Business & Economics

History’s lessons for the European debt crisis

Stephen Gross

The countries of Europe currently stand at a fork in the road: do they continue along the path toward a single European economic space, or do they begin unraveling the transnational experiment in integration inaugurated in the wake of the Second World War? The former could mean the establishment of a unified fiscal policy, including the creation of a common Euro bond, while the latter would see Germany and other northern countries unwind their support for the threatened economies of Greece, Spain, Portugal, and Italy, which could lead to the disintegration of the EU itself. Yet for all the drama, Europe has dealt with economic crises before. Knowing this history can help us understand the likely ways that Angela Merkel, Nicholas Sarkozy, Jean Claude Trichet, and other European leaders will respond to the current challenge.

The very first institution of European integration, in fact, was born in a moment of crisis. After 1945 the countries of Western Europe managed their trade with one another through a cumbersome series of bilateral agreements leftover from the Great Depression and the Second World War. European states tightly regulated the commodities to be traded and the credits granted for foreign trade in the hopes of balancing their exports with their imports. As economic historian Barry Eichengreen put it, trade on the continent came to resemble “a spaghetti bowl of more than two hundred bilateral arrangements.”

By 1947 and 1948 this rigid system had begun to fall apart, and intra-European trade slumped. As Europe teetered on the brink of another depression, European and American leaders proposed a central clearing agreement — the European Payment Union (EPU) — that used Marshall Plan funds to subsidize European countries running a trade deficit, provided a mechanism for countries to readjust their currencies against one another, and linked EPU membership to trade liberalization. The effects of the EPU and the Marshall Plan were clear: within a few years intra-European trade began to grow as the countries of Western Europe took their first significant steps toward economic interdependence.

The European project faced another major challenge in the early 1970s. During the 1950s and ’60s Western Europe had grown accustomed to currency stability under the Bretton Woods monetary system. Among other things, this led to the creation of the Common Agricultural Policy (CAP), a system in which the European Community harmonized its agricultural prices through generous price supports and subsidies. Coordinating the price supports of Western Europe’s incredibly diverse range of agricultural products proved challenging enough under a system of fixed exchange rates. But the breakdown of the Bretton Woods monetary regime made managing the CAP next to impossible, and threatened to undermine the entire project of integration.

As in the late 1940s, European leaders responded by moving toward deeper integration. In 1969 European leaders drafted the Werner Plan, which called for Western Europe to gradually adopt a monetary union as well as a European-wide central banking system. In the meantime, Western European nations adopted an ad hoc currency arrangement called the “Snake in the Tunnel,” which aimed to recreate the currency stability of Bretton Woods on a regional basis. Europe’s currencies were allowed to float against one another within a narrow band. Although the single monetary union of the Werner Plan remained unrealized in the 1970s, the collapse of Bretton Woods pushed European leaders one very large step closer toward economic integration on the continent.

A third major crisis led to the creation of the European Union that we know today. In the early 1980s the economies of Western Europe struggled with high unemployment and slow growth. Although Europe had, by this point, built a common customs union and eliminated tariff barriers on most commodities, many non-tariff barriers remained for services such as finance, insurance, and telecommunications. Helmut Kohl, Jacques Delors, and others believed the solution to Europe’s economic malaise to lie in more, not less, integration, and as a result they pushed for the creation of a single, liberalized market in financial services.

Yet European leaders quickly realized that the removal of capital controls and the free flow of investment across borders meant their existing monetary arrangement would be too decentralized for a continental financial market. Only a monetary union, with a single currency under the guidance of a single central bank, would be able to manage a European-wide market in finance, insurance, and other services. In 1988 and 1989 the Delors Committee advocated just that, by demanding that Europe move quickly ahead with issuing a single currency and creating a central bank. The Maastricht treaty of 1992 and the creation of the Euro in 1999/2002 were a direct result of Europe’s economic problems in the 1980s.

Looking back, it is clear that when confronting major economic crises, European leaders have consistently resolved them by moving forwards with integration, not backwards. Just as important, these crises have shown just how much EU institutions rest on a delicate balance that demands ever more integration. Indeed, history reveals something of a logic to European integration: advancing on one front has often meant that Europe must advance on many fronts. When European leaders created a Common Agricultural Policy and pricing system, they realized they needed exchange rate stability for the CAP to flourish. And when Europe moved toward a free market in finance and investment, European leaders understood that this required a common monetary policy and a single central bank.

The underlying question European leaders face today, then, is how far integration will proceed. Can the European project survive if it maintains its current arrangements of a monetary union without a common fiscal policy, or does it need to move forward yet again? Recent events suggest that European leaders are, at times grudgingly, following in their predecessors footsteps by responding to the Greek debt crisis with greater integration.

Last week, the European Financial Stability Facility (EFSF) gained the authority to buy state bonds from private banks and insurers in order to support threatened euro-zone countries. (http://www.spiegel.de/international/europe/0,1518,775892,00.html) While an ad hoc arrangement, this represents a remarkable shift, creating one more mechanism by which economies like Germany are obliged to support weaker Eurozone members. The new powers of the EFSF are not an outright fiscal union, but they are a step in that direction.

The question to watch for now is, how long before the EFSF becomes a permanent feature of the EU?

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