The Greek government-debt crisis began in October 2009. In its aftermath, numerous books and articles have been published predicting the breakup of the eurozone, the monetary union between nineteen of the twenty-eight European Union (EU) member states. Commentators have proposed a variety of reasons why such a breakup might occur: a public-debt crisis, the collapse of Italy’s banks, the European Central Bank’s (ECB) expansionary monetary policy, accelerating inflation in southern Europe, the rejection of austerity measures, insufficient fiscal integration, the election of euroskeptic parties, or even a war among the major international currencies. The complexity of the TARGET2 system used by the central banks to make transfers within the eurozone has also been cited.1 Increasing balance differences between creditor and debtor central banks would inevitably lead to the implosion of TARGET2 and the euro.

The adoption of a common currency comes at a cost: a single currency establishes a fixed exchange rate system among the member states.2 In the case of the eurozone, this is dependent upon sufficient deposits being held by the Economic and Monetary Union (EMU) to absorb the externalities of the euro—factors affecting the euro that are not reflected in market prices. Can this arrangement be maintained? Writing in 2014, Jens Nordvig offered a prediction for the future prospects of the eurozone.3 As part of his analysis, Nordvig noted that between the years 1918 and 2012 a total of sixty-seven monetary unions were formed. The eurozone, Nordvig believes, will share their fate.

They all failed.

## The Inflationary or Deflation of the Euro

In his recent book, L’euro: comment la monnaie unique menace l’avenir de l’Europe (The Euro: How the Single Currency Threatens the Future of Europe), Joseph Stiglitz condemned the anti-inflationary mandate of the ECB:

In the case of Europe alone, the cumulative loss due to the financial crisis amounts to thousands of billions of dollars. Nobody, not even the most ardent defender of the ECB’s focus on inflation, could make sense of this figure. The bank’s priorities were wrong, but it was not the fault of the ECB: its mission was focused on inflation, it was doing what it had been told to do, quite simply.4

He also offered an alternative solution for managing the 2008–2009 financial crisis:

If wages and prices had risen in Germany, the value of the euro would have fallen, and the countries affected by the crisis would have become more globally competitive. This method would have been much more effective: the costs borne by Germany would have been lower than those imposed on countries in crisis.5

Stiglitz’s proposal would have had no practical effect. His implicit criticism that the ECB implemented an insufficiently inflationary policy is nonetheless significant. This overly restrictive policy is, in fact, the supposed cause of the 2008–2009 crisis.

Philipp Bagus, on the other hand, is suspicious about the support among the traditionally inflationary Latin countries for the euro and the creation of the ECB:

The governments of the Latin countries, especially France, considered the euro an effective means of getting rid of the abhorred deutschmark. The deutschmark was, before the introduction of the euro, the standard that exposed the mismanagement of irresponsible governments. Although the Bundesbank inflated the money supply, it was producing money at a slower pace than the countries, especially those in southern Europe with high inflation rates, that used a central bank to finance their deficits more generously. The exchange rate against the deutschmark served as a point of reference and comparison. The governments of the inflationary countries feared this comparison with the Bundesbank … The euro was advantageous for the Latin countries in that inflation could be continued while the direct proof of an appreciating deutschmark had disappeared. Hidden inflation could continue.6

The irreconcilable views of Stiglitz and Bagus are reflective of the philosophical differences between Keynesians and monetarists regarding the role of money. For John Maynard Keynes and his successors, relative levels of consumption and savings remain constant, and households determine consumption primarily according to their income. Levels of economic activity and employment are dependent on demand, which could, in turn, be encouraged by printing money. For the heirs of Jean-Baptiste Say, such as Milton Friedman, Friedrich Hayek, and Ludwig von Mises, money only has value if it can be used to buy other goods; the value of the goods does not depend on the quantity of money, but on all the other goods available. Monetary creation may have an effect on the nominal prices of goods, but not on their real value. According to Murray Rothbard, any amount of money is sufficient for trade:

