Practical analysis for investment professionals
09 June 2016

Book Review: Europe’s Orphan

Europe’s Orphan: The Future of the Euro and the Politics of Debt. 2015. Martin Sandbu.

The European Union (EU) contains only 7% of the world’s population but accounts for almost a quarter of the global economy — even after the epic losses it sustained during the financial crisis.

Global investors, whether they have euro-denominated assets or not, continue to be transfixed by the calamitous eurozone and the politico-economic failures in the EU, of which the impending “Brexit” referendum in the United Kingdom is but the latest ugly manifestation.

Europe’s Orphan: The Future of the Euro and the Politics of Debt is a spirited defense and a thoughtful reinterpretation of the eurozone’s unpromising recent history. Although the book has received accolades from the Europhile establishment and from the pro-EU Financial Times, its author, political scientist Martin Sandbu, as a Norwegian, stakes his claim to neutrality.

Sandbu begins Europe’s Orphan as he ends, with a restatement of the many powerful technical arguments in favor of a large currency union. Robert Mundell’s theory of the “optimum currency area,” for example, compares the benefits of broad monetary unification for achieving full employment with those of the blunt instrument of exchange rate devaluation as a way out of crisis. Theoretically, without the safety net of devaluations, countries are forced to address deeper structural inefficiencies, such as high unemployment, weak tax bases, kleptocracy, clientalism (as in Greece), excessive social spending, and unaffordably early retirement dates.

A secure single currency for a market of 330 million Europeans could foster predictability, productivity, and growth for businesses, Sanbu explains. It could make it easier to invest across borders, helping channel savings from the capital-rich surplus countries to their younger, savings-deficient, and higher growth counterparts. In time, financial and human capital would be allocated more efficiently and at lower costs to the ultimate benefit of asset owners as well as workers, thereby supporting the European ideal of combining a restrained capitalism with social responsibility.

Although Sandbu doesn’t elaborate beyond a rich account of the recent crisis, there are many historical comparisons that might offer useful perspectives, not least the earlier Exchange Rate Mechanism (ERM) based around the former deutschemark, the evolution of the US dollar, or even the British Empire’s pound sterling.

As for the EU’s current doldrums, Sandbu believes that Germany, now “in the grip of a logic putting debt relationships above all other considerations,” is both the problem and a big part of the potential solution — if it changes its attitudes towards debt. The creation of the euro without the inclusion of the United Kingdom upended the balance of power in Europe. It left Germany, with its persistent trade surpluses, alone responsible for the euro’s survival during the financial crisis, when market speculators became convinced it would fail. The remorseless logic of monetary union seemed to press the Germans to exact greater fiscal union as the price of preventing a disastrous collapse of the monetary experiment. Sandbu believes this German line of thinking was quite unnecessary and instead proposes alternative solutions.

Sandbu seems at heart appalled by Germany’s embrace of the sanctity of debt that drove the debt crisis negotiations, the actions of the European Central Bank (ECB) under Jean-Claude Trichet, the ogre of footloose financial markets, and especially the rise of fringe parties. For Sandbu, the structure of the euro — a monetary not a fiscal union — was flawed in design from the start. The crisis experience of many eurozone countries, who Sandbu believes were held for ransom as their democracies were trampled by the ECB and Germany, was an entirely avoidable catastrophe.

Some insights Sandbu digs out from a dense and in places rather journalistic chronicle of events before and during the crisis do serve to undermine the arguments of the euro-skeptics. An evaluation of the pre-crisis credit bubble that provided a windfall that most states consumed away and which is usually blamed on the euro and was made worse by a lack of synchronization among economies, is shown to be due to excess flows of international capital before 2007. Large current account deficits, a balance of payments crisis, and excessive debt build-ups were hardly unique to the eurozone and would probably have happened anyway.

Earlier and more radical debt restructuring, according to Sandbu, could have saved €10s of billions for Greece and other debtor countries. In Ireland, for example, the sanctity of private bank debt — mostly run up in speculative real estate lending — and the primacy of senior bondholders were initially upheld at the cost of impoverishing the state and plunging the country into unnecessarily deep austerity.

In Sandbu’s narrative, Trichet, the imperious president of the ECB at the time, believed that governments should have primacy over markets and repeatedly made the situation worse at critical stages of the crisis. Unwilling to countenance radical debt restructuring or write-downs, he famously rebuked the European Council about the threat of market speculators during an early bailout of Greece. Later he is said to have been the driver behind the fatefully premature tightening of ECB interest rates in 2011, which his successor Mario Draghi quickly reversed as economies crumpled under the strain.

But Sandbu doesn’t just identify where the EU came up short, he also proposes five solutions to bring about a reinvigorated eurozone, one that even the United Kingdom would be inclined to join:

  1. Compulsory fiscal and political union is not necessarily the way to make monetary union work. The risk is that citizens will turn their back on Europe if they are dictatorially mishandled as they were during the crisis. Risk-sharing Eurobonds or other ways of transferring resources among countries and a determinate path to fiscal union are unnecessary.
  2. The underlying productivity of the national economies matters most, since stronger individual economies make their respective debt burdens lighter.
  3. Restructuring sovereign debt and “bailing-in” or writing off private bank debt should be a first, not a last, resort in any crisis. The principle that creditors should take a hit in return for some help should have been applied in 2010 rather than 2015.
  4. The fault lines in the political and economic structure of Europe need to be addressed. This includes allowing more flexibility for countries to counter-cyclically spend their way out of recession within the already existing framework of the European Fiscal Compact.
  5. Finally, Sandbu is optimistic about the EU’s future, if its leaders can begin to address structural economic issues, such as tax policy, high unemployment, productivity disparities, and zombie banks, without depressing wages and leeching wealth towards the surplus countries,

Although there is a curious and distortive recency and a distinct lack of longer historical context throughout the book, many of Sandbu’s arguments in favor of the euro carry some weight. Though superbly edited and indexed by Princeton, the book might have benefited from a better definition and explanation of the European Fiscal Compact. Lastly, though Sandbu doesn’t mention it, his book is also a strong argument in favor of European corporates diversifying their funding sources away from bank debt and towards the equity markets or directly from asset owners.

More book reviews are available on the CFA Institute website or in the Financial Analysts Journal.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
Mark Harrison, CFA

Mark Harrison, CFA, was director of journal publications at CFA Institute, where he supported a suite of member publications, including the Financial Analysts Journal, In Practice summaries, and CFA Digest. He has more than 12 years of investment experience as a portfolio manager and securities analyst. Harrison is a graduate of the University of Oxford.

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