A Euro Visionary at the IMF

Maurice Obstfeld has long been clear-eyed about the single currency's flaws.

More integration is needed.

Photographer: Yoshikazu Tsuno/AFP/Getty Images

Maurice Obstfeld, who's just been appointed chief economist for the International Monetary Fund, has followed the common European currency project for decades -- since it was a relatively loose association -- and warned early on about the problems the euro faces today. Perhaps if European politicians listen to him now, they will argue less about how to make the currency union work.

Obstfeld, a macroeconomist who has co-authored textbooks with both Kenneth Rogoff and Paul Krugman -- economists on opposite sides of a bitter debate over austerity, government debt and economic growth -- is clearly capable of finding a middle ground. In that sense alone, he's a wise choice for the IMF job. His policy recommendations for Europe, however, have been clear and consistent: If the monetary union is to work, the euro zone needs more integration.

"Europe's Gamble" is what Obstfeld called the union in 1997, not long before the introduction of the euro, in a 300-page paper. This includes a highly readable history of the union, beginning with the European Coal and Steel Community that was formed in 1951 to bind Germany closer to the countries it had invaded, notably France. Obstfeld provides plenty of juicy, long-forgotten tidbits about countries scrambling to meet the common currency criteria: a fiscal deficit as close as possible to 3 percent of gross domestic product, inflation close to that of the member nations with the slowest-rising prices, a debt-to-GDP ratio of 60 percent (or at least strong evidence that it was headed that way). Profligate Germany, for example, tried and failed to revalue its central bank's gold reserves to book the difference as revenue for its budget and cut the deficit -- even as it tried to keep out shakier Italy, Spain and Portugal for fear they would make the new currency much "softer" than the Deutsche mark.

The paper also contains paragraphs that now read as striking predictions:

  • Because monetary policy will be geared toward price stability in the union as a whole, the ECB will not lower interest rates in response to purely nation-specific demand or supply shocks. If the local downturn is persistent, the country will suffer a protracted bout of unemployment above the EMU average. The high unemployment will persist while the national price level falls, and the limited scope for labor to migrate to other euro-zone countries will lengthen the adjustment process.
  • EMU could  put countries in the position of having to cut budgets in circumstances of recession and rising unemployment. In this case, EMU would not be neutral with respect to fiscal policy, but destabilizing.
  • European economic integration has always been a politically motivated enterprise. And at the moment, the political costs of not proceeding with EMU bulk so large that Europe's leaders are desperate to start on time. But while the non-economic motives behind EMU may be laudable, any political achievements will be imperiled if electorates perceive the economic consequences as negative.

To ensure its own success, Obstfeld wrote, the monetary union needed to overcome "the existing political stasis to force fundamental fiscal and labor market reform in its member states. If Europe's leaders cannot do an end run around domestic opposition in the name of European integration, EMU could prove unstable."

About 15 years later, in 2013, Obstfeld returned to the subject of the euro. The crisis in the common currency area that followed the global financial meltdown only reinforced his conviction that more integration was needed. In "Finance at Center Stage: Some Lessons of the Euro Crisis," Obstfeld formulated the euro's central problem as a "trilemma": "Once financial deepening reaches a certain level within the union, one cannot simultaneously maintain all three of (1) cross‐border financial integration, (2) financial stability, and (3) national fiscal independence."

Since Obstfeld's 1997 paper, European banks have expanded astronomically. The assets of BNP Paribas and Santander, for example, exceed the GDPs of France and Spain, respectively. That asset growth has been caused partly by the disappearance of friction in financial dealings within the euro zone and the -- largely unjustified -- convergence of interest rates among European countries. At the same time, the Maastricht treaty, drafted in 1991, had left the supervision of banking systems to nation-states, which did not have the resources to properly discipline the banks, much less backstop them when the crisis broke out. Obstfeld wrote in 2013: 

No one foresaw that banking systems would grow big enough to imperil national solvency, or that a substantial number of countries might be suffering through simultaneous and mutually reinforcing sovereign debt crises. Nor was it anticipated that, with the policy interest rate near the zero lower bound, discretionary fiscal policy at the national level might appear as a potentially more useful stabilization tool than it did before 2008. Recent experience has thus given more weight to concerns that national fiscal problems might be explosive and contagious, while suggesting at the same time a greater payoff from leaving more scope for countercyclical fiscal response. 

Since the crisis, EU countries have agreed to give up their bank supervision powers to the European Central Bank, correcting what Obstfeld singled out as the major oversight of the monetary union's architects. They agreed on how to handle bank crashes, stipulating that their creditors would need to be "bailed-in." They haven't, however, moved toward more fiscal unity precisely because the crisis convinced them of the value of independence and flexibility in this area. 

Even if all the euro zone members wanted to advance toward pooling their fiscal resources, that would be difficult, Obstfeld admits. "For one thing, the scope for EU or euro area wide democratic representation in fiscal decisions would have to expand," he wrote. "Through what agencies would the center actually collect taxes from EU or euro area citizens, when some national governments already have problems doing so domestically? Absent full political union, collective responsibility for nationally issued debt raises decisive moral hazard problems."

Yet Obstfeld stops short of saying his "trilemma" is impossible to resolve. After all, the monetary union suffered a lot of setbacks even before it became fully operational, and its members didn't integrate their economies immediately. Supranational banking supervision appeared politically impossible in the early 1990s, but it eventually became feasible. The same goes for fiscal integration, Obstfeld implies. "If it is to work, banking union requires some degree of national fiscal resource pooling: in our financially integrated world, the size of modern banking systems in many cases exceeds the fiscal capacities of the state," he wrote.

To a certain extent, this pooling is already going on in the form of the European Financial Stability Facility, which raises money for bailouts on member states' guarantees. It's still a long way from a common budget, but it's a step in that direction. 

Obstfeld warned that, for the monetary union to stay intact, its supranational institutions would have to become more democratically accountable and that it would be counterproductive to set "over-ambitious deficit reduction goals" for crisis-ravaged countries. On the surface, that would make him an ally of politicians who have tried to resist German pressure for more discipline, such as Greek Prime Minister Alexis Tsipras. Yet these seem to be tactical considerations for the new IMF chief economist. On strategy, he appears to be in agreement with German Finance Minister Wolfgang Schaeuble, who has long called for a fiscal union that would give the EU control over members' budgets.

As long as the IMF has a role in fixing European crises -- and the EU wants it involved in the third bailout of Greece -- Obstfeld's cautious analysis will put pressure on European hard-liners such as Schaeuble to avoid excesses and ease Greece's debt burden, but it will also advance their ultimate goal of closer European integration and a common approach to fiscal and financial discipline to back up the common currency. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author on this story:
    Leonid Bershidsky at lbershidsky@bloomberg.net

    To contact the editor on this story:
    Mary Duenwald at mduenwald@bloomberg.net

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