This analysis is by Bloomberg Intelligence Economist Maxime Sbaihi. It originally appeared on the Bloomberg Professional service. It consists of three sections. The first one looks at the roots of the crisis in the euro area. The second one examines progress and the remaining deficiencies as of today. The final section offers theory and practical solutions for the currency union’s future.
What’s Gone Wrong in the Euro Area
The euro area is five years into an existential crisis and no end is in sight. The roots lie in the mismatch between the initial political idea of a currency union and the means given to make it a working economic reality. The lack of organic, self-corrective mechanisms in the euro area’s structure has permitted the buildup of imbalances and thrown many members into their own deep crises. In this first analysis of a three-part series, we look closer at what went wrong.
The choice was made by a few intellectuals to begin laying the foundations of a monetary union, in the expectation that sharing a currency would prompt the economic and political union needed to support such an arrangement. Jean Monnet’s post-war strategy was summarized by Tommaso Padoa-Schioppa — one of the euro’s founding fathers — as a chain reaction “in which each step resolved a pre-existing contradiction and generated a new one that in turn required a further step forward.” Intellectuals persuaded national governments to participate in uniting Europe economically, one step at a time. Thus the European Exchange Rate Mechanism was born in 1979, with the promise made in 1986 to scale it up to a single market. The Maastricht Treaty was then signed in 1992 amid monetary turbulence that pushed the U.K. out of the currency agreement. The euro eventually came into being in 1999.
From the start of the new millennium, members of the single currency enjoyed its benefits without any immediately chafing constraints. Unfortunately, institutional convergence fell short of what was needed and they took few — too few as it turned out — steps toward economic integration. Common discipline merely took the form of fiscal rules in the Stability and Growth Pact, requiring members not to exceed thresholds of 3 percent of GDP for deficits and 60 percent for public debt. Yet even these prohibitions were ineffectively enforced, with France and Germany escaping sanctions despite breaches in 2003. Equally troubling, bank supervision, taxation and spending, and wage-setting mechanisms remained national matters.
The virtual evaporation of sovereign spreads between the core and the periphery reflected the common illusion that a fragile design would be sufficient to support a functional monetary union. In July 2007, Greece could borrow for 10 years at 4.9 percent, only 20 basis points higher than Germany’s equivalent yield, despite very different inflation and fiscal outlooks. Markets judged the collective political will too strong to let a euro-area member leave or default, despite a clear no-bailout clause in treaties. The original flaw of currency marriage without a binding prenup on shared responsibilities created ambiguity, which led to severe mispricing of risk across a range of lending activities, particularly in the periphery.
Illusion of Success: German, Greek Sovereign Yields
Artificially low borrowing costs were compounded further by the European Central Bank setting monetary policy on a euro-area-wide basis. Doing so allowed higher wage growth and inflation in the periphery to erode competitiveness and reduce real lending rates relative to the core. The incentive to spend in the periphery nations was strong. And spend they did. They filled their growing financing needs, reflected in deeper current account deficits, with the core’s saving surpluses.
Higher Inflation in Periphery Opened Window to Crisis
Current Account Adjustments Come at Cost of Internal Devaluation
The lenders are as culpable as the borrowers — they didn’t complain about recycling their savings in the periphery, where investments offered higher nominal returns than at home. The imbalances kept building over the years, leaving periphery nations vulnerable to shocks. And in 2008, the onset of the financial crisis saw the plumbing clog for peripheral countries and capital inflows came to a sudden stop.
The euro area woke up to a balance-of-payments crisis without access to the naturally correcting mechanism of a floating exchange rate.
While the roots of the problems were common, the countries didn’t experience the same crisis. Portugal and Italy suffered a gradual loss of competitiveness. Italy’s high pre-crisis public debt levels also reflect fiscal mismanagement. The same can certainly be said for Greece, which misrepresented its public accounts. Spain and Ireland faced the bursting of housing bubbles that turned into sovereign debt crises as the associated bank losses were taken on by those states.
