now many states are facing Armageddon—especially California—as the global crisis has crashed revenues and caused deficits to explode. This is not an exception but rather demonstrates my argument.)

The following table shows the debt ratios of a selection of US states. Note that none of them even reaches 20% of GDP, less than a third of the Maastricht criteria.

Alaska 15.7 Montana 12.2
Connecticut 12.1 New Hampshire 13.0
Hawaii 12.2 New York 10.5
Maine 11.0 Rhode Island 16.9
Massachusetts 16.5 Vermont 12.6


By contrast, euro states had much higher debt ratios—with only Ireland coming close to the low ratios we find among US states.

Those who follow Modern Money Theory believed that market “discipline” would eventually impose debt and deficit limits far below Maastricht criteria—to ratios closer to those imposed on US states. And with no fiscal authority in the center to match the US Treasury, the first serious economic or financial crisis would expose the flaws of the design of the euro. Because the crisis would cause member state deficits and debts to grow. At the same time markets would begin to realize that these member states are much like US states but without the backstop of a European treasury.

And that is precisely what has happened.

To be sure markets have not reacted simultaneously against all member states. If you think about it, this makes sense. There is a desire to hold euro-denominated debt—the euro is a strong currency and much of the world wants to buy European exports. So markets run out of Greece and Ireland and now Italy but need to get into other euro debt. Since Germany is the strongest member and by far the biggest exporter, it benefits the most from a run against the periphery.

Yet as Germany is a net exporter with a relatively small budget deficit, it is hard to get German debt. The biggest issuer of debt was Italy, and there was a strong belief in markets that because Italy’s debt is so large, it is like a Bank of America—too big to fail. And ditto for France and Spain. So spreads widened for Greece and Ireland and Portugal, but have only recently increased for Spain and Italy.

With the agreement to accept a “voluntary” haircut of 50% on Greek debt, no prudent investor can any longer pretend that Italy, Spain or even France is a safe bet. Faith based investing in euro debt is over. And note that if the stronger nations really do bail-out a Spain or an Italy, our friendly credit rating agencies will quickly downgrade the strong nations (they have already threatened France) for contributing funds to rescue their neighbors. Even Germany will not be safe if it participates in a bailout of Italy by committing funds.

There is thus a damned-if-you-do and damned-if-you-don’t dilemma. A bail-out by member states threatens the EMU by burdening and eventually bringing down the strong states; and allowing too-big-to-fail Italy to default would prove to markets that no member state is safe.

Further, the losses to French banks (especially) posed by 50% haircuts on the periphery will expose the French government to unbearable debts (so that she will become the next Ireland). Note that US financial institutions are also exposed to these losses (money market mutual funds have a trillion and a half dollars worth of exposure). It is hard to believe that any US money managers can make a case that it is still prudent to invest in euro debt.

No amount of faith in the European integration is going to hide the flaws any longer. A comprehensive rescue by the ECB—which must stand ready to buy ALL member state debt at a price to ensure debt service costs below 3%–plus the creation of a central fiscal mechanism of a size appropriate to the needs of the European Union is the only way out. If these actions are not taken—and soon—the only option left is to dissolve the Union.


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