Countries which joined the European Union using the euro have basically given up their rights to print money. They share the common currency, but when it comes to sovereign credit, they have to be on their own. The European Central Bank (ECB) accepts their debts on equal terms at its discount window; so all the member countries, no matter how their sovereign financial strength is, can borrow at as low an interest rate as Germany. The banks began to load up their balance sheets with the government debt of weaker European countries. Due to the time of George Soros writing in July 2010, The European banks hold nearly a trillion Euros of Spanish debt; half is held by German and French banks. So we can see the connection between the European sovereign debt crisis and the European bank crisis.
With the existence of the euro in 1999, the interest rate differentials have been narrowed in, which in effect, creating the real estate bubbles in Spain, Greece and Ireland. Those fast-growing European members developed the growing trade deficits between euro zones; Greece especially has budget deficits which exceed the limit set by the Maastricht Treaty. But they still can borrow at the same low rate as Germany. That is why they cannot feel the pressure of their more and more serious deficits.
Germany both insisted on strict fiscal discipline on weaker members and reduces its own fiscal deficit. The reinforcement of reduction in tax receipts, employment and exports has even made the budgetary target not able to be met and need further reductions. Even if it were met, Soros cannot see how weaker members regained the competitiveness because there is no exchange rate depreciation because of the common currency, so the wages and prices need to be decreased, producing deflation.
The introduction of the common currency has make the borrowing costs for the members greatly reduced as they have two strong members like Germany and France. Spain has sound macroeconomic policies, maintained the reasonable sovereign debt level and has supervision on its banking system. However, it still enjoyed the enormous real estate boom that has burst, resulting in 20% employment.
Another flaw of the euro is member countries are well prepared for the danger of inflation, but not the possibility of deflation. And the “gravest defect” in the euro is as Soros has pointed out: It does not allow for error. It has the goal of budget deficit max of 3% and total sovereign debt of 60% GPD, but they do not have an adequate enforcement mechanism. When it comes to the time that several member countries have far exceeded the maximum level, there is no mechanism for adjustment or exit. Soros noted that is in direct conflict with the lesson learned from the Great Depression in 1930, and might push Europe into prolonged stagnation.
Germany has a very strong economy compared to other countries in Europe; it has a strong currency and balanced budget. But in the euro zone, it has imposed its predilection on other countries without considering the differences of needs and preferences. However, it doesn’t recognize what it's doing. And with the strongest economic power in the euro zone, it is in the driver’s seat. Effectively, Germany determines the financial and macro economic policies of the euro zone. So what Germany should do?
It has three main guiding principles. First, it’s more a banking crisis than fiscal one. When the sovereign debt is in doubt of its creditworthiness, it brought out the question of solvency of the banking system because banks have been loaded with country bonds of weak countries. Those banks will have only one option to obtain short-term financing and deposit their excess cash — the ECB.
Secondly, tightened fiscal policy is offset by loosening up monetary policy. Soros recommended specifically that the ECB might buy Spanish treasury to reduce punitive interest rate that Spain must pay on its bonds. This would allow Spain to meet its target of reducing its budget, but that is not possible with “a change of heart by Germany”.
Last but not least, is to put idle resources to work by investing in key sectors for the future such as education and infrastructure, for example, better pipeline systems for Europe, broadband coverage or a smart electricity grid.
The action must be similar to the one that the U.S. government has taken to rescue the U.S. financial system after the fall of Lehman Brothers; helping Europe to find its way out of the difficulties would then strengthen the structure of the euro. This cannot be done without German leadership. Soros hopes Germany, as it has done in the past, lives up to the responsibilities.
The writing of George Soros in July 2010 can be viewed completely in the following link: George Soros: The Crisis and the Euro