The Eurozone’s crisis appears to have ebbed after the European Central Bank’s recent policy responses. However, many of the region’s underlying problems remain unresolved.
The euro crisis is now officially in its fourth year. It started in October 2009 when the Greek government admitted that its budget deficit was much higher than it previously stated. In the years that followed, the crisis not only deepened in Greece and spread to other countries, it also exposed serious flaws in the governance of the euro and the Eurozone.
There are basically four options to reform the Eurozone’s governance. The two main dimensions that will determine the future shape of the Eurozone are the possible combinations of extended political integration and fiscal transfers. The options range from a renewal of the Eurozone’s original guiding principles with a focus on member state responsibility to a political union with nation-state-like features.
In early October, the euro looks as if it is on a slow road to recovery, at least measured against recent expectations. Many experts considered September to be the decisive month for the fate of the euro, and expectations tended to be pessimistic. From that perspective, things developed fairly well. The decision of the European Central Bank to renew its bond purchase program has reassured the financial markets and bought important time. The decision of the German constitutional court that the euro rescue strategy is in principle consistent with the German constitution, given certain limitations, removed doubts about the future of the rescue mechanism. The Dutch elections resulted in a stable pro-euro coalition. Taken together, and contrary to more apocalyptic predictions made during the summer months, early autumn has been a comparatively quiet time for the Eurozone.
However, this situation is not a reliable predictor of future events. Part of the difficulty in solving the euro crisis is due to the fact that there is no clear vision about where the Eurozone is heading in terms of governance structures and architecture. The euro crisis includes a debt crisis, a banking crisis, a growth crisis, and a competitiveness crisis. That is why it is unrealistic to hope for grand bargains and comprehensive solutions to cut the Gordian knot. However, a clear vision for the future of the Eurozone’s governance structures is a precondition for political action and for kicking the can in the right direction.
Is there a light at the end of the recession tunnel?
At first glance, no. The latest data on the economic sentiment in the Eurozone reinforce the trend of the last months. The European Economic Sentiment Indicator, which measures the outlook on the part of business, consumers, industry, and services, continues to decline for the Eurozone as a whole as well as for the crisis countries, with the exception of Spain. Also, the outlook for Germany is deteriorating. The ifo Business Climate Index continued to fall in October, the sixth consecutive monthly decline.
Nevertheless, there are some cautious signs that reforms in the crisis countries are beginning to gain traction and yield positive results. Among these are the reduction in the current account deficit and the improvement in price competitiveness. Unit labor costs in Greece, Spain, and Ireland have fallen quite substantially and are forecasted to continue to do so (see figure 1).
Equally remarkable is the development of the current account deficits of the crisis countries. Greece managed to reduce its current account deficit from an extremely high level. Spain achieved the same, and Ireland managed to turn its deficit into a surplus (see figure 2). In other words, fundamentals are beginning to improve. While this is not yet reflected in business expectations, the conditions for an improvement are being built.
While reforms in the crisis countries are crucial for a recovery in the Eurozone, the other main pillar is the governance of the euro itself.
Governing the Eurozone
The institutional architecture of the Eurozone was built on three main assumptions. First, mechanisms compensating for the loss of the exchange rate as an adjustment tool are not needed. Countries will adjust to the new currency regime by internal reforms and will modernize their economies once they cannot resort to devaluations. Second, rules to prevent excessive budget deficits in the form of the Maastricht criteria are enough to guarantee the stability of the euro. Third, specific provisions for crisis management are not needed. Crises will not happen if members stick to their obligations and follow the Maastricht rules.
The euro crisis has made it blatantly obvious that these assumptions do not hold any longer. Crisis management has become the almost-exclusive focus of European political leaders. The rules of the Maastricht treaty have prevented neither excessive budget deficits nor the resulting threats to the euro. The euro did not initiate a broad dynamic toward reforms and higher competitiveness. The burning question, therefore, is how to redesign and amend the euro’s governance structure to prevent future crisis and support the way out of the current crisis.
Conceptually, there are two main dimensions of Eurozone reform. The first is political integration. The question is whether the Eurozone needs deeper political integration and a transfer of decision making to the European level or whether the primacy of the member states needs to be preserved and strengthened. The second dimension concerns fiscal transfers between member states. Fiscal transfers can, in principle, be used for emergency measures or in an institutionalized form.
