“The truth is rarely pure and never simple.”
Oscar Wilde, The Importance of Being Earnest
If Oscar Wilde were still around, he could write a wonderful comedy about European Economic and Monetary Union (EMU). Like the life of his protagonist, Ernest John, the evolution of EMU is rarely pure and never simple. But it would take a Wilde imagination to see exactly how EMU gets to a happy ending.
Despite its name, EMU was not and is not primarily an economic endeavor. Introducing the euro lowered transactions costs and facilitated the flow of trade and finance within the euro area. It also reduced inflation in Europe’s formerly high-inflation periphery. However, a common currency is neither necessary (think Canada and the United States) nor sufficient (think northern and southern Italy) for closer economic integration. Nor is it necessary to keep inflation low and stable (think United Kingdom).
Instead, its founders viewed EMU as a profound step toward a more perfect political union in Europe (see, for example, here). Helmut Kohl famously elevated the importance of European integration to a question of war and peace in the 21st century. Some (and perhaps many) EMU advocates understood that a common currency would lead to stresses – financial, economic and political. Yet, their experience with the disaster of 20th century European nationalism (and with the policy developments that led up to the euro) led them to expect that these stresses would cause future European leaders to make greater sacrifices of sovereignty to save and advance political union.
That outcome remains possible, but it was never pre-ordained. Moreover, recent trends are not favorable. In the absence of acute financial crisis, even the sporadic progress toward greater risk-sharing among euro-area sovereigns slows or comes to a halt. While Europeans generally support the euro, “they show no appetite to delegate more power to the European Union (EU).” Instead, the persistent economic stresses in the member states – including high unemployment, fiscal incapacity and impaired banking systems in many countries, combined with the public perception in several core countries that they are being unfairly (and even secretly) taxed – are nurturing the strongest anti-European political reactions since efforts to promote integration began in the 1950s.
Polls show a sizable loss of trust in European institutions since the global financial crisis began in 2007 (see chart). And political parties opposed to European integration are clearly on the rise. In Greece, the poll-leading Syriza party opposes existing fiscal agreements with the European Commission and the IMF. In Britain, popular support for the Independence Party (UKIP) that wishes to exit the EU (not the monetary union, which Britain never joined) reached a record 25% in a recent poll. In Germany, the AfD party (launched in 2013), which objects to transfers to the euro-area periphery, recently entered three state parliaments for the first time. Most ominous for EMU and the EU, polls in France show the leader of the right-wing anti-EU Front National atop the array of potential candidates for the next presidential election in 2017.
Trust in European Institutions (Share of respondents expressing trust)
Source: Eurobarometer.
For more than 60 years, the partnership of France and Germany has been the key driver of European integration. The key product of that partnership – the European Union (not the monetary union) – has contributed enormously to the welfare of more than 500 million people, expanding the free flow of goods, services, capital, and people across European borders. Its success has made another war in the center of Europe unthinkable for generations of Europeans. Yet, it is hard to imagine today how any German chancellor would work with a nationalist President of France to preserve the gains of European integration, let alone advance them.
European politicians were certainly warned about the instability of a monetary union that includes such an economically diverse group of countries. History does not provide an example of such a broad currency union that survives in the absence of fiscal and financial union. Fiscal union means sharing sovereignty over tax and spending decisions. Financial union means sharing sovereignty over (and fiscal burdens resulting from) banking regulation, supervision, resolution, and deposit insurance. The simple contrast of EMU with the U.S. monetary union – which has enjoyed fiscal and financial union since the Great Depression and political union for much longer – makes these differences clear.
Leading economists highlighted the risks. Two examples suffice. In 1997, Martin Feldstein famously argued in “EMU and International Conflict” that “the adverse economic effects of a single currency on unemployment and inflation would outweigh any gains from facilitating trade and capital flows among the EMU members.” In 1999, future Nobel Laureate (2011) Christopher Sims warned about “The Precarious Fiscal Foundations of EMU,” stating “it is unlikely that EMU can long survive with the degree of vagueness and weakness in the associated fiscal structure that currently characterize it.” He argued that the incentive to leave EMU – say, on the part of one country in fiscal distress – could fuel a destabilizing spiral of higher interest rates and financial contagion. He also warned that adherence to the Maastricht fiscal rules – needed to enforce fiscal discipline in normal times – can undermine economic stability in a world of zero interest rates and deflation.
