The first eight years of the euro were notable for their lack of economic instability, which from a political perspective served to dull the urgency to secure greater economic coordination and integration. Whether member states like it or not, this will have to change if the euro is to survive the next decade intact.
Should monetary union also mean greater economic integration? In the 80s, central bankers were fairly unanimous in their view that a single currency could not be considered without political and hence economic union. Helmut Schlesinger (Bundesbank President 1991-93) was clear on this back in 1994. “The final goal is a political one in which the economic union is an important vehicle to reach this target”. It was the realisation of the lack of political will at the national level, combined with the birth of the Stability and Growth Pact (SGP) in 1997, which eventually softened the Bundesbank stance.
Nevertheless, those at the political centre of Europe carried the baton of political union. Romano Prodi (EU Commission President, 1999-2004) was clear in his wider ambitions, telling the Financial Times early on in the euro’s life that he wanted to build on “the consequences of the single currency and create a political Europe”. His ambitions were built less on the economic considerations of the Bundesbank, more on the political ambitions of Brussels. Again, appetite at the national level was minimal and momentum waned, especially with the euro seemingly doing well regardless.
A lost decade
Leaving aside the end ambition of political union, the means of greater economic coordination were from many angles a requirement of the single currency. The goal of the single market dominated the eighties and the push for a single currency defined the nineties. Closer coordination of economic policies should have been the aim of the last decade, but all efforts and frameworks failed miserably.
Take the Stability and Growth Pact (SGP). This had all but fallen apart by the middle of the last decade. Of itself, this was primarily down to insufficient improvement in structural deficits, combined with lack of momentum towards implementing fines on breaches of the debt and deficit criteria. Between 1999 and 2007 member countries were in breach of the 3 percent and 60 percent debt criteria 25 percent and 60 percent of the time respectively. Fines amounted to zero, yet every month governments were reminded by the ECB, under both Duisenberg and thereafter Trichet, that member states were failing to do enough to tackle underlying structural deficits. For the euro area as a whole, the structural deficit deteriorated for most of the period between 1999 and 2007.
Institutionally, there was no incentive for member states to face up to the growing need to improve structural budgets in the face of ageing populations.
Furthermore, the levels of debt and deficit limits do not reflect the relative costs and risks to the financial stability of member states and the wider euro zone. Japan is able to manage gross public debt approaching 200 percent of GDP, with yields substantially lower vs. most major markets, with the high level of domestic savings allowing the debt burden to be nearly fully held internally.
Secondly, the institutional framework for policy co-ordination and monitoring is woefully vague and ineffective. The Maastrict Treaty stipulates that “member states should regard their economic policies as a matter of common concern and shall co-ordinate them”. It goes on to say that where economic policies “risk jeopardising the functioning of economic and monetary union…the Council may make the necessary recommendations to the Member State concerned”. Whilst the monitoring of economic conditions has been effective, the incentive for member states to take collective action has been minimal. Member states who push for action on another risk reprisals for their own economic credentials. Some view Germany’s persistent current account surplus just as economically problematic as the deficits of other euro zone members.
The final main thrust of economic policy coordination was the Lisbon Agenda, launched in 2000 with a ten year view to improve the euro area’s competitiveness vs. the rest of the world. This is widely regarded as having failed in its main aim of increasing overall euro zone competitiveness, with many, often conflicting targets. However, the motivation behind the initiative was a desire to catch up with the rest of the world, particularly the US, not to look inwards at possible issues within the euro zone itself. As such, the relative and ultimately debilitating decline in competitiveness seen in some member states fell outside of the Lisbon framework.
The road ahead
For the euro to survive this crisis and secure its future, there are three main necessary, but not sufficient, conditions that will have to be met.
1. The Stability and Growth Pact needs to be drastically reformed or more likely binned and re-born. Deficit prescriptions should be based around the cycle, requiring structural surpluses during periods of above trend growth (i.e. saving or paying down debt during the good times). Furthermore, debt prescriptions should also show flexibility, incorporating a measure of domestic savings as a proxy for the stability of the level of gross debt.
2. A more structured approach to providing support to member states is required, along the lines of a European Monetary Fund. Granted, this is not a new suggestion, with interest gathering pace within the EU itself, although just how funds are gathered remains up for debate. The main focus however should be on fees, paid by all, on a sliding scale, rather than on fines for breaches of set criteria (which failed in the SGP). The sliding scale would allow those countries whose policies were deemed in-line with economic stability criteria to pay progressively less over time (like a no claims bonus for insurance).
3. Economic policy co-ordination should also be undertaken by such a European Monetary Fund or similar quasi-independent institution. The parameters and mechanics can be debated, but some structure is necessary to over-come the unenforceable sentiments that currently characterise policy co-ordination and monitoring. Whilst national governments won’t necessarily take kindly to advice on their domestic economy, the link between economic imbalances and the stability of the euro currently being illustrated in financial markets should be sufficient incentive.
4. Leaders must change the mind-set of blaming markets during a time of crises, rather than looking at the underlying causes. Calls to ban sovereign CDS (Credit Default Swaps) and the like only serve to push up funding costs via the detrimental impact on investor sentiment. In contrast, it’s worth noting that there was silence from governments when they were able to fund their liabilities at most 30bp over Germany during the middle of the
past decade. Many commentators questioned whether this adequately reflected the underlying risks.
Yes, most of these proposals amount to much greater economic and fiscal policy co-ordination. The need for this should be clear from the IMF’s current prescription for Greece, which involves incompatible policy prescriptions (debt reduction against deflation) owing to the constraints of EMU. Our analysis of fiscal austerity of the extent Greece is aiming for have only ever succeeded against the backdrop of strong real growth (average 8 percent) and inflation (average 7.5 percent) the latter reducing the real debt burden.
The euro will have a tough time over the coming six to twelve months, that’s pretty much given, although the opportunity does exist for political leaders to face up to the institutional short-comings of the euro and secure the single currency’s future. This will mean member states ceding more control to euro area wide institutions, some current and some yet to be created. Without it, attracting international finance and funding a rising public debt burden will simply prove untenable for an increasing number of countries in the coming years.
Simon Smith is Chief Economist at FxPro Financial Services