[I]n the case of money, “demand” means the various goods offered in exchange for money, plus the money retained in cash and not spent over a certain time period. In both cases, “supply” may refer to the total stock of the good on the market. … What is the effect of a change in the money supply? Following the example of David Hume, one of the first economists, we may ask ourselves what would happen if, overnight, some good fairy slipped into pockets, purses, and bank vaults, and doubled our supply of money. In our example, she magically doubled our supply of gold. Would we be twice as rich? Obviously not. What makes us rich is an abundance of goods, and what limits that abundance is a scarcity of resources: namely land, labor, and capital. … As the public rushes out to spend its new-found wealth, prices will, very roughly, double—or at least rise until the demand is satisfied, and money no longer bids against itself for the existing goods. Thus, we see that while an increase in the money supply, like an increase in the supply of any good, lowers its price, the change does notunlike other goods—confer a social benefit [emphasis original].7

Recent history suggests that Rothbard was right. A decade after the financial crisis, monetary creation has resulted in high levels of inflation in almost all of the thirty-six OECD (Organisation for Economic Co-operation and Development) member states.

The supply of goods has not increased.

By the mid-1970s, the Keynesian hypothesis that the rate of growth can be correlated with a steady increase in nominal wages had become untenable. Monetarism came to be seen as the most useful economic theory in the fight against inflation. In the early 1980s, the OECD central banks set a goal of 2% annual inflation. A consensus seems to have emerged among central bankers in favor of 2% inflation. It is thought that maintaining inflation at this level will prevent the occurrence of a deflationary episode that could cause overindebted Western economies to spiral into depression.8

Between 2004 and 2014, annual average inflation in the eurozone was 2.1%. Given the ECB’s mandate to limit inflation to 2%, this was a remarkable feat. Eurostat figures demonstrate that differences in the rates of inflation between member states have been lower than in previous decades, especially between France and Germany, which are in near alignment.9

The prediction made by Bagus has not been fully realized and there is, as yet, insufficient evidence to support the criticisms made by Stiglitz.

While inflation has been constrained at 2%, on average, for the eurozone as a whole, this is not the case for several of the member states. If the national currencies had been preserved, the franc, lire, and peseta would have lost 3%, 6%, and 11.4%, respectively, of their value against the deutschmark. Inflation differentials between these three countries form an almost perfect geometric sequence: 3, 6, 12. If this series continues over time, inflation-rate differentials will become unsustainable and investors will eventually realize that the Italian or Spanish assets are overvalued in comparison to the German or Dutch assets. Overvalued assets will be sold to buy undervalued assets and artificially induced movements of capital will end up destabilizing the markets. The degradation of TARGET2 balances suggests that such a moment is close at hand.

Since 2014, the euro has lost much of its value in order to prevent the Mediterranean countries from sliding into recession. Between March 2014 and April 2015, the value of the euro fell from US$1.40 to US$1.18—a 16% loss. Germany was subsequently forced to abandon the monetary orthodoxy of the Bundesbank and has finally agreed to a €2,300 billion ECB buyback program for bonds and shares in the most highly indebted eurozone countries. During a talk in October 2015, I noted that

[T]he devaluation of the euro, which is supposed to boost exports from the Mediterranean countries, has had a damaging effect on German exports. Changes in the price of the euro have no effect on intra-Eurozone trade. Nor do they affect the competitiveness differential between Eurozone companies exporting to the dollar zone. Thanks to the devaluation of the euro, German companies have found themselves in an even stronger competitive position.10

This devaluation was not brought about by an increase in German wages, as recommended by Stiglitz. It is difficult to see how such an increase could have occurred without German exporters giving up some of their competitiveness, or without monetary creation—in particular by the return of a massive budget deficit, which would be very unpopular with German voters.

The notion of an automatic link between monetary creation and inflation does not seem as obvious as it may have been in the past. Consider the case of Japan, which has a current public debt of 1 quadrillion yen, or 250% of GDP. Inflation is almost zero, and growth remains relatively weak. In 2017, inflation was 0.5%, and growth 1.7%. Paul Krugman has long argued that Japan is caught in a liquidity trap: when the central bank’s policy rate tends to zero, individuals are more likely to keep their savings in liquid form than to buy government bonds, which are nevertheless considered to be moderate-risk financial assets.

