Ten years after its creation, the Eurozone is seemingly in deep crisis. The first strand is its assessment by the financial markets. Their verdict: crisis. Low growth, slow recovery from the twin crisis of 2008/10, the developments of CDS spreads and government bond prices, the hysterical media reports of relegation from or voluntary leaving of the Eurozone by this or that country – all these suggest a deep crisis. The EU has reacted accordingly, with a 110 bill € package for Greece and a 750 bill € guarantee package (together with ECB and IMF) for the Eurozone. Individual Eurozone countries have started frantic and massive budget consolidation packages – as requested by the financial markets.
The second strand is less obvious, but nonetheless extremely important and should guide EU economic policy makers: Is there no alternative to accepting the verdict of the financial markets as ultimate arbiter of the economic policies of the world’s economies? What are the real problems of the Eurozone? Why do we have to give in to the wishes of a self-serving financial sector? First, they, i.e. “the markets” got us into an existence-threatening crisis (the policymakers of the world having previously given in to their demands for ever “lighter” regulation), then we, the taxpayers, save them with unprecedented aid packages, as requested – but when these costs are showing up in national budgets, the markets cry “foul” once more and demand that all other budget items (apart from their own rescue packages) be “structurally consolidated” – right now. And when the EU authorities do again what the markets request, i.e. save the banks from a significant default haircut by helping Greece and the Eurozone, the markets cry “foul” once more, because now the (previously derided) EU Treaty conditions and the credibility of the ECB have supposedly been compromised.
Faulty Eurozone Governance Structure
The architecture of the Eurozone suffers from a “birth defect”. It was clear from the start that the Eurozone did not correspond to the ideal of an “optimal currency union”, because it combined too many countries with very different inflation and economic policy differences. The (compromise) idea of the founding fathers was that by supplementing the common monetary policy with the strictures of the stability and growth pact (SGP) on the fiscal policy side, countries would eventually be guided towards becoming more like an optimal currency union (“coronation theory”). So we had a joint monetary regime, run by the ECB, setting equal conditions for all Eurozone members , combined with a rules-based fiscal policy coordination tool, the SGP, which was supposed to force individual members into “responsible” and sustainable fiscal policy. Two things were wrong with this thinking: a) from the macroeconomic policy point of view, there was no joint Eurozone fiscal stance aligned with the ECB’s monetary policy stance, only individual countries’ obligation to conform to the SGP, and b) the third element of an economic policy triangle was completely neglected, i.e. the growth component. GDP growth was – as the then mainstream predicated – to arise spontaneously, if only the monetary/fiscal policy mix was right (but even that lacked a mechanism, since ECB and some member states refused to agree to a regular policy dialogue between the fiscal and monetary authorities). The French demand for an “economic government” as policy partner to ECB was denied.
The result of this birth defect was already visible before the crisis. EU growth lagged behind that of other regions, inflation differences within the Eurozone increased, thus causing competitiveness problems for a number of catching-up countries, and as a result some countries showed persistent surpluses, others persistent deficits in the current account. Since adherence to the SGP was not really enforced, because when the large countries violated it without sanction, also some of the smaller ones felt entitled to do the same, some countries built up persistently high debt levels. At that time, however, the financial markets must have been asleep, for bond spreads within the Eurozone hardly differed between the stability-oriented core and the catching-up periphery – very different from today. (One notable exception was the increase in the Austrian spread after the EU countries imposed sanctions on Austria’s newly installed right-wing government in 2000.)
The crisis even more visibly revealed these structural problems of Eurozone governance and left EU and member states’ authorities sitting like the proverbial rabbit in front of the snake, i.e. in terror of the financial markets verdict. Financial markets have, however, revealed themselves not as “objective” judges, combining the assessments of millions of independently acting investors, based on countries’ fundamentals and policy actions, but rather as impossible-to-satisfy institutions, acting more on self-interest and herd behaviour, thus violating the basic pre-conditions for qualifying as efficient markets. The balance needs to shift back to politicians whose democratic legitimacy holds them accountable to their electorate for their actions.
Where to go from here?
