Today’s Eurozone operates in a way that is momentarily advantageous for capital-owners in the surplus countries and creditors at large, but damaging for workers and entrepreneurs, debtors of all types and most users of public services. This column argues that this is unsustainable. The Eurozone must be reformed to avoid the risk that the EU itself could be destroyed by political conflict among the winners and losers. 2014 is a window of opportunity for seriously re-considering the Eurozone’s functioning and for moving away from the ‘Maastricht orthodoxy’. To recover from stagnation and regain citizens’ trust, Europe needs a genuine paradigm shift on the Eurozone.
The most important reform in Europe today is that of the Economic and Monetary Union (EMU). However, one could get the impression that this reconstruction process has stalled before it even properly started.
A year and a half after the first report of the ‘Four Presidents’ (Van Rompuy 2012), today’s policy debate on the EMU’s deepening appears strikingly modest when compared to Europe’s economic woes and growing fears of a strong result for Eurosceptics and populists in the May 2014 European elections.
With EU unemployment stabilised since the summer at around 26.6 million people, annual EU GDP growth projected at 0.0% and euro zone inflation hovering below 1%, 2013 might be considered the year of pure stagnation. Such an image, however, masks growing divergence in countries’ socio-economic outcomes, particularly inside the Eurozone. The core-periphery gaps in unemployment rates, NEET rates, household income developments, at-risk-of-poverty rates or income inequalities keep widening.
After years of recession and unemployment at unprecedented high levels, it is no surprise that the Eurozone periphery’s growth potential is falling, undermining the entire Union’s growth prospects and lengthening the spell of financial sector deleveraging. But our policy response can easily be perceived as more of the same. A feeling of inertia seems to pervade the EU debate, with observers developing caricatures of an elitist ‘Brussels consensus’ allegedly as firm as it is aloof from the continent’s reality.
In fact, there is some debate, and economic policy has shifted in various ways since 2012. The timeframe for fiscal consolidation has been slightly extended, the ECB has impressed the markets with its resolve, and wages in Germany have timidly grown, which just about explains the modest GDP rebound in mid-2013. More recent examples of progress include the ECB’s forward guidance, agreement on an EU-wide Youth Guarantee backed by €6billion inside the EU budget, and the Commission’s decision to launch an in-depth review of Germany’s current account surplus as a potential macroeconomic imbalance.
However, in the absence of a manifest new policy paradigm, the small steps of the economic recovery appear to be random or improvised. Without structured and intellectually coherent thinking about the way forward it is also more difficult to identify the further measures that are needed, and choose the right speed of implementation.
In the last 18 months, we have been in a mental transition from the old paradigm which I call ‘Maastricht orthodoxy’ and some others call ‘Berlin consensus’. In the first phase of the Eurozone crisis, this paradigm delivered the software for the very incremental crisis response often associated with the Franco-German ‘Merkozy’ tandem. But while the approach to European economic policy has changed somewhat, it has not changed enough: the EMU construction continues to be fixed through small repairs, instead of addressing its fundamental design flaws (De Grauwe 2013).
What are the key assumptions of the ‘Maastricht orthodoxy’ and why are they unhelpful in the current economic and political context?
1) The EMU can function and be sustainable without significant common fiscal capacity or institutionalised solidarity mechanisms between member states
Even when monetary policy has hit the zero lower bound and had to resort to increasingly unorthodox measures, fiscal stimulus through cross-country transfers or debt relief is considered extremely reluctantly by many policy-makers who prefer to avoid the idea. The fact that a currency union of structurally diverse countries needs a common budget to cope with asymmetric shocks and ensure counter-cyclical stabilisation was documented already in the 1970s in the Marjolin and MacDougall reports of the European Commission, the latter advocating a common budget of 5-7% of GDP (excluding defence). The IMF also advocates fiscal risk-sharing in the euro zone to reduce its vulnerability to shocks and to strengthen private investors’ confidence. For the moment, only a strict Fiscal Compact has been introduced, constraining national fiscal policies. The function of fiscal policy could be partially re-created through a fiscal capacity at the EMU level, for which many technical options have already been developed.1 However, the upcoming European Council debate appears to be geared towards discussing only small-scale transnational ‘solidarity’ in the form of (most likely) preferential loans or carve-outs from deficit rules, conditional upon implementation of structural reforms.
