Edward Hadas

The euro zone debt crisis shows that something is seriously wrong with Europe. But what is it?

Most financial professionals think the problem is economic. They have long considered continental Europe something of a mess – slow GDP growth, inept governments, smothering regulation and a culture that doesn’t “get” markets. European residents seem equally gloomy, especially about the economy. In the most recent Eurobarometer survey, 71 percent of respondents did not expect the crisis to be over two years hence.

The economic worries of both financiers and citizens are misplaced. Even if the slow patch does last a few more years, the European economy will continue to do what a modern economy is supposed to do. European consumers are basically as well off as Americans after adjusting for longer European holidays and different lifestyle choices. There is probably greater justice in the distribution of incomes and consumer goods in Europe than in the United States. The euro zone’s low trade deficits – less in total since 1990 than the United States ran in the last six months – suggest that Europe is globally competitive. Europe probably has a worse unemployment problem than the United States, but national governments are belatedly trying to remedy that.

Where Europe is really weak is not in economics but politics. A lack of political cohesion turned relatively minor financial problems – one small reprobate government (Greece) and two small careless ones (Portugal and Ireland) – into a disproportionately large struggle to avoid a devastating financial meltdown. Despite the risk, politicians and bureaucrats spent years bickering. They may have finally found the necessary toughness and solidarity, but there are enough unanswered questions to suggest that further crises are a lively possibility.

The indecision and discord needs to be kept in proportion. Politically, Europe is far more stable than it was a century ago, when a much smaller trigger set off the First World War. It is more unified – fiscally and financially – than it was in that war’s aftermath, when the anti-solidarity policy of reparations and the anti-flexibility of the gold standard wreaked havoc.

Still, Europe could do better. I suggest a three-pronged effort to make the region stronger.

The first is supposedly underway: balanced national budgets in normal economic times. An earlier effort to mandate this, the Stability and Growth Pact, failed, but the intervening crisis may have concentrated minds and strengthened resolve. If it hasn’t, then the euro project is liable to topple over as soon as economic challenges arrive.

Second, national politicians and the European Central Bank should agree – and state it publicly in no uncertain words – that the fiscal compact implies that the cost of future national fiscal failures will be shared between debtor and creditor nations. There will always be disputes about how to apportion the losses, but those can be resolved if everyone accepts the principle of shared responsibility. A bad loan is a sign that both sides messed up. A multi-country currency union cannot survive without solidarity among its members.

Third, Europe needs to make the economy the servant of something greater, something with more political resonance than a prosperity pact. A merely materialist agreement will always be vulnerable to economic downturns.

Half a century ago, when the predecessor to the European Union was founded, there was a good reason to emphasise economic unity: other sorts of multi-national convergence were much more challenging. Europe is not like the United States, which can boast of a single “American way of life” both culturally and politically. (U.S. states’ rights were effectively crushed 150 years ago in the Civil War.) Nor is Europe like China, which established a national language and culture three millennia ago.

On the contrary, European nations have basically been moving apart for centuries, developing their own national languages and cultures. The nations often behaved like teenage gang members, convinced of their own superiority and always up for a mutually destructive fight.

After the biggest fight, World War Two, the peacemakers followed their profession’s best practice: build trust by focusing on a common effort in the least controversial area – the economy. It has worked, although almost every step has been difficult. The last step, the merger of monetary and fiscal policies, proved traumatic.

But after 60 years of economic success, it should be clear that greater unity need not destroy national diversity. Italians may never be as much like Germans as New Yorkers are like Californians, or as Shanghainese are like Beijingers. But Europeans should be able to find enough common ground – if only as an entity able to hold its own against the United States and China – to give the EU stronger support than mere economic self-interest. If not, there really will be something wrong with Europe.

