Late in 2011, the European Union (EU) convened a meeting of its twenty-seven heads of state to hammer out an unprecedented agreement on fiscal unity that was designed to calm persistent fears of the dissolution of the euro and possibly of the EU itself. Powerful market forces had disabled the remedies put in place by Eurozone leaders over the previous eighteen months by continuously devaluing European sovereign bonds, bank debt, and other securities.
The agreement that followed, presented in Brussels with much fanfare on Friday, December 9, 2011, was a reluctant acknowledgment that the interests of all Europe necessitated that high-cost bailouts of a few countries would require all the rest to accept tight, centrally controlled fiscal and budgetary standards. The agreement was soon called the "Merkozy Plan" after its principal sponsors, German chancellor Angela Merkel and French president Nicholas Sarkozy. Markets appeared to be relieved: the Euro Stoxx 50 index rose 2.8 percent that day.
The plan provided for a "Fiscal Compact" to limit national debt levels of all EU countries, with mandatory fines for those in violation; a "Golden Rule" that each country would pass a balanced-budget amendment to its constitution, which would have to be certified as legally sufficient by the European Court of Justice; "firewalls" to prevent the crisis from spreading to other countries by leveraging and accelerating the deployment of previously agreed 440 billion [euro] of European Financial Stability Funds (EFSF); and a new promise to lend 200 billion [euro] to the International Monetary Fund (IMF), funds that are to be lent out again, under the IMF's strict controls, to distressed Eurozone member countries. It was intended as a major step in shifting national sovereignty over economic policy to the European Commission, the EU's faceless, central governing body.
For the Merkozy Plan to be applicable to all member countries of the EU, it would have to be ratified by all of them. The United Kingdom did not go along, however, so the compact was redirected to apply only to the seventeen countries that utilized the euro (collectively "the Eurozone"), with the other EU countries participating voluntarily.
By the following Monday, however, the markets had reconsidered its support. Over the next three days, the Euro Stoxx index dropped nearly 6 percent, bringing its 2011 decline to 21.3 percent, as compared to a decline of less than 1 percent for the U.S. S&P 500 index. Bond spreads for Italy and Spain, which had narrowed by more than one hundred basis points in anticipation of the agreement, widened once again. (1) The eurodollar exchange rate also weakened--it had already declined by 12.8 percent against the dollar since rising to its peak for the year at 1 [euro] to U.S. $1.48 in May 2011. The gloom that had spread over European (and American) financial markets since the beginning of the year but then had lifted after the announcement of the Merkozy Plan quickly returned.
Investors in key financial markets evidently did not believe the December agreement went far enough; the EU had made earlier promises to control debt levels, but even Germany and France had regularly ignored them with impunity. Why would this agreement be any different?
Many economists claimed that the Merkozy Plan headed in the wrong direction. The best solution, they said, was to issue "Eurobonds" collectively guaranteed by all the countries of the Eurozone to stem the panic. Instead, the plan offered a long-term effort to improve the credibility of the Eurozone by providing the missing fiscal union that would assure acceptable government debt levels in the future. Neither Germany nor France was prepared to guarantee the rest of Europe's debt without these assurances, so this was the best that could be done for the time being--at least until the Merkozy Plan's commitments were fully and legally put in place.
Italy alone had more than 3 trillion [euro] of public debt outstanding, and if it had to sustain this level of debt at then prevailing market rates of 6.5 to 7 percent, its finances would collapse. Italy would also have to be bailed out at a cost far greater than the resources the Merkozy Plan had been able to assemble.
The Economist pointed out that only the European Central Bank (ECB) had the financial capacity to turn markets around ("A Comedy of Euros" 2011), but this idea was anathema to the Germans, who feared that printing enough new money to save Italy would be inflationary, would undermine the euro, and might not be repaid.
The critics' consensus was that the governments of the EU had once again done too little, too late to win the race against market forces that were about to undo the thirteen-year experiment with a single European currency, which many academics on both sides of the Atlantic had considered poorly designed and premature.
