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European Debt Crisis – Economic Collapse In 3 Minutes
Reforms to Avert a Breakup
If one wishes to minimize the likelihood of breakup, then what kind of reforms is needed? Here, there is no magic potion, only the standard measures pointed to by the literatures on optimum currency areas (OCA) and the democratic accountability of economic policymakers.41
Measures to further enhance labor mobility within the euro area are a first set of reforms pointed to by OCA theory.42 Regulations to ensure that French ski resorts extend equality of treatment to instructors trained in other European countries-and more generally, the removal of residual barriers to the mutual recognition of technical credentials, the portability of pensions, and the receipt of social services-will relieve the pressure that countries with depressed labor markets otherwise feel to do something, anything, including reintroducing the national currency, to address their unemployment problem. Concretely, the European Union has made some progress in the requisite direction, making qualifications more transparent and transferable by creating a standard portfolio of documents (the“Europass”), removing many remaining administrative and legal barriers to mobility, coordinating cross- border social security provisions through the introduction of a European health insurance card, and making occupational pension rights more portable.
Note, however, some uncomfortable implications of this advice. Facilitating labor mobility within the monetary union implies reinforcing barriers to immigration, legal and illegal, from outside the union. Australia allows citizens of New Zealand to work freely in its country, and vice versa, but only New Zealand permits the relatively free immigration of citizens of Fiji.43 Customs and immigration officials in Australia spend much of their time repatriating illegal Fijian immigrants entering through New Zealand, straining the arrangements designed to ensure integration of the two national labor markets. In the European context, limiting the strains on the labor markets of the countries on the receiving end of the labor flow and hence the political fallout may require limiting immigration from outside the union. Among other things, this may mean limiting labor mobility from North Africa and the Middle East, regions where earnings differentials vis- à- vis the European Union are large and where the efficiency effects of freer labor mobility would be especially pronounced.44
Harsh treatment of undocumented immigrants from these countries may also create strains with their governments, which would not be helpful for a European Union that is trying to encourage democratic values and market- oriented economic development in what is sometimes referred to as “Wider Europe.” One can even imagine differential treatment of workers from EU member states that have and have not adopted the euro. Allowing, indeed encouraging, workers to relocate freely within the monetary union would become more uncomfortable politically if workers from member states outside the
euro area were also permitted to freely migrate to relatively prosperous euro area member states. One can imagine political pressure to situate the immigration ring- fence at the borders of the euro area, not at the borders of the European Union itself. In the short run, this would create problems for the Schengen Agreement, which has been implemented by Denmark and Sweden, as well as most euro area member states.45 In the longer run, it is likely to create strains between EU members inside and outside the fence and to disrupt the operation of the single market.
The idea that euro area member states would only take measures to further enhance labor mobility among themselves if there was also a credible barrier against immigration from tiny, prosperous Denmark is not especially compelling, but one can imagine such concerns becoming serious if and when, say, Turkey is admitted to the European Union. Measures to enhance the countercyclical use of fiscal policy are the other reforms pointed to by the literature on optimum currency areas. European countries are uncomfortable with their loss of monetary autonomy, because having tied the monetary hand behind their backs; they have little scope for using fiscal policy counter cyclically. Inherited debt ratios are high, which means that increasing deficit spending in slowdowns threatens rating downgrades and increases in borrowing costs. The Stability and Growth Pact, whatever the practice, in principle limits the scope for discretionary fiscal policy and even automatic stabilizers in countries close to or exceeding its 3 percent of GDP threshold for excessive deficits. To be sure, for countries like Portugal, where the problem is excessive labor costs and inadequate competitiveness, expansionary fiscal policy to boost aggregate demand is beside the point; the imperative is to cut labor costs, and using fiscal policy might only slow the inevitable adjustment while threatening debt sustainability.