The Scope of the Problem
The conceptual foundations of the euro area appeared to be cracking as the practical fissures suddenly became apparent. There was no lender of last resort, no scope for fiscal transfers to replace capital inflows, and limited labor mobility. The crisis was made worse because the region had no pre-existing solidarity or rescue mechanisms to help distressed countries. Those nations faced a choice between two painful options to correct their deficits: an internal or external devaluation. The former meant prolonging the downturn, the latter exiting the currency union and accepting a sharp shock to incomes. As leaving became a more attractive option, the prospect of a break-up quickly turned into contagion risk as investors woke up to the reality. Borrowing costs for governments rose to prohibitive levels and private inflows had to be replaced by public ones, in the form of unlimited liquidity provided by the ECB as well as bailout packages with strict conditions attached.
Years of contentious bailout implementation have shown the limits — the failure, some would say — of the currency union. Financial turbulence originating in the U.S. revealed the euro area’s flaws, some of which remain uncorrected and are now fertile ground for populist parties.
Euro Area Must Battle Delay and Doubt
In this second part of our series on the euro area’s existential crisis, we analyze efforts to strengthen the region’s institutional architecture. Progress has been made yet flaws remain. Leaders seem to have relapsed into complacency, failing to apply imaginative solutions to the region’s problems. Losses of national sovereignty implied by further integration are harder to sell at a time when citizens are growing more skeptical toward the euro idea. The third part in this series will outline three concrete steps policy makers could take, accounting for these political constraints.
As the table below shows, the euro-area toolbox has been expanded significantly since the outbreak of its crisis in 2010 with the Greek prelude. The currency union now has a small yet permanent solidarity structure (European Stability Mechanism), a stronger fiscal and macroeconomic surveillance framework (“six pack,” “two pack,” fiscal compact, Macroeconomic Imbalance Procedure) and a new financial supervisory framework (European System of Financial Supervision). Europe has also taken decisive steps towards a banking union (Single Supervisory Mechanism, Single Resolution Mechanism). On the monetary policy side, the European Central Bank reluctantly turned into a lender of last resort for sovereigns (through the Securities Market Program and then Outright Monetary Transactions) and is now implementing a sovereign quantitative easing program, both unthinkable years ago.
Crisis Efforts Have Filled Out the Euro Area’s Toolbox
The crisis response has also inched some intellectual battle lines forward in Europe. In June 2012, at the height of the crisis, a vast project of self-examination was launched to develop “a specific and time-bound road map for the achievement of a genuine Economic and Monetary Union.” Nothing less. To formulate concrete proposals, a first version of the so-called “four presidents” report (European Council, European Commission, Eurogroup, ECB) was published in December 2012. Among other ideas, it called for mandatory “arrangements of a contractual nature” between member states and EU institutions to carve reform commitments in stone.
Unfortunately, since then a follow-up to that report has been delayed over and over. An update is expected again at the June 25-26 European summit but it’s a fair bet to say that new concrete steps are unlikely now that the economic outlook is improving. Furthermore, the ECB’s quantitative easing is altering the usual euro crisis-resolution pattern: the market stress that repeatedly shook leaders out of their complacency to find a policy response has vanished. As the world has seen, the only way they know how to act together is with their backs against the wall.
It’s important at least to keep the impulse toward reflection alive, because the euro area remains an incomplete union. Too little attention is still given to economic imbalances, compared with fiscal ones. The Macroeconomic Imbalance Procedure allows for monitoring, yet the tool is too backward-looking and focused on deficits. While peripheral members are adjusting their current deficits — mainly through internal devaluation — surpluses remain at the core. For example, the European Commission now expects the German current account surplus to rise to a record 7.9 percent of GDP this year. That would make 2015 the fourth consecutive year of violation of the 6 percent MIP limit, and still no sanction is in sight. Wages and productivity can also continue to diverge with no mechanism or exchange rate to correct the anomalies.
Fiscal policies remain a national matter. As such, the overall euro-area fiscal stance hardly allows for a cycle-fitting policy mix. Except for the fiscal stimulus in 2009 — which was coordinated and maximized spillover effects — fiscal non-cooperation is the rule among euro members. In the absence of cross-border fiscal transfers or a central mechanism for debt forgiveness, national fiscal consolidation is the only immediate solution left to bring debt levels down. Loans granted by neighbors to Greece came with strict pro-cyclical fiscal targets, even though that exacerbated the downturn.
The problem is not limited to Greece. How should record-high public debt be brought down when growth and inflation are set to remain sluggish and austerity fatigue is rising? That’s the multi-trillion-euro existential question that the region now has to answer. Some political parties (Greece’s Syriza, Spain’s Podemos, France’s National Front) are already finding popularity attacking the default taboo.
According to Jean Monnet’s chain reaction function for Europe, the crisis should trigger further integration. It’s hard to envision a resolution where the next step would not be fiscal unification to complement the single monetary regime. Yet this theory is challenged in practice. After wearying years of crisis patch-up and austerity, the loss of sovereignty associated with further integration is not politically acceptable anymore and euroskepticism is rising. As European Commission President Jean-Claude Juncker once put it, “We all know what to do, we just don’t know how to get re-elected after we’ve done it.” Back in the heady days of European dreams, democratic legitimacy wasn’t Monnet’s priority. “I thought it wrong to consult the peoples of Europe about the structure of a community of which they had no practical experience,” he wrote in his memoirs.
Monnet’s close-your-eyes-and-move-forward method is now showing its limits, with a growing democratic deficit added to the pressures on the euro area’s still incomplete structure. National citizens seem less willing to compromise in the interest of the euro area. The currency union can’t stay in its current form if it wants to last, yet the conditions for further integration are not favorable. The third and final part of this series suggests some possible solutions to the problems, taking into account these political constraints.
How to Fix the Euro Area Without Breaking It
The euro area faces the challenge of fixing its remaining design flaws without alienating doubtful citizens further from the very idea of a common currency. There are three workable solutions that satisfy both the political and economic constraints. The most urgent problem to tackle is the legacy debt overhang.
The euro area is the result of decades of metamorphosis. Jean Monnet wrote in 1976 that “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.” It all started as a free trade zone before being enhanced to a customs union, later becoming a common market and eventually the currency union as we know it. The next integration stage would be a fiscal union to complement the single monetary policy. That means some tax and expenditure decisions would be made at a supranational level to be shared accordingly by members. It also implies a form of political union to avoid the tyranny of taxation without representation. This solution is nonetheless the most difficult hurdle to overcome in Europe’s advancement, as it can hardly be implemented without popular support. Those advising swift and bold integration need to be reminded that euroskepticism is flying high in many member states.
A correction course for practical euro-area policy must take into account popular opinion. That being said, there are four general ways to proceed from the euro area’s present shape: dismantling, splitting, stabilization or reinforcement. Note that the latter doesn’t necessarily imply a full economic and political union. But before coming to that, let’s take a look at the other three alternatives. The chart below lays out the principal benefits and drawbacks of pursuing each of these four paths for Europe.
A dismantling or splitting would mark a return to economic fragmentation in the region, with the re-introduction of multiple free-floating currencies. This could prove destabilizing for European economies sharing such a high level of financial and trade interconnectedness. It would also revive the risks of national central banks using their regained independence to launch a continental currency war. While a return to a less-integrated Europe cannot be ruled out, strong economic cooperation seems inevitable if the region wants to continue sharing wealth and peace in a globalized economy. That was the instinct of the founding fathers 70 years ago.