2) Internal devaluation is the best, if not the only way to restore competitiveness on the Eurozone periphery.
Due to the absence of common resolution mechanisms for unsustainable public or private debt or at least common fiscal shock absorbers in the EMU, the impact of financial sector bubble-bursting has been highly asymmetric. In the absence of exchange rate adjustment, fiscal stimulus or temporarily higher inflation to accelerate the rebalancing process, reduction of labour costs and household incomes has been the main mechanism for troubled countries to improve their trade balance and achieve primary fiscal surplus so as to prove solvency to foreign creditors. Because internal devaluation at a time of deep downturn in the Baltic countries was followed by a rebound in GDP, the Maastricht orthodoxy tends to prescribe this recipe for simultaneous use even to much larger euro zone economies, despite its clearly contractionary effects and the fallacy of composition. While internal devaluation may increase profit margins in adjusting countries, this may not necessarily boost investment if the economic environment is contractionary and asset prices fail to fall as fast as wages and pensions. But even if internal devaluation were a good economic cure and a functional equivalent of currency devaluation, we would need to acknowledge that its social impact is much more severe than that of the pre-Maastricht version. Moreover, the euro’s appreciation since 2011 has largely neutralised the peripheral countries’ international competitiveness gains obtained through internal devaluation.
3) All member states should have current account surpluses, and the bigger they are, the better off we will be.
So far, solidarity in the EMU has been limited and lukewarm: emergency loans to EMU countries experiencing private capital outflows have been made conditional on strict programmes of fiscal consolidation and internal devaluation, elevating primary fiscal surplus as a new key priority of economic policy. Growth, employment and other Treaty objectives have become de facto secondary. As public expenditure and imports were cut, current accounts of the deficit countries improved, but aggregate demand in Europe fell. At the same time, countries with current account surpluses faced almost no pressure to adjust. Their wage growth has remained modest, and high savings rates have far exceeded domestic investment. The surplus countries export their capital outside Europe through the financial sector (with very mixed results), while overall demand remains deficient. The Maastricht orthodoxy ignores that higher growth could be achieved – in Europe and globally – with a different allocation of income, involving higher wages, lower inequalities, higher investment in Europe’s economy and lower current account surplus. Such a model would also be more conducive to geographically more balanced growth and to fulfilling citizens’ expectations “beyond the GDP”.
4) Unemployment is due to supply-side rigidities only.
The Maastricht orthodoxy tends to focus on labour market reforms rather than employment policy. It does not appreciate that unemployment can be caused to a large extent by cyclical factors (deficient demand for labour) for even prolonged periods of time, and focuses on structural reforms on the labour market’s supply side, such as reduction of employment protection legislation, skills mismatch, strengthening of labour mobility, lowering of unemployment compensation to ‘incentivise return to work’, and decentralisation of collective bargaining to enable greater flexibility in wage-setting. While Europe certainly needs greater skills investment and a better-connected labour market enabling people to exercise their free movement rights, other supply-side reforms in the present context of collapsed demand risk being ineffective or even counterproductive. Without an off-setting fiscal and/or monetary expansion and industrial policy stimulating creation of new jobs for unemployed people to move to, lowering of employment protection, unemployment benefits or wages results in further reduction in aggregate demand. It is to no avail if firing is easier and workers are up-skilled thanks to EU funds, unless companies invest in new productive activities where labour could be reallocated. That is also why ‘flexicurity’ is an inadequate labour market paradigm today and a more comprehensive employment policy is needed, including a significantly lower tax wedge on low-paid labour, decisive investment in the green, white and digital economies, and greater labour market resilience to economic changes, based on better social dialogue.2
5) The ECB has to focus only on price stability (of AAA-rated countries).