Options for the Eurozone
Combining these two dimensions in a matrix illustrates the main options for European policy makers.
The original Maastricht treaty from 1992 includes three main elements:
- Member states must not run a budget deficit of more than 3 percent of GDP.
- They must have a debt level of no more than 60 percent of GDP.
- Eurozone members should not be liable for, nor assume, the commitments or debts of any other member state.
In this original Maastricht framework, it is the member states that are exclusively accountable and responsible for healthy public finances. As long as the rules work, the stability of the euro is not threatened as over-indebtedness and resulting instability cannot be an issue.
However, the rules obviously failed, and the main elements of the original Maastricht provisions, such as the debt ceilings, are under pressure. Others, such as the no-bailout clause, have been totally pushed aside. The option of a Maastricht 2.0 scenario would need to include strengthening the original provisions, ensuring compliance, and providing a framework that puts national responsibility for public finances first. This implies that future crises of the euro are to be prevented by an improved version of the original framework. Some of the recent reforms in the EU—above all, the debt brake—go arguably in the direction of Maastricht 2.0.
A future political union is being widely discussed. It builds on the idea that the fundamental reason for the euro crisis is the fact that there is no nation-state standing behind the euro that defends it unconditionally. So, saving the euro may require the establishment of a European nation-state—or at least something that resembles a nation-state.
While it is obvious that the European Union cannot become a nation-state overnight, it could assume the functions of a nation-state in key areas to guarantee the survival of the euro. These key functions would include a banking union, common deposit insurance, at least some mutualization of debt, and larger redistribution through fiscal transfers between the Eurozone’s member states.
These moves would imply a centralization of fiscal policies and therefore a much stronger role of the EU in fiscal policy, if not a European finance ministry with corresponding competencies. As this would touch upon the core functions of national parliaments, a political union might need to follow to ensure democratic control. In other words, in economic and financial matters, the EU would become the main actor and decision maker. While there are many proposals and plans on how and in which areas European integration should move forward, concrete steps have not been taken, and workable plans have not been developed.
Currently, the European Union is a complex combination of national, supranational, and intergovernmental decision making. While the big political decisions regarding the Eurozone are taken in the Council of the European Union by the national government leaders, the day-to-day business in the EU’s areas of competence is carried out by the European Commission. National economic policies remain firmly in the hands of national governments.
To be sure, there have been some attempts to achieve a higher coordination of national economic policies. The last decade saw the introduction of the “open method of coordination.” This method aims at directing national policies toward common and agreed goals. It rests on instruments such as evaluation and benchmarking of policies. There are no hard sanction mechanisms; the method works mainly through peer pressure.
A greater coordination of the economic policies of member states would require enlarging the scope and the depth of coordination, as well as palpable sanctions. Areas that offer themselves to greater coordination in order to support a smooth functioning of the euro include wage policy, pension policy, and fiscal policy. For example, a coordinated association could aim at preventing the emergence of large imbalances in the Eurozone by mutually adjusting national economic policies.
The model of an emergency union comes quite close to the current working of the Eurozone in the face of the crisis. It is a series of rather unsystematic emergency measures that try to prevent the worst on a case-by-case basis. The worst, of course, is a fragmentation of the Eurozone. This process does not have a well-formulated goal, but is highly event-driven.
While it is true that the European Union has been built in times of crisis and that a step-by-step process is not a bad thing in itself, the question is whether the measures add up to something that prevents future crises. So far, the bailouts—especially in the case of Greece—bought time, tried to keep states liquid, and forced them to introduce reforms. The ECB’s announced bond purchase program has a similar intention, and so has the European Stability Mechanism, the main instrument to guarantee the liquidity of governments that lose access to financial markets.
Whether this approach can work and bring the euro into shallow waters depends on whether the crisis is due to a temporary exceptional situation or to deeper institutional flaws in the governance of the Eurozone. If the latter is true, the case-by-case approach is unlikely to work, and bridge financing is not enough to let the storm pass.
The most consistent options of the four are the Maastricht 2.0 scenario and the political union as they define clear responsibilities for decision making, either on the level of the nation-state or on the European level. Both are ambitious. The Maastricht 2.0 would need to address and overcome obvious weaknesses in the old institutional architecture. The formation of a political union would imply a transfer of authority unseen in the history of the nation-state with many foreseeable and unforeseeable challenges. The main issue, however, is what the preferred option for the future of the Eurozone actually is.