It remains unclear whether the eurozone is likely to fall into a comparable liquidity trap. The household investment rate in France dropped from 11% to 8% between 2008 and 2015. Over the same period, the ECB’s key interest rate was lowered from 4% to 0%. The rate of savings or deposits did not increase. Between 2000 and 2014, the cash holdings of French households remained stable at around 16% of total financial investments.11 The situation in Japan is quite different. Low nominal interest rates pushed Japanese households to put most of their savings into cash accounts, which in 2015 represented 50% of the total amount of financial assets.

While inflation has been reasonably well controlled in the eurozone, it remains a destabilizing influence due to interest-rate differentials between member states. These inflation differentials highlight the structural difficulties faced by the ECB in setting an optimal policy rate for a diverse range of economies, whose prices may change by +0.4% to +4.6%. This was the case for Ireland and Lithuania in 2017.12 For the member states with the largest inflation differentials, the ECB’s monetary policy has exacerbated inflationary or deflationary tendencies. The result is a procyclical policy rather than the contracyclical policy mandated by the ECB. Projections for 2018 set inflation at 1.2% for France, 1.4% for Italy, and 2% for Germany. These differences are too small to disturb the monetary union.

The way in which inflation is perceived varies throughout the eurozone. In a 2005 Flash Eurobarometer study (no. 175), updated in 2008 (no. 251) 78% of respondents believed that the euro had very strong inflationary effects. In Greece and Italy, the figure was as high as 85 and 89%. In Austria, Germany and France, it was 89%, 80%, and 79%, respectively.13 The extent of the discrepancy between perceived and observed inflation is striking.

Clearly, the euro does not have the same value for everyone.

## Mercantilist Effects

Since 2007, the Germany economy has produced an impressive series of annual trade surpluses: 195, 142, 125, 155, 158, 190, 200, 217, 248, 253, and 245 billion euros, successively. Germany’s trade surplus in 2016 dwarfed that of China (209 billion euros), and was the country’s largest since records began after the Second World War. At 2,128 billion euros, Germany’s cumulative trade surplus since 2007 is equivalent to 92%, 120%, and 190% of the 2017 GDP of France, Italy, and Spain, respectively. During the same period, the French economy accumulated a series of annual trade deficits: 42, 56, 45, 52, 74, 67, 61, 53, 46, 48, and 63 billion euros, successively, for a sum total of 697 billion euros. Since 2010, the European Commission (EC) has expressed concern about the size of the German trade surplus. Surpluses that exceed 6% of GDP are considered excessive by the EC. The German trade surplus has been more than 7% for several years now—the figure was 8% in 2017—but the EC has no legal basis to demand or enforce a reduction.

Before the creation of the euro, such imbalances would inevitably have led to a sharp loss in the value of the franc. In 2015, I estimated that if the franc had been retained, the exchange rate against the deutschmark would have been around FRF 4.2.14 This figure was based solely on the historical decline of the franc against the deutschmark, from FRF 1.23 in 1963 to FRF 3.38 in 1998. In 2018, the figure would likely have been 5.5 FRF. Between 2000 and 2018, the franc would have lost at least 40% of its value against the deutschmark. The same reasoning can be also applied to the changes in rates between the dollar and the old mark, which increased from 4.17 to 1.6 deutschmarks to the dollar between 1960 and 1995. This represents a 255% decrease in value for the dollar against the mark over three decades.

The undervaluation of the euro against the deutschmark has gradually turned Germany into a mercantilist nation. This is one of the reasons for the current trade tensions between the United States and the EU, which, at their heart, are really concerned with German industrial production.15 An undervalued euro for Germany is fueling artificially high trade surpluses which, in turn, provide German companies with the means to invest in and conquer new markets. The German labor market is overheating as a result of the abnormally high level of activity. This is especially true in the regions where the export industries are based: Bavaria and Baden-Württemberg. In these two states, or Länder, unemployment rates are well below 5%. The International Labor Organization considered this a lower limit. In June, 2018, the unemployment rates in these regions were 3.2% and 2.8%, respectively. At the same time, the national unemployment rate had fallen to 5.2%, its lowest level since reunification. Although it might seem promising, the current rate masks deep disparities between the labor markets of the old western Länder and the new eastern Länder.

