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Restructuring the eurozone

What’s at stake: As initially designed, the eurozone has failed. The current arrangements have proved unstable – encouraging countries to run excessive budget deficits while also giving banks an incentive to both finance profligate governments and also fuel real estate bubbles. On May 6 in anticipation of the European Council of the following day the […]

By: Date: May 20, 2010 Topic: Banking and capital markets

What’s at stake: As initially designed, the eurozone has failed. The current arrangements have proved unstable – encouraging countries to run excessive budget deficits while also giving banks an incentive to both finance profligate governments and also fuel real estate bubbles. On May 6 in anticipation of the European Council of the following day the French Presidency and the German Chancellery released a letter setting out a few avenues for reforms of the governance of the eurozone. The Commission has since then published its proposals for strengthening policy coordination. The initiatives, if approved by national governments, would represent the most significant advance in eurozone economic governance since the euro’s launch in 1999.

The Commission’s proposals

Eurointelligence summarises the main points of this 11 pages document. The main drift of the proposal is a much broader policy co-ordination process that extends far beyond the current focus on annually reported deficit. Specifically it includes an upgrading of the debt sustainability criterion in the Maastricht Treaty, and a more automatic application of the penalty procedures of the stability pact. Furthermore, the Commission proposes early-stage co-ordination in budgetary processes. At the moment, member states only present their budgets as a fait-accompli, after they have been decided. There are no proposals for a common European bond, though this could still happen within the co-ordination mechanisms proposed in the paper. Olli Rehn’s paper also proposes stronger co-ordination of policies to reduce intra-eurozone imbalances, upgrading a current peer review process to a more binding policy co-ordination process under Art. 136 TFEU. The Commission will also produce regular assessment of macroeconomic imbalances.

Paul de Grauwe argues that the recent proposals developed by the European Commission continue to follow the logic of strengthening the fire code rules and ignoring the need to create a fire brigade that is willing to extinguish the fire before it punishes the reckless. It is clear that this approach is not workable once a crisis erupts. In this sense the Commission is fighting the wrong enemy. This “fighting-the-wrong-enemy” syndrome is even more pronounced in the recent proposal made by the German government to impose balanced budget rules in all the Eurozone countries. Such a proposal, if implemented, would do little to avoid the kind of crisis that the Eurozone experiences now.

So far, the main political cleavage on how to reform the governance of the eurozone appears to be between those that reduce the entire debate to fiscal discipline and those who don’t.

It’s the deficit, stupid!

Peter Bofinger and Stefan Ried propose a new framework for fiscal policy consolidation in Europe based on a paper published by the German Council of Economic Experts in November 2009. At its centre is a European Consolidation Pact that supplements the Stability and Growth Pact in times of crisis. It would have five elements. First, participating countries would have to detail a path to balancing their budgets. Second, they would have to implement an automatic tax increase law in their national legislation. Third, every country participating in the pact would be able to apply for European Consolidation Pact guarantees for each newly issued government debt that is in line with the specified path to balancing its budget. Fourth, each guarantee issued would be paid for with a percentage fee to the European Consolidation Pact. Fifth, non-compliance with the automatic tax increase law or voluntary exit from the Consolidation Pact would leave future government bond issues with no guarantees.

Michael Burda and Stefan Gerlach argue that to be effective and to restore credibility, a new Pact must raise the level of transparency on how governments are really following the rules. This must involve auditing national accounts by non-political experts – something to which Germany, France, and others have objected, as it implies a loss of sovereignty. But that is just the point. The likelihood of an outside review of fiscal policy will provide excellent incentives for politicians to keep their fiscal house in order.

Marco Annunziata has a proposal, not far removed from what is already under discussion in German policymaking circles that every eurozone country should be required to introduce a clause into its constitution imposing limits on budget deficits and obliging a government to cut expenditure by a specific amount when the limits are exceeded. Tony Barber argues that constitutions are not an appropriate place for eternal rules about economic policy. Constitutions are not an appropriate place for eternal rules about economic policy.  Constitutions lay down principles of government. They establish whether a country is a monarchy or a republic, a presidential system or a parliamentary system or a mixture of the two. They guarantee inalienable human rights.  But they should not set out detailed formulae for economic policy, because no one can possibly know what economic circumstances will arise in the years after the constitution was written.

Jan Kregel and Rob Paranteau argue that the fiscal retrenchment the core nations are insisting upon is highly likely to boomerang right back on them. An ostensibly moral stance advocating balanced government budgets is revealing a profound ignorance of the simple accounting of sector financial balances. Those preferring to impose a “fiscally correct” policy on the peripheral nations should best recognize these accounting realities, and soon. Hiking taxes and slashing government expenditures will suck cash flow out of the private sectors of the peripheral eurozone nations. It would therefore appear that fiscal retrenchment is about to set off two related contagion effects. First, the loans on the books of German, Dutch and French banks are likely to sour as private sector cash flows are squeezed in the periphery. Bank holdings of government debt issued by the periphery may not default, but the mortgages and corporate loans these banks have outstanding to the periphery will experience rising loan losses. Second, the export sales of German and Dutch companies will fade with the falling import demand of the periphery. As their domestic incomes fall, they will import less.

One dimensional focus on fiscal discipline will solve the eurozone problems.

Paul Krugman notes that it’s stunning to see so many smart people focusing only fiscal profligacy and pretending not to notice the elephant in the room: optimum currency area issues. In a similar fashion, Barry Eichengreen writes that Europe needs to establish – and fast – the elements of a proper monetary union that are currently missing.

Martin Wolf notes that private sector bubbles lie at the heart of the eurozone’s instability – and that this problem cannot be addressed through fiscal austerity. In another op-ed, Wolf writes that the survival of the eurozone will depend on fundamental economic reforms, and governance reforms. The German view that reduces the entire debate to fiscal discipline is wrong.  The system must be able to handle divergence, facilitate debt restructuring, and promote economic adjustment. The eurozone cannot rely on markets alone. It will have to police divergence in upswings and cushion adjustment in downswings. Any such policing must influence the policies of both demand-deficient and excess-demand economies.

Adam Posen writes that the reform of euro area economic governance will ultimately have to include greater systemic fiscal transfers and stabilization, not just increased budget discipline. Although obviously fiscal irresponsibility as in Greece has costs, increasing fiscal stringency in euro governance without improving counter-cyclical stabilization and limiting divergences over the long-run will make matters worse.  Fiscal transfers within the euro area, perhaps building on the IMF’s useful initiative, would be a way of improving matters.  In a diverse monetary union, the direct economic benefits in terms of credibility for peripheral countries of binding government’s hands are insufficient alone to make up for the loss of counter-cyclical policy.  It is in the monetary union’s interest to reduce divergences or better offset nation-specific shocks, and full fiscal reform can achieve that. One dimensional focus on fiscal discipline will not.

Michael Spence argues that a step in the right direction could be taken by partial fiscal centralization with a limited countercyclical mandate. A long-term solution to Europe’s problems is a central EU fiscal capacity that accumulates the resources to respond to shocks during periods of growth. One could think of it as a stabilization tax that becomes negative in downturns.

Javier Andrés discusses how to facilitate changes in competitiveness. One way to operationalize the control of competitive differences is the inclusion of the external position of each country as an added factor monitoring of fiscal discipline. Another possibility is the imposition of limits on wage growth in countries with recurrent account deficits. This rule could apply to all wages bargaining in a country or, if you run into legal difficulties for interfering in the autonomy of the parties, public sector wages, although in this case its impact on all prices and wages in the deficit country would be slower.

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