The history of the integration of the European Union has been a process driven by the political will of the member states. The question now is whether or not political will is enough to save the EU from fragmenting in face of the Eurozone’s economic problems.
I was recently asked my opinion on the current state of European economic integration. I’m not an economist. I’m not a European. I have, however, worked in the global bond markets for 20 years. I was in Spain throughout the 1990’s during the European integration and monetary union. Subsequently, I have worked with financial institutions in the US on bond-related matters, throughout the global credit crisis and ensuing financial market turmoil.
Everyone knows that the Eurozone is in trouble. Is the Eurozone “dis-integrating,” de-converging economically beyond repair? