Editorial Board

How to Avert the Next European Economic Crisis

The European Union’s economic crisis exposed grave flaws in the design of its single-currency system. A new report from the International Monetary Fund examines the biggest of these defects and recommends fundamental reform: The EU, says the IMF, needs to take a step toward fiscal union.

It’s not what most European policy makers want to hear. But it’s advice they should follow.

The IMF’s report shows just how vulnerable the EU was, fiscally speaking, in 2008 and afterward. In the U.S. -- which is technically a republic, but can also be viewed as a kind of economic federation -- shocks at the state and local level can be cushioned by private and public financial flows. Ownership of assets is dispersed, which spreads the pain, and distressed companies and households have a variety of lenders to choose from. Large-scale government help is crucial as well: Unemployment insurance, for instance, puts money into hard-hit areas and meets the cost with federal taxes and borrowing.

In the U.S., Canada and Germany, these offsets can ease about 80 percent of the shock to local output. In the euro area, the same channels are only half as effective. Markets aren’t as well integrated, and when panic spread five years ago, credit flows within the union contracted sharply just as they were most needed. Unemployment insurance and other ways to spread risk were almost non-existent. All this was a formula for catastrophe -- a catastrophe that parts of the EU continue to endure.

The EU, in its characteristically halting fashion, has begun building some of these needed props. For instance, plans are under way for a form of banking union, which (done right) would pool resources to support or resolve troubled banks. By severing the link between banking stress and national solvency, a union would help to keep governments creditworthy and avoid an abrupt contraction of credit in future crises.

Outright sharing of fiscal risk, however, is barely being discussed. The politics are sensitive, and for understandable reasons. Citizens of creditworthy countries such as Germany don’t want to find themselves permanently on the hook for transfers to countries such as Greece, whose fiscal profligacy made it, in large part, the author of its own downfall. The challenge is to make some kind of fiscal union politically feasible -- which means designing it in such a way that the EU is not divided into two permanent classes of givers and takers.

There’s more than one way to do this. Full fiscal union along U.S. or Canadian lines won’t happen -- not until there’s more solidarity in Europe, which will take years. A better proposal for now is to create a rainy-day stability fund. Governments would pay a proportion of their national income into it, and then draw on it when they encountered economic shocks. In macroeconomic terms, this would mimic the effect of a shared unemployment-insurance system.

How big a fund? The IMF estimates that annual contributions of 1.5 percent to 2.5 percent of GDP would be enough, with time, to provide the same fiscal cushioning that Germany gives its regions. That seems cheap at the price. Another advantage of such a plan is that it wouldn’t require collective decisions about taxes and spending. And this kind of fund would not persistently move resources from the center to the periphery. The IMF shows that, had it been in place when the euro was created in 1999, every country would have benefited at one time or another.

None of this is to say this idea would be easy to put into effect. The conditions under which governments could tap the fund would need to be carefully defined, for instance. These and other tricky technical issues can be resolved -- but not unless EU governments are willing to start the discussion. That can’t happen too soon.