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Euro Puzzles


Syriza’s election in Greece turned discussion in Europe once more to 
the possibility of a Grexit. Cutting Athens loose, however, would not help Greece, and do little to repair the eurozone’s remaining problems.


(c) REUTERS/Yannis Behrakis

The genie has again slipped out of the bottle: Europe is again discussing the possibility of Greece leaving the euro. Policymakers are once again debating whether this would be helpful or not for Greece, whether there could be contagion to other euro area countries, and what all of this means for the governance of the euro area. A more general discussion on the future of the Economic and Monetary Union is warranted, and is officially being pursued in the European Council. It will need to address three major issues: financial and banking fragilities, competitiveness divergences between member states, and the euro area’s inadequate fiscal governance.

Who Will Blink First, Alexis or Angela?

Opinion polls show that Greek citizens want to renegotiate terms with their creditors – but want to stay in the euro. This is the mandate that they gave Prime Minister Alexis Tsipras. The new Greek government has exercised brinkmanship in trying to achieve this: it unilaterally declared that it would not respect the agreement between Greece’s previous government and the country’s creditors, that it would increase government spending, and that it was insolvent at the same time.

The response has been predictable: the rest of the euro area – and in particular the European Central Bank and Germany – felt blackmailed and called Greece’s bluff. The ECB made access to its liquidity more difficult for Greek banks, while Chancellor Angela Merkel’s government has signaled it considers a Greek exit from the eurozone manageable.

What Have We Learned from Athens?

This response was necessary, but insufficient. A monetary system cannot function credibly if a small part of the union can hold the core of the system for ransom. A country cannot unilaterally decide to increase expenditure at the expense of other parts of the union and hope to receive funding for it. It also cannot unilaterally refute agreements between its previous government and its European partners.

Yet at the same time, ignoring the Greek vote is not an option. Greeks need to believe that their lives will improve. This perspective cannot be achieved via gambling, unilateral action, or blackmail; rather, it needs to be the result of domestic action and an agreement between the partners of the Eurogroup. The essential elements of a deal include serious domestic reform, such as reduced corruption, further preferential funding, a significant reduction in savings demanded by the Troika, and more certainty about the terms of the debt should growth rates disappoint.

The heated discussions about Greece show that a monetary union needs political collaboration and trust to work. There needs to be trust that agreed principles are followed – but also trust that the prescribed solutions will not destroy an economy. While previous Greek governments have put their country in a bad situation with irresponsible fiscal policies, too much of the adjustment burden during the crisis has been loaded onto the backs of the Greek citizens, and too little onto private creditors.

Where Did the European Fracture Start?

The euro area was always comprised of two groups of countries with substantially different socio-economic models, which means they had different macroeconomic policies and outcomes. There were the core countries such as Germany and France, which had continuously belonged to (or shadowed) the Exchange Rate Mechanism (ERM), introduced in 1979, and the peripheral countries like Spain, Portugal, and Greece, which had stayed mostly outside the ERM or joined late.

Different initial conditions in the core and the periphery, mainly in terms of interest rates, led to a credit boom in the periphery after the introduction of the euro, financed by capital flows from the core. The result were increasing different levels of competitiveness within the eurozone, which were insufficiently monitored and difficult to counter in the absence of the exchange rate instrument. As a result, current-account balances and net foreign asset positions diverged to an unprecedented degree between the core countries (in surplus) and those on the periphery (in deficit). When the financial crisis hit in 2008-09, private capital flows from the core to the periphery suddenly stopped, leaving a mountain of external (private and public) debt in the periphery owed to creditors in the core countries.

Why Did the Cracks Widen?

Instead of producing real and sustainable convergence between the core and the periphery, the single currency resulted in imbalances and was ill-prepared to deal with them. This shortcoming, along with deeply entrenched opposition to bank resolution in a system characterized by major inter-dependencies between political systems and financial institutions, was a major hindrance in getting to grips with a European financial-cum-sovereign-debt crisis.

