The euro's reality gap

The euro's reality gap

Bulletin article
01 June 2010

Europe faces a critical choice between greater integration or disintegration. The gap between the rhetoric of a united Europe and the reality of national interests and politics has always dogged the EU. Until recently, it caused little harm other than to make outside observers disdainful of Europe. However, that gap is proving lethal for the euro. Unless reality is brought into line with rhetoric, the eurozone could unravel.

The package of measures unveiled on May 10th to stabilise the eurozone is impressive. An additional €60 billion has been earmarked to assist countries with severe balance of payment problems. The EU will establish a 'special purpose vehicle' (SPV) with funds of up €440 billion to provide loans to struggling member-states. The IMF will guarantee half as much again. And in a major U-turn, the European Central Bank has started buying the government bonds of eurozone countries. EU leaders argue that all this will put an end to "speculative attacks on the euro". The subtext is that the markets are over-reacting and that investors are essentially conjuring up a crisis so that they can profit from it.

Speculation has not caused this crisis, however. The underlying problem in the eurozone is one of solvency, whereas the EU's bail-out package is designed to address a liquidity crisis. The markets are therefore right to remain sceptical that it can work.

Unless the economic growth prospects of Greece, Portugal, Spain and Italy improve, their debts will prove unsustainable. In order to qualify for loans from the SPV, they will have to meet strict timetables for reducing budget deficits. But what if that proves impossible? The EU has bought itself some time – struggling eurozone economies should be able to refinance their debts for around three years – but it has not addressed the underlying cause of the crisis.

The eurozone currently fulfils few, if any, of the criteria for a successful currency union. There are varying degrees of trade integration between the participating economies, but they are far from fully integrated. Nor are they flexible – in most places labour markets remain tightly regulated and numerous sectors are sheltered from competition. Labour mobility between the eurozone countries is virtually non-existent. There is no mechanism to either prevent the emergence of huge trade imbalances between the members or to deal with them when they arise. These problems might be manageable if there was a fiscal union to transfer funds between the countries, but there is not.

As things stand, it is hard to see how the struggling countries can grow their way out of trouble. They need a big external stimulus to offset budget cuts and falls in real wages at home: their exports need to grow faster than their imports, for a lengthy period. Since they have no national currencies to devalue, they will depend on stronger demand elsewhere in the eurozone and on their companies becoming more price-competitive. But both requirements could prove elusive.

First, the EU lacks a tool to make Germany and other eurozone countries with big external surpluses rebalance their economies. Their governments still do not recognise that the deficit countries cannot rebalance until the surplus countries do so. Second, the best way for the southern eurozone countries to become more price competitive is to raise productivity. The financial package does give them a breathing space to push through structural reforms. But such reforms will only boost productivity in the long term. These countries do not have much time, which means they have to ensure that wages grow less rapidly than in the rest of the eurozone (a feat achieved by Germany and the Netherlands in the past). The markets are rightly sceptical of the ability of the Southern Europeans to pull this off. It is one thing for a member-state to cut wages relative to the rest of the eurozone when most member-states' wages are rising rapidly. It is much harder to do so when wages elsewhere in the eurozone – especially Germany – are stagnant or falling. Moreover, if every economy in the eurozone attempted this simultaneously, the result would be slump and deflation. The only way out of the eurozone's fiscal straight-jacket is stronger economic growth. But that requires more consumption and investment in the bloc's surplus countries, especially Germany. On May 12th, the European Commission proposed tighter policy co-ordination within the eurozone, with a view to reducing trade imbalances and ensuring closer scrutiny of the underlying sustainability of countries' public finances. If adopted, these proposals would be a welcome step forward. Unfortunately, it is hard to imagine the governments of the countries running big surpluses granting the Commission the power to demand changes in their tax and labour market policies. But unless the Commission is able to do this, the extra powers to monitor government budgets that the Germans and others want to give to the EU institutions will achieve little.

If macroeconomic imbalances persist, a fiscal union will be essential to the eurozone's survival. But the obstacles to such fiscal supranationalism are daunting. The crisis has cruelly exposed the limits of solidarity between the member-states. And far from forming the embryo of a fiscal union, the latest financial package threatens to undermine that solidarity even further. Governments will be called upon to underwrite a succession of huge loan guarantees to struggling member-states, but these economies will remain in crisis because the underlying problems have not been addressed. This will hardly be conducive to persuading sceptical Germans of the merits of a fully-fledged fiscal union.

The eurozone is on an unsustainable path. That is no fault of the markets. It is the result of the gap between European rhetoric and reality. There needs to be an acknowledgement that if the euro is to work it will require greater integration. The problem is that most countries did not realise this when they signed up to the single currency. Political elites need to start explaining why further integration is essential.

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