In short, euro-area institutions would need to adapt substantially to preserve EMU.
Yet, in the absence of acute financial crisis, institutional adaptations have remained grudging over the 15 years of monetary union. Recently, euro-area members have strengthened mutual fiscal surveillance, but without creating incentives for the relatively healthier countries to use their fiscal capacity in the current zero-bound world anticipated by Sims. Following the October 26 ECB assessment of the capital of 130 euro-area banks, the euro area will soon transfer the regulation and supervision of its largest banks to the Single Supervisory Mechanism inside the ECB. It also has developed an institution – the European Stability Mechanism – to aid in their resolution. But it has not ended the “doom loop” that links euro-area banks and their sovereigns (through the banks’ impaired domestic assets and the national sovereign’s contingent liability for resolving the banks). Finally, a serious discussion of euro area-wide deposit insurance is simply not on the table because of the enormous expansion of risk sharing that it would entail.
Domestic economic adaptations have remained similarly grudging. Compelled by a fiscal and banking crisis, Spain has moved relatively faster than other euro-area economies to make its economy more competitive, but still suffers like much of the region both from institutional rigidities and an enormous shortfall of aggregate demand. Italy and France have implemented few (if any) significant labor or product market reforms despite their poor economic performance. And Germany has continued to tighten its fiscal stance even as it remains the only large euro-area economy with meaningful capacity to do otherwise.
Against this worrisome background, the burden of maintaining financial stability has fallen mostly on the European Central Bank – easily the euro area’s strongest institution. Considering the context, the ECB has been extraordinarily effective. Absent President Mario Draghi’s 2012 commitment to do “whatever it takes” to save the euro – combined with the critical backing of German Chancellor Angela Merkel – it is doubtful that EMU today would have 18 members (soon to be 19 when Lithuania joins in January 2015). Reflecting Draghi’s credibility, investors never tested the ECB’s promise to undertake “outright monetary transactions” (OMT) in the debt of fiscally distressed countries. Instead, European bond yield spreads collapsed.
To preserve price stability – its primary mandate – the ECB will need to go much further, expanding its balance sheet massively. (See our earlier post on the mechanics.) Current purchases of private assets (such as covered bonds and asset-backed securities) almost surely won’t suffice. Yet, the alternative of buying government debt – without the fiscal conditionality of the as-yet-untried OMT program – once again raises the specter of large transfers from the healthier economies to those in fiscal distress. If such sovereign debt purchases are needed to meet the ECB’s mandate, they may prove consistent with the Maastricht Treaty, but the subject already is a source of political conflict and any implementation would surely be court-tested.
Ultimately, even if the ECB achieves its price stability objective – a necessity for the preservation of EMU – it is merely buying time. Ironically, its success in tempering the euro-area financial crisis diminishes the incentives of countries and policymakers to adjust. Yet, the crisis has shown that EMU is an unstable regime and that preserving it will entail greater sharing of risk and sovereignty across borders.
Stabilizing EMU (and preserving the broader EU) will require Europeans to compromise more, precisely when the will to do so has diminished sharply. The staggering cost of policy failure does not ensure success. Effective compromise will involve politically unpopular sacrifices by virtually everyone. As Wilde might say, the result will be neither “pure” nor “simple.”
The architects of the Maastricht Treaty probably wanted a strong political union, not just a monetary union. Had it been politically feasible in 1992 when the Treaty was signed, they might have endorsed the issuance of commonly backed euro-area debt by a European Parliament empowered to tax and spend and to operate a banking union. However, it has never been clear that Europe’s citizens want such a federal regime. Today, they still appear to like the euro, but not its economic or political consequences.
Europeans will need Oscar Wilde to write a happy ending.