A new economic architecture emerges from the Euro-crisis
Dr Michael Arghyrou is a reader in Economics, and is internationally recognised as a leading expert in European economics, providing regular commentary to major media organisations.
In this article, Dr Arghyrou argues that fiscal centralisation and increased market pressure on governments are vital to strengthen the economic union of the Eurozone.
Euro-governance: Never fit for purpose?
The global financial crisis of 2007-2009 and the subsequent, still ongoing, European sovereign debt crisis, revealed serious flaws in the institutional design of the Economic and Monetary Union (EMU). It has become evident in the intervening years that the original Euro-governance framework could never guarantee the long-term sustainability of the Euro.
As a result of these deficiencies, the steps taken to preserve the Euro were largely improvisational – reactionary responses to the pressure of events.
In 2012, to provide an integrated institutional response to the European crisis, the Van Rompuy report (from the then-President of the European Council) set four major themes for the future direction of travel:
- the creation of an integrated economic policy framework
- the creation of a European banking union
- the creation of a European fiscal union
- ensuring the democratic legitimacy and accountability of economic/financial decisions in the EMU area
Progress in these areas has been slow and in the meantime the Eurozone has had to deal with the fallout from an unsuitable governance framework.
Exposure – the Greek crisis
The Greek crisis can largely be explained by Greece’s deteriorating fiscal and macro-fundamentals during the period 2001-2009. However, its intensity and effect on other Euro periphery countries could have been mitigated. If the EMU had a credible crisis management infrastructure in place, the issues could have been dealt with at an earlier stage and the spread halted.
However, during the crucial period between November 2009 and March 2010, EMU authorities failed to provide a credible commitment that Greece and, by extension other periphery countries under market pressure, would definitely stay in the Eurozone.
Markets perceived the failure to provide this commitment as a withdrawal of the previously perceived fiscal guarantees. As a result, the Greek crisis spread to other EMU countries, as markets switched from the pre-crisis convergence trading model to a pricing model based on international risk and national fundamentals.
This resulted in the majority of periphery countries losing access to international sovereign bond markets and increasing segmentation of the European banking system. In turn, this posed serious challenges to the single monetary policy and the process of economic recovery.
What we learned
First, in all periphery countries the crisis has an undisputed supply-side background: The size of macro, fiscal and banking imbalances accumulated between 1999 and 2007 was large enough to make a significant, equilibrium-restoring, economic downturn in these countries unavoidable, as the demand-driven levels of economic activity had to adjust to significantly lower levels of natural output.
These imbalances were the result of the inadequate pre-crisis Euro- governance infrastructure and markets’ failure to impose penalties on countries accumulating them.
Second, the crisis could have been less severe if the EMU had in place credible institutional backstops stabilising expectations by convincing investors that default on public debt and collapses of national banking systems would not be allowed to happen.
Structural changes for a new dawn
The roots of the European fiscal and banking crises lay in significant supply-side divergence among the EMU member-states preceding the Euro’s creation, which were further reinforced following the Euro’s launch in 1999.
To address the deficiencies described above, European authorities have been putting in place the building blocks of a new, and overdue, European economic architecture:
- First, to create a more effective framework to prevent the accumulation of fiscal, external and financial imbalances. This is pursued through the Fiscal Pact, the Euro Plus Pact and the introduction of a single banking supervision mechanism. The latter allows banks following excessively risky business models to have their operations’ licence withdrawn; while the two pacts postulate that countries not complying with fiscal and other macro targets may eventually face financial fines.
- Second, if a national banking and/or fiscal crisis does occur, put in place effective backstops containing the extent of the crisis nationally and preventing it from spreading to other countries. On the banking front, this means deciding bank resolutions at the union level and having in place harmonised national deposit guarantee schemes. On the fiscal front, the new framework allows for financial support through programmes of financial assistance and potentially unlimited European Central Bank (ECB) intervention in the secondary market for sovereign bonds.
- Third, the new euro-governance framework must achieve higher market discipline being imposed on banks and sovereigns. As far as the former is concerned, bank resolution is governed by the principle of bailing-in bank shareholders and creditors; with regards to the latter, no explicit mechanism exists.
Overall, the post-2010 institutional reforms have gone some way towards addressing the shortcomings of the pre-crisis Euro-governance system.
However, banking institutions and national authorities still operate under not entirely binding inter-temporal budget constraints. As a result, the moral hazard problem is not eliminated – countries taking more risks because others bear the burden of those risks – and the imposition of market-imposed discipline is undermined.
What does the future hold?
We should complement the monetary union with a full fiscal union, as envisaged by the Van Rompuy Report, and grant the ECB officially the role of lender of last resort. These solutions, however, are politically impossible for the foreseeable future.
The second-best option is to achieve a higher degree of fiscal co-ordination/harmony yet this is also strongly resisted on moral hazard terms. It raises important questions about democratic accountability/legitimacy, which only a high degree of political integration (if not a fully political union) can resolve.
Compared to the pre-crisis regime, the progress so far achieved towards building a new European economic architecture is limited and not fit to prevent future crises.
Given the current political constraints, the most feasible and effective way forward is to explore channels increasing further the markets’ ability to exercise pressure on national authorities towards delivering sustainable economic outcomes. This sets a challenging agenda for academics and policy-makers alike.