Soros on the euro - but what about the other flaws??

On Fareed Zakaria's CNN show this week we had the privilege to hear the views of the billionaire financier George Soros (see http://www.cnn.com/video/#/video/podcasts/fareedzakaria/site/2010/02/28/gps.podcast.02.28.cnn) on a variety of issues.  What caught my ear though was his comment that the euro was "fundamentally flawed" as the European Union doesn't have a Treasury to enble fiscal transfers to occur, so as to offset the asymmetric shocks ( - unexpected events that occur which affect one member state much more than the others).  This is of course just one of the basic problems with the euro's architecture, and Soros is right in pointing out that this is probably the most obvious flaw to think about in the light of the Greek debacle.

But what really got my attention was that Soros then went on to say that "either Europe takes the steps to make up for it's institutional deficiency or it may not survive" ( - I assume he means the euro here).  So I want to add a little to what Soros said, by i) talking about other things that might be wrong with the euro and ii) by thinking a little about what form these institutional measures might take. i) I'll do today and I'll leave ii) to tomorrow.

So let's start with the other flaws. 

First, the "Maastricht criteria".  These were the hurdles which member states had to negotiate to become a member of the euro club.  The rewards for negotiating these hurdles were significant, as it meant lower interest rates, added credibility internationally, and to be blunt, a seat at the heart of the European integration project. It's like the local neighborhood clubhouse - who wouldn't want to become a member unless they didn't like their neighbors too much (for example the UK).  So if you have to fulfill certain criteria (like having a certain minimum salary - to continue our clubhouse analogy) you would maybe manipulate things a little to get in.  The Commission was aware of this, particularly when certain member states asked if they could sell gold to lower their budget deficits, and so the Commission made up quite strict rules about how to measure budget deficits, which all the "northern" (read less corrupt and less politically manipulated) member states duly abided by.  Southern (read generally more corrupt and more politically manipulated) member states of course stayed relatively silent on this, and now we see why.  Countries like Italy got in because of statistical anomalies and Greece actually didn't get in first time around, so realized what it needed to do the second time around.  The main point here is that the Maastricht criteria were flawed to begin with - the statistics which were used to base the entry decision on were produced by each individual member state - so they depended on the quality and honesty of the statisticians and politicians involved in the production of the stats.  The result is that if you have flawed entry criteria you're going to get problems at some point along the way as members don't live up to expectations.

Second, "surveillance".  The European Commission made a big song and dance about member state surveillance back in 2004 when the Stability and Growth pact (or SGP - see http://europa.eu/scadplus/glossary/stability_growth_pact_en.htm) was revised to soften the actual criteria (because Germany and France had run up against the deficit limits that were supposed to trigger sanctions).  Clearly they haven't worked, and not because it wasn't a good idea, but because the Commission can only monitor what is produced by the member states.  Once again its the member states that produce the statistics, or manipulates the statistics for political purposes, so this wouldn't be detected by the "surveillance" process. 

Third, and probably most importantly, the ECB's treatment of public debt in monetary transactions.  There is no mechanism whereby the ECB can basically "grade" the member states on their fiscal policy. Now of course this doesn't happen in the US, and in the case of Canada there are provisions for it to happen (a line item in the Bank of Canada's balance sheet) but it has never happened.  The reason is that both Canada and the US (and I presume other monetary unions) have federal debt issuing capabilities.  So when the Federal Reserve does open market operations it uses US federal bonds and notes, but in the case of the ECB, it has to use member state bonds because there is no EU federal debt.  So the rules are that the ECB cannot discriminate between different member state bonds.  So this means that the member states do not feel the fury of the markets because there is always a buyer (and therefore a "backstop") for Greek bonds in the form of the ECB.  And from the individual investor perspective this clearly poses an adverse selection problem.  If I'm holding German, French and Greek bonds and the ECB is looking to buy euro-denominated bonds for its monetary policy transactions, which am I going to sell?  It's a no-brainer!! 

OK, so given that the euro design is flawed, what should happen now?  More on this next time in part II!!