Monday, June 22, 2015

The eurozone’s ‘five presidents’ report’: An assessment

The long-awaited report rightly aims to complete a financial union in the eurozone, but over-emphasises structural reforms and underplays the need for stronger counter-cyclical policies.

The eurozone in its current institutional setup may not survive the next severe political or economic crisis, and needs reform. The presidents of the European Commission, the European Central Bank (ECB), the European Council, the European Parliament and the Eurogroup have now presented their widely anticipated report – the ‘five presidents’ report’ – on how to complete the monetary union. It contains some important proposals, such as a strong emphasis on completing the banking and capital markets unions. But two key aspects are missing: a more activist ECB in order to prevent future shortfalls in demand, and strongly counter-cyclical fiscal policies at the national level. What is more, the case for a convergence of structural policies in the eurozone is less strong than the report assumes.

The report contains four sections, devoted to the economic, financial, fiscal, and political union respectively. Each of these unions is divided into two stages, the first to be completed by June 2017 and the second by 2025. The economic union concerns the co-ordination and implementation of economic policies such as labour market reforms, and aims to foster structural convergence among eurozone countries towards common standards (formalised as a ‘Maastricht’ for structural policies in stage two, similar to the original convergence criteria before the introduction of the euro). It also seeks to strengthen the implementation of the macroeconomic imbalance procedure (MIP, the eurozone’s monitoring system to prevent crises), and to introduce national ‘competitiveness authorities’ to monitor wage developments.

The financial union aims to complete the banking union, including common deposit insurance and a full and common backstop for the banking union’s resolution capacity. It also seeks to speed up the creation of the capital markets union, and the report suggests a proper European securities market regulator in the future. The fiscal union focuses on strengthening and streamlining the current rule-based setup, as well as the creation of a ‘fiscal stabilisation function’ at the eurozone level in stage two which tries to tie European investments to the business cycle. The political union seeks to better integrate the European semester (the coordination of economic policies) into national and European democratic processes.

What the eurozone needs

Four main shortcomings of the eurozone architecture contributed to the current crisis. First, the ECB allowed demand in the eurozone to fall below trend by conducting less aggressive monetary policies than was needed. Second, national fiscal policies were not counter-cyclical enough, both before and during the crisis. That means, policy did not lean against the wind when too much or too little demand forced wages and prices to veer off course before the crisis; and spending and tax policies were pro-cyclical during the downturn, aggravating the recession. Third, sovereign debt in some countries was allowed to reach critical levels; and because no lender-of-last-resort to governments existed, liquidity problems became insolvency crises. Finally, the banking sectors of many member-states grew too large and took on too much risk. While this also happened outside the eurozone, the lack of a common backstop meant that eurozone governments were tasked with supporting their national banking system, which destabilised government finances, too. It also meant that banks in some regions were unable to provide financing for the economy, and capital markets were to underdeveloped to pick up the slack. If the eurozone had been a true monetary union, like the US, banks and capital markets would instead have helped to spread economic shocks across the whole monetary union.

The five presidents’ report does not address the first issue at all – despite the severe fall in inflation and inflation expectations in the last two years, and the ECB’s hesitation to implement more aggressive steps such as ‘quantitative easing’ to pre-empt such a fall. There are political reasons for not touching the ECB and its mandate: the ECB is the most reliable and unconstrained institution in the eurozone. Opening a Pandora’s box of changes to its mandate or its institutional role could unsettle a delicate political balance. But at least an acknowledgement that the ECB needs to do its utmost to keep demand in the eurozone stable – something it has persistently failed to do during the current crisis – should have been included.

“It is a mistake to leave out the ECB’s monetary policy from the report.”

The second issue, counter-cyclical fiscal policy, is addressed half-heartedly. The report emphasises that fiscal policy needs to be set counter-cyclically, at both national and eurozone levels. But the five presidents aim to strengthen the existing fiscal rules that emphasise debt reduction and for which counter-cyclical policy is an afterthought. The IMF has recently shown how strongly counter-cyclical policy contributes to stronger and more robust economic growth. This applies with added urgency to members of a monetary union that by definition lack independent monetary policies and currencies to cushion economic swings. The urgency is increased still further if the monetary union concerned has trouble exiting a long economic slump, as the eurozone does.