Once upon a time there were 11 prosperous merchants who lived in a land of peace and plenty. They decided to form a league that would work together for everyone’s greater good. But then a charming man in a fine suit came around with a tempting speech: “I love your project and trust your businesses. I will lend you money at a very attractive interest rate”. How nice, thought the merchants. Our customers will love us if we use the money we borrow to give them better deals.

All went so well that six other merchants were proud to join the league. Mr. Fine Suit seemed pleased. He reduced the already low interest rate on the loans. The merchants all planned to repay, but today was never quite right. Today, in fact, was always a good day to borrow more, while tomorrow always looked like a better day to raise prices.

Then one day Mr. Fine Suit changed his tune. “You know, you have a mighty nice little enterprise going here. But business is business, my friends. Interest rates are going to rise for some of you.” The merchants were angry, but what could they do? They promised to be more frugal, but still had to pay up. As the months went by, Mr. Fine Suit became more hostile. Just last week he came to the G-store, the most prosperous and prudent of all the merchants, with a really nasty threat. “You know, between us, I’ve never liked your stupid league. You’re much smarter than the rest. Leave the league and I’ll keep on lending you money at a low rate. If not, well, here’s a little reminder of what I can do.” He increased the interest rate by two notches before leaving the room with a menacing smirk.

The story is a parable of the euro zone debt crisis. The merchants are the member governments, the customers are the taxpayers and Mr. Fine Suit represents the banks, fund managers and individuals who lend to governments. These investors in government debt tend to think and act alike; just about two years ago their message to the euro zone changed from “We’re behind you all the way” to “Nice little monetary system you have here. It would really be a shame if something happened to it”.

The euro zone’s weaker members and the EU as a whole have responded to the threat with tougher budgets than were ever contemplated while investors were still friendly. But the investors have started to behave like an extortionist, demanding ever higher interest rates and threatening to withdraw funding totally. Even fiscally healthy Germany (the G-store) is now under threat. Of course, investors do not think of themselves as extortionists or even as malicious. They think of themselves as merely law-abiding professionals trying to protect the value of their investments, either by making sure the governments will be able to pay up or by selling before the governments default. But many sensible individual fears — “I don’t want to be caught out” — can add up to group menace– “You must meet our ever harsher demands – or else”.

The fable of Mr. Fine Suit could be elaborated to include the European Central Bank as policeman, but the addition would not change the moral: the mix of governments and financiers can easily become toxic. It has always been thus, at least as far back as the English King Edward III’s 1343 default bankrupted the lenders of Florence. The political-economic logic behind these recurrent crises is straightforward. On the one hand, governments which are too weak to cover current expenses with tax revenues are bad credit risks. On the other hand, when previously supportive lenders suddenly turn against profligate governments, they look arbitrary and rapacious.

In recent years, these basic truths have been obscured by the widespread acceptance of a principle associated with the British economist John Maynard Keynes — governments should sometimes spend a little more than they take in to keep the real economy humming along. Even if the Keynesian principle is right, it justifies neither the imprudent deficits which Greece ran up after it entered the euro zone nor the ease with which it was able to borrow to fund those deficits.

In the euro zone, Mr. Fine Suit is now on the rampage. In the United States, he is still very friendly. But the stubbornly large American deficits – currently more than twice as high as the euro zone’s as a share of GDP – are a sign of political inadequacy. Like Edward III and the government of Greece, the U.S. government has consistently decided to spend significantly more money than it is willing to demand from taxpayers. Unless Congress finds a way to balance revenues and expenditures, sooner or later America’s Mr. Fine Suit will be coming around with a baseball bat.

Photo: An employee at the National Bank of Belgium holds a new 500 Belgian Franc note (front) and two small reproductions of paintings by Belgian famous surrealist Rene Magritte. REUTERS/Nathalie Koulischer

“The Owl of Minerva takes flight only as the dusk begins to fall.” Or, to speak more directly than G W F Hegel, we can only become wise about the direction of history late in the day. The aphorism is pertinent to the euro crisis. Is this the twilight hour for the single currency or are the clouds over the euro no more than an early morning mist in pan-European history? The euro’s fate will look inevitable in retrospect (that is Hegel’s point), but for now the balance of historical forces is far from clear.