Another weakness of the euro area’s economic governance architecture was that it lacked a mechanism to monitor and correct macroeconomic imbalances, except in budgetary policy. Enforcement of the deficit rules – limiting government deficits to 3 percent of GDP, among others – was inadequate, public debt sustainability received relatively little attention and private debt was completely ignored. Similarly, scant focus was trained on external debt – and current account imbalances.

When the global crisis triggered the European crisis, Europe’s policy system was largely unprepared. The initial policy response in 2009 was timely and coordinated, consisting of monetary policy easing and a substantial increase in fiscal deficits. But crisis management faltered after the May 2010 elections in Greece, which triggered the European debt crisis, and several stressed countries started losing market access.

What is the Situation Now?

So far, the overall crisis response has not produced the desired results. The banking union project may now be nominally complete, but it remains a work in progress. GDP has not grown since 2008, and unemployment rose from 7.5 percent to 12 percent in 2013. Inflation has fallen substantially, and in December 2014 area-wide deflation (of -0.2 percent) was recorded for the first time since 2009. Internal adjustment has proceeded, with current-account deficits shrinking substantially. However, current account surpluses have, if anything, increased in Germany and the Netherlands, reaching 7 percent of GDP and more in 2014. Some wage and price adjustment was implemented in the crisis countries, but relative prices between the three biggest euro-area countries – Germany, France, and Italy – have adjusted only marginally. The very low area-wide inflation rate has not helped: the lower it falls, the more difficult it becomes to achieve the necessary adjustment.

The extent of Greece’s difficulties and its inability to adjust effectively – through exports, for example, or decreasing wages – may render it an outlier, but the obstacles Greece faces are not qualitatively different from structural issues that have arisen throughout the currency union. Besides the severe macroeconomic imbalances at the beginning of the crisis, four common problems can be identified.

First, from 2011 to 2013, fiscal policy in the euro area was pro-cyclical. In 2014, fiscal policy was flat and did not counteract the continuing deterioration of the economy, public investment and R&D expenditure were cut during the crisis. Second, Europe has taken a gradual approach to bank resolution; unresolved banking issues continue to plague credit provision. Third, the ECB has been slow to respond to the deteriorating economic situation, and has tried to avoid taking risks. It also misjudged the situation twice, resulting in erroneous rate increases. And lastly, no serious and significant measures to address price divergence between Germany, France, and Italy have been undertaken.

What Has to be Done Now?

Progress needs to be made in three directions simultaneously. First, bank survival must be made independent of the stability of member states; second, divergences in competitiveness need to be ameliorated; and third, fiscal coordination should be further advanced.

At a famous summit in June 2012, the European leaders announced that they intended to “break the vicious circle” between banks and sovereign states. This was a new step in European integration. The creation of the so-called banking union is arguably the most significant deepening of policy integration since the start of the euro, and certainly since the start of the crisis. The aim was to make the financial system more resilient and weaken the link between banks and states.

To achieve this, three major steps had to be undertaken: first, bank supervision had to be moved from the national to the European level. Second, mechanisms for bank resolution, in particular for banks operating across borders, needed to be developed. Third, mechanisms were needed to reduce the risk for taxpayers and share the remaining risks across the union.

Are the New Powers of the ECB Enough?

Policy makers have made significant progress on all three, but the work is not finished. In particular, the link between national public resources and fragile banks will remain for quite some time. The biggest success so far is the creation of a strong and centralized supervisor in the European Central Bank, the Single Supervisory Mechanism. The ECB has not only hired 1,000 new experts for its banking supervision, it has also brought substantial transparency to Europe’s banks by assessing the quality of their balance sheets with stress tests, and harmonizing bank reporting. Banks that fell below certain thresholds for risk-weighted capital in these stress tests are increasing their capital to become more resilient. Yet important steps remain unfinished.

A first important question is whether the ECB, as a newly established supervisor, will be able to ensure that deposits can circulate freely within banking groups. During the crisis, national supervisors put limits on subsidiaries to reduce the exposure of depositors to capital flows and risks in other countries. This policy has rendered bank integration across borders less beneficial, and has undermined financial integration. Yet the idea of abandoning the policy altogether has implications for deposit insurance, and will therefore remain controversial.