In the regions of Thuringia and Berlin-Brandenburg, unemployment rates were 7% and 8%, respectively, at the end of 2017. This is, in fact, a consequence arising from the monetary unification of July 1, 1990, which established a 1:1 exchange rate between the deutschmark and the ostmark. At the time, the real exchange rate was probably around 1:5. This decision was partially responsible for the collapse of the East German economy and the exodus of more than three million young Germans from East to West, depriving the former German Democratic Republic of almost 20% of its population.

In common with the new eastern German Länder, the countries of southern Europe suffered from the effects of a single euro. The single currency is overvalued in relation to their economic potential. In 2016, unemployment rates throughout the Eurozone were uniformly higher than in Germany: Portugal (9.8%), France (10.1%), Italy (11.7%), Spain (18.2%), and Greece (23.7%). According to Eurostat figures, the highest unemployment rates among the young were in Greece (48%), Spain (40.5%), Italy (34.1%), and France (24%). The lowest rates of youth unemployment were in Germany (6.7%), the Netherlands (9.6%), and Austria (10.6%).16

As a result of these disparities, the establishment of a European federal budget has been proposed, based on massive transfers from states with budget and trade surpluses to states in chronic deficit. In 2011, Jérôme Creel suggested creating an equalization scheme inspired by the German federal system:

According to the rules of the German tax transfer mechanism, 320.08 billion euros should be transferred to the eight least well-endowed countries in terms of per capita tax revenue directly from the 351.04 billion euros redistributed by 8 countries with the highest per capita tax revenue in the euro area, indirectly through the European institutions. According to our calculations, Greece would thus benefit from a transfer of 44.9 billion euros … this transfer would offset its deficit of 32 billion euros in 2009. … The Europeanization of national taxation is at the heart of the democratic arbitrage between the internalization of externalities and the potential economies of scale on tax levies by central public intervention, and the degree of heterogeneity of preferences that comes up against the hypothesis of the uniformity of public goods offered by the central level in monetary union. … In theory, budgetary transfers between countries are accepted by the richest because the mobility of populations is insufficient.17

Aside from the question of whether such an idea would be accepted by German voters, there is no reason to believe that an EMU-wide equivalent of the German equalization system would produce the expected results. In 2015, the sum total of western Germany’s transfers to the east amounted to €1,600 billion—ten times the GDP of the former GDR in 1988. Despite these measures, large disparities can still be observed between the old and the new Länder. In eastern Germany, per capita productivity is 15% less than in the west. This productivity gap affects almost all sectors of the economy in the new Länder. Agriculture is a rare exception. There are considerably larger and more numerous industrialized farms in the east than in the west.

In a paper devoted to the cost of federalism in the eurozone, Jacques Sapir advocates for transfers amounting to 8% of Germany’s GDP:

The total amounts to 257.71 billion euros per year [to cover] what is necessary for the eurozone to survive beyond the immediate financial requirements, which already imply a significant contribution from Germany and France. Who would be the contributors? France could not contribute; it needs to finance a catch-up effort on the order of 1.5% to 2% of its GDP. Transfer financing would therefore depend on Germany, Finland, Austria, and the Netherlands. We thus consider that Germany would bear 90% of the financing of the sum of these net transfers—i.e., between 220 and 232 billion euros per year (equivalent to a total of 2200 to 2320 billion over ten years), or between 8% and 9% of its GDP. Other estimates give even higher levels, as much as 12.7% of the GDP.18

Mandatory transfers of this magnitude would dissolve Germany’s trade surplus and obliterate the productive efforts of an entire nation. No German political party would ever agree to such a measure. The current political parties in Germany have, in fact, tacitly agreed to retain the euro. And, in fairness, up until now it has worked to the benefit of the German economy.19

