Europe’s Institutional Mismatches Will Create More Turbulence in 2014 than in 2013

Published in Caixin’s ‘China 2014’ Special Issue.

2013 has been a remarkably calm year in Europe, arguably the calmest since the onset of financial crisis in 2007.

The year started with two significant events that in different circumstances could have shaken financial markets. First, in, Italy, the euro area’s third-largest country, an election in February elevated an almost unknown political force, the Five Star Movement led by comedian Beppe Grillo, to the top of the political landscape on a platform rejecting the country’s mainstream parties and European commitments. Second, in Cyprus in March, a combination of inadequate risk management in local banks and a bungled European policy process led to the imposition of capital controls despite the fact that such controls contradict the ground rules of the euro area monetary union.

But global investors were largely unperturbed by these two shocks. They were reassured by promises from European policymakers in 2012 to do “whatever it takes” to defend the integrity of the euro area, including through the creation of a European Banking Union and the possibility of massive purchases of sovereign debt (known as Outright Monetary Transactions, or OMT) by the European Central Bank (ECB). Later in 2013, investors shifted their focus to the exit from Quantitative Easing and paralyzing fiscal battles in the US. The turmoil in emerging markets during the summer was also a distraction from Europe, which suddenly appeared less troubled than other parts of the global economy. Several European politicians declared that the worst of the European crisis was over.

Several reasons suggest that 2014 will be a bumpier year for Europe, however.

First, the implementation of the first phase of banking union, with the transfer of supervisory authority over most of Europe’s banking system from national authorities to the ECB, involves an assessment of the banks’ financial soundness, known as Asset Quality Review (AQR). This review will probably expose previously unrecognized weaknesses in some banks, possibly requiring public intervention and restructuring, accompanied by political tensions.

Second, the banking union will remain incomplete. Member states are unlikely to agree on a workable design for its two other necessary components, a European authority empowered to resolve crises over troubled banks and a European deposit insurance system. The realization that banking union is essentially limited to supervisory integration at the ECB may reawaken investors’ worries about the vicious circle between banks and sovereign credit that destabilized the euro area in 2011 and early 2012.

Third, the combination of the delay in restoring the banking system back to soundness, fiscal austerity, and the ECB’s continued reluctance to engage in unconventional monetary policies, suggests that the European economy will remain anaemic. Growth performance could be dampened by the failure of Italy, France and other countries to undertake structural reform.

Fourth, the European Parliament election in May 2014 is expected to crystallize citizens’ dissatisfaction with their current governance in most countries outside of Germany, sending shockwaves throughout Europe’s political establishment. For example, the xenophobic and anti-establishment National Front is predicted by many to become France’s leading party in that election. Comparable trends are observable in the United Kingdom, the Netherlands, and other EU member states.

How Europe’s politicians and policymakers will react to such developments could range from further paralysis of decision-making to the jolts provoking more boldness to reform.

A renewed debate on Europe’s institutional mismatches is likely over what European jargon refers to as “political union” as a necessary complement to banking union, fiscal union, and economic union.

 EU institutions, as currently defined by the European treaties, are too weak to deal with these problems. The European Commission has shrunk in stature during the crisis, lacking the policy leadership that had been assumed to be its defining ability, except in specific areas such as competition policy, and hobbled by a (not entirely undeserved) reputation as an overpaid and inefficient bureaucracy. The European Parliament has less control over the power of the purse than most national legislatures. Too many of its members lack dedication or gravitas. It is insufficiently representative of the European electorate: in particular, the number of parliamentary seats is not proportional to member states’ voting populations and electoral processes vary widely across countries. The European Council of national heads of state and government is unaccountable as a collective body, even though each member is democratically accountable to national constituents. There is no mechanism to endow it with a political mandate to channel the preferences of the majority of European citizens. This lack of legitimacy has repeatedly paralyzed it when decisive action was needed.

In summary, the core EU institutions – the Commission, Parliament and Council – are affected by a combination of democratic deficit, or the lack of proper representation and accountability to the European citizenry, and executive deficit, or the inability to make and implement policy decisions at the right moment. These twin deficits perversely feed each other, sapping the EU’s popularity in many countries.

The ECB stands in contrast to the other institutions’ ineffectiveness. In several instances, it has filled the EU’s executive vacuum and saved Europe’s day by making bold policy commitments while generally maintaining its credibility. As a consequence its authority has increased through the crisis, not least because of its new supervisory tasks as a first step towards banking union. But its independence also means that it cannot rely on a democratic mandate based on the public’s consent. Trusting it with too much policy power and no corresponding accountability may not be sustainable. The ECB is acutely aware of this risk and limitation.

Simultaneously, the crisis has exacerbated centrifugal forces kept in check in previous decades. For example, the UK has entered uncharted territory by openly contemplating its own exit from the Union. The UK also faces a forthcoming referendum on Scottish independence, and in Spain with the exacerbation of tensions between Catalonia and the central government in Madrid.

To be sure, countervailing forces of cohesion should not be underestimated. The euro area has preserved its integrity so far, against widespread predictions in early 2012 that Greece would leave the monetary union during that year. Even so, a British exit would transform the nature of European integration and may disrupt Europe’s future.

Germany’s dominance of intergovernmental decisions raises particular concerns. German preferences are often enlightened, but they also occasionally reflect German prejudices or parochial special interests. Citizens of other countries feel increasingly disempowered, with some justification, even if Germany is restrained in the use of its outsized influence. The French-German “couple” used to bring a degree of balance. But it can no longer work as in the past, and is at best a minor corrective.

A debate on how to address these multiple mismatches has started in Germany, but needs to become more vibrant on a European scale. The overwhelming majority of Europeans are committed to democracy and the rule of law and can find common ground in how to embed these principles in a reform of Europe’s institutional arrangements, both within the current treaties and through their eventual revision. What Europe needs is institutional innovation and experimentation, as it found in banking policy.

The ambition that underpins European integration should not be underestimated. For most EU member states, including the four largest euro area countries, European integration has become a core component of national identity. The crisis has revealed major vulnerabilities in the EU construct, but has also highlighted some of its strengths. Jean Monnet, a founding father of the EU, noted that Europe is shaped by its response to successive crises. The inception of European banking union was triggered by market volatility in 2011-2012. Similarly, further steps towards fiscal, economic and political union could well result from other episodes of turbulence.

Institutional challenges are not the exclusive preserve of the EU, as was illustrated this year by the dysfunctional treatment of fiscal policy by the US Congress. Less democratic regimes face similar challenges as well. Europeans have a lot to learn from the experiences of other countries all around the world.

Europe’s institutional mismatches will not all be successfully resolved in 2014. But one can expect, and perhaps hope, that they will become clearer and start being debated more openly and broadly. A proper diagnosis is the first step towards healing. 

This piece was first published in Chinese by Caixin in its special issue, China 2014. The text above is the author’s English version.