Europe’s sovereign-debt problems have prompted a search for more effective approaches to economic governance in the European Union, particularly in the euro area. Having mounted exceptional efforts, first to provide financing for Greece’s adjustment programme, and then to create a safety net for other distressed countries, the European Council established a task force, chaired by President Herman van Rompuy and composed largely of EU finance ministers, to make proposals for reform.
The van Rompuy Task Force will submit its final report in October.
At the euro’s planning stage, most observers fell into two camps. Some believed that the absence of political union – reflected in the euro’s lopsided design, which centralised monetary authority but left budgetary and other economic policies (largely) in national hands – would ensure the common currency’s failure. Others believed that the euro itself would trigger political unification.
Neither view has come close to reality so far – and it remains unclear whether the current proposals will settle the issue, in particular, by clarifying what elements of political union are essential for the euro’s survival.
In retrospect, then, the euro appears to have been a hazardous experiment. But the decision to move towards monetary union reflected what seemed most urgent and politically possible at the time: elimination of intra-EU exchange-rate instability, which had dominated the policy agenda for decades.
There was no support for centralising any significant elements of fiscal policy – nor is there today. But such a transfer of authority was not seen as necessary back then for monetary union to work.
Instead, the euro’s founders believed that exposure to deeply integrated markets for goods and services and a tough competition regime would keep national price and cost trends broadly in line, and that common and simple fiscal rules would prevent individual countries’ budgetary behaviour from deviating strongly.
The fiscal rules, later elaborated into the Stability and Growth Pact, are in themselves elements of a political union.
The original vision was that this set-up would help to assure a growth-friendly policy mix, with fiscal prudence keeping interest rates low on average. This approach was chosen not only because of political expediency; “indirect coordination” was seen as economically superior to the more direct coordination implied by “economic governance.”
Indeed, the adoption of fiscal rules was seen as a necessary substitute for the harsh discipline that financial markets had previously exercised over EU countries. It was recognised that, once a country adopted the euro, financial-market discipline would be constrained to credit spreads on sovereign debt – which turned out to be even smaller than foreseen, as interest rates converged to a remarkable degree until 2007-8.
Governments and EU institutions were unwilling to draw the attention of financial markets to the weakness of the single currency’s two underpinnings: the fiscal rules were ignored, and national price and cost trends diverged, partly explaining the emergence of growing country imbalances within the euro area. Increasingly, the small spreads between sovereign bonds relied on the implicit assumption that no euro area member would be allowed to get into major difficulties, despite the constraints imposed on intergovernmental rescue operations.
Fiscal discipline came back with a vengeance last year, when the state of public finances in a number of countries had deteriorated massively, owing to the recession and financial-rescue packages. In line with past experience in emerging economies, excessive market tolerance was rapidly replaced by very pessimistic assessments of debtor prospects.
Once contagion effects within the euro area became ominous, governments reacted by overseeing the Greek adjustment program and by creating the European Financial Stabilisation Facility (EFSF), a temporary safety net for other major debtor countries. Both initiatives were coordinated with the International Monetary Fund, ensuring strict conditionality on the external finance obtained. Having gained time, EU governments, the European Commission, and the European Central Bank have now turned their attention to improving future governance. Understandably, the initial efforts of the van Rompuy Task Force were directed at more effective crisis prevention: intensified budgetary surveillance and monitoring of movements in real exchange rates and external imbalances.
A number of useful initiatives are under way in both areas. However, in normal times, the policy recommendations arising from intensified monitoring – as well as the ultimate imposition of sanctions – will have to continue to rely on the persuasive power of discretionary decisions taken by the EU’s Economic and Financial Affairs Council (ECOFIN). A country in trouble retains primary responsibility for correcting policy.
Improved surveillance – and the scary experience of having confronted the potential costs of being deprived of access to international financial markets – offers hope that the decentralised model for the euro area’s non-monetary policy components will work better than in the past.
The future role of financial markets in disciplining budgetary policies under such a reformed regime depends to a major extent on the ability of the van Rompuy Task Force to define a crisis-management mechanism to replace the EFSF. Neither this new mechanism, nor potential ECB purchases of bonds issued by the weakest euro area sovereigns, should be allowed to undermine the critical role that financial markets can play in supplementing the closer mutual monitoring of policies.
A future crisis-management mechanism – if, indeed, governments can agree on one at all – should retain some ambiguity as to how the insurance provided to member states will operate, focusing instead on procedures, in particular regarding creditors’ participation in sharing losses, and on the principle of IMF involvement in shaping loan conditionality. Leaving scope in this way for financial markets to impose discipline offers the best hope for maintaining individual countries’ primary responsibility for their non-monetary policies, which was central to the original vision for the euro.
©Project Syndicate, 2010, www.project-syndicate.org.
The author is professor of economics (emeritus) at the University of Copenhagen, and was an independent member of the Delors Committee on Economic and Monetary Union in 1988-1989.