While the EU, and the euro zone, experience a few days of quiet in the dying dog days of summer, it may be worthwhile considering what awaits decision-makers not only in Europe but — in an era of global financial markets where tremors in one part of the world spillover onto other financial markets with striking speed — for the rest of the world.
Over the past several months we have heard time and time again that the euro zone is not an "optimal currency area." That much is plainly obvious but even the creators of the common currency concept understood that the main motive was a political one. Back then, it seemed easier to persuade politicians, and the public, that a common currency was a logical step towards a greater political union, contrary to the historical experience with currency unions. The common currency step, in advance of a stronger political union, was simply a gamble that politicians took and managed to persuade more than a few of their electorate, to buy into. After all, Europe was determined to set aside its quarrelsome past and what better symbol to show the world that conflict was a thing of the past than by creating a monetary union? Moreover, in advance of the introduction of the euro, there had been considerable progress in creating a Single Market where goods, services, and capital could easily move across borders. The idea that policy makers in the 1980s did not understand that monetary union without some form of fiscal and political union could spell trouble is pure fiction.
What is now equally clear is that the apparent early success of the euro — especially the spectacularly successful delivery of new euro notes and coins across the euro zone — made it easier for policy makers, and more than a few economists, to fall asleep at the switch. Most observers shrugged at the possible impact that successive "asymmetric" shocks would have on the internal build-up of imbalances that would end up (exacerbated by a "global" financial crisis that would engulf the U.S.) as the European sovereign debt crisis. Even the "teuro" (an amalgam of the German word "teuer," or expensive, and euro) controversy in Germany (where else?) that lingered did not deter the policy makers and "experts" from celebrating the success of the single currency.
Just as economists began to understand that single currency areas, with all of the theoretically required characteristics of "optimality," do not exist, they also began to contemplate the possibility that, once in place, a monetary union may well begin taking on some of the features of extant and apparently successful monetary unions (e.g., the US or Canada). And, why not? The so-called "endogeneity" of common currency areas seemed like a sensible outcome even if, at birth, the euro area was a bad idea.
The thinking was as follow: The longer a single currency is in place, the more familiar markets and the public become with prices and transactions in the euro. Combined with the elimination of barriers to the movements of goods, services and, to a lesser extent, labour, one would expect the continued presence of the single currency to influence market behavior in the direction of viewing developments through the prism of a single economic area and not dominated by country-specific considerations. Eventually, the euro would look like most other single currency areas. After all, if regional differences co-exist in federations, such as Canada and the U.S., then why should it be different in the euro zone? Or, rather, why couldn’t the euro zone develop the qualities of successful currency unions over time as it became more entrenched in the daily lives of its citizens?
In the economic sphere, observers from many walks of life underestimated how retention of sovereignty in areas of fiscal policy, banking and financial regulations, conspired to choke the forces that would make an otherwise sub-optimal currency union more optimal in the longer run. In the political sphere — and with apologies to the late U.S. Congressman Tip O’Neill’s phrase that “All politics is Local” — citizens in Europe, let alone those who live in the euro zone, have never been given a real opportunity to create a political class that could be held accountable to their constituents. Few even care about elections to the European Parliament because, in Europe, "local" still means that politicians elected in each one of the EU member states’ political chambers continue to have far more influence on their lives than do Members of the European Parliament.
So we are nearing a turning point of a sort. There are many other loose ends that need to be addressedeyond the ideological battle between those who favor austerity first (followed debt relief for good behavior) pitted against those who believe that economic growth can only be stimulated via more short-term deficit spending now and a credible plan to restore fiscal balance later when economic growth returns to some historical norm.
There are, of course, a number of pressing issues at the political level that, no doubt, also need to be tackled. But, the economic loose ends must come first, before markets and the public (in many parts of the euro zone especially) completely lose patience with the status quo and force politicians to tear down what they have been building for over five decades.
These include:
- More coherent coordination between fiscal and monetary policy. Contrary to the impression left by some that the strains between fiscal and monetary policy are a peculiar feature of the euro system, the failure of monetary and fiscal policies to work in harmony always leads to a painful end. If few question the viability of the U.S. monetary union then why does the so-called "fiscal cliff" that the country is being driven towards such a concern? Simply because monetary policy is trying to do what it can while politicians ignore that it is increasingly out of synch with a fiscal policy that is hostage to special interests and in limbo until the Presidential elections are over. In contrast, Canada has since learned that monetary and fiscal policies cannot behave as two solitudes. No wonder Mario Draghi, the ECB’s President, begs euro zone politicians to develop a euro area wide mechanism to deal with fiscal questions. Remember the "fiscal compact" that was supposed to deal with the problem? It failed to deal with current fiscal realities. Instead, it appeared to reinforce notions that, as far as each euro zone member is concerned, "we are definitely not in this together."
- A credible common banking and financial system regulator and supervisor. Once again, the myth persists that, if only there had been a single regulator and a banking union, the sovereign debt crisis in Europe would not have happened and there would be financial stability today. In the UK, for example, the institution responsible for financial system stability, failed in its remit only a few years after it was made independent from the Bank of England (BoE) because it could not or did not communicate with the monetary authority. Now, the BoE is once again back in charge. Similarly, in the U.S., where regulatory responsibility remains diffuse – but less so than before the global financial crisis – there was a realization that the lack of a central authority, (once believed to represent protection against the possibility that a single institution might be tempted to internalize or sweep under the rug conflict between monetary and financial stability objectives) may well be needed precisely because the link between the two objectives remains unclear. Of course, time will tell whether centralization is the right choice. In the European context, permitting sovereign states to retain authority over financial regulation simply facilitated the ability of some of the sovereigns to rely on their banks to help finance their profligate fiscal policies while further hampering the ability of the single central bank, the ECB, to manage the spillovers from financial stability to and from a single monetary policy.
- Debt mutualization. Regardless of the understandable concerns that German authorities, among others, have expressed over the possibility that euro bonds are a back door way to subsidize the bad financial behavior of some of the less disciplined states of the euro zone, there is no getting around the fact that financial markets will only believe that the euro will survive if there exists a liquid market for debt that is backed by the power and cooperation of the collection of states that make up the euro zone. Proposals to create a common bond issue — that is eventually retired and which absorbs some of the excessive debts accumulated by some euro zone members — neither addresses the need for such debt, nor the underlying problem. First, what credibility is there that this form of debt mutualization is a once and for all measure? Second, why only include debts that exceed what is now widely regarded as an artificial ceiling for debt to GDP ratios, a relic of the Maastricht Treaty? More importantly, individual euro zone members, especially the most influential ones, will only be able to apply the necessary discipline and demonstrate that they have "skin in the game" if, through the issue of a common debt pool, they reveal their ability to manage their fiscal policies in a coherent fashion. The introduction of euro bonds does not imply that individual euro zone members will not be able to raise funds on their own. Instead, markets will be in a better position to assess the relative need for such funds and the prospects for repayment. Prices for these instruments will then better reflect the underlying risks for these sovereigns.
There are a host of other issues that would take too much space to discuss, including how sovereign debt needs to be restructured and the degree to which this type of debt is subordinate, or not, to other debts. The bottom line, however, remains the same. There is a long list of important things to do and time is not on the side of euro zone policy makers.