Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday 2 May 2014

The Eurozone: out of the ashes?

I was at a gathering a year or so back in which sensible economists were thinking about the transition path for the Eurozone to full fiscal (and banking) union. They viewed recent events as confirming that monetary union alone was not tenable, and that fiscal union was the way forward. Many share that view. I remember asking whether there was any likelihood that the treaty changes required for fiscal union would find democratic support, given recent events. To say that this interjection was regarded as unwelcome was an understatement.

In one sense this reaction was understandable. Democracy within the Eurozone is a strange thing. On occasions it has been of the ‘last time you voted you got the answer wrong, but don’t worry, we are going to give you a second chance by having another vote’ variety. On others it has been ‘if you vote the wrong way you will have to leave’ type. In these circumstances worrying about democratic opinion and fiscal union may seem beside the point.

But in a way, that is the point. My interjection at that meeting could have been far blunter. How can you be planning to move towards fiscal union when the governance structures of the Eurozone have clearly failed with a more limited set of tasks? That would be a classic economist’s mistake: of designing a set-up which works well in the hands of a benevolent social planner, but falls apart when run by actual politicians.

Take, for example, the ECB. Compared to the US Fed or the UK Bank of England, it comes a poor third. It actually raised interest rates in 2011, making its own contribution to the subsequent recession. It has consistently gone well beyond its remit in promoting certain fiscal policies or structural reforms. It took two years before coming up with OMT, giving us two years of continual crisis. It is only now thinking about QE. A basic problem is that it is not accountable for its actions, which is a serious deficiency for an unelected institution with such power.

The other reason for the 2012 recession was fiscal contraction. If you regard some fiscal contraction in the periphery countries as necessary to correct a lack of competitiveness, then the problem has been the lack of offsetting fiscal expansion elsewhere (not just Germany, but countries like the Netherlands). This has not happened in Germany in part because there is no compelling need within Germany for fiscal expansion: it has been benefiting from the lack of competitiveness of other countries, as its current account surplus shows.

In a fiscal union, fiscal policy is decided at the centre, so these national obstacles to fiscal expansion could be brushed aside. (This, of course, is one good reason why Germans might be rather reluctant to vote for such a union.) But in practice what would aggregate fiscal policy determined in Brussels look like? All the indications are that it would look much like the fiscal policy we currently have: obsessed with debt, and completely ignorant of any significant multiplier effects. The fundamental misunderstandings about fiscal policy that are embedded in German thinking are now deeply ingrained elsewhere.  

To make the more general point, if a core problem is with the governance structures of the Eurozone, then handing those structures more power through fiscal union could be a huge mistake. But this realisation seems to leave us in a horrible position: we do not like the place we are in, we cannot and/or should not ‘go forward’ to fiscal union, yet ‘going back’ by leaving the Euro seems too traumatic. (See, for example, Kevin O’Rourke.)

Yet this may be a too limited, one dimensional point of view. As I have argued before, the 2010-12 crisis and the subsequent recession demonstrated the failure of one version of monetary union, but there are other possible versions. As studies before the formation of the Euro showed, monetary union needs countercyclical fiscal policy. The Eurozone ignored this point, partly because it worried that fiscal policy in the Eurozone would no longer be ‘disciplined by the market’. Until 2010 this fear was understandable, but after Greek default the opposite is true. So the need for central control on that account has disappeared.

The current Eurozone fiscal architecture is chaotic, but within it there are now two mechanisms to discipline national governments. The first and currently dominant is central control from Brussels. The second is national control through a combination of fiscal rules decided at the national level and independent national fiscal councils. Having two systems in place can be a nightmare, but the optimistic view would be that this presents the opportunity for evolutionary change. The central control mechanism could be gradually phased out, but held in reserve for when the national system broke down.

Many years ago I suggested that Eurozone countries could be allowed to opt out from the Stability and Growth Pact if they established their own sound fiscal rules and institutions. There are now enough fiscal councils around that it would be easy to get advice on whether countries had established these sound fiscal rules and institutions. A great advantage of this form of fiscal control is that there are established channels of accountability at the national level. Memories of the 2010-12 crisis, and market discipline, should ensure that a combination of fiscal rules and fiscal councils prevent deficit bias, yet leave scope for countercyclical action when required.

