The history of the Eurozone has been a story of exceptions and half steps.
- Some of the initial Maastricht criteria were waived for some countries.
- Mountains of research – which made clear that a monetary union without a fiscal union was incomplete (Eichengreen and von Hagen 1996) – were ignored; the Stability and Growth Pact was a created as a second-best solution.1
- The Stability and Growth Pact was overruled by Germany and others when domestic political constraints were given precedence over the pact’s requirements – this fatally undermined its credibility;
- The integration of Eurozone banking and capital markets was achieved without the prudential and supervisory infrastructure necessary to match this integration.
Whenever there was a strong political hurdle to overcome, the process stopped – regardless of how suboptimal was the stopping point. After all, ‘muddling through’ was working, or so it seemed, as the global economic expansion was delivering growth regardless of the policies adopted.
The take-away message from this history is clear. European leaders wanted the euro but at the minimum political cost.
The events of the last couple of years – and the serious implications for growth over the next decade – make one thing very plain. European leaders must now make a clear-cut decision; either they move on and complete the Economic and Monetary Union that is needed to underpin the euro, or they accept the risk that the Eurozone will fail in its current form.
The European bicycle must accelerate now; it can’t remain still. In simple terms, markets seem to have lost confidence in the soundness of the European policy framework. The lack of decisive action risks a permanent reversal of the integration of European capital markets.
Lessons from the euro’s first decade
There are two important lessons from the first decade of the euro.
- The choice of structural policies across countries was key to the development of intra-European imbalances; and
- The Eurozone must move towards a system of common debt management.
It is useful to start the discussion about intra-European imbalances back in the early 1990s.
- From 1990 to 1995, Germany’s real effective exchange rate appreciated sharply as a consequence of unification – by almost 30%.
- In reaction, Germany adopted a policy of competitive disinflation to correct this appreciation. And it worked.
- By 2008, its index of real effective exchange rate was back to where it was in 1990.
In other words, the first decade of the euro saw Germany correcting the “unification shock” via wage moderation. Rather than boosting competitiveness via much needed structural reforms in goods, services and banking markets, Germany opted for stringent wage moderation and some labour market reform.
- This German policy choice delivered very weak growth, averaging barely above 1% over 15 years – recall that during a large part of the decade Germany was dubbed "the sick man of Europe."
- As Germany accounts for such a large share of Eurozone GDP, this very weak growth greatly conditioned the monetary policy of the ECB, producing a monetary stance that was too loose for some members, producing rapid growth in the Eurozone periphery.
Why is this relevant? Because a system of common monetary policy that is heavily conditioned by an initial strong disinflationary effort – combined with a framework of national fiscal policies where the political economy of fiscal surpluses makes the achievement of the optimal fiscal stance rather difficult – is clearly suboptimal.
For example, Spain faced too loose a monetary policy; it probably should have been running fiscal surpluses of the order of 5-6% of GDP to offset the negative real interest rate its borrowers enjoyed. Yet pleas in Spain for improving public infrastructure were politically impossible to ignore when surpluses were in the 1-2% range. The efforts to strengthen the macroprudential framework for banks with dynamic provisioning offset this asymmetry to some extent, but not fully.
By chance or by design, Spain’s looser-than-optimal fiscal policy stance supported Germany’s competitive disinflation efforts and helped deliver an optimal policy stance for the Eurozone as a whole.
Fast forward to today and one can see the mirror image of that situation. Spain and other Eurozone members must now engage in a disinflationary process of wage moderation and structural adjustment that – with monetary policy at the zero bound – would require a Germany policy stance that is looser than optimal for Germany. Germany should now be complementing an easy fiscal policy stance with a wide-ranging package of structural reforms that boost its domestic demand. It is critical for European policymakers to understand that the choice of structural policies matters as much, if not more, than the conduct of fiscal policy.
Imbalance debate echoed at the global level
This is the debate that the G20 is having at the global level – China, the US or Germany can choose from a menu of policies to stabilise their economies, and each choice implies a different outlook for global imbalances.
Germany is choosing to continue with wage moderation and fiscal discipline because, from a political standpoint, that is the easy path. There is a clear constituency supporting those actions in Germany. The real test of Germany’s commitment to the Eurozone, however, is whether it is willing to take on the constituencies that oppose the reform of its inefficient goods, services, and banking markets. This is what Spain failed to do over the years.
Spanish labour markets were allowed to remain very rigid, and the savings banks were allowed to continue funding the housing market and the regional governments. But what cannot go on forever will not – Spain is being forced to tackle these problems in a crisis setting.
Unless Germany finds the courage to address its structural shortcomings in order to boost potential growth via domestic demand expansion, the Eurozone will remain at risk. Fiscal adjustment alone is not the solution. The Eurozone must move towards an effective system of review of structural policies, including sanctions, which boosts potential growth and reduces intra-European imbalances.
The experience of the last two years has also shown that in a world of low inflation fiscal policy may have to be used in a discretionary fashion. The Eurozone therefore needs a centralised fiscal policy mechanism to deal with tension between discretion and rules. With high debt levels and an adverse demographic outlook, debt intolerance has likely increased on a permanent basis. This is especially so for less liquid markets.
In this context, developing a European debt market would improve efficiency and lower the cost of debt issuance for all countries, Germany included. To restore credibility and avoid free riding, this would have to be combined with an agreement to legislate, at the national level, balanced budgets over the cycle. This should be regulated by a very strong mechanism of independent, ex ante authorisation of national annual budgetary ceilings.
Countries would retain full control over the composition of taxes and spending but not over the levels of the deficits. In addition to completing the European fiscal policy framework, this would also create a liquid alternative to US Treasuries that would consolidate the euro as a reserve currency and contribute to the resolution of the global imbalances.
A crisis is something too valuable to waste. It is time for European leaders to move forward and complete the Eurozone’s policy framework.
Bayoumi, Tamim and Paul Masson (1995). “Fiscal flows in the United States and Canada: Lessons for monetary union in Europe” (1995). European Economic Review, Volume 39, Issue 2, 253-274.
Chari, V.V. and Patrick J. Kehoe (2007). “On the need for fiscal constraints in a monetary union”, Journal of Monetary Economics, Volume 54, Issue 8, November 2007, 2399-2408.
Dixit, Avinash and Luisa Lambertini (2003). “Symbiosis of monetary and fiscal policies in a monetary union”, Journal of International Economics, Volume 60, Issue 2, August, 235-247.
Eichengreen, Barry & von Hagen, Jürgen (1996). “Federalism, fiscal restraints, and European monetary union”, American Economic Review, 86, May,134-38.
1 Also see Bayoumi and Masson (1995), Chari, and Kehoe (2007), and Dixit and Lambertini (2003).