Without Some Fiscal Redistribution, the Eurozone Is Headed for Divorce

This essay is an edited version of remarks delivered as part of a Myron Scholes Global Markets Forum panel discussion on Greece’s debt crisis. The discussion, presented by the Initiative on Global Markets at Chicago Booth, took place September 29, 2015.

As long as Greece continues to spar with its eurozone partners over its economy, there will be discussion of how the Greeks found themselves in the crisis they’re in now. Like most complex problems, this one is the product of numerous factors and the fault of numerous individuals. But though it’s worthwhile to examine the origins of the Greek crisis, we shouldn’t get so busy dissecting it that we forget to ask the underlying question: Does the European Union make sense?

In order to study whether it makes sense, start with something very basic: take a look at a $20 bill. The reason the piece of paper is worth anything is because it has a picture of the White House that basically says, “There’s a political power that backs this and accepts this piece of paper for your taxes.”

On the other side, there is a figure that all Americans recognize: Andrew Jackson. He is not exactly a hero, and some people might actually disagree with the suggestion that he was a great president. But you don’t see Clinton. You don’t see Reagan. You don’t see George W. Bush. You see someone everybody recognizes as part of a common set of values.

Let me look at a €20 bill. On one side, do you see the European White House? You see a bridge, and you see a geographic expression of Europe. Then look at the other side: you see a monument. I’m offering cash to anybody who might be able to identify this monument, but my money is safe because you can’t identify it. It’s fake. The eurozone governments could not agree on which monument to put on the bill, so they decided to use some monuments that look like something familiar. There’s a Gothic window that looks like a lot of Gothic windows, but it’s not a Gothic window that exists anywhere.

(I recently learned that in the Netherlands, a town is building a bridge that looks like the one on the €20 bill. This is the ultimate in reverse engineering.)

Why do I go into these details? I think the fundamental questions are, What does it mean to be a common currency area? And what does it mean to be a common country?

Think about Louisiana. When Hurricane Katrina hit the state, there was no doubt that a massive amount of help would go there. In Louisiana, with all due respect, some people are pretty corrupt. I think there is not much difference between the corruption in Louisiana and the corruption in Greece, but no one in the United States said we shouldn’t send money to Louisiana because they’re corrupt. In Europe, however, they do. Actually, they find ways to say it, and still claim, “It’s not that we don’t believe in solidarity; it’s just that they are corrupt. We’re doing them a favor by not sending them money because they’re going to be more corrupt,” which might be true, and that’s the reason Louisiana is still corrupt.

But how many people know what fraction of their taxes goes to Louisiana or to Mississippi? Nobody knows, because it’s not a salient part of anybody’s campaign. Can you imagine if a presidential candidate said, “We should stop any transfers from Connecticut to Mississippi or Louisiana”? I don’t think he or she would be a very successful presidential candidate.

In Europe, however, that’s exactly what Angela Merkel is campaigning on. In a recent interview, George Mason University’s Tyler Cowen asked me to assess Merkel, and I said she is fantastic at running Europe for the interest of the Germans. It’s not a criticism. She’s elected by the Germans. Why should she pay attention to anybody else? She’s successful in promoting the interest of the Germans at the expense of everybody else—hiding behind the idea that we don’t want to subsidize the laggard because that would be bad for the laggard, and risk sharing is wrong.

In fact, risk sharing takes place in Europe, but it’s the other way around: from poorer countries to richer ones. Greece was “saved” by neutralizing the losses of French and German banks on the backs of everybody else in Europe. There is transfer, but it’s reverse transfer, from the poor to the rich.

Let’s look at the rules. In the early 2000s Germany was in violation of the rule prohibiting deficits from exceeding 3 percent of GDP. France and Germany changed that rule to allow the violation. Germany is now in violation of the foreign account rule that says if you want to have a common currency area, you’d better be sure nobody is running a gigantic surplus because on average you have to be on balance. If there’s somebody with a gigantic surplus, there must be somebody with a gigantic deficit. Either you finance the deficit, or you have to cut down the surplus.

Germany has a gigantic surplus. It’s a violation of the rules to have this excessive surplus, but nobody has even raised this issue in any debate in Europe. Germany, thanks to the fact that it’s a financial safe haven and everybody is flocking to the bund as a safety device, is saving €30 billion a year as a result. Again, it’s a transfer from the poor to the rich.

The rules in place in Europe are designed to please the Germans. And still, it’s not that the Germans don’t violate rules. They talk about corrupt Greece, but who was corrupting Greece? Who was selling arms and other things to Greece with the help of bribery? The German firm Siemens was at the top of the corruptors’ list. It’s true that Greece was corrupt, but it’s not entirely Greece’s fault because it takes two to tango.

So what are the mechanisms of risk sharing we really need in Europe at this moment?

The first one is a true banking union. Think of Puerto Rico: there’s been no run on Puerto Rican banks, and there are two reasons. For one, Puerto Rican banks are not full of Puerto Rican bonds because their banks are not induced by regulation to buy Puerto Rican bonds. By contrast, EU banks are encouraged by regulation to purchase their own governments’ bonds. This makes Puerto Rican banks more stable. The other reason is the US government has an independent agency, the Federal Deposit Insurance Corporation (FDIC), which provides insurance that covers Puerto Rican banks, up to at least $250,000. We need common insurance for deposits in Europe, paid with common funds. Germany is absolutely right, however, that a similar deposit insurance should be designed so as to reduce opportunism on the part of the insured banks, what we economists call moral hazard. So I agree with Germany’s proposal that—in the case of a bank rescue—the equity holders should be wiped out and some of the losses should be imposed on the bondholders.

The second mechanism is unemployment insurance. In the US, when a lot of people in Louisiana are unemployed, people from Massachusetts help pay for that unemployment insurance—and they don’t complain, because it’s not a permanent transfer. There are times when Massachusetts has more unemployment than Texas or Mississippi. Then things work in reverse.

Good unemployment insurance (which is federal at the European level) is a way to make a downturn less severe. It needs to be designed properly to avoid moral hazard, because I agree with the Germans that giving a lot of money to the latest Greek government is very dangerous; they’re likely to waste it. That’s the reason I like to put money in the hands of people. Unemployment insurance can be designed in a way that is fair; it’s not a unilateral transfer from one place to the next. We share.

Sharing, and in particular risk sharing, will be necessary if the EU is going to serve the interests of all its members. This means European countries have to confront the inevitable decision: either they are willing to go in the direction of risk sharing or they are not. Clearly, the best case is that the currency union will be a happy marriage for all involved. If not, as in any unhappy marriage, you have to find the best way to end it. An amicable divorce, after all, is better than a feisty and contentious one.

Luigi Zingales is Robert C. McCormack Distinguished Service Professor of Entrepreneurship and Finance and Charles M. Harper Faculty Fellow at Chicago Booth.