What went wrong?

Source: The Economist

In the night between the 8^th and 9^th December the European Union took a step closer towards becoming a fiscal union. Or rather a “fiscal compact”, as it has been called. Or perhaps a “stability pact on steroids” as Wolfgang Münchau referred to Angela Merkel’s proposals before the summit. However you decide to call the fledgling product of an intense night of fraught negotiations, there is no doubt that the 26 countries who signed up to it ceded a hefty chunk of their national sovereignty to the European machinery. Tax and spending plans will now be supervised at the European level and automatic sanctions will be triggered by profligate government spending.

In many ways this pact seeks to address the woeful flaws in the original Stability and Growth Pact forced on the recalcitrant European Community members by Germany in 1997. The Pact was a classic example of the “turkeys don’t vote for Christmas” dilemma. Under its original rules, when a country exceeded the government deficit limit of 3% of GDP or the debt-to-GDP ratio of 60%, the Council of Economic and Finance Ministers could issue a warning to the offender on recommendation of the Commission. Should the country not mend its spendthrift ways, a name and shame policy would ensue whereby the warning would become public. In the event of public opprobrium not being sufficient to cajole the country back into the straitjacket of fiscal rigour, the Council had the option of applying sanctions. Herein lies the snag: the countries applying the sanctions are the same ones that could find sanctions being applied to them at some point in the future should they deviate from the road of fiscal discipline! There was no incentive to set a precedent by applying the sanctions and every incentive to close an eye on excessive spending. Thus in 2003 the excessive deficit procedure (as this rather convoluted process is known) was not enforced against, lo and behold, France and Germany, the latter having preached the mantra of fiscal rectitude since its macroeconomic policy was blighted by the woeful Weimar Republic.

Source: BBC

But despite what many believe, the original flaws of the euro lie not in fiscal profligacy alone. In fact, Greece was arguably the only country blithely throwing money around in the run-up to the crisis; Spain actually had a budget surplus on the brink of the crisis. There was a debt problem, but this was in the private sector. Fuelled by the low interest rates afforded by the introduction of the euro the private sector, most notably companies and mortgage borrowers, embarked on an unprecedented spending spree. Thus whilst Spain's government may have succeeded in not breaching the 3% deficit limit, it oversaw an unrestrained debt-fuelled boom. What's more, southern europe's debt-hungry markets were happy to buy up Germany's exports, thus  fuelling Germany's surplus. And to further compound the problem,  Germany's excess savings, as a result of its citizens' frugality, were  siphoned off into spendthrift countries.

Source: BBC

 Another phenomenon we have witnessed since the introduction of the single currency has been an asymmetric shock within the eurozone. According to two policy experts “Germany’s wage trends have been themost important cause of the euro crisis. Those wage trends created anasymmetric shock that destabilized Europe”. Since the euro’s introduction Germany “ruthlessly held down wages” in an attempt to boost its competitiveness, aided by the artificially low exchange rate, whilst other members, most notably the Mediterranean countries, let their wages rise excessively. Germany thus boosted its competitiveness at the expense of its southern European neighbours, creating an asymmetric shock that fed into the current economic crisis. Whilst to claim that “Germany adopted a beggar-thy-neighbour export model” is a bit excessive, the competitiveness gap is certainly at the heart of the euro’s travails.

Source: BBC

You might be forgiven for thinking the euro’s design flaws ended here. Alas, policy-makers overlooked another crucial aspect of monetary unions, namely that of some sort of fiscal stabiliser. In most successful monetary unions, there is also a degree of fiscal union to allow for diverging economic conditions in its constituent regions. In other words, a region as diverse as Europe ought to have allowed for some sort of stabilisation mechanism to allow its members to deal with asymmetric shocks. This would have enabled them to adjust wages and prices without the grinding recession that they are witnessing now. Such “cushioning” mechanisms can be achieved through a partially centralised budget (not a fiscal superstate as some commentators would have you believe), where falling tax revenues in an adversely affected region will be compensated by rising revenues in a boom region. However, the enormous political implications of even a minimal budgetary centralisation make it an unfeasible option, at least for now.

Source BBC

What ought to have happened then was a closer coordination of macroeconomic policies, i.e. a sort of fiscal union which would have prevented the asymmetric shock and thus not placed the eurozone in such a precarious position regarding the current economic crisis. Furthermore, the only mechanism that policy-makers did not fudge, the single monetary policy, has been rendered essentially useless as an adjustment mechanism because of the vast differences in the economic conditions of member states. As Paul Krugman writes, the competitiveness divergence has to be reversed, and there are no two ways about it. Either prices rise in the north, or they fall in the south. Obviously the first option would require higher inflation than the fiscal hawks in Germany or in the European Central Bank are prepared to accept. Inflation is anathema, as such they have forced swingeing cuts on their southern neighbours which is merely compounding their recession. In attempting to balance between the different needs of the eurozone member states, the ECB has arguably interpreted its mandate of price stability too narrowly, placing the burden of adjustment entirely on southern Europe.

Source: Cartoon Stock

Southern Europe ought to have tackled the competitiveness gap long ago, when the piercing eye of the markets was not focused on its every move. Now that the eurozone finds itself in the eye of the storm it ought to abandon its fixation with price stability and recognise that with no room for fiscal manoeuvring because of ballooning deficits, indebted states cannot keep forcing austerity on their economies when global demand is sputtering. The long-term adjustment ought to be coupled with a short-term loosening of monetary policy, even if this leads to slightly higher inflation.

When the euro was conceived twelve years ago policy-makers thought, naively, that they could divorce monetary and fiscal policy. In their blind pursuit of the European unification dream they blithely waved away economic and political practicalities, crossed their fingers and hoped that members’ fiscal policies would somehow align themselves automatically. Events of the past year have made that hope look like a forlorn pipedream.