And the Other Banks?

Another important question is how the ECB and national authorities will continue to clean up and restructure the banking system. And the role of private creditors in bank restructuring and resolution needs to be examined. Tough legislation has been put in place but enforcement may be less credible. If a bail-in is not enough to solve banking problems, fiscal resources will again be used. The joint funding mechanisms developed will only suffice for small to medium-sized banks. Bail-in and risk sharing will in any case not be enough to reduce the link between banks and national sovereigns – banks will also have to reduce their exposure to sovereign debt and other claims of the countries in which they are located.

Overall, the process of repairing and deepening financial integration in the EU, and the eurozone in particular, is bound to take time. The crisis has dented investor confidence. However, the establishment of a strong supervisor and the progress made on banking resolution should be considered game changers.

What Do We Need to Hold Things Together?

To address competitiveness divergence, the euro area needs a proper policy framework. Leaving adjustment to market forces alone is unlikely to work, as labor mobility in the euro area will remain much lower than in the United States. The framework should thus ensure that wages move in line with productivity. Such a system could be introduced in each euro area state. These national mechanisms would constitute national competitiveness councils, with a Eurosystem Competitiveness Council consisting of both national Competitiveness Councils and the European Commission. Its primary task should be to ensure that no euro-area country fixes a wage norm that would result in significant competitiveness problems for itself and/or others.

The fundamental question for the eurozone is whether to move ahead with fiscal integration, accepting that national parliaments would lose some power; or whether to implement full decentralization in which fiscal decisions are taken at the national level. This latter option would accept defaults without mechanisms to safeguard financial stability, and would therefore be politically, socially, and financially unstable.

A More Constraining Framework 

Europe needs a reform of the fiscal framework along the lines of “fiscal federalism by exception,” as originally proposed by Jean-Claude Trichet in his Charlemagne Prize speech of 2011. This puts the focus of fiscal surveillance on debt sustainability as well as ensuring a proper fiscal stance. The closer a country moves to unsustainability, the stronger the intervention would be, with the ultimate sanction being a complete removal of credit. This enhanced governance would be in addition to possible debt restructuring. The fiscal framework should also ensure that the sum of deficits in the euro area achieves a reasonable area-wide fiscal stance. The new framework would thus not only in extreme cases be able to overrule national parliaments in prohibiting borrowing, it would also have the right to force member states to run higher deficits if the eurozone economy hit a substantial recession. In other words, the notion of “fiscal federalism by exception” should be made a symmetric one.

The governance of fiscal surveillance could be organized in a Eurosystem of Fiscal Policy, with a governing council comparable to the eurosystem of central banks. At its centre would be a eurozone Finance Minister – or a European Budget Commissioner, as Wolfgang Schäuble has suggested. In normal times, fiscal deficits would still be managed on the national level, and the recommendations of the Eurosystem of Fiscal Policy would not be fully binding. But in exceptional circumstances it would take control.

Coordinate but Do Not Share Risks

It is important to note that this model does not imply the creation of a “federal budget”. All government spending would remain at the national level. It is also important to note that the proposal does not foresee risk sharing beyond the current ESM capacities. It is essentially an improved framework for fiscal policy coordination. A much more far-reaching step would be to establish a fiscal mechanism for proper risk sharing across countries, such as a European unemployment insurance mechanism. This would introduce real risk-sharing. But this would arguably only be possible if labor market conditions were to be significantly harmonized.

If anything, the Greek case demonstrates that the euro area needs to increase integration and improve its coordination framework. A monetary union cannot credibly work if any member can act unilaterally. The banking union needs to be completed, competitiveness divergences need to be kept in check as labor markets will remain largely national, and fiscal policy needs to ensure debt sustainability, while defining a proper fiscal stance for the eurozone in recession.

Pia Hüttl, a research assistant at Bruegel, contributed to the article. 

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