Still, one can imagine a variety of other countries suffering negative aggregate demand shocks that can be offset by temporary increases in budget deficits that would benefit from greater freedom to use fiscal policy in countercyclical fashion. For them, reforms of the Stability and Growth Pact that encourage governments to run budgets close to balance or even in surplus in good times so that they can allow deficits to widen in bad times would make life with the euro more comfortable.46 My own view is that reform of the Stability and Growth Pact should encourage changes in fiscal institutions and procedures that work to solve common-pool and free-rider problems and thereby contain deficit bias in good times.47 The alternative, where the European Commission and Council agree to fines and sanctions against countries whose deficits are deemed excessive, assumes a level of political solidarity-a Europe in which different nationalities view themselves as members of a common polity, such that a majority of members can impose fines and sanctions against a renegade minority-that does not exist and that is unlikely to exist for the foreseeable future. In the absence of deeper political integration, in other words, a stability pact with anything resembling the current structure is unlikely to be enforceable.48
The same conclusion applies to proposals to strengthen the operation of the monetary union by supplementing it with a European system of fiscal federalism. A system of temporary transfers among member states or an expanded EU budget where contributions and expenditures are keyed to a member state’s relative economic situation could provide an alternative to a national monetary policy as a buffer during periods of cyclical divergence.49 Economic activity would be more stable, because intra country transfers would render demand more stable. But making such transfers effective would require significant expansion of the EU budget, especially insofar as the majority of that budget is tied up in agricultural subsidies and ongoing transfers to relatively low-income member states. And again, significantly increasing the share of tax revenues that member states pay to the European Union and whose disposition is then decided by the member states as a group would require a level of political solidarity that does not exist.
Another way of thinking about this is that fiscal federalism is an insurance pool through which members of the monetary union that are temporarily better off assist their brethren who are temporarily worse off-participants require a system of collective self- help if they are going to willingly expose themselves to the vicissitudes of monetary union. Rodrik (1996) has made an argument like this to explain why more open economies have larger governments-their citizens are willing to expose themselves to the risks of trade openness only if they can count on help from their stronger neighbors in the event of a temporary worsening of their economic situation due to international competition. The analogy here is that countries suffering temporary unexpected economic costs as a consequence of their participation in the monetary union would accept the latter only if they can temporarily expect transfers from their neighbors to buffer the effects. The difference is that Rodrik’s argument applies to citizens of the same country, whereas the present argument concerns transfers between sovereign states. One suspects that the citizens of different countries will be less enthusiastic about giving money to one another; lacking a common national identity, they lack the requisite political solidarity, absent significant steps toward political integration at the European level.50
The European Union is made up of diverse national identities, and absent a sense of European identity, resistance to such transfers may be considerable.51 At the level of the European Union, there is also the question of whether a system of interstate taxes and transfers could be agreed on for a subset of member states-those participating in the monetary union-without the active involvement of non euro area members.
A similar implication flows from the observation that the risk of a breakup could be reduced by enhancing the democratic accountability of the ECB. The modern literature on monetary policy distinguishes a central bank’s operational independence and democratic accountability. A central bank should have the independence to select and implement its tactics independent of political pressures, but in choosing the objectives at which those tactics are directed, it should be answerable to the polity. National central banks ultimately answer to national legislatures, which have the power to alter their statutes in the event that those responsible for the formulation of monetary policy are perceived as pursuing objectives inconsistent with their mandate-where the latter is decided by the polity as a whole.52
But in Europe, there is no euro area or EU government that can act as an effective counterweight to the ECB.53 The powers of the European Parliament are limited relative to those of national parliaments and legislatures. The Parliament holds hearings at which the president of the ECB delivers a statement and answers questions but cannot threaten to replace the president in the event of disagreement over objectives. The mandate of the ECB is a matter of international treaty, signed by the governments of the member states, and cannot be altered by the Parliament. Altering it requires the unanimous consent of the member states, which would be a formidable obstacle in practice.54 This means that the ECB is less democratically accountable than the typical national central bank. In turn, this leaves less cope for the European polity to influence its objectives. In the event of serious disagreement, political groups that object to how the central bank chooses to operationalize its mandate are likely to choose exit over the relatively ineffective option of voice.55
Making voice more attractive would require giving the European Parliament more power to refine the institution’s mandate and replace the president and perhaps other members of the board in the event of serious disagreement over objectives.56 But there was a reluctance to significantly enhance the powers of the European Parliament during the constitutional convention process of 2003/ 2004, reflecting majority sentiment against creating anything resembling a European government. And even limited steps in that direction were resisted by the French and Dutch electorates in their referenda on the draft constitution. This is a reminder that monetary union without political union is problematic.57 Because the latter is not likely to change anytime soon, collapse of the former cannot be dismissed out of hand.
41. An earlier attempt to ask these same questions is found in Cohen (2000).
42. These are supplemented by measures to enhance the flexibility of real and nominal wages. The ECB (2007) argues that real wages remain less flexible in the euro area than in the United States and that the degree of wage bargaining centralization and percentage of employees organized in trade unions-actors likely to condition the extent of such flexibility have remained largely unchanged. At the same time, there has been a reduction of wage minima affecting young people and the implementation of subminimum wage regulations for youths in some euro area countries, which some would argue has enhanced wage flexibility in certain segments of the labor market. Such arguments would suggest that further reforms along similar lines would make it easier for countries suffering shocks requiring downward wage adjustment to cope with the single currency. This would appear to be the ECB’s own view (see the same reference).
