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'The Big View', May 2012

The EURO disease: not only a debt crisis

by Dr. Antonio Villafranca, ISPI, Milan

The European Union is facing its most relevant and potentially devastating crisis since its creation in the 50’s. Many point out that the entire European integration process has always been marked by crises with the latter working as a tool to further enhance cooperation. To some extent, this is taking place today as well. In few months the European economic governance has been deeply reformed and an unprecedented cooperation is now established in many fields, starting from fiscal policies. The ex ante/ex post surveillance on public accounts was significantly strengthened thanks to a strict EU legislation (the so-called ‘Six Pack’) passed last Autumn. For the first time, the latter include (partially) automatic sanctions when criteria are not met, not only in terms of the traditional deficit/GDP ratio but also in terms of debt/GDP ratio, with the amount exceeding 60% to be reduced in 20 years. More recently, fiscal consolidation and strict control over national accounts have been further enhanced by the ‘Fiscal compact’. In concrete terms, there is not much substance in this new (“extra-EU”) Treaty as it does not add much to what was already decided in last autumn. But it was deemed necessary by Ms. Merkel (together with Mr. Sarkozy who recently lost French presidential elections for unconditionally joining German austerity), as she was struck by declining support for the German government coalition in regional elections, including the historical defeat in Baden-Württemberg, a traditional sealed fortress of Christian Democrats, and in North Westfalia, the largest German lander. As Daniel Gros from Ceps puts it, the only really substantive binding provision of the new Treaty is that member states undertake to limit their structural deficit to 0.5% of GDP, preferably at the constitutional level.

But the crisis is not only transforming fiscal cooperation in Europe as it is taking its toll also on other traditional economic fields. The macroeconomic surveillance procedure introduced by the ‘Six Pact’ and the ‘National Reform Plans’ (linked to the ‘Europe 2020’ strategy) to be presented by member states (together with the ‘Stability Programmes’) in the framework of the ‘European Semester’ go well beyond the fiscal field, even if control/implementation procedures are quite loose.

To sum up, there is no doubt that, once again, the crisis has proven itself as the best way to scale-up cooperation in Europe. But it would be a big mistake to assume that previous experiences should hold true also today. In a nutshell, the main reason why one cannot simply learn from the past is the fact that the past has definitely gone. First, the bipolar system out of which European integration flourished does not exist anymore. In today’s international political/economic system, transatlantic relations are not anymore the cornerstone of the western order. Emerging countries (starting from China) are moving the American spotlight towards transpacific relations, while the European Union is still trying hard to carve out its own place in the new multipolar world. Second, the Eurozone crisis cannot be simply defined as a debt crisis as it hides unprecedented structural weaknesses with largely unpredictable socio-political consequences. The very creation of the Euro is marked by an ‘original sin’: the belief that economic convergence among Eurozone countries would be prompted simply by creating a single currency. In other words, persistent current account imbalances are not supposed to emerge and, if they occurred, they should be transitory and, to some extent, benign as capital movements towards the periphery would favour catching-up processes (i.e. convergence) in the Eurozone. In the first ten years of the Euro, these strong assumptions were only partially and insufficiently confirmed, with interest rates convergence probably being the most relevant success (in 1995 the average interest rate of 10-year bonds issued by PIIGS was 12.1%, around 40% higher than equivalent rates in France and Germany, while this difference was only 2.1% in 2003). But more importantly, Eurozone countries diverged in terms of competitiveness which, inside a currency union, can be gauged by focusing on labor productivity and prices. Setting average productivity in the Eurozone from 2000 to 2008 to 100, Greece showed very bad performance (only 68.9) and the same holds true when it comes to other PIIGS countries (e.g. 53.1 in Portugal, 89.6 in Spain, and 92.4 in Italy with a sharp decrease from the previous decade). In addition, PIIGS countries were not able to counterbalance the negative impact of low productivity on competitiveness with decreasing prices. Conversely, Germany was able to improve productivity (up to 109.7) and, at the same time, to tame inflation, especially through successful wage moderation policies. As a result, year by year PIIGS countries kept on piling-up current account deficits, while Germany jumped from a deficit in 2000 (-35.2 billion euros) to an impressive surplus in 2011 (over 190 billion euros). Indeed, bad current account performance is not only limited to PIIGS countries, as European ‘giants’ are also involved (the French current accounts deficit was over 70 billion euros in 2011). Therefore economic divergence and, consequently, declining competitiveness in PIIGS countries are at the core of the European crisis, while the debt crisis is its inevitable consequence when private capital is not easily available. In other words, the debt crisis is only the symptom but the enduring lack of competitiveness of PIIGS countries is the real disease.

To conclude today’s EU crisis has many roots (mainly financial roots) and various implications (including political implications), but it is deeper and more dangerous as it involves the medium-to-long run ability of Eurozone countries to compete both inside and outside the EU. ‘Current account crisis’ is probably the best definition one can give of today’s Eurozone disease. Evidently, it is not only a matter of definition: if one agrees on the disease, it is easier to find the most effective medicine. In this perspective, austerity and fiscal coordination are only a partial response to the current account crisis. The latter requires a broader EU intervention touching upon raw nerves of member countries as it implies a stricter coordination of all the economic policies of the Eurozone (but not necessarily of the EU as a whole), ranging from energy and industrial policies to labour and welfare state policies. In addition, rescue mechanisms for states on the brink of default needs to be reinforced (as neither the EFSF nor the ESM can suffice) and higher solidarity should mark the Eurozone with many options available: Eurobonds, also in a preliminary form where risk is not entirely shared by countries (i.e. up to 60% of the debt/GDP ratio); a ‘federal’ budget partially allowing to move funds from rich to poor countries; new rules and incentives to reduce segmentation of the EU labour market and help labour mobility (from rich to poor countries). This is the only way through which economic convergence can be effectively achieved in an homogenous area, as the Eurozone should be. Only such achievement would ultimately let the single currency work at full speed.