Europe must change nature of its union
ECONOMIC COMMENT:HERE IS the biggest question about the euro zone: can we envisage a set of reforms that are not only politically feasible and economically workable, but would let it prosper, as it is. If so, what might they be?
We already know that, as designed, the euro zone did not meet this test. Hence all the improvisation of today. The original design created huge imbalances. When the flow of finance dried up, these delivered a wave of financial and fiscal crises and a legacy of unaffordable debt. Furthermore, the forces driving those imbalances generated divergences in competitiveness. These also need to be redressed, as quickly as possible.
In response, the euro zone has developed a strategy based on fiscal austerity and structural reform. In addition, the European System of Central Banks, as lender of last resort, and the International Monetary Fund and euro zone governments, via the temporary European Financial Stability Fund and, soon, the permanent European Stability Mechanism provide indirect financing for fragile economies and sovereigns. The €100 billion proposed rescue of Spanish banks is the latest example of this strategy at work. It is unlikely to be the last.
Will the strategy work? Probably not. As Mark Cliffe and his team at ING note, in a report entitled Roads to Survival, a good way to think about the challenge is in terms of the external and internal imbalances bequeathed by the incontinent cross-border lending prior to the crisis.
If external deficits are to be reduced, domestic demand must shrink. If done too swiftly, this would raise unemployment, possibly enormously. In the long run, high unemployment, aided by market-oriented reforms, should drive down nominal wages. But this could take many years.
Meanwhile, persistently weak economies mean a growing mountain of bad private debt, high fiscal deficits, rising public debt, high interest rates and extremely fragile financial systems.
This strategy, then, looks neither politically feasible nor economically workable. Now consider alternatives. A federal union, with a federal government that finances spending throughout the union, is certainly economically workable. We have many examples: the US, Canada, Australia, Switzerland. But we can safely say that, whatever the position may be a century from now, the euro zone is very far from able to share such a government.
A less ambitious – but still ambitious – alternative would be a transfer union, by which I mean a system of permanent transfers from richer to poorer member countries, as is normal within countries. This is surely politically infeasible. Above all, it is neither necessary nor desirable from the economic point of view. It is unnecessary for poorer countries to run sustained current account deficits, provided wages remain in line with productivity (as ceased to be the case for several members during the pre-crisis boom). It is undesirable for countries to receive large and sustained net transfers, because that tends to entrench backwardness.
If the current policies seem unlikely to work and either a federal or a transfer union is ruled out on grounds of political or economic infeasibility, what is left? I suggest the combination of two ideas: “insurance union” and “adjustment union”.