As part of ECFR's Reinvention project, we are running a series of blog posts looking at particular thematic issues facing Europe as it attempts to deal with the financial crisis. In the second of the series Jean Pisani-Ferry looks at the economic side of the crisis.
In the two years since the outbreak of the Greek crisis, much has been done to rebuild the architecture of the European Economic and Monetary Union (EMU). There is now a crisis management regime in place and crisis prevention has been strengthened through the six-pack legislation and the new fiscal treaty. This is by no means a trivial achievement. But more is needed, for two reasons, one systemic and one macroeconomic: first, the very concept of a bare-bones EMU, whose only two pillars are monetary and fiscal, has not survived the crisis; second, Europe still lacks a consistent strategy to tackle the adjustment problem between its North and its South. Action is urgently required on both fronts.
Start with the systemic issue. Financial integration – a premier achievement of the first EMU decade – has suffered a major setback since the beginning of the crisis. The euro area financial landscape is increasingly being fragmented along national borders. Countries in the periphery have been suffering a sudden financial arrest. Private capital that had flown massively to the South of Europe before the crisis has been returning to the North and the gap is being filled by official flows, particularly Eurosystem liquidity. Furthermore, consistent evidence suggests that national supervisors are making things worse by letting banks in their jurisdiction reduce their cross-border exposure. So the same euro that was considered the natural complement of the single European financial market is actually in the process of undermining, if not destroying, the single financial market. The process under way is undermining the euro itself, because a financially fragmented euro area would lose a significant part of its economic raison d’être. More, the unwinding of cross-border interlinkages reduces the potential cost of a break-up and thereby makes this option gradually more workable.
In this context the banking issue has gained increasing relevance. The escalation of the euro crisis revealed that a strong correlation between sovereign and banking stress represents a major threat for monetary union. The vicious cycle is rooted both in the home bias that still prevails in the banks’ bond portfolios and in the fact that, absent a supranational crisis resolution framework, national governments are solely responsible for backing up their banking systems in case of insolvency. The policy response to date has mostly relied on the temporary ease offered by the Eurosystem’s large-scale provision of liquidity and the strengthening of capital and liquidity requirements. But to make EMU resilient, a more systemic approach is needed: the link between banks and sovereigns has to be broken. Corresponding reforms all involve stepping up European integration significantly, be it through the joint issuance of government bonds (to provide banks with a genuinely safe asset) or through the establishment of a ‘banking union’ (with a common regime for deposit insurance, supervision and crisis resolution). In other words the solution is bound to involve more risk-sharing among euro-area members.
Germany is reluctant because both a banking union and Eurobonds can serve as channels for transfers. This is a legitimate concern. All insurance schemes can serve as implicit conduits for redistribution and Germany has reasons to fear that it would find itself on the giving side. But this is a motive to be tough on the preconditions for, and the design of such schemes, rather than to deny that they are part of what is needed to stabilise the euro area.
The macroeconomic issue is no less challenging. Southern Europe has massively lost competitiveness vis-à-vis the North, its public finances are in dire conditions and the private sector is over-indebted too. Thus far, Europe has concentrated on the fiscal dimension of this nexus, with consolidation packages being implemented across the board under the pressure of Germany, the EU institutions and the sovereign bond markets. The implicit assumption is that budgetary retrenchment will drive the whole macroeconomic adjustment process. Certainly, a sometimes unprecedented dose of fiscal consolidation is needed to make public finances sustainable and regain market confidence, but the adjustment Eurozone members need to go through is not exclusively a fiscal one. The relative pace of private and public sector deleveraging is a very delicate issue, as both are desirable but each complicates the other. Moreover, competitiveness comes at the expense of budgetary sustainability, at least in the short run, because price deflation worsens the debt dynamics.
Europe thus far has not devised a proper strategy to address this complex nexus. The policy discussion has concentrated on the need for policy changes in Southern Europe, but the EU lacks a comprehensive approach to its internal rebalancing. In reality, price competitiveness in the countries in trouble cannot be considered in isolation. It is by nature a relative concept. Within a currency union, rebalancing competitiveness inevitably means adjusting relative prices, and assuming that the ECB sticks to its 2% inflation target, lower prices and wages increases in the periphery mean higher prices and wages increases in the North.
The growth theme that France aims at introducing in the policy discussion should be used to this end. It cannot be interpreted as meaning that each and every country can grow out of its problems. Adjustment in Southern Europe is needed, and this inevitably implies recession or at the very least stagnation. The European macro conditions in which this adjustment takes place matter, however. To put it simply, it is much easier for a country like Spain to become a place to invest in profitably if wage growth in Germany is 4% or 2% annually. In the former case, competitiveness can be regained faster and without giving rise to a vicious debt-deflation cycle. In the latter one, there is a risk for Germany to end up supporting its neighbours through transfers. From a German standpoint, it is hard to dispute that wage increases at home are preferable to pay-outs to the neighbours. This is perhaps why Minister Schäuble declared on May 4 that he would welcome such increases.
Banking union and a comprehensive rebalancing strategy are by no means the only two items on the policy agenda of the euro area. But a move on these two fronts would go a long way towards addressing the core problems the monetary union has to face at this juncture. They should be prioritised by the heads of state in the new discussion that is starting after the French presidential election.
Also in this series:
Tibor Dessewffy on populism in Hungary - "Leaders will play by EU rules only as long as their interests so dictate, and this is heightened by the sense that the crisis is sinking Europe as a whole"
Hans Eichel on Franco-German leadership - "Merkande must avoid making Merkozy’s mistake (due in particular to the French part of the tandem) of publicly presenting the other European partners with faits accomplis"
Ivan Krastev on Soviet lessons - "it is Germany’s view of what is happening in the Union that will more dramatically affect the future of the European project than the troubles of the Greek or Spanish economies."
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