The only person standing between a solution to the eurozone sovereign debt and banking crises and a total meltdown is Angela Merkel. She refuses to countenance a change in the role and charter of the European Central Bank (ECB) to allow for (admittedly inflationary) quantitative easing; she rejects the issuance of pan-eurozone "Stability Bonds"; she is dead set against the establishment of European institutions such as a European Monetary Fund, a European supervisor of the members' budget deficits, and a European central debt depositary. She is at odds with virtually all the leaders of Europe, including France's Sarkozy and and the UK's Cameron. Merkel has become a liability and political parties within Germany as well as influential members in her own coalition are beginning to realize it. Will she resign? Will she be pushed over, Margaret Thatcher-style? Will she declare early elections or a referendum? It is anyone's guess. But she will quit the scene soon, either willingly or willy-nilly.
As the crisis in Italy is threatening to spread to France, Austria, Belgium, and other "solid citizens" of the eurozone, pundits have hitherto ignored the greatest threat: Germany. With its economy stagnant (0.5% projected GDP growth this year), Germany has assumed hundreds of billions of euros in new commitments to the faltering euro project. Normally, in times of crisis, investors would snatch up German bunds, driving up their prices and driving down their yields. This time, yields on Germany's much-vaunted bunds remained stable and its latest debt auction shockingly undersubscribed. Investors are shying away, terrified that the toxic waste generated by the likes of Greece and Italy will drag down the mighty Germany. This time around the country cannot extricate itself via an increase in exports: it is in the same predicament as China and Japan with exports slowing across the board.
In an article I published in 1997 ("The History of Previous European Currency Unions"), I identified five paramount lessons from the short and brutish life of previous - now invariably defunct - monetary unions:
To prevail, a monetary union must be founded by one or two economically dominant countries ("economic locomotives"). Such driving forces must be geopolitically important, maintain political solidarity with other members, be willing to exercise their clout, and be economically involved in (or even dependent on) the economies of the other members.
Central institutions must be set up to monitor and enforce monetary, fiscal, and other economic policies, to coordinate activities of the member states, to implement political and technical decisions, to control the money aggregates and seigniorage (i.e., rents accruing due to money printing), to determine the legal tender and the rules governing the issuance of money.
It is better if a monetary union is preceded by a political one (consider the examples of the USA, the USSR, the UK, and Germany).
Wage and price flexibility are sine qua non. Their absence is a threat to the continued existence of any union. Unilateral transfers from rich areas to poor are a partial and short-lived remedy. Transfers also call for a clear and consistent fiscal policy regarding taxation and expenditures.
Problems like unemployment and collapses in demand often plague rigid monetary unions. The works of Mundell and McKinnon (optimal currency areas) prove it decisively (and separately).
Clear convergence criteria and monetary convergence targets for all the countries involved in the project. "Convergence" in this sense means the alignment of economic policies and statistics until the members become indistinguishable. Germany and Greece, France and Spain should all have had the same economic profile at the beginning of the process of monetary union. They didn't and still don't, of course.
The current European Monetary Union is far from heeding the lessons of its ill fated predecessors. Europe's labour and capital markets, though recently marginally liberalized, are still more rigid than 150 years ago. The euro was not preceded by an "ever closer (political or constitutional) union". It relies too heavily on fiscal redistribution without the benefit of either a coherent monetary or a consistent fiscal area-wide policy. The euro is not built to cope either with asymmetrical economic shocks (affecting only some members, but not others), or with the vicissitudes of the business cycle.
This does not bode well. This union might well become yet another footnote in the annals of economic history.