The ECB’s Treaty mandate is unique among other large central banks in that it has price stability as the sole primary objective, with growth and employment as secondary. The ECB interprets this mandate through a nominal inflation target of ‘close to but below 2%’, which it is severely underachieving at present. Year-on-year inflation of 1.2% in Germany coupled with 0.8% in Italy, 0.7% in France, 0.0% in Spain and -1.9% in Greece (all figures October 2013). Coupled with very low or negative growth, it means that the Eurozone’s weaker economies are sinking deeper into debt, from which they cannot recover in the absence of expansionary monetary, fiscal and/or wage policies at home or somewhere else in the currency union. Experience of the past few years has confirmed that a central bank influences the economy in many more ways than by maintaining price stability – for example it can help to avert a liquidity crisis (LTRO) or prevent self-fulfilling prophecies threatening the currency union (OMT). The ECB has acted innovatively, but it could do more (and earlier) for economic growth if it were allowed to.
6) Moral hazard is a greater risk than long-lasting recession on the EMU periphery.
The Maastricht orthodoxy’s taboo on fiscal transfers between EMU countries and reluctance to consider solutions such as common debt issuance is based on the fears of some governments about having to explain to domestic taxpayers and other voters why they write cheques for other governments. On the other hand, in countries suffering prolonged recession, governments have to explain to their taxpayers and other voters why they are not able, together with their European partners, to get the economy going, create jobs and enable repayment of old debts. While employment, education and social policies and other public investments are largely of national competence, national governments have been decreasingly able to influence socio-economic outcomes and consequently have been losing voters’ trust. Technocratic governments installed in troubled countries during some of the most acute moments of the Eurozone crisis managed to carry out fiscal consolidation and overdue structural reforms but wielded little influence over the Eurozone’s aggregate fiscal stance or the use of surplus countries’ excess savings; hence they also unsurprisingly failed the electoral test. Sticking to the Maastricht orthodoxy will lead to steadily weakening of the pro-European mainstream in Southern European countries, and some of these countries may not be far from a disastrous situation where Eurozone membership and democracy are no longer compatible.
In conclusion, today’s functioning of the EMU may be momentarily advantageous for capital-owners in the surplus countries and creditors at large, some of whom also espouse the ‘Maastricht orthodoxy’, but it is damaging for workers and entrepreneurs in the real economy, debtors of all types and most users of public services. This dynamic is not sustainable: it must be either altered through reform of the EMU, or the EU itself risks being destroyed by political conflict between the EMU’s winners and losers. Not everyone may perceive such risk as acute, but even those who are optimistic about the Union’s political resilience should be concerned about the near certainty of a long period of low economic activity, high unemployment and accumulating social hardship in Europe, i.e. secular stagnation or weak recovery, with no improvement in member states’ capacity to promote quality employment and public services.
The fact that the Eurozone has become a club of creditor and debtor countries contributes to a policy stalemate instead of progress. The financial and economic asymmetries fuel political polarisation too, and unbiased and legitimate actors that could help overcoming the divide are not many. It is no surprise that a former President of the European Commission recently considered it necessary to encourage the formation of a ‘Latin front’ as counterweight to Berlin’s views. Indeed, changing the under-performing paradigm requires initiative not only from those who have represented it, but also from those who have been negatively affected by it.
So can we move away from the failed orthodoxy? Could we start working on a Fair Deal? Can we start serious discussions about a more ‘social Maastricht’ or at least a more complete EMU with an institutional framework and policy mix that favour real economic growth over mere ‘adjustment’? The key responsibility lies with each member of the European Council, as well as with leaders seeking a mandate from European Parliament elections. Real controversy is needed if any progress is to be made.
Let us not forget that the single currency never was a purely financial or economic project. It was launched two decades ago with a strong political mandate to help keeping Europe united. However, the euro can only fulfil its unifying mission if the costs and the benefits of the EMU are more fairly distributed among the participating Member States, and if the rules of the game help boosting the growth potential of all of them. To deliver this, we need a new paradigm.
De Grauwe, P (2013), “Design Failures in the Eurozone: Can they be fixed?” LEQS Paper No. 57/2013, LSE.
Van Rompuy, H (2012), “Towards a geuine Ecoomic and Monetary Union”, at http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/134069.pdf