The Evolving Euro
In a previous post we argued that the current fiscal relationships in the euro zone are not sustainable as the members have moved away from the „no bailout” system by implicitly accepting collective liability for a part of the debts while strict conditionality has not always followed. We also claimed that there are only two ways to move to a stable fiscal relationship – either to 1) move towards a tighter fiscal union with the member states giving up more of their fiscal sovereignty while the EFSF/ESM and the ECB would offer temporary support or 2) to explicitly move back to the „no bailout” system by letting the weakest members default. Finally, we stated that we felt that the move towards a tighter fiscal union was the less risky alternative as defaults might be followed by exits from the EZ and political turmoil and that might ignite a process of disintegration in the EU that would risk running out of control.
Now the EZ has taken several further steps towards a tighter fiscal union. The European Commission has outlined its plan to create a common supervisor for all EZ banks. The German constitutional court has allowed ratification of the European Stability Mechanism and rejected complaints against it as largely unfounded. The European Central Bank last week offered its support to governments that would enter into a macroeconomic adjustment program with the EFSF/ESM and accept strict conditionality with respect to bringing their fiscal houses in order and implementing structural reforms. While the EZ might now be closer to turning the corner, there are several important issues that remain untackled or insufficiently addressed, both with respect to designing Eurozone 2.0 and dealing with the current emergencies.
Fighting the fires of debt overhang and youth unemployment
A key issue in the EZ going forward is how to reignite growth. While the Compact for Growth and Jobs adopted by the European Council on 29 June outlined a number of steps such as continuing structural reforms and raising the lending capacity of the European Investment Bank, there is still insufficient attention to several key issues impacting growth.
One of them is the overhang of public debt. Even if further increase in debt to GDP ratios in the EZ is soon halted, in several problem countries the debt to GDP levels will be above the 77-90% range beyond which the public debt burden has been shown to have significant negative effect on growth (see e.g. Caner et al. and Reinhart and Rogoff). This means that the public debt levels have to be brought down by means of either sizeable privatization of state and municipal assets, which could be a condition in the macroeconomic adjustment program, or by way of debt restructuring, although the latter is exactly what the European leaders have so far been trying to avoid with the sole exception of Greece. However, debt restructuring does not necessarily have to happen on the state level, it can also take place on the municipal level.
The other key area that we believe is insufficiently covered is dealing with youth unemployment. Here among other things it should be possible to learn more from the dual system of vocational training in Germany where apprenticeships in companies are successfully combined with formal vocational school education. Another policy option is temporarily (for example, for up to a year) exempting young people with limited or no previous full-time work experience and their employers from making social security contributions when hiring them, thereby significantly lowering the marginal cost of employing a young person who has just finished school.
Eurozone 2.0: dos and a don’t
Deposit flight from fiscally weak member states to those perceived as stable is unlikely to be completely stopped before an EU wide deposit insurance scheme is in place. If there is not sufficient trust in the solvency of a sovereign, a deposit insurance scheme supported by it cannot work. While a single deposit guarantee scheme for the EU was proposed already in June, a detailed roadmap toward it is still lacking. Another necessary building block is a common bank resolution mechanism, which is also still being developed. Completion of the banking union is necessary to break the vicious circle of fiscally weak states trying to support struggling banks, which, in turn, are major lenders to the states.
However, pushing ahead with the financial transactions tax (also called Tobin tax) proposal is counterproductive. It is strongly opposed by the UK and Sweden whose own experience in the 1980s has proved its ineffectiveness (see Aslund). At least as long as the financial transactions tax is not applied uniformly across the major financial centers, imposing it will just result in trading activity moving elsewhere and the tax revenues being many times lower than expected. Moving ahead with banking regulation that is unfriendly to London as a financial center will also make the prospects of the UK joining the EZ even more remote than they are today.
An important adjustment mechanism in a currency union is labor mobility. However, labor migration, in particular, if it is not of temporary nature, has far-reaching implications for the national social security systems that the EZ and the EU still haven’t addressed. In particular, if working population migrates to another country in the EU, they would pay social contributions in the host country while the current pension liabilities of the home country under the pay-as-you-go system remain unchanged. To solve this issue the EZ and, more broadly, the EU would need to create a „pension union” that would guarantee a minimum purchasing power standard adjusted pension across the EU paid from the EU budget. At the same time a part of the national social security contributions would have to be paid into the EU budget. Needless to say, harmonization of the retirement age across the EU would be one of the prerequisites of such an arrangement.
Conclusion
The Eurozone has been in a state of change already for several years. Democratic decision making takes time and it is clear that Eurozone 2.0 will not be launched for several more years. The president of the European Commission in his recent State of the Union address admitted that completion of the new design would require changes in the EU treaties. Nevertheless, Eurozone 2.0 should be designed in such a way as to make it stronger and more flexible, not more exclusive. Mundell’s question of what countries and what characteristics constitute an optimum currency area remains as relevant in 2012 as it did in 1961.