Origins of the Experiment
Shortly after World War II, the reorganized governments of continental Europe found themselves endangered by three different threats.
One was the urgent need to revive the economies of the war-torn region, which was to be assisted by the formation of the World Bank, the IMF, and the General Agreement on Tariffs and Trade (now the World Trade Organization), as agreed to in 1947. In addition to these new institutions, the U.S. Marshall Plan (1947) was aimed to help Europe especially.
A second concern was over the possible rise of Communist parties within Europe and the threat of hostilities with the Soviet Union, for which the North Atlantic Treaty Organization (NATO) was put in place in 1949.
A third was to prevent the ending of a war with Germany from seeding the beginnings of another. This latter concern would require a different way of thinking from what had emerged after World War I. It would be based on the idea that an economically prosperous Germany, integrated into Europe, would create commercial and financial entanglements that would tie it and the rest of Europe together in such a way as to make war an impracticable solution to cross-border conflicts and therefore unlikely.
Some in Europe sought a set of new European institutions, separate from the global institutions formed after the war, to assure its economic and political integration. German chancellor Konrad Adenauer and French president Charles de Gaulle were early leaders in the this effort, as were three French civil servants--Jean Monnet, Robert Schuman, and Robert Marjolin, who rose to become the principal journeymen tasked with delivering the requisite European institutions. This Franco-German effort, one that continues today, began with the creation of the European Coal and Steel Community (1951), Euratom (1957, for the peaceful use of nuclear energy), and the Treaty of Rome (1958) among six continental countries. This treaty established the European Economic Community (EEC), a form of customs union with an executive body (the European Commission); a Council of Ministers; and a development agency, the European Investment Bank. Britain joined the EEC in 1973, after French objection to U.K. membership was withdrawn. Defense was left to NATO, which encompassed the same countries, although France withdrew from NATO in 1966 and did not rejoin until 2009.
European economic development benefitted from the establishment of these institutions. Several academic studies have demonstrated that the reduction in intra-European tariffs provided significant stimulus to the private sector, but the benefit only went so far (Erixon, Freytag, and Pehnelt 2007). Economic growth within Europe was still uneven.
By the 1970s, politics in Europe had swung to the left, triggering extensive nationalization of private industrial corporations and banks, a rise in the power of labor unions, a surge of Euro communism, and outbreaks of terrorism by radical groups--all while economic output drifted into a state of low growth and high inflation (which some journalists called "Stagflation").
By the end of the 1970s, continued weak economic performance in Europe (a condition that journalists called "Eurosclerosis"), especially in competition with the United States and Japan, was coming to be considered a threat to European standards of living. This concern shifted political sentiment back toward more conservative, market-driven policy ideas. Margaret Thatcher became prime minister of Britain in 1979 and led the way in confronting labor unions, reforming financial markets, privatizing industrial companies that previously had been nationalized, and actively pursuing free-market economics. The resulting economic success in the United Kingdom under Thatcher soon spread her policies to the continent.
The Single Market
In 1985, the European Commission, then presided over by Jacques Delors (another pro-Europe, French civil servant), ordered a study of an "integrated market" for Europe, free of various residual trade and other barriers that had survived the Treaty of Rome. Delors delegated the job to Arthur Cockfield, a market-oriented euro skeptic newly appointed to the commission by Margaret Thatcher. Only a few months after Cockfield arrived in Brussels, he produced a mammoth white paper listing three hundred barriers to intracommunity trade, with a timetable for abolishing them (Cockfield 2007). He engaged Italian economist Paolo Cecchini to conduct a study of the costs of the remaining internal trade barriers and the value to be obtained by their removal. Cecchini's report, published in 1986, declared that the member countries could boost their collective gross domestic product (GDP) by 5 percent by eliminating these barriers (Committee of the European Commission 1998). Soon afterward, the now twelve members of the EEC passed the Single Market Act, which would go into effect in 1992, and renamed the EEC the "European Union."
Although many Europeans were doubtful that this law would change very much, Delors, French president Francoise...