Commission based monitoring would be still needed in the background for two reasons. First, if a government persistently ignored the advice of the fiscal council, or compromised its independence, control at the Eurozone level could be re-established. Second, there may be occasions (like now) when coordination of national fiscal decisions is required, and here a Commission role would be essential.

I am not optimistic that this evolutionary change is going to happen anytime soon. Like any bureaucracy, the Commission will resist a reduction in its power. Germany’s own regional fiscal setup involves strong central control, so it will resist a change like this. Arguably this unholy alliance has helped create the dysfunctional system we now have. However, perhaps at some point countries like France will become galvanised by harmful pressure from the Commission to argue for some kind of alternative. That alternative does not have to be fiscal union, and in some countries a good part of an alternative institutional structure is already in place.


  1. "To say that this interjection was regarded as unwelcome was an understatement."

    I find that disturbing. (Unless it was just "We are here to talk about economics, not politics".)

  2. Surely the single currency (like the ERM before it) requires stability i.e. no asymmetric shocks. One interest and exchange rate and 18 (then) untethered fiscal policies has not worked. In practise these national fiscal Councils would be unable to initiate countercyclical policy because they would be injecting inflation into the eurosystem and the response of the ECB autopilot would be hoist rates (& thereby increase the cost of borrowing and raise the exchange rate) and squeeze out the counter cyclical recovery. In the ERM/ euro world one countries growth is also an asymmetric shock and is unacceptable. If you can't devalue you can't run an effective counter cyclical policy.

    Your fiscal Councils sound just as undemocratic as the centralised policy.

    If it is politically impossible to get the Germans to give ground under the stability pact regime (to the contrary they forced through the uber austerian fiscal pact) then, to my mind, it is beyond the realms of political reality that they would agree to fiscal competition within the single currency area. It is inconceivable that the Commission would agree to be sidelined.

    Any hope of even a moderate counter cyclical policy set depends on a country's prior departure from the euro...

    1. I'm afraid your first paragraph is just wrong. I disagree with the second. In the UK, would you be just as happy for the Commission to do the fiscal forecasting as the OBR?

    2. No doubt my wrongness stems from giving too much credence to all the rhetoric emanating from EU officials emphasising the necessity for stability, no asymmetric shocks etc. Oh and the chronic lack of stability, the recessions that were engineered to protect the peg (in the case of the ERM) & which were only reversed after exit and devaluation.

      As for paragraph 2: A fiscal council with policy making power is just a local gang of unelected technocrats as opposed to an international gang of unelected technocrats. The unelected bit stays the same. If, however, they are just intended to provide an independent forecast then the (ahem) asymmetry problem arising from differing fiscal policies which the stability pact was intended to address remains.

      A single currency which is not backed by a single treasury and a single fiscal policy is a necessarily fragile construct.....

  3. The Euro currency, by ignoring sticky prices and wages, is a neoliberal project; it's straight-up classical economics.

    I expect that would surprise some Tories and UKIPers (and New Labour and Orange Book Liberals), given that they claim allegiance to Thatcher-Reaganism against the apocalypse of the 1970s. But there it is.

    And if the last six years won't shift them then only falling into deflation looks likely - or some political pressure through the election of some unpleasant parties in the upcoming European elections.

    1. It is not about sticky wages/prices, but it is monetarist/new classical in arguing about the importance of rules and policy credibility and breaking inflationary expectations and classical in arguing about the importance of hard currency.

    2. Ignoring sticky wages and prices is not neoliberal - its just wrong!

  4. Good commentary bringing up some issues that I had not considered.

  5. The EZ countries are basically in worse financial shape than before the crisis. Debtlevels have gone up considerably. Deficits are still as crap.
    Same with the banksector, most banks in the South are bust were it not for funny bookkeeping and that kind of stuff. Very little of the mess have been cleaned up.
    Governance structure has somewhat improved (but nowhere near what you would need to make a union function), but on the other hand it there goes something wrong now it is likely simply by public pressure game over at least for the EZ in its current form.

