The Dilemma: Fiscal Union or Break-Up

Professor Rodrigues made an important contribution to helping us think clearly about what can happen in the eurozone and what would be the consequences. In a reaction to the presented paper, let me make four general observations and then comment on her scenarios. Let me make clear that I am speaking in my personal capacity, and none of my views expressed here should be attributed to the Slovak Ministry of Finance.

First, the conventional wisdom here in Slovakia is that the euro is a political project without any economic fundamentals. This is clearly wrong. There are actualy two competing economic rationales that are behind european monetary integration. One is the optimum currency area: an idea that if some of the countries are interlinked enough, cooperating enough, trading enough, investing enough together, they should have common currency. Obviously, this was never the case for all the members of the euro area. Nobody with enough intellectual honesty ever thought that that was actually the case.

On the other hand there is a rule in the management of the small open economies – an impossible trinity of sorts – which says that you can only have two out of three  things: fixed exchange rate, independent monetary policy and free movement of capital. What happened in late 1980s was that the EC members tried to build an economic union with fixed exchange rates, free capital movement and independent monetary policies. There were some agreements about common monetary policy, but especially countries in the periphery where cheating on it, so in the end they ended up with looser monetary policies, so with free capital movementthe fixed exchange rates had to go. That was the reason for the exchange rate crisis in Europe in the early 1990s.

Both national leaders and bureaucrats in Brussels were trying to learn a lesson from it. They’ve decided that there will be no independent monetary policies in Europe. Therefore they’ve created the European Central Bank and the common currency.

And this is the economic story behind euro. It is very difficult, if not impossible, to have economic union with independent monetary policies: We’ve tried and we’ve failed. Unfortunately, on the other hand, we’ve created monetary union among countries that are not an optimum currency area. The tension between these two notions is actually the economic root of our current problems. It is not – by and large – a story of fiscal profligacy, with the possible exception of Greece. It is not a story of politicians coming to Brussels and creating something out of thin air. It stems from the economic fundamentals.

My second point touches upon an institutional challenge. We’ve tried to build  institutions to counteract some of these problems. We had the Lisbon Strategy, now we have the EU 2020 strategy. We’ve had cohesion policies. But when you look at these instruments, which should help building something resembling a full-fledged economic union, they were never as binding as the fiscal or monetary arrangement. The Stability Programme is an important document and is taken seriously both here and in Brussels. National Reform Programmes are just loose talk. It has rarely been translated into any kind of action. Nobody in Brussels or Slovakia actually thought that it is something binding which will guide government policies.

In a reaction to the current crisis, we have created another set of fiscal institutions and rules. But they cut only in one way: in the way of more fiscal austerity. When you want to persuade a country to spend more money than they want (think Germany), or coordinate a fiscal stimulus across Europe, you don’t have the instruments. But when you spend less money than you should, some might argue like Germany is doing right now, there is nothing in Brussels, or in the Eurozone, or in the European Union which can force you to spend more.

My third point is a question – what are we going to do about some of the countries with unsustainable debt levels? I’m not talking only about Greece, but also about countries like Italy, which has primary surplus, but a huge debt and slow growth, and even countries like Belgium. If we are heading into a slow-growth world, and an ageing world, some of these countries will have problems, which may be difficult to solve even in the medium or long term, the current situation notwithstanding. The EU as a whole, and the Eurozone as a whole, has a better debt-to-GDP ratio than the US or Japan. But some of its members might not be able to sustain their debt levels over a decade or two. There are two possible solutions. One of them is debt mutualisation – explicit or via higher inflation, the other is at least partial write-down, or managed bankruptcy.

My fourth point is political. People keep asking whether we can build some kind of the European political community. This is the wrong question. The right question is whether some kind of European political community already exists, albeit in a rudimentary form, on the ground across peoples of Europe. If people do already think in terms of European identity. Because if this is not the case, then we cannot really have a sensible, workable, effective, efficient set of rules at the European level, which will have any kind of democratic legitimacy. If we don’t have this European political community already emerging in the hearts and minds of the people in the member states, you cannot really create it from top down, by some agreement on the national level. You can shape it, you can influence it, but you cannot create it. I’m quite optimistic about this, but many people I talked to say that I’m naive.

As far as Professor Rodrigues’s study is concerned, I think that two scenarios are more realistic than others: Scenario A is just a prelude to Scenario B. If we continue with business as usual, at some point sooner or later, this month or the next year, we will probably end up with Scenario B – at least a partial Eurozone breakup. Some others quantified the impact of partial Eurozone breakup on the European economy and the estimates edges from -1 % to -11 % GDP cummulatively in 2012 and 2013. It is not the end of the world, but it is a very serious downturn, at least comparable with the Great Recession of the 2008-2009. The political impact of such a development for the future of Europeis hard to estimate, but it obviously will be serious as well.

Why do I think that fiscal union within a smaller core group wouldn’t work? I think it could work, but only in the impossible event that would tie Germany to the peripheral countries, with countries such as Austria and Finland left out. That is clearly not the case. What would happen is that rich countries with triple-A ratings would come together and create their fiscal union, while the periphery would be left out. So there would be no transfer of wealth from the core to the periphery, no debt mutualisation, no risk sharing, nothing like that. Obviously, it can happen, but without keeping all of eurozone intact. At least some of the Southern countries would have to leave the euro, or at least default on their debt. Then we would again end up with Scenario B, with the resulting fiscal union in the core as a bonus.

That leaves us with attempts at more fiscal integration. If some kind of European demos already exists on the ground, we can try to achieve fiscal union in the Eurozone along the lines of Scenario D. If we do not, and continue with  muddling through as usual, there will be more trouble in the periphery, with the resulting shock waves felt across the whole continent.

This column is part of the Eurozone Scenarios Project of the Friedrich-Ebert-Stiftung and Social Europe Journal. The long version of the scenarios paper can be downloaded here. A Statistical Annex is also available.