The report should have put counter-cyclical national fiscal policy at the centre of its recommendations on fiscal matters, and urged policy-makers to review the eurozone’s fiscal rulebook in that light. Of course, the five presidents do want to strengthen the MIP. However, correcting imbalances once they appear is not the same as preventing them. Moreover, the MIP in its current form is of little use during the downturn. The report does call for the aggregate fiscal stance of the eurozone (the combined fiscal policies of eurozone countries) to be appropriate for the eurozone business cycle. This is a welcome contribution to the eurozone governance, if it can be agreed – not least because it would force a country like Germany to invest more for its own sake. But the emphasis on a eurozone fiscal stance also makes the omission of monetary policy (which serves essentially the same purpose as the aggregate fiscal stance: to stabilise the eurozone business cycle) all the more striking.

The ECB’s lender-of-last-resort function to governments is rightfully excluded entirely from the report. While such a function is of fundamental importance for the stability of a monetary union, the ECB’s OMT programme has so far been remarkably successful in arresting panic in bonds markets. Given how controversial this programme is in countries like Germany, policy-makers should not waste precious political capital on trying to formalise the ECB’s role as the eurozone’s lender-of-last-resort.

The report urges the eurozone to complete the banking union, and make significant progress on the capital markets union, by 2017. This is a laudable and ambitious agenda. In a more complete monetary union like the United States, private financial connections across state borders help to cushion regional economic developments. For example, if a business in Florida is owned by investors in Boston, both a boom and a recession in Florida will be felt in Boston, too, thereby spreading both gain and pain. Such a ‘private risk-sharing’ across states has been shown to be just as important as fiscal risk sharing in smoothing the business cycle. In the eurozone, such private cross-border risk sharing is underdeveloped, both because cross-border ownership and capital flows are underdeveloped. Banks, in addition, are so closely tied to their sovereign and to their regional economy that in a crisis, they destabilise rather than stabilise the government and the economy. De-coupling banks as much as possible from their sovereign, and making sure that capital markets and banks are diversified across the monetary union, is a crucial step toward making the monetary union more resilient, and the report is rightly setting ambitious goals both in scope and in timeline.

“Completing the financial union is a laudable and ambitious agenda.”

Why the focus on structural reform and ‘competitiveness’?

The report puts a strong emphasis on ‘competitiveness’ and structural convergence between countries, under the headline ‘economic union’ – which not coincidentally is the first chapter. And yet, the four issues outlined above were much bigger reasons for the crisis in the eurozone than the lack of structural reforms. Divergence in wages and prices, for example, was mostly a symptom of the weakness of counter-cyclical policy. Of course, the right mix of structural policies may well help countries to grow faster. But the problem is that economists do not understand very well which combination of structural policies in what sequence is most conducive to economic growth. The best hope for finding the right mix of structural policies is not an outside actor that moves a country closer to some defined benchmark; rather, it is the constant bargaining and local problem-solving that democracy is still best-placed to deliver.

Can the emphasis on economic union be explained politically? There is a political case for structural convergence. If there is ever going to be a true fiscal union, including risk sharing and temporary fiscal transfers, it needs political legitimacy, especially in the currently stronger countries. Such legitimacy is easier to establish if the public of a stronger country does not have the impression that it subsidies a more generous welfare state or laxer labour markets policies elsewhere. This is implicitly the argument that the report makes. But there is also the opposite political case. Since a true fiscal union is not on the cards, the outside meddling in domestic policy issues (and that is how the aim for structural convergence will be perceived in most countries) will delegitimise the eurozone, especially if the focus on structural policies does not improve the citizens’ economic well-being. The proposed measures to create a political union – for example to strengthen parliaments’ involvement in the European semester – are well-intentioned but unlikely to create the European polity that could overcome such national categories of thought and allegiance.

The five presidents’ report is a welcome attempt to focus the discussion on the institutional setup needed to make the euro a success. However, given the limited political appetite for further integration, it is important to focus reform efforts on where they are needed the most: to complete the banking and capital markets unions, as the report rightly recommends; to make the ECB a more activist central bank; and to make national fiscal policy strongly counter-cyclical. Such a policy mix would also be the best hope for escaping the eurozone’s current economic slump. The main obstacle to the implementation of the report will be Germany: neither common deposit insurance nor a common backstop for the banking resolution fund, nor an aggregate eurozone fiscal function and a strengthened MIP (which would target Germany’s current account surplus) will be to the Germans’ liking. If forced to make a choice, Jean-Claude Juncker should focus his political capital on completing the financial union first.

Christian Odendahl is chief economist at the Centre for European Reform.

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