Thursday, January 13, 2011

Reflections on Tommaso Padoa-Schioppa and the euro

By Charles Grant

At the end of last year, Europe lost Tommaso Padoa-Schioppa, an eminent central banker and economist, and one of the founding fathers of the euro. As EU leaders struggle to cope with the continuing euro crisis, they would do well do ponder some of Padoa-Schioppa’s insights on the economics of monetary union.

Following Greece and Ireland, Portugal may soon require a rescue from its fellow eurozone members. With the benefit of hindsight it is only too evident that the euro has suffered from design flaws, and that European leaders have mismanaged the currency. Too many countries joined the euro before they were ready. Fiscal discipline has been too lax, though new rules will make it harder for governments to over-borrow. Some eurozone governments did far too little to promote structural reform, and have therefore suffered from inflexible economies and poor productivity; in 2010, Greece, Portugal and Spain belatedly implemented some structural reforms. The penal rates of interest at which Greece, Ireland and Portugal have had to borrow have revealed the need for a bail-out mechanism and a procedure for ensuring the relatively orderly restructuring of sovereign debt (both are on their way). The behaviour of many banks – and not only in Ireland and Spain – has shown that the tighter system of pan-European financial regulation now being put together is sorely needed.

The statesmen who designed the euro have been criticised for putting politics ahead of economics: motivated by the desire to promote European unification, they ignored the economics – or assumed that once the project got underway, the necessary rules for economic governance would somehow fall into place. There is truth in that criticism, but many people have forgotten that economics did play a role in the birth of the euro.

In 1987, Padoa-Schioppa wrote a report explaining that the exchange rate mechanism (ERM) – which limited fluctuations among many European currencies – could not survive the removal of exchange controls that was agreed in that year. He wrote: “The complete liberalisation of capital movements is inconsistent with the present combination of exchange rate stability and the considerable national autonomy in the conduct of monetary policy.” He also argued that the end of the ERM and the return of currency instability would endanger the single market.

This report convinced Jacques Delors, the then president of the European Commission, and other leaders, that moving towards economic and monetary union (EMU) was urgent. So in 1988 EU leaders tasked a committee – which had Delors as its chairman and Padoa-Schioppa as its joint rapporteur – with drawing up plans for EMU. Delors and Padoa-Schioppa got most of what they wanted, though the Germans forced them – reluctantly – to accept the principle of binding rules on budget deficits. Most of the Delors committee’s report ended up in the Maastricht treaty in 1991. The ERM would not have survived the currency crises of 1992 and 1993 – when the capital markets nearly tore it apart – without the momentum towards monetary union.

In 2000, when a member of the executive board of the European Central Bank (ECB), Padoa-Schioppa wrote a brilliant essay for the CER, ‘Europe’s new economic policy constitution’. He complained about the weakness of the arrangements for co-ordinating national fiscal policies, arguing that if the eurozone could develop its own fiscal stance, the ECB could better manage monetary policy and more easily keep down interest rates. He also warned that the eurozone would not work well unless governments made labour markets more flexible; doing so would facilitate “higher non-inflationary growth. This in turn would increase fiscal sustainability on both the income and expenditure sides of the budget.”

Padoa-Schioppa’s death has deprived Europe of a courteous public servant who was utterly committed to European unity. Many of his insights have long-lasting relevance, and not only on labour markets. The EU’s new procedure for a ‘European semester’, involving peer review of national budgets, is a step towards the fiscal co-ordination he called for. Above all, Padoa-Schioppa understood the relevance of the euro to the single market. If the euro disappeared, giving way to competitive devaluations and wild currency swings, there is a serious risk that member-states would either impose tariffs against each other or resort to hidden forms of protectionism. Alternatives to the euro would not look pretty.

Like Padoa-Schioppa, the CER has long argued that a healthy eurozone requires much more thorough economic reform. In the flurry of regulatory and institutional reforms now underway, one of the most serious underlying problems in the eurozone is not being addressed. This is the growing gap in competitiveness between the eurozone’s core in northern Europe, and the southern states. This has led to large current account imbalances within the eurozone, and these have left the southern countries struggling to grow and to pay back debts.

One economist who foresaw that these imbalances would be a problem was the CER’s Simon Tilford, whose remarkably prescient CER report, ‘Will the eurozone crack?’, was published in September 2006. Simon wrote: “The core problem is that membership seems to have reduced pressure on governments to undertake the reforms needed to ensure the currency union is a success. Freed from the risk of a currency crisis and higher debt service costs, Italy [and the other southern countries have] done little to strengthen public finances, make labour markets more flexible or introduce more competition. The result has been declining productivity, inflation above the eurozone average and a sharp decline in competitiveness relative to other members of the eurozone. Unable to devalue its currency, Italy now risks getting caught in a vicious circle of very slow economic growth and rising debt.”

Simon predicted, rightly, that the markets’ inability to distinguish between the debts of different eurozone countries would lead to a damaging lack of fiscal discipline. He also pointed out that Germany’s “de facto competitive devaluation”, through low wage growth, would exacerbate eurozone imbalances. “While this has massively boosted the country’s competitiveness and its exports, it has depressed consumption and investment, causing the country’s trade and current account surpluses to balloon. An economy as big as Germany’s cannot depend indefinitely on exports to drive real GDP growth, without imposing intolerable pressures on other members of EMU.” On the other hand, “a German economy growing under its own steam would boost demand across the eurozone, cushioning the impact of structural reforms, and crucially, make it easier for other member-states to restore their competitiveness without forcing their economies into a prolonged recession.”

One reason to be gloomy about the euro is the intellectual rift that divides European leaders. It is as though the doctors examining the patient do not agree on the diagnosis or the medicine required. At the risk of some generalisation, leaders from Germanic and Nordic cultures believe that stricter fiscal discipline and structural reform will suffice to cure the patient. Those from Latin and Anglo-Saxon cultures think that medicine is necessary but not sufficient: they also focus on the imbalances and the need for the core countries with external surpluses to generate demand in the eurozone.

Despite all the problems, I expect the euro to survive, because the political will of EU leaders – including those in Germany – to do what it takes to preserve the currency remains strong. But political will on its own will not suffice; Europe’s leaders must also listen to economists if they want to put the euro on a truly sustainable footing.

Charles Grant is director of the Centre for European Reform

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