In this post I argue that membership of the Euro-zone requires an adjustment substitute to currency depreciation. I propose fiscal policy as the desired channel for this adjustment and a more comprehensive version of the EFSF as the form of that fiscal policy at this stage of European economic integration.
The events of this year have shown what economists have been saying for years: The eurozone, in its present shape, is an unfinished project. Given the wage and price rigidities of our individual markets and the limited mobility of our labour forces, we need some form of intra-euro-zone redistribution to occur in order to deal with asymmetric economic shocks. This mechanism would come as a replacement for the currency devaluations that used to occur before countries joined the euro-zone. When this tool was eliminated it put an end to currency manipulation as a source of European squabble. However, the policy hole that it left must be replaced by some form of alternative solution. No one is politically deaf to the point of seriously suggesting that the European Commission should become a fiscal authority, no matter how much economic sense it makes. However, this absence of a recession smoothing tool and the pressure it puts on affected Europeans is socially and politically very dangerous. What if the bomb sent to the German Chancellery building had reached Angela Merkel? What if someone had died?
This vacuum endangers not just our citizens, who must needlessly endure economic hardship, but in its inertia it attacks the very sustainability of the idea of European integration, as an engine of peace and prosperity. So, for the last year, we have spent a substantial amount of resources and legislative prowess trying to address this issue. As a result we have taken giant leaps in economic governance integration. Most relevantly, I believe that the EU Financial Supervision Package, the increase of budget monitoring powers of the Eurostat and the banking stress tests go a long way towards decreasing the risk of another financial debacle similar to the one experienced in 2007-2009. However, these are solutions to the problems we are aware of, not the ones we have not yet considered. A fiscally redistributive tool would allow us to smooth the pain of the next shock, no matter what it is. It would be the second best general solution to this problem, given that our lack of clairvoyance eludes us from the set of first best solutions.
Given the legal and political impossibility of a proper fiscal Europe, we have opted for a guarantor Europe. The European Financial Stability Fund (EFSF) is a little known Luxembourgish firm, effectively run by the German finance ministry, that can issue debt guaranteed by several euro-zone countries. So it is not really an example of European governance. The money is then channelled, with several unpleasant strings attached, to a country in need, on the promise that it will pay the interest and initial value to the EFSF who will then pay its creditors. Just in case that country falls short or outright defaults, the fund was provided with a guarantee from a number of EU countries that ensures that its own payments will not fall short. In effect, this allows any country willing to accept the conditionality to borrow at a cheaper cost by borrowing the credit worthiness of it’s guarantors. Greece’s specific fund is only a scaled down version of the EFSF.
There are at least two problems with the EFSF in its present form, both of which could be fairly easily solved. The first is that it is incomplete, the second is that it is hard to transform it into a permanent tool.
The EFSF as insurance over time as well as space
Redistribution can occur along time as well as space. Thus, aside from the guarantee provided by each country which at an early stage is fundamental, a complementary approach to the EFSF could see EU member states guarantee themselves at a future time. That would effectively turn the EFSF into an insurance mechanism. This would deal with the opposition of Germany that it’s citizens should not be bailing out the Greeks. At the same time, a system with insurance premia that reflect the risk of each country ensures that there is some progressiveness in the manner in which the countries are incentivised against running deficits. This would be a very efficient complement to the SGP. The existence of actual funds rather than virtual ones may also go some way towards deterring markets from speculating against these countries. Finally, the fund could be divided into two. A first fixed and strongly conditional one which would serve the purpose of dealing with too high deficits and another looser complement that would be meant to smooth purely uncontrollable outside shocks, that could be financed by the contributions excessive of the fixed deficit related fund. Spreading risk over time and consumers is why we all cherish our national health care services, so it seems like a good idea.
Implementation through enhanced cooperation
The other problem is the one of feasibilty. The above proposal is not what is under discussion by the member states. What is under discussion is the creation of a permanent version of the EFSF, as it is now, complemented with some form of burden sharing by the private sector. However, recent news reports have indicated that the deal struck at last week’s European Council meeting about the creation of a permanent mechanism to deal with sovereign debt crisis, is proving too unorthodox and member states seem to be breaking ranks. There has been outrage at the Franco-German Deauville agreement that excluded other EU grandees and fears abound that the Council agreement will not withstand the pressure of judicial scrutiny at member state. This sheds some doubt as to the European Council’s ability to create the a permanent mechanism akin to the European Financial Stability Fund by unanimous decision and without referring the treaty change to their respective electorates. If this were to be the case, we would be back to muddled fiscal waters. Or would we?
According to articles 326-334 of the Consolidated Treaty on the Functioning of the EU, if every political alternative has been exhausted (which will be the case), and with the consent of the European Parliament and of the Council (through qualified majority voting, article 329,1.), a minimum of eight member states can engage in “Enhanced Cooperation”. This would not require a treaty revision, only independent and non contingent national constitutional revisions. Moreover, ratification wise, it would frame the issue in a much more voter friendly manner. It would not be a vote on the EU, but rather on the fiscal sustainability and credibility of each member state involved. There will be 17 euro-zone member states by this time next year. I’m sure we could find at least eight that would be able to ratify this measure without much problem. The rest would then follow.
As time passes and events unfold, “Enhanced Cooperation” is becoming an increasingly appealing solution to the impasse that seems to be looming over this entire endeavour. Hopefully our leaders be faster in adopting that solution than they were in first creating the EFSF. It would save a lot of people a lot of pain…