On a dark, damp, December morning in Dublin 16 years ago, a group of European leaders emerged from a tense all-night meeting and declared victory.
"It's done!" one eager Irish official shouted. "The baby is born."
The "baby" was an agreement that had eluded European leaders for years and held up their grand plan for a common currency. That deal, reached after months of bitter acrimony, would pave the way for the euro's launch in 1999. But its flaws would help spark the financial crisis that is now sweeping the continent.
The problem at the time was simple. How could euro zone countries ensure that their currency would not be undermined by one or two members who overspent and ran large budget deficits? Germany wanted a "stability pact" with strict spending controls and tough penalties for governments that failed to comply. France wanted a "growth pact" with flexibility and exemptions for exceptional circumstances.
The compromise reached on Dec. 13, 1996, was called the Economic Growth and Stability Pact. It included the limits set out by the Germans: Countries using the euro had to keep their annual deficits below 3 per cent of gross domestic product and their public debt under 60 per cent of GDP or face sanctions. But it also included exemptions sought by the French. Governments could ignore the limits in some situations.
The deal worked. By the time the physical currency hit the streets in 2002, the euro zone had 12 members; five more would later join. More importantly, the pact gave the euro zone the appearance of stability and accountability. Investors, showing confidence in this new and powerful currency backed by one of the world's largest economic blocs, began to shower cheap money on euro zone borrowers.
And that's when the trouble started.
Before 1999, each country borrowed money at interest rates based on the strength of their economy and their ability to repay the debt. That left wide discrepancies between what Germany paid in interest costs and what weaker countries like Portugal and Greece paid. But once they all adopted the euro, lenders treated them largely the same. Overnight, many countries saw the interest rate they paid cut in half, or more.
Low interest rates, coupled with a booming global economy, sent just about everyone across Europe on a borrowing spree – not just government, but businesses, banks and citizens. The same thing was happening across the Atlantic in the United States, where low interest rates were fuelling an enormous real estate bubble. Similar bubbles soon developed in Ireland and Spain.
Around the same time, some northern euro zone countries, in particular Germany and France, went through a wrenching process to improve their productivity and exports, largely by cutting or holding down wages. Many southern countries, such as Portugal and Greece, didn't follow suit – preferring to boost wages, benefits and social programs to accommodate national political needs. Between 1997 and 2007, labour costs increased 12 per cent in most northern euro zone countries. But they rose 32 per cent in the southern countries.
The south was slowly losing its competitive edge. Cheap money papered over the problem. As money flowed into a revived German economy from rising exports, it got lent or invested in Greece and elsewhere across Europe to fund government spending and a construction boom.
"Due to the fact that we have this easy access to cheap money, financial liberalization, no longer any kinds of controls, this was a strong incentive [to borrow]," said Kurt Hubner, professor of European Studies at the University of British Columbia. "At the same time we didn't have any kind of unified regulation of financial markets. All this was in the hands of the nation states ... so [in] the banking system, nobody knew exactly what was going on."
Awash in easy money, governments began to blow through the debt and deficit limits set out by the stability pact. In fact, some of them were in violation of it from the very beginning. Italy and Belgium didn't meet the financial requirements, but were allowed into the euro zone on their promise that their finances were heading in the right direction. Greece didn't qualify at all at first but won entry into the euro zone in 2001, even though many across Europe suspected the accuracy of the country's national accounts.
And by 2003, Germany and France had exceeded the deficit limits but invoked the special circumstances clause to avoid sanctions. Other countries took note. With the global economy on a tear between 2004 and 2007, rising deficits weren't seen as a worry – countries could just grow their way out of trouble.
"The European Union during this entire period applied the rules [in the pact]," said Amy Verdun, a political science professor and European specialist at the University of Victoria. "They would say, 'Okay, now you are in excessive deficit,' and [countries] would move out of excessive of deficit because there was just growth."
Some believe that allowing the euro zone's leading countries, Germany and France, to break the stability pact was one of the biggest errors in the euro zone's history. Others believe the original sin happened earlier, arguing that the creation of the single currency without political or fiscal union was always unworkable.
"The core mistake within the entire architecture of the euro was the creation of the common currency in the first place," said Constantin Gurdgiev, a finance lecturer at Trinity College in Dublin. "Absent an organic, democratically anchored federal union, a common currency zone is simply not viable even at the level of the 'strong Nordic' euro, let alone at the level of the euro that binds together vastly divergent states."
Greater union has been a goal for many Europeans ever since the end of the Second World War, when French businessman Jean Monnet set aside his family brandy business and pushed for greater harmonization among countries to avoid another conflict. Mr. Monnet – who famously tried to buy a ticket on the Titanic but found the vessel overbooked – is known as the Father of Europe for helping launch the European Coal and Steel Community in 1950, the first postwar effort to bring European nations together for an economic objective. It proved so successful that it led to the creation of the European Economic Community in 1958 and ultimately the European Union in 1992.
Mr. Monnet's goal was a kind of United States of Europe; many economists believe a common currency shouldn't have happened until a tighter political or fiscal union was achieved. The so-called "crowning theory" held that the euro should come after a more formal union, not before. The debate ended after the signing of the stability pact. But it has since been revived, with politicians like German Chancellor Angela Merkel and others pushing for a tighter union of fiscal policy and banking systems.
Theo Waigel, the former German finance minister who helped draw up the Growth and Stability Pact, has criticized countries for failing to adhere to its rules, particularly Germany and France. The move by those countries to invoke the special measures clause after falling offside on the deficit limits was "a serious political abuse of trust, because from that moment on confidence in the rules and the institution waned," he told a German publication. "An economic and monetary union requires co-operation, intensive co-ordination and also convergence – not only for its financial policy but also its economic policy."
The current crisis has shown that the euro zone is just a collection of intergovernmental institutions with only weak central leadership, added Prof. Hubner of UBC. "We are back in this kind of game of nation states and where national interests seem to dominate very much the situation," he said.
He argues that the Growth and Stability Pact was too inflexible and that European leaders are now trying to draft yet another rigid pact that will likely do more harm than good.
Still, Prof. Hubner believes the euro and the European Union will survive the current crisis. And he is not alone in hoping that it will. "What is the European project of integration all about? It's about overcoming narrow-minded national interests on a continent that's had a history of wars and of confrontation. And in this regard, the project of European integration is a huge success that needs to be saved."