The technicalities of the euro crisis are bewildering, even to financial professionals. There are rescue funds constructed with baroque techniques of financial engineering, arcane details of labor market reforms and political feuds that have festered for decades. But something much bigger is at stake – whether or not there should be, in the words of Angela Merkel, “more Europe.” If so, the crisis can be resolved relatively simply: lenders would accept the losses caused by their past mistakes and errant governments would promise to play by the fiscal rules henceforth.

But should there be more Europe? Most British politicians think not and most mainstream continental politicians are in favor, if only warily. The reasons on both sides are fundamentally Hegelian. It is a question of which historical forces should prevail.

The anti-euro case is based on one of the strongest forces of the last few centuries – nationalism. The sentiment is sometimes expressed in economic terms, as when the previous British government rejected membership of the monetary union. A multinational currency always goes directly against the nationalist flow, even where the economic case for it is strong. In order for the euro to succeed, Germans must abandon hopes of duplicating their super-strong national currency and Greeks and Italians must either abandon longstanding traditions of loose fiscal behavior or learn to tolerate interference from EU authorities.

On the pro-euro side, two grand historical forces have provided most of the support for both the European Union and its currency. Both are faltering.

The first is a peculiarly modern force, the fear of war (Hegel thought war was a major spur of historical progress). While Europeans still dread another conflagration, nearly seven decades of peace, including the non-violent fall of the Communist bloc, have been enough to render the threat of war largely theoretical, and irrelevant to the European monetary system.

The second force is the desire for ever greater prosperity. This force, which has come into prominence during the last two centuries, influenced the European leaders who wanted to bring Europe together after the Second World War. They thought the economy was the most promising domain for cooperation, and they were right. European politicians and voters alike have proved willing to sacrifice national traditions and rivalries for the sake of European prosperity. The EU now has free trade, standardized regulation and almost unconstrained mobility across borders. The single currency was supposed to be the culmination of economic integration.

The bitterness surrounding the euro crisis shows that the lure of prosperity is now, at best, barely enough to inspire European governments to change their ways. While most politicians still believe that the euro will eventually bring their nations more wealth and economic stability, they and their voters are seriously in doubt whether those goods are worth more than national self-determination.

Philosophers of history might speculate that the desire for prosperity is a waning force today because it no longer has the same power to inspire the comfortable citizens of the EU as it once inspired the impoverished men and women scraping a living amidst the rubble of post-war Europe. Whatever the reason, the euro will not survive the next crisis (even if it scrapes though this one) unless European leaders make a stronger effort to identify their project with historical forces more politically compelling than ever more material gain.

The stakes are high. If the member nations retreat on the euro, further disintegration is likely. That owl of wisdom will probably look down on the movement towards European unity as no more than a wrong turn on history’s path.

But the euro and indeed the entire European project could draw on stronger forces. You don’t have to be a Hegelian to see that Europe as a whole, rather than individual jurisdictions, has been shaped and guided by such great ideas as Christianity and the philosophies of Greece and the Enlightenment. More recently, the entire region has striven to realise the dreams of democracy, honest government, economic security and educational opportunity.

Supporters of the euro and of “more Europe” might look to the French revolutionary call for liberty, equality and fraternity. These are ideals which erase neither national borders nor local customs, and so they can co-exist peacefully, if somewhat delicately, with nationalism. But the euro does indeed have the power to enhance the liberty that comes with effective economic management: the equality of citizens protected by fiscally sound governments and the fraternity that binds the strong and weak.