The only way for EMU member states to minimize the cost of externalities in relation to the single currency is to achieve gains in productivity that bring them closer to German levels. Productivity statistics compiled by the OECD suggest that France is much more likely to stay in the eurozone than many analysts believe. Between 2013 and 2016, the hourly productivity rate in France has steadily increased. It was also above the German rate during this period. Recent labor law reforms might result in further productivity gains. Any attempt by Spain or Italy to catch up seems unlikely to succeed. In Italy, rather than increasing, productivity fell slightly between 2013 and 2016, from US$47.80 per hour to US$47.60. With a public debt that amounts 132% of GDP, and a GDP that has, in turn, been declining since 2007, Italy is in a perilous state. When the ongoing Italian banking crisis is taken account, it seems likely that if the eurozone does indeed break up, it will be due to Italy. That is, unless the deterioration of TARGET2 balances forces Germany to leave first.20

## The Future of the Eurozone

As a result of its growing trade surpluses, Germany retains a significant TARGET2 credit. At the end of 2017, this credit amounts to nearly one third of Germany’s GDP. The balance is currently growing at a rate of 15 billion euros every month and is expected to reach a total of 1,000 billion euros during 2018. It will become clear at some point that Germany’s monetary claims against the other eurozone states no longer have any real value. Some economists, such as Hans-Werner Sinn, believe that Germany should exit the euro quickly, since the TARGET2 balance sheet is ultimately destined to collapse.21

This situation represents a trillion-euro political dilemma for the German government. TARGET2 credits are, in effect, credits without collateral. The exit of Germany from the EMU would mean the end of the single currency and the total loss of all its euro credit balances. If Germany does not take the initiative, it risks being caught out by the departure of another eurozone member. This would, of course, take place at an even higher level of imbalance in the TARGET2 system.

Some financial analysts have viewed the 2015 decision by the Bundesbank to repatriate all 2,000 tons of gold stored abroad as part of preparations for the breakup of the eEurozone. While it is difficult to discern the motives of the Bundesbank, it is clear that the TARGET2 system will no longer be viable if the differences in balances continue to increase at the rates observed in January 2016. It is no coincidence that since the spring of 2017 the Bundesbank began regularly asking the ECB to raise its key interest rate. The official explanation has been that such a measure is needed to contain inflationary pressures in Baden-Württemberg, Brandenburg, Hesse, and Saxony. Nonetheless, it does not seem unreasonable to wonder whether the real goal is to curb TARGET2 balances. The ECB rate of zero directly contributes to drifting balances.

Since the end of 2015, major eurozone financial institutions located outside the former mark zone have borrowed from the ECB at a zero interest rate in order to buy massive quantities of German government bonds at a ten-year yield of 0.3%, along with Dutch bonds yielding 0.46%.22 Each of these transactions has further inflated the TARGET2 credit balances of Germany and the Netherlands. The concentration of intrazonal purchases of government bonds and other assets is in these two countries and not in Spain or Italy—where yields on ten-year bonds are significantly higher, 1.3% and 2.7%, respectively—which shows that investors have more confidence in German and Dutch public debt.

It might also indicate that investors anticipate a return to national currencies.

In order to limit TARGET2 balance differences, Germany has a vested interest in raising the ECB’s key interest rate above the average rate of its government bonds. In doing so, it risks weakening the highly-indebted states of the EMU. These member states would experience great difficulty in servicing their debts, perhaps, in turn, triggering departures from the Eurozone.

This is the dilemma faced by Eurozone leaders. It is a systemic contradiction that must be dealt with swiftly if Nordvig’s prediction about an inevitable break-up of the EMU is to be avoided.

Translated and adapted from the French by the editors.

