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The euro is an experiment in making a currency without a government. That's why it's in trouble.

- June 28, 2015

The European Union appears to be on the brink of an unprecedented rupture. After months of meetings between the 19 E.U. states that use the euro, Greece broke off talks ahead of a June 30 deadline for continued financing of their vast debts and is likely to default and leave the euro.

Negotiations have dragged on for months. Facing harsh demands from Greece’s E.U. and IMF creditors for deep cuts in public spending and increased taxes, Prime Minister Alexis Tspiras abruptly announced on Friday that instead of continuing the talks, he would put the humiliating” and “unbearable” bailout terms to a nationwide referendum on July 5. Critical stopgap financing from the European Central Bank (ECB) is also in jeopardy, and even if the referendum were to pass, it would be moot given the June 30 expiration of the credit line. Greeks prepared for the banks to be closed this coming week and capital controls instituted.

After 16 years of expanding membership, the euro zone now faces the real possibility that one of its core members, Greece, may spiral out of the currency and into economic chaos. For years, German Chancellor Angela Merkel and other European leaders have said that Greece will stay in the euro no matter what, but it now appears that the 18 other states of the euro zone are hunkering down and preparing for a “Grexit,” as a Greek departure has been dubbed. There is less fear of financial contagion to other parts of the euro zone than in the early years of the crisis, but given the novelty of the situation, no one really knows what will happen.

The truth is that the E.U. is poorly equipped to handle the stresses and strains of the euro crisis, not because of its economic shortcomings but because of its incomplete political development. The euro is a unique experiment in monetary governance without a government. The challenges of the Greek crisis reveal the disastrous costs of attempting to substitute economic orthodoxy for effective political authority. While the five-year euro-zone crisis has led to significant institution building and more open political contestation at the European level, it is not enough to save Greece from likely default and exit from the euro.

Markets generate political strains

Scholars have noted that the euro zone’s biggest challenges lie not in its economic suboptimality, but instead in a particular political problem. The design of the euro zone is notably different from every other successful single currency in history in that it is disembedded from the broader social and political institutions needed to provide a solid, durable foundation for monetary union. The euro lacks, quite simply, the political institutions needed for adjustment when the currency is removed from national control. Markets need political authority to stabilize them, and it is this lack of governance that may sink the euro, not its economic shortcomings.

If the euro zone is to work, it needs Europe-level political authority and power in at least four areas: a central bank that can generate market confidence and liquidity; a banking authority that can regulate financial risk and uncertainty across the euro zone; mechanisms for fiscal redistribution and economic adjustment in times of crisis; and a sense of political solidarity to navigate the conflicts that arise in financial crises. Yet it only partially meets these criteria today.

The historical record clearly indicates the need for such broader political frameworks: While financial crises can be weathered in nation-states such as the United States or Japan, cases of incomplete political development, such as the 19th-century Scandinavian Monetary Union (made up of Sweden, Denmark and Norway) and the Latin Monetary Union (France, Italy, Belgium, Switzerland and eventually, Greece) disintegrated in the face of crisis.

Perhaps the closest parallel to the E.U. case is the pre-World War I Austro-Hungarian Empire, which had a single currency, central bank and various types of political and diplomatic integration, but no fiscal union. Over time, debts began to rise and markets began to speculate against the solvency of the two states. Economic pressure meant that political solidarity splintered, which in turn contributed to the collapse of the monetary union, followed at the end of World War I by the collapse of the larger Austro-Hungarian Empire.

A glass half-full

The good times of the 2000s financial bubble insulated the E.U. from these harsh lessons of history, but when the financial crisis spread across the Atlantic in 2010, the shortcomings of the euro zone’s political and institutional foundations became starkly evident.

The euro-zone crisis has led the E.U. to build new institutional foundations and upgrade its political solidarity in significant and surprising ways, far beyond what the original foundations for Economic and Monetary Union included. The European Central Bank has played an unexpectedly aggressive role (to the tune of over 1 trillion euros in loans) in keeping the euro zone’s members solvent, and the newly created European Banking Union may help avoid future crises. Economic adjustment has been eased by the 2012 creation of the European Stability Mechanism, a slush fund for countries in trouble. But more robust institutions of fiscal redistribution, such a single, E.U.-wide Eurobond or the automatic stabilizers present in every other functioning monetary union, remain off the table.

Instead, E.U. officials, led by Germany’s powerful chancellor, Angela Merkel, in partnership with the International Monetary Fund’s Christine Lagarde, have relied heavily on the mantra of austerity policies, the squeezing of public-sector budgets to reduce annual budget deficits and long term debt. The problem is that austerity does not produce the economic growth needed to fill tax coffers and move a country out of debilitating economic stagnation. While other countries in trouble such as Ireland, Spain, Italy and Portugal have limped their way out of their immediate financial crises, the Greek political and economic situation has remained intractable.

Austerity is no substitute for governance

The most sensible path today is to allow Greece significant debt reduction and a pause in its debt payments — but without any new financing. This would allow the Greeks themselves to figure out how to fix their broken political economy, setting limits on them without default. But the E.U. and the IMF have rejected this option.

History suggests that the current policy, which attempts to substitute austerity for governance, is unsustainable. The E.U.’s usual ways of doing business are unsustainable, too. The bloc traditionally has been insulated from intensive public scrutiny. Instead, deals were struck in back rooms, and mainstream parties seemed unwilling to openly debate the goals and values of further European political development. Those days are over, and European leaders must come to grips with the new normal.
Throughout history, the arc of democratization and political development has been marked by conflict and strife. Austerity and financial orthodoxy cannot patch over the fundamental political differences generated by the deep integration that started with a single European market and now encompasses almost all aspects of everyday European life.

In the long run, the euro crisis has the potential to create a stronger footing for open contestation and democratic debate, along with broader institutions to support the euro. However, Greece’s sad experience as a member of the euro zone now places that future in serious doubt.

Kathleen R. McNamara is associate professor and Director of the Mortara Center for International Studies at Georgetown University and the author of “The Politics of Everyday Europe: Constructing Authority in the European Union.”