Merely stabilizing the euro area is also unsustainable. As discussed in the second part of this series, internal contradictions mean the euro area may not last if it stays in its current shape. If one concludes that further integration is the right path forward, there are three reasonable, incremental and practical steps to make the euro area more robust without eliminating national sovereignty or turning extant institutions upside down.
1. Introduce the possibility for member states to restructure their debt. Treaties don’t ban it, but it remains taboo. It offers an alternative to prolonged austerity, while lifting the ambiguity that led to the mispricing of sovereign risk prior to the crisis. The trick is to alleviate some of the public debt burden in an orderly way, avoiding financial disruptions or moral hazard. The myriad of financial instruments available provides help, such as the idea of swapping current government bonds for GDP-indexed ones in order to smooth the fiscal burden over the economic cycle. The PADRE (Politically Acceptable Debt Restructuring in the Eurozone) plan is also worthy of consideration, suggesting a debt buyback via the European Central Bank, financed by re-channeling its own profits. The thing to remember is that there is no miracle solution, and debt restructurings, however they are presented, favor those who borrowed at the expense of those who lent. Yet the high public debt levels now narrow the immediate choice of remedy to either this option or years of fiscal consolidation with an uncertain outcome. Even the Bundesbank isn’t opposing the idea. Its March monthly bulletin comments: “A framework and procedure could be developed in the longer term which would allow government bonds to be restructured in a more orderly and structured way than is currently the case.”
2. Fulfill the capital markets union. The European economy is too dependent on its banking sector: about 80 percent of non-financial corporate debt is composed of bank loans. This overreliance was highlighted during the crisis when banks shut off the avenue of credit as soon as they started experiencing severe turbulence. And no alternative financing route was available to make up for it. The idea is to create this extra lending capacity in the form of a Europe-wide capital markets union to complement the banking union. To do so, the European Commission launched the Capital Markets Union plan last year. The goal is to reduce financial fragmentation by encouraging cross-border flows. Harmonizing the national regulations is vital in this effort. The stakes are particularly high for the job-intensive small and medium-sized enterprise sector. It only accounted for 8 percent of Europe’s securitizations market which remained just one-fifth the size of the U.S. at the end of 2013, according to a joint BOE-ECB paper.
3. Create competitiveness councils. The euro-area labor market is more of a juxtaposition of its 19 national labor markets than a common one. Welfare and wage bargaining systems, as well as languages, differ from one member state to another. Some labor market conventions weaken the link between productivity and pay, making wage imbalances between members more likely to emerge — and still no exchange rates to correct them. Common market institutions, rules and regulations for all members would provide a backstop but cannot be expected to overcome longstanding cultural differences. Structural reforms can surely help to bring some convergence — for example, through the removal of wage-indexation schemes — yet that remains a national choice. Andre Sapir of the think tank Bruegel came up with a reasonable intermediary solution taking the form of a new oversight body in each member state. Its role would be to monitor competitiveness indicators, compare them with peers and eventually formulate wage evolution proposals to employers and employee representatives. These non-binding recommendations would provide a valuable public touchstone for wage negotiations. A similar framework has worked successfully in Belgium since 1996.
These three ideas are more than just patches. Their implementation would make the currency union stronger by giving national governments an alternative to austerity, providing the private sector with more diversified funding sources, and shoring up national competitiveness. In 2012, just after his famous “whatever it takes” speech, ECB President Mario Draghi wrote in the German press: “Solutions offer binary choices: either we must go back to the past, or we must move to a United States of Europe. My answer to the question is: to have a stable euro we do not need to choose between extremes.” He added, “Those who claim only a full federation can be sustainable set the bar too high.”
It’s certainly too soon to make the jump to the “United States of Europe” that thinkers from Victor Hugo to Winston Churchill have dreamed of. The immediate challenge is to make the euro area robust enough to avoid making the same existential mistakes of the past without betraying its citizens. The improving economic outlook could help to reconcile them to the initial idea. Still, they probably need years, if not decades, to make up their minds. As the expression goes, one needs to give time to time.