Monday, May 10, 2010

Closing the gap between rhetoric and reality is key to the euro's survival

by Simon Tilford

Europe faces a critical choice between greater integration and disintegration. The gap between the rhetoric of a united and integrated Europe and the reality of national interests and politics has always dogged Europe. For much of the EU’s history this gap simply held Europe back and undermined the seriousness of the EU in the eyes of the outside world. However, the gap between rhetoric and reality is lethal when it comes to the euro. Unless the reality is brought into line with the rhetoric, the eurozone will unravel.

The package of financial measures announced over the weekend of May 8th-9th to stabilise the eurozone crisis provides some big headline numbers. There will be an additional €60 billion for countries experiencing balance of payment problems. The EU will establish a ‘Special Purpose Vehicle’ with funds of up €440 billion to provide loans to struggling member-states and the IMF will guarantee half as much again. In a major U-turn, the ECB has suggested it may even step in to buy government bonds directly. But the EU’s response is still a case of ‘shooting the messenger’. There is too much talk of ‘speculative attacks on the euro’, of giving a ‘clear signal to the markets’ that the euro will be defended, even talk of keeping the ‘wolves’ from the gate. The subtext is that the markets are overacting and that investors are essentially conjuring up a crisis so they can profit from it. The assumption is that the adjustment needed in Greece, Portugal and other member-states is possible if only the markets will let them make it. As such, the EU is still working on a false premise.

Even assuming the package is approved and the money found (these are big assumptions given the strength of opposition in many member-states to bail-outs) it will not satisfy the markets for long. It does not address the underlying issue: the terrible economic growth prospects of the southern eurozone economies and Ireland. Unless these economies can avoid deflation and get their economies growing, they have no future in the eurozone. In order to qualify for loans from the new Special Purpose Vehicle member-states will have to meet strict deficit reduction terms, with the decision over whether money should be made available to be decided by majority. But what if these conditions are impossible to meet? The EU has bought itself some time – struggling eurozone economies will be able to refinance their debts for the time being – but it has not solved the crisis.

Unfortunately, the eurozone fulfils few, if any, of the criteria for a successful currency union. There are varying degrees of trade integration, but the participating economies can hardly be described as fully integrated. Nor are they flexible – labour markets in many economies remain highly regulated and many sectors are sheltered from competition. Labour mobility between the participating economies is virtually non-existent. There is nothing to prevent huge trade imbalances between the members rising and nothing to address them when they do. This would all perhaps be manageable if it was offset by a large degree of political integration and a fiscal union of some form – but neither exists. Moreover, as the last three months have graphically exposed, there are no eurozone crisis management mechanisms in place. Indeed, the EU’s strategy since the beginning of the year has been tailor-made to provoke precisely the contagion it has been so anxious to avoid.

To suggest that the markets are partly to blame for the crisis or for prolonging it only serves to reinforce perception of European other-worldliness. The markets have simply called the EU’s bluff. Indeed, they should have done so earlier – that way the crisis might have been avoided. Until relatively recently, the markets treated the debt of the various eurozone member-states as largely indivisible. The Greek authorities could borrow at similar interest rates to their German counterparts. This made no sense, but it reflected investors’ belief that it was impossible for a member of the eurozone to default. The financial markets were guilty of buying into the myth of an integrated eurozone.

The markets are right to doubt the sustainability of the current membership of the eurozone. It is hard to see how the struggling member-states are going to generate economic growth. They need a big external stimulus to offset budget cuts and falls in real wages. In short, their exports need to grow much more rapidly than imports, for a lengthy period. This is highly unlikely. Their import demand will be weak, of course, reflecting the collapse in domestic demand. But they need much stronger exports. In the absence of devaluation, they are dependent on a revival of demand elsewhere in the eurozone and the ability of their companies to become more price competitive and hence build their market share within the eurozone. The former is highly unlikely to happen – if anything, the export dependence of the likes of Germany and the Netherlands is being reinforced. There is nothing to force adjustment on these surplus economies within the eurozone and scant recognition that they need to rebalance in order to give others a chance of doing so.

What of the latter? The best way of improving price competitiveness is through higher productivity. But that is a long term challenge; they do not have that amount of time. They have no choice but to try and cut costs relative to the rest of the eurozone. Can they do so? The markets are rightly sceptical. It is true that Germany and the Netherlands have successfully pursued eye-watering wage restraint within the currency bloc. The problem of course is that it’s impossible for every economy to do this simultaneously. It is one thing for a member-state to cut costs relative to the rest of the eurozone when most member-states’ costs are rising pretty rapidly. It is a whole different ball game to do so when costs elsewhere in the eurozone – especially Germany – are falling, reflecting further wage restraint. This is a zero-sum game, whose result will be slump and deflation.

If the imbalances persist, a fiscal union will be essential for the eurozone to survive – the crisis-hit states will not be able to grow unless they can close their external deficits. But the obstacles to such fiscal supranationalism are insurmountable. The crisis has exposed the lack of solidarity between the member-states. A Parisian may grumble about seeing a chunk of his tax revenues flowing to the Pas de Calais or Marseille. Similarly, a resident of Bavaria may resent transfers to Bremen or Berlin. But there is sufficient solidarity between the regions of these countries to underpin such transfers on an ongoing basis. This solidarity does not exist within the eurozone.

The eurozone is on an unsustainable path, notwithstanding the latest package of measures. That is no fault of the markets. It is the result of the gap between European rhetoric and reality. There needs to be an acknowledgement that if the euro is to work it will require greater integration. The problem is that when countries signed-up to the single currency, they were not made aware that it would require such integration. Political elites need to start explaining why it does.

Simon Tilford is chief economist at the Centre for European Reform


Anonymous said...

The choice has been made, Simon. Eurozone leaders will take the steps necessary to make it happen as the alternative of EMU and possibly even EU break-up is worse politically than the steps that need to taken now. Its the ultimate triumph of neo-functionalism and the Monnet method. The price is, of course, many disgruntled voters and another constitutional crisis of the EU, but Germany is not Britain with its electoral system and its elite-level Euroscepticism. It will continue to support the measures.

And as for your defence of 'the markets', it seems you are copying the line Barber took in his recent FT blog. I do wonder how you can be so uncritical towards the operation of financial markets and rating agencies in particular after the experience of the last two years.

Republikanin said...

Congratulations :)

Anonymous said...

It seems like Europe needs the return of the Deutschemark, just as much as the Germans want it back.

In summary, the Euro seems to have been good in theory but fundamentally flawed in reality. The issue for Europe over the next few years to decades will be how to quietly ditch the Euro whilst not admitting defeat.

P.S. I bet the Swedes are glad that they rejected the Euro in their referendum!