    It is hoping that the market for some reason not get nervous again either for the banks or the countries itself. If it gets nervous there is a huge problem. All the safety shields are simply not big enough. My guess for a year or so now has been this month as most likely candidate for a crash or something similar and I hate to be wrong.
    Anyway hard to see the stockmarket not to far from now tanking at best crashing likely. Which will be the end of the giant 0.8% growth.
    Anyway the figures in some countries like Spain look utter rubbish GDP musy have taken a much bigger hit. Which simply mean that 0.X growth could very well be around 0.0 in reality.

    The problem with the stability thing is. Enforcing is still a huge problem.
    But more important countries go over it not for economic reasons but for political reasons. It might work economically they do it, it might be a disaster and they still would go over it. Simply not an economical thing.
    And the Commission is basically a combination of not having a clue when it is dangerous or not (and it might be helpful for the whole zone) and moronic politics. All have to comply to show that the ones that actually have to comply, comply.

    Doubt btw if the 3% is still ok. It is based on 2% inflation and 2% structural growth. The EZ is running straught in a Japan scenario with low inflation and low growth as half the countries donot have the sound industrial base Japan has while the rest is equal at best. Basically on alot of points much worse, all the Southern PIIGS have ended up in the EM group competition wise (which is completely overcrowded).
    From that pov it should be further reduced.
    Inflation will likely be Japanese like only when worldwide commodity prices get under upward pressure more demand there it will hit in (same again as Japan).

  6. This is another nice example how a model that normally works well under somewhat peculiar circumstances shows a lot of flaws.
    Problem with all the current Hans Brinker policies there are a lot of those.

    Markets look considerably overvalued/-priced. Basically most market participants know this (the large ones do at least that it is very likely), but they are riding the QEwave.
    This creates however a pretty unstable situation. Basically all are gambling on the greater fool. Which is totally unrealistic.
    Reason QE wave plus ZLB or close returns on nearly anything.
    At one point however markets are so far stretched that the upside potential is simply not worth the risk taken. Probably we are there already 3% for 10Y Spain is madness for instance.
    Just extrapolate trends now and markets would go to all time highs within a very short period of time, which is with still a lousy economy completely ridiculous. Even with a great economy it would be.

    Back to my point. As I see it we are close to at best a major correction, worst a crash.
    Further from there cycle might be looking not too bad, but when the market crashes a completely new story will start.

    In other words normal rules are likely to be iverruled by the particularities of the moment.

    Similar with your RE story. Available income vs costs is a pretty good to determine house prices. But if you put your interest artificially low (not Macro low but normnal market low) you get first an impuls. Which as said will likely create a bubble here. And a subsequent down goes usually much faster than up (with some delaying factor).

  7. A New Eurozone is coming.

    Bible prophecy foretells in Revelation 13:1-4, it is out of the European Debt Crisis, that is out of tossing waves of sovereign, banking, and corporate insolvency of the Club Med Nations, specifically Portugal, Italy, Greece, and Spain, that a New Monster is rising to replace the Creature from Jekyll Island. It is completely different from the Interventionist of creditism, corporatism and globalism. The Regional Animal, has the form of a leopard, feet like those of a bear and a mouth like that of a lion; and thus operates by stealth, roots outs it enemies, and devours its prey by crushing, ripping and tearing them apart.

    And as seen in Revelation 13:5-10, there is a Regional Leader waiting in the wings of Europe’s stage, who will soon step into the limelight, and through cunning and shrewdness, will rise to power through regional framework agreements, to rule the Eurozone, with the help of a Regional Monetary High Priest, seen in Revelation 13:11-18. The word, will and way of the Sovereign will replace all traditional constitution, national and historic law. And that of the Seignior will establish seigniorage, that is moneyness, for all residents of the EU. The mandates of fascist leaders will coin diktat money which will establish economic value and grease the wheels of economic activity.

    In the age of credit the economy, there were two economic goods, consumable output and leisure, demanded by households. Now in the new economy, that is the age of debt servitude, there is increasingly one economic good, consumable output demanded by regional fascist leaders.


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