Why George Soros thinks the euro will survive
George Soros’s speech on the euro is getting a lot of attention. Tony Fratto, a CNBC contributor and former treasury secretary, tweets that he’s “never had anything recommended to him more frequently.” Joe Weisenthal, at Business Insider, called it “brilliant.”
The truth is that the speech itself is a bit of a slog. The first 1,500 words or so are about Soros’s theory of “reflexivity,” and they’ll probably dissuade all but the most committed readers. Then Soros gets to the bit that’s gotten people excited: A clear explanation of how the euro evolved, and why it is, in essence, a classic bubble. Here’s the key bit:
The process of integration was spearheaded by a small group of far sighted statesmen who practiced what Karl Popper called piecemeal social engineering. They recognized that perfection is unattainable; so they set limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they achieved it, its inadequacy would become apparent and require a further step. The process fed on its own success, very much like a financial bubble. That is how the Coal and Steel Community was gradually transformed into the European Union, step by step.
Germany used to be in the forefront of the effort. When the Soviet empire started to disintegrate, Germany’s leaders realized that reunification was possible only in the context of a more united Europe and they were willing to make considerable sacrifices to achieve it. When it came to bargaining they were willing to contribute a little more and take a little less than the others, thereby facilitating agreement. At that time, German statesmen used to assert that Germany has no independent foreign policy, only a European one.
The process culminated with the Maastricht Treaty and the introduction of the euro. It was followed by a period of stagnation which, after the crash of 2008, turned into a process of disintegration. The first step was taken by Germany when, after the bankruptcy of Lehman Brothers, Angela Merkel declared that the virtual guarantee extended to other financial institutions should come from each country acting separately, not by Europe acting jointly. It took financial markets more than a year to realize the implication of that declaration, showing that they are not perfect.
The Maastricht Treaty was fundamentally flawed, demonstrating the fallibility of the authorities. Its main weakness was well known to its architects: it established a monetary union without a political union. The architects believed however, that when the need arose the political will could be generated to take the necessary steps towards a political union.
But the euro also had some other defects of which the architects were unaware and which are not fully understood even today. In retrospect it is now clear that the main source of trouble is that the member states of the euro have surrendered to the European Central Bank their rights to create fiat money. They did not realize what that entails – and neither did the European authorities. When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank accepted all government bonds at its discount window on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker euro members in order to earn a few extra basis points. That is what caused interest rates to converge which in turn caused competitiveness to diverge. ...
It took some time for the financial markets to discover that government bonds which had been considered riskless are subject to speculative attack and may actually default; but when they did, risk premiums rose dramatically. This rendered commercial banks whose balance sheets were loaded with those bonds potentially insolvent. And that constituted the two main components of the problem confronting us today: a sovereign debt crisis and a banking crisis which are closely interlinked.
That’s well done, but not revolutionary. At the end of the speech, however, Soros pushes against the increasingly pessimistic conventional wisdom and makes one of the smarter arguments I’ve read for why, despite everything, Germany might well make the concessions needed for the euro to come through this crisis intact:
The likelihood is that the euro will survive because a breakup would be devastating not only for the periphery but also for Germany. It would leave Germany with large unenforceable claims against the periphery countries. The Bundesbank alone will have over a trillion euros of claims arising out of Target2 by the end of this year, in addition to all the intergovernmental obligations. And a return to the Deutschemark would likely price Germany out of its export markets – not to mention the political consequences. So Germany is likely to do what is necessary to preserve the euro – but nothing more.
Let me put that another way: It’s well understood that Germany has to subsidize the euro zone if the euro is to survive. It’s less well understood that the currency zone itself is an ongoing subsidy to Germany. It keeps their currency cheap and their exports booming. It keeps the other countries in the euro from defaulting on their debts, many of which are owed to German financial institutions.
So if the euro breaks up, Germany is likely to lose one of the main drivers of their economy — cheap exports — and face a financial crisis. And that’s in addition to the political consequences, and the likely global recession, and the shame of having failed the grand dream of a united Europe alive. As Soros says, “The ‘center’” — by which he means Germany and France and the other key architects of the euro -- “is responsible for designing a flawed system, enacting flawed treaties, pursuing flawed policies and always doing too little too late.” If this comes apart, they won’t escape the blame.