PHOTO: German Chancellor and leader of Germany’s conservative Christian Democratic Union (CDU), Angela Merkel gives her closing speech of the party convention at the fairground in Leipzig, November 15, 2011. REUTERS/Tobias Schwarz

Debt is a moral matter. While most economic activity is concerned with the “is” of how things are (investment, consumption and so forth), debts are always entwined with an “ought” – to repay. In discussing controversial debts–for example government borrowing in the euro zone and the U.S.–the moral question should be addressed directly: should these debts be paid off in full, or is some forgiveness justified?

Aristotle can help frame the argument. The philosopher condemned all lending at interest because money cannot create wealth by itself; a loan is just a way for the lender to take advantage of the borrower. Some proponents of Islamic finance make a similar argument, but it is not quite right. Capitalism has shown that loans can indeed produce wealth. If the lent funds are invested well, enabling the borrower to improve his lot and the world’s, then interest payments are the lender’s just reward for providing the fruitful funds.

But Aristotle’s moral logic remains relevant; his condemnation is appropriate for loans which do not share wealth justly between borrower and lender. Unfair loans should not be made, and where they have been, full repayment only compounds the original injustice.

Libertarians, believers in the right of individual to make their own decisions, have another contribution to the moral discussion. They point out that loans are freely agreed contracts which should be honoured. Both sides should understand the possible consequences of their free choices. Borrowers should repay, even if that requires making sacrifices, and creditors who make bad lending decisions should suffer losses.

In the euro zone, some libertarians (and most Germans) consider the borrowers’ obligations to be paramount. The governments of Greece and the other over-extended nations can and should repay all their agreed debts. The citizens just have to work harder and pay more taxes.

Other libertarians take the opposite moral line. Losses are the just punishment for the foolish creditors. And the Aristotelian logic may justify forgiveness. The lent money has mostly been spent unproductively, so the borrowers now have few gains to share with the lenders. The original loans turned out to be unjustly generous to the debtors, but the terms have become unjustly harsh.

Which side has the stronger moral logic? Forgiveness looks right for Greece, where the debts are particularly high and the government and economy are particularly inept. For the rest, it is a closer call.

Turn to the U.S. government, which is building up its own substantial debt pile. The American moral debate on the practice is as old as George Washington, who warned that such debts “ungenerously throw upon posterity the burden which we ourselves ought to bear.” Today, the National Research Council writes of “an unfair and crushing burden on future generations.”

Foreign debts are particularly crushing. Citizens get to spend now on consumption and investment but are obliged to repay foreigners later, with interest. This deferment has produced $4.5 trillion of foreign debt in the U.S., 30 percent of one year’s GDP. That is far less than Greece’s full year of GDP, but enough to worry about.

If the U.S. authorities were committed to full repayment of thee foreign debts, they would strive to keep the dollar’s value constant and to avoid inflation. That way, the foreigners would receive not just the contracted dollars but the full agreed economic value. While American authorities may care in theory, they are not concerned enough to refrain from loose monetary policy, which pushes the dollar down.

In this case, pro-repayment libertarians have right on their side. The largest and one of the richest economies in the world – and the issuer of the global reserve currency – is honor-bound to make good on its debts. While the creditors should have noticed that the country was becoming less responsible, their neglect does not excuse American indifference.

For purely domestic U.S. government borrowing, Aristotelian scrutiny is more appropriate. Do the ultimate borrowers, the mostly poor beneficiaries of federal programs, gain enough from these loans to justify the higher taxes that will be needed later to repay the mostly rich lenders? There is no obvious answer to that question, but it is well worth asking.

More generally, philosophical arguments ratify what practical experience teaches. Lenders should be wary about lending to governments. The choice to borrow rather than to raise funds through taxes is usually a sign of political weakness. When the time comes to repay, governments may be unable or unwilling to persuade the people that the sanctity of contracts is a principle worth protecting.

Also, the proceeds of loans to such governments are likely to be spent foolishly. Then full repayment will fail the Aristotelian test of justice. The rioters in Athens may know little about the Ancient Greek philosopher’s doctrine on lending, but they could be protesting in his name.