How Belgian debt, Italian anarchy and Greek profligacy led to economic chaos in Europe

I am going to describe the beginnings of the Euro from a German point of view. I apologize if this post seems unduly harsh. It is meant to give you a more caricaturised view of the breakdown in the euro-zone which dominates the German press. It may help explain why the Euro is a union that served political purposes like cohesion instead of economic ones.

Once upon a time, the Germans were embroiled in two devastating world wars which brought with them horrific loss of life, and a destruction of German productive capacity and its currency. The Second World War saw every major German city from Dresden and Hamburg to Cologne, Munich, Frankfurt, and Berlin crushed by carpet bombing. The country was destroyed and the people were traumatized.

Afterwards, what was clear was that the Germans had committed unspeakable atrocities during the war and that the nation’s only hope of redemption was through rebuilding a demilitarized society integrally fused into the Western European body politic. There could be no more German nationalism, no more wars, and no more hyperinflations.

By 1973, all was well. The Germans had rebuilt their society and the Europeans had created the European Union of Italy, Belgium, Luxembourg, the Netherlands, Germany and France. A widening to include Denmark, Norway, the UK and Ireland was underway. (Norwegian voters later rejected admission and have never joined.)

Unfortunately, the trauma of inflation was about to revisit the Germans. The U.S. had effectively ended any link to the gold standard in 1971. And in February 1973, the Bretton Woods forex exchange market closed for good. The next month a floating currency regime came into being.

At the same time, U.S. support for Israel in the Yom Kippur War led the Arab members of OPEC  to reduce oil production  and institute an embargo against the US and other allies.

The result was stagflation in Europe and elsewhere. The UK suffered worse than the Germans. But the Germans were especially panicked by these episodes given their economic history. This volatility played a major role in the formation of the European Exchange Rate Mechanism (ERM).

The goal in Europe was to create a European Exchange Rate Mechanism (ERM) which minimized currency volatility and set the stage for monetary union by fixing a maximum 2.25% range for currency fluctuation. But this also required a degree of economic harmonisation between countries on fiscal and monetary policy.

The roots of the European sovereign debt crisis go back thirty years

Eventually ERM became the Euro with the Euro’s treaty terms being set in Maastricht in 1992. The problem, at the time, was Belgium. See, the Germans wanted the Belgians in on the currency union. A core of the Benelux states of Belgium, the Netherlands, and Luxembourg along with France and Germany would have suited the Germans just fine.

But, the Belgians had a huge amount of debt – over 100% of GDP.  That was a problem, particularly because it allowed the unstable Italians an entree into Euroland.  The Germans looked at the Italian Lira as a soft currency and wanted no part of a currency union with the Italians. The Italians seemed to have a different governing coalition almost every year. They were completely incapable of reining in spending and had a weak currency as a result. However, Italy was a founding member of the EU. So, once you let the Belgians in, with their huge debt to GDP burdens, you had to let the Italians in too.

And, once you let the Italians in, well, you had to let in the Spaniards, Portuguese, Greeks and pretty much everyone else.

The Germans, who had seen their currency destroyed by Hyperinflation in the 1920s and the Nazis in the 1940s, were keen to ensure a strong currency.  The Deutsche Mark had been a strong currency and this strength was seen as a major source of the German economic miracle which brought the country back from collapse after World War II. So, at the time of the Maastricht Treaty, the Germans wanted more European integration to keep the tensions which had led to two devastating wars in the 20th century at bay. But they also wanted to prevent free riders (like Portugal, Italy, Greece and Spain) from watering down the Euro with an inflationary economic policy and making it a weak currency.

The mechanism eventually chosen to stop free riders was the Stability and Growth Pact (SGP). This provision set strict limits on fiscal policy, namely an annual budget deficit of no greater than 3% and a debt-to-GDP ratio either of no greater than 60% or declining toward that mark.

The roots of the European sovereign debt crisis go back thirty years

But, of course, the SGP is bogus, completely unworkable,  as we now see. It was an artificial limitation chosen for artificial reasons. We should see the bailout of Greece and the contagion to Portugal, Spain and Ireland as confirmation. The euro-zone was not supposed to be about bailouts. That was the point of the SGP. But the SGP is ineffective because even the Germans are over the 3% hurdle.

A European treasury with an effective fiscal transfer mechanism would have been a better way to implement the euro-zone. If you had a pre-funded fiscal mechanism to support countries as an automatic stabiliser against the unharmonised EU fiscal and economic regimes, you wouldn’t need a bailout. Obviously, it would be more desirable to have a monetary union of more harmonised countries but the US states are not harmonised either. What US states do have are automatic stabilisers.

The point is Slovakia (which is now balking at a Greek bailout) wouldn’t have a say because any fiscal transfers would be pre-funded and to the degree the Greeks still couldn’t get their finances in order, they would default without contagion – which is the real problem here. As the euro-zone is organized now, these problems occur only in the worst possible economic times, when you are sure to get a political response to an economic problem. Not only that, you also get a bailout which is a moral hazard and contagion which imperils the union.

However, the reason a European treasury was never created is because it represents an Amerifinication of Europe, the United States of Europe. And no one in Europe wants this.  As a European commenter recently wrote to me:

This is unsustainable at the political level, because Europeans think of themselves as belonging to very distinctive nations first, and distant and recent union second (if they feel they belong in that union at all – Maastricht was far from a slam dunk when we ratified it). People will begrudgingly accept social transfers within their borders, but they’re not going to stand for massive help outside of them, especially to help people retire earlier than they do.

Greece already got a lot of EU money from the regional structural fund. Look how well they improved their productivity thanks to it… this union is plainly not working.

  1. Professor Pinch says


    Nice post. I think you capture German sentiment well.

    To me, the Maastricht treaty was a good idea, but it was poorly designed and executed. No mechanisms/tripwires were put in place if countries were approaching critical thresholds and most of all, the EU never designed programs to get wayward countries in compliance if they went outside what was permissible. I think that’s one of the reasons why we’ve seen the Euro act the way it has: nobody was in compliance with Maastricht rules before, nobody warned countries to fix their debt problems before either. There’s precious little to be confident in the Euro area’s leadership in based on past experiences and behaviors.

    One thing is for certain: the longer this goes on, the more it will cost to clean up eventually.

    1. Edward Harrison says

      I have been meaning to write about German depression for a while. I may get around to it. But the fact is the German economy is barely more vibrant than the Japanese one. They have been in a soft depression since economic union, attenuated of course by their vaunted export model. However, if it weren’t for German exports, the Germans would have been in a world of trouble a while ago.

      That is exactly why the Germans missed the 3% hurdle under Schroeder – a moribund domestic economy. So once the Germans and the French missed the hurdle – without penalty- it was game on for fiscal profligacy. And that is exactly what led up to this crisis. It has taken YEARS to build but here we are.

  2. Jake says

    Always a good reminder to look at the history to get a sense of what the players in the game are thinking. Thanks for the post Ed.

  3. Sam Costanzo says

    Why not add reckless lending of German banks? and German inspired deflationary policy straight jacket of EMA? and German mercantilism? Debt doesn’t accumulate without willing lenders. Takes two to tango.

  4. Edward Harrison says

    It is meant to give you a more caricaturized view of the breakdown in the euro-zone which dominates the German press. That is the point of the post. The Germans’ own culpability is another set of issues.

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