Again, two strands need to be distinguished. The first would be a correction of the Eurozone policy architecture (“governance”). This requires an extension of the existing Macroeconomic Dialogue between the ECB, the ECOFIN/Eurozone Council and the EU institutions dealing with the real economy. Growth policy must be coordinated with monetary and fiscal policy at the Eurozone level in a tri-partite dialogue. As a model one could envisage that first the monetary policy stance (expansionary-contractionary-neutral) is agreed and aligned with the fiscal policy stance for the Eurozone as a whole, and the appropriate growth-enhancing measures with respect to e.g. infrastructure, R&D, education, labor supply are agreed. In a second stage, the fiscal and growth measures are broken down on to the national level and encapsulated in the national budgets. Such a breakdown would only set a budget surplus/deficit target for each country, but leave the structures to the individual country. At present, the reverse is true: Member states decide their national budgets (within the ineffective SGP) and it is hoped that –somehow magically – their individual budgetary stances add up to the optimal Eurozone fiscal stance, appropriate to the monetary stance.
This is the rough model, as long as there is no stronger political will in the EU to go further towards a genuine federal model. If that were the case, however, the coordination task would be a lot easier, since then the federal EU/Eurozone authority could set this policy mix in a democratically legitimized manner, without having to resort to slow and painful inter-country negotiations.
This policy mix would need to be supplemented by a stronger EU mechanism of fiscal federalism, i.e. a larger EU budget in order to even out imbalances within the Eurozone countries. This would be one way to right the incomplete structure of the Eurozone as an optimal currency union. The EU/Eurozone would have to become the derided “transfer union”, just like within every member states funds flow from more prosperous to poorer regions, both in structural terms, but as well in the shorter run, when specific regions are hit by a downturn or crisis harder than others.
Stronger fiscal coordination among Eurozone member states would also mean that tax competition among member states needs to be checked. Why should Eurozone countries compete among each other for investments by granting tax privileges to firms and employees? This is counterproductive and leads to beggar-thy-neighbor policies, where not joint growth and welfare is optimized, but growth of one country is maximized at the expense of other countries belonging to the same club. It will exacerbate the internal tensions of the Eurozone, if newly acceding countries have a zero-corporate income tax rate, inducing firms of other countries to create financing agencies in that country and transferring profits there. One principle of a functioning currency union must be that economic activity is taxed where it takes place and regions do not compete via tax rates, but via competence, innovation, educated workforce and man-made environment.
Fiscal coordination should also strengthen the countercyclical qualities of the expenditure/tax systems. It is important to strengthen automatic stabilizers, at both sides of the budget equation, just as it is important to strengthen the growth-enhancing elements during budget consolidation. High elasticity with respect to cyclical fluctuations reduces the need for discretionary measures – which frequently are frought with time lags, recognition and effectiveness problems.
The Eurozone as a whole needs to be competitive vis-a-vis the rest of the world, but there is evidence that the primarily export-oriented wage policies undertaken by the export surplus countries (Germany, Austria, Netherlands, Finland, to name the most important ones, in addition to most of the new member states of the EU) has left the vast growth potential of Eurozone demand untapped. This has contributed to structural export surpluses of the net exporters which by keeping wage growth low have contributed to high deficits in some Eurozone countries. In order to reduce some of these imbalances, net exporters would have to allow higher wage growth, without making themselves uncompetitive. Of course, not only wage costs determine export competitiveness. It is much more the broad export portfolio in products and services which makes German exports desirable. High absolute wages in these countries drive the search for productivity increases and for the development of new products which can command high prices. Thus, once more, an “industrial policy” which promotes competitiveness not via low wages, but high productivity and value-containing products and services needs to accompany a successful Eurozone policy.
Reining in the Financial System
The second strand refers to the role of the financial system, its alignment to the needs of Eurozone growth, and its appropriate regulatory framework. The very intricate system of financial market regulation (“the Lamfalussy model”) which relies on member states’ authority over regulation, plus a Europe-wide coordination has provide ineffective – as the deep recession which the crisis has brought over the Eurozone amply proves. Especially with respect to government financing, the recent events have shown that the market-driven system is inadequate, giving wrong signals to investors and putting undue pressure on governments to consolidate their budgets while in the trough of a severe recession. One longer-term way out would be the issuance of Eurozone bonds, which would eliminate (or reduce) spreads, if at – arguably – higher debt costs for the best-performing countries. In order to maintain debt discipline, the recent Bruegel proposal to pool up to 60% of GDP of individual governments’ bonds into a common pool (at a joint and low interest rate) and leave the higher-than-60% debt with individual countries (thus at different prices according to market assessment) seems a promising proposal. Other meaningful ones have been floated. While markets play an important role in pricing debt at the date of issuance, their role as daily traders has proven counter-productive. Minute or second-phased trading on “events”, or perceptions, coupled with herd behaviour negates to “objective” function of true markets. Since every trade generates fees for the trader, there is a perverse incentive to trade as high volumina as frequently as possible. While certain liquidity is necessary, in order for bondholders to be able to sell their bonds when cash is needed, the present volume enhancing structure is disruptive and self-serving, instead of providing low-risk low-cost opportunities for governments and investors.
The crisis has also shown that financial market regulation needs to cover all products in all jurisdictions in a similar way. Regulatory arbitrage, in addition to tax arbitrage, has disrupted markets, promoted investment decisions not driven by fundamentals but tax or regulatory advantages and has favoured some of the excesses which led to the crisis.
A sovereign debt restructuring mechanism needs to be agreed world-wide. The Greek situation shows that under any imaginable scenario Greece is highly unlikely to be able to pay back all its existing debt. Early and orderly restructuring would give clear signals and enable Greece to start on a growth path by widening its product portfolio, promote innovation and consolidate its budget without punitive (mis-)allocations of government resources to bondholders. Of course, such a mechanism should have started before the recent ECB purchases of Greek debt, when most of that was still held by private investors.
Eurozone banks need to undergo similar stress-testing with effective recapitalizations or closures, as appropriate. There must be serious action on the “too-big-to-fail” financial institutions: they must either be broking up by extending the Volcker rule to them (separation of commercial from investment banking), or along other lines. Banks must be able to fail without endangering the whole Eurozone financial system – and without exacting several hundred billion euro from unwilling taxpayers. The crisis has also shown that higher equity ratios need to be required, so that banks can withstand more shocks by themselves. A centralized competence for prudential systemic regulation at the Eurozone level (or EU level) is needed.
The objective of these regulatory efforts must be to shrink the financial system back to its “serving role” for the real economy and government finance. The interest conflicts for rating agencies have shown that the markets cannot be left to themselves. An independent (from individual countries) institution for the evaluation of risks of the Eurozone countries should be created which feeds into the pricing mechanism for Eurobonds and individual country government bonds. Its remit should require it to base its assessments on fundamentals and scenario forecasts of future developments – and not on short-term trading requirements.
Both the architecture and the economic policy content of the Eurozone have been shown to be inadequate. The crisis has laid the weaknesses bare for everyone to see. Much time and money has been wasted to combat the crisis. Some more fundamental questions have barely begun to be asked. It is clear that the economics and the politics of the eurozone do not match. As long as “markets” are the final judge of government action, and are able to influence the financial results of such assessments to their own advantage, a sustained way forward will be severely impaired. By regulating financial markets properly and by setting up adequate economic policy institutions for growth and stability the eurozone could finally exploit its full potential for the welfare of its citizens. To put the “financial market genie” back into the bottle will be difficult, especially when considering the vast lobbying power of financial market actors. If neither the form nor the structure of eurozone economic policy making is changed significantly, the present crisis will repeat itself over and over. Some important steps have been taken by the Eurozone recently. Welcome as they are, they come late and cover only a small part of the necessary territory. Political will and recognition of the inconsistency of an integrated monetary union with fragmented economic policymaking are necessary.
Finally, a word on the short term. Inexplicably, and in contradiction to a few months ago, many Eurozone countries very recently have started to produce budget consolidation programs – at unprecedented levels. While financial markets may request this, economics would dictate to wait with consolidation until the recovery has taken hold. This was the narrative only 3 months ago. In the present situation, wholescale large budget consolidation will reduce effective demand in the Eurozone even further and thus threaten the recovery. A way out of this dilemma would be to announce detailed consolidation plans over several years, but with a starting date at the earliest in 2011, if and when serious recovery has started. In order to be credible, they would need to contain binding rules for enactment and implementation. Empirically, larger-scale budget consolidations have been much more successful when they occurred during high-growth periods, because automatic stabilizers then reduce the budget gap.