43. For whose foreign policy it has traditionally borne responsibility.
44. For arguments to this effect, see Rodrik (2002) and Bhagwati (2003).
45. And, by Norway and Iceland
46. To be clear, I am not arguing that the 3 percent ceiling is too low but rather that it leaves inadequate room for countercyclical policy, because deficits are excessive in good times. There are too many alternative reform proposals for these to be usefully surveyed here. See Fischer, Jonung, and Larch (2007) for a survey of alternatives.
47. On fiscal decentralization as a source of common- pool problems, see Rattso (2003) and Eichengreen (2003). My own scheme for reform is as follows. The rationale for the pact is that deficits today may imply deficits tomorrow and that chronic deficits will force the ECB to provide an inflationary debt bailout. But not all deficits are equally persistent. Chronic deficits are a danger only where countries fail to reform their fiscal institutions. Countries with large unfunded pension liabilities, such as Greece and Spain, will almost certainly have deficits down the road. Where workers are allowed to draw unemployment and disability benefits indefinitely, deficits today signal deficits tomorrow. Countries that have not completed privatizing public enterprise, such as France, are similarly more likely to find future fiscal skeletons in the closet. Where revenue- sharing systems that allow states and municipalities to spend today and to be bailed out tomorrow, central governments will almost certainly suffer chronic deficits. Thus, the pact should focus not on fiscal numbers, which are arbitrary and easily cooked, but on fiscal institutions. The Council of Ministers could agree on an index of institutional reform, say, with 1 point each for privatization, pension reform, unemployment insurance reform, and revenue- sharing reform. It should then authorize the European Commission to grade countries accordingly. Those receiving 4 points would be exempt from the Stability and Growth Pact guidelines, as there is no reason to expect that they will be prone to chronic deficits. The others, in contrast, would still be subject to warnings, sanctions, and fines.
48. This argument has a long lineage; see, inter alia, Kindleberger (1973) and Eichengreen (1997). As De Grauwe (2006) puts it, while the European Commission decides when a country’s deficit is excessive and when its government must therefore cut spending and raise taxes, it is the national government that must implement those tax increases and spending cuts and that will be rewarded or punished for doing so by its constituents. In contrast, the commission cannot be replaced, except in the event of dereliction of duty. In effect, the commission-and therefore the Stability and Growth Pact-lacks democratic legitimacy. It will continue to lack such legitimacy until European political integration proceeds further and results, inter alia, in direct election of the commission.
49. Early influential statements of this view were Inman and Rubinfeld (1992) and Sala- i-Martin and Sachs (1992).
50. In addition, Rodrik’s premise and central result have been questioned by Alesina and Wacziarg (1998), who argue that the actual association is between government spending and country size, with small countries both spending more on public consumption and being more open to trade.
51. Thus, authors such as Alesina, Baqir, and Easterly (1999) show that more diverse political jurisdictions are less likely to provide public goods, including coinsurance against shocks, to their residents.
52. Some authors (for example, Alesina and Tabellini [2007, 2008]) argue that the need for democratic accountability of independent agencies like the ECB can be overstated. They argue that EU member states have shown themselves prepared to accept limited democratic accountability for such institutions as the price for policy efficiency, pointing not just to the ECB but also to the case of the European Commission. My own view is that the effort to draft a European constitution (including the Nice Summit that preceded the constitutional convention and the Brussels Summit that followed it) point to a deep and abiding desire in Europe for the adequate democratic accountability of such institutions.
53. Accountability can be defined and provided in different ways; see, in the context of the ECB, Bini- Smaghi (1998), Buiter (1999), Issing (1999), and De Haan and Eijffinger (2000). By referring here to democratic accountability, I attempt to distinguish accountability of policymakers to democratically elected politicians from other mechanisms for accountability-for example, accountability to the public through the mechanism of public opinion, achieved through the release of voting records and board minutes.
54. De Haan and Eijffinger (2000) observe that the power of the European Parliament to alter the ECB statute is quite limited. They state that they “would prefer that, in the case of the statute of the ESCB, the European Parliament should have the final say and thus could act as a real parliament” (402), but they don’t explain how to bring this about.
55. In principle, there are alternatives to democratic accountability, as previously noted. But given the difficulty of modifying the central bank’s statute or ousting members of its board, reflecting the treaty- based nature of its structure, it can be argued that these provide an inadequate substitute.
56. Alternatively, and less desirably in my view, this power could be delegated to another political body such as the Euro group (the group of finance ministers of the members of the Euro area).
57. As emphasized by De Grauwe (2006).