1. TARGET is the Trans-European Automated Real-Time Gross Settlement Express Transfer System.
2. The euro is a single currency, in that it is the currency for settling taxes in each member state of the monetary union. But it remains, from a purely economic point of view, a currency with a fixed exchange rate, which sustains—virtually—the former currencies of which it is composed, through the budgetary, economic, social, and fiscal policies of the member states of the EMU.
3. Jens Nordvig, The Fall of the Euro: Reinventing the Eurozone and the Future of Global Investing (New York: McGraw Hill, 2014).
4. Joseph Stiglitz, L’euro: comment la monnaie unique menace l’avenir de l’Europe (Mayenne: Editions Les liens qui libèrent, 2016), 181.
5. Joseph Stiglitz, L’euro: comment la monnaie unique menace l’avenir de l’Europe (Mayenne: Editions Les liens qui libèrent, 2016), 44.
6. Philipp Bagus, La tragédie de l’euro (Paris: L’Harmattan, 2012), 57–58.
7. Murray Rothbard, What Has Government Done to Our Money? (Auburn, AL: Ludwig von Mises Institute, 1963), 24–25.
8. Deflation is not a problem in itself, if it is the result of productivity gains and economies of scale, and if incomes are little affected. It becomes an unbearable constraint if it affects an overindebted economy whose agents see their incomes drop considerably. Most loans are at fixed rates, so debtors find it impossible to repay their loans. Through defaults and bankruptcies, the crisis spreads and takes a depressive form as in 1929.
9. For our reference sample, the values calculated on the basis of a 100 index of prices in 2003 were, at the end of 2016, 117.3 for Germany, 120.5 for France, 124.2 for Italy, and 130.5 for Spain. These indices were calculated on the basis of composite inflation for the period covered by the Eurostat data and supplemented, for the years 2015–2016, by the data available on the website inflation.eu
10. Gilles Dryancour, “Les malédictions de l’euro,” talk given October 1, 2015 at the National Assembly.
11. Banque de France, Focus, no. 14, July 21, 2015.
12. Further analysis could reveal which countries benefit most from the ECB policy rates; those that do might be designated as part of a central group for the euro. All the other countries would be part of a peripheral group, and sooner or later they would be better off leaving the monetary union to regain their monetary autonomy and setting a policy rate adapted to the structure of their economy.
13. Eurobarometer, Flash EB 175 – L’euro, 4 ans après l’introduction des billets et des pièces (2005); Eurobarometer, Flash EB 251 – Public attitudes and perceptions in the euro area (2008).
14. This figure was based solely on the rate the franc has eroded against the mark in historical terms—it increased from FRF 1.23 in 1963 to FRF 3.38 in 1998.
15. Without wishing to join the debate over whether it is legitimate for the US Government to impose 25% tariffs on German cars, it must be admitted that if they were still sold in marks, their price in dollars would have risen well above this percentage and the question of these protectionist measures might not have been raised.
16. Eurostat, Euroindicateurs 75/2017, May 2, 2017.
17. Yann Echinard and Fabien Labondance, La crise dans tous ses Etats (Grenoble: Presses Universitaires de Grenoble, 2011).
18. Jacques Sapir, “Le coût du fédéralisme dans la zone Euro,” RussEurope: Blog de Jacques Sapir sur la Russie et l’Europe, November 10, 2012.
19. In the short term, it does not seem likely that there will be a political challenge to this model. Nonetheless, French president Emmanuel Macron and German chancellor Angela Merkel agreed in June 2018 on the establishment of a euro-area budget. Without specificying the full details, Merkel clarified that the budget would be only a few tens of billions of euros. This was contrary to the expectations of France, who have a budget of several hundred billion euros. The project was denounced by the Christian Democratic Union in Germany, which announced that it would oppose it within the grand coalition. The Dutch prime minister declared an intention to refuse any idea of redistribution of the prosperity brought by the single currency. The unanimity of EMU member states required for the creation of a eurozone budget remains elusive.
20. The deterioration of TARGET2 balances is only one of a number of imminent threats to the eurozone. This deterioration is a direct consequence of the productivity differentials between the EMU member states, though I did not analyze it in detail. Indeed, if the flow of imports and exports were more balanced in the domestic market, the issue of TARGET2 balances would not be as acute.
21. Hans-Werner Sinn, Der Schwarze Juni: Brexit, Flüchtlingswelle, Euro-Desaster - Wie die Neugründung Europas gelingt (Freiburg im Breisgau: Verlag Herder, 2016).
22. Current figures as of June 2018.