References
Aslund, Anders. 2011. „Sweden’s Experience with the Tobin Tax”, http://www.piie.com/blogs/realtime/?p=2433 Peterson Institute for International Economics, 3 October 2011
Barroso, José Manuel Durão, 2012. State of the Union 2012 Address, the European Commission, 12 September 2012.
Caner, Mehmet, Thomas Grennes and Fritzi Koehler-Geib, 2010. „Finding the Tipping Point – When Sovereign Debt Turns Bad”, The World Bank, July 2010.
European Council. 2012. Conclusions of the European Council, 28/29 June, 2012.
Reinhart, Carmen M. and Kenneth S. Rogoff, 2010. „Growth in a Time of Debt”, National Bureau of Economic Research, January 2010.
Spiegel. 2012. „Germany to Help Train Europe’s Jobless Youth”, http://www.spiegel.de/international/europe/german-labour-office-to-provide-job-advice-for-struggling-eu-nations-a-852359.html , 27 August 2012.
8 Responses to “The Evolving Euro”
Tom • September 12th, 2012 at 7:26 pm
The EZ’s institution building especially fiscal union still seems very tentative and fragile. The ESM with only half a trillion I would call dabbling in fiscal union. ECB OMT effectively increases the ESM’s spending by covering its secondary-market flank, but still leaves open the possibility of ESM being exhausted in Spain and Italy.
The biggest vulnerability now is the constant brinksmanship that will be playing out between bailout recipients and donors, already in Greece, soon in Spain. There’s a kind of MAD doctrine about it that seems to keep donors stringing recipients along without seriously enforcing reforms.
ThomasGrennes • September 12th, 2012 at 10:38 pm
Yes, the gamesmanship by creditors and debtors illustrates the moral hazard problem. The backward-looking orientation of reformers has also been a destabilizing factor. Although crisis managers often use expressions, such as "building fire walls", they
have not yet succeeding in isolating the problem.
Aegean1972 • September 13th, 2012 at 3:05 am
Europe realised that it is about 30 years delayed in its unification process. And now they are trying to catch up the lost time, while being inbetween their worse debt/political crisis of the last 30 years. The answer to Europe's general problem is strong growth. JOBS! But this is the era of delevaraging and we are also heading for the peak of joblessness for the middle class in the western world. Thats not a good coincidence.
So how is Europe (or america) going to bounce back in such a "perfect storm" situation? The answer isnt simple. But it will certainly require strong political will and major changes. Politicians (in the last 40 years) have been working for the lobbies/sponsors, not for the people. And thats what got us here in the first place. If that doesnt change soon, expect major social unrest all over the western world.
The time to make changes is NOW. Because it will take a decade for things to get back to "normal". If and only if major changes are made and corporations realize that without a middle class their earnings will collapse. And when earnings collpase so do organizations.
ThomasGrennes • September 13th, 2012 at 1:12 pm
Yes, growth is crucial, but not easy to achieve. The dilemma is that it is difficult to find
policies that are not too austere for short-run stabilization but also provide sufficient
discipline to address long-run debt problems. The United States faces the same dilemma, and makers of fiscal policy in Europe and the U.S. have lost their credibility
when they promise to deal with long-run policies.
Tom • September 13th, 2012 at 5:26 pm
Thanks for that. To me these weaknesses seem inherent with aid-for-reforms and unsolvable. The only way to enforce any conditions is with the threat of being frozen out of aid. The risk of economic factors leading to default is lessened but a new risk of political factors leading to default appears.
ThomasGrennes • September 13th, 2012 at 10:18 pm
Response to Tom: Yes, Eurozone authorities have substituted a political process for an
economic process in the bond market. The bail out is intended to stabilize the credit market, but it increases the importance of political risk. A prospective buyer of sovereign bonds must always take into account the ability and willingness of a debtor government to repay its debts. Now it must also consider the ability and willingness of creditor countries to extend the bail out. For example, if the interest rate spread on Spanish government bonds decreases, does this signal an increase in the probability that Spain will repay, or a greater likelihood that Germany and other creditors will extend the bail out?
EdDolan • September 14th, 2012 at 3:13 pm
"Deposit flight from fiscally weak member states to those perceived as stable is unlikely to be completely stopped before an EU wide deposit insurance scheme is in place."
I agree a comprehensive deposit insurance scheme is a key to stopping deposit flight from weak EZ members. However, the scheme would have to not just ensure against insolvency of individual banks, but against a country's exit from the EZ. That is, there would have to be a guarantee that the depositor could withdraw euros even from a solvent bank in the case where a country leaving the EZ declared that the banks could redenominate deposits into the local currency (as was done in Argentina, if I remember correctly.) That would be pretty radical insurance.
Even that radical variant of insurance could not guarantee against a complete collapse of the euro in which all countries returned to national currencies and the ECB ceased to exist. Maybe the insurance agency could promise to pay depositors in some weighted basket of national currencies?
Andris_Strazds • September 17th, 2012 at 2:00 am
Ed, the Economist had a piece on this a few days ago. http://www.economist.com/blogs/freeexchange/2012/… Such an insurance could be provided by the ECB, not the deposit guarantee scheme. It would be pretty radical, though, as you say.
