A difficult equation

by Jean Pisani-Ferry on 27th April 2012

In 2005, France and the Netherlands were the two countries that voted no to a European constitutional treaty. It seems they are set to disrupt again the European conversation. On Saturday 21 April, the Dutch coalition collapsed as right-wing populist Geert Wilders refused to endorse the budget cuts needed to limit the budgetary deficit to three per cent of GDP. On Sunday 22 April, candidates advocating backtrack on European integration captured one-third the first round of the French presidential elections. On 6 May, the country is widely expected to turn left and elect François Hollande, who is unhappy with the German-inspired fiscal discipline treaty signed at end-March and has called for putting emphasis on growth.

These are the first skirmishes in what is bound to be a debate of great significance for Europe. It revolves around two major issues, austerity and integration.

Start with austerity. The question here is not whether deficits should be reduced. They have to in view of the dire situation of European public finances, and also because the countries whose competitiveness deteriorated during the first decade of monetary union must tighten to deliver the necessary wage/price adjustment. It is indeed telling that because they have benefitted from wholesale central bank liquidity provision, euro countries that found themselves in serious external imbalance at the onset of the crisis have reduced their current account deficit much less than non-euro countries in a similar situation. Germany, the arch-advocate of austerity, is right on this point.

The problem however is that austerity has perverse effects too. Private and public deleveraging can hardly take place at the same time, unless trade partners generate enough demand for exports. Recession and price deflation reduce tax receipts and worsen the dynamics of public debt, threatening the return to sustainability. Also headline deficit targets lead governments to respond to recessions by introducing austerity packages one after another, generally without much regard for the adverse supply-side effects of hasty consolidation measures. So there is a need for approaching austerity and rebalancing strategically. The EU in this respect has made three mistakes.

First, finance ministers in October last year tried to reassure markets by demonstrating toughness and endorsing headline instead of cyclically-adjusted deficit targets. This may be justified for a country at the verge of losing access to capital markets but certainly not for a country with relatively low debt and a moderate deficit, as the Netherlands. Ministers should change course and revert to their original 2009 commitment, which was to plan consolidation efforts and stick to them through fluctuations and shocks.  

Second, the euro area still shies away from a comprehensive approach to its internal rebalancing. Price competitiveness is not an absolute but a relative concept, yet the policy discussion still pretends to ignore this basic fact. This is paradoxical, because the European Central Bank’s policy framework provides clear guidance: the ECB is committed to 2 per cent inflation in the euro area as a whole, which implies that lower wage and price increases in Southern Europe arithmetically mean higher wage and price increases in Northern Europe. It is time to say loud and clear (a) that the ECB will fight hard to keep average inflation on target, and (b) that Northern Europe – and especially Germany – will not attempt to counter higher domestic inflation as long as price stability is maintained on average in the euro area. This would significantly help map out a sensible rebalancing strategy. 

The third mistake is of omission: as ECB president Mario Draghi recently said, Europe has a fiscal compact but it does not have a growth compact yet. For sure, there are no quick fixes in this field: initiatives on infrastructure investment may grab headlines but they certainly do not measure up to the challenge. Nevertheless, a serious discussion should start on how to use the EU budget for performance instead of redistribution only, how to foster pro-growth reforms at national level and how to help elicit investment in the tradable sector of the periphery. A well thought-out growth compact would help overcome immediate hurdles. We should not forget that students of the post-war Marshall plan have found that it is not the sheer size of the money pot that made it so successful, rather that it helped overcome zero-sum games and self-fulfilling pessimism. This is a lesson worth keeping in mind.

Austerity however is not the only dimension of the debate. Integration is the other one. The matter here is that developments over the last two years have exposed the weaknesses of a ‘bare-bones’ monetary union that relies on a single monetary policy and fiscal discipline only. Recent reforms have drawn lessons from the Greek crisis and have equipped the euro area with crisis management capabilities and this is a very welcome addition to the policy architecture. Yet more is needed to restore confidence, ensure financial stability and ward off financial fragmentation.

A key characteristic of the European crisis has been the very strong correlation between banking stress and sovereign stress. Time and again, bank woes have affected sovereigns and concerns over sovereign solvency have affected banks. This major potential threat to financial stability has been temporarily alleviated, but not solved, by the central bank’s large-scale provision of liquidity. Concerns about Spain have shown that the problem was still there. Systemic reforms to address it all involve a significant step towards integration: either the joint issuance of government bonds that play the role of safe asset in the banks’ portfolios; or a ‘banking union’ consisting in a common regime for deposit insurance, supervision and crisis resolution; or both. Either one involves significant risk-sharing among euro-area members and involve some degree of fiscal mutualisation. The question then is whether there is enough trust and political acceptance for integration to start discussing such reforms.

This is where politics strikes back. In France, in the Netherlands but also elsewhere, a significant proportion of the citizens see Europe as a threat to their way of life. Telling them that the euro is an unfinished construct that requires even more commitment that what they already feel excessive is a hard call for politicians. The question for the coming months is whether the European leaders will have enough political capital to embark on further reforms and make the case for them in front of angry citizens, or whether they will limit themselves to agreeing on mere platitudes, and hope for the best.

A version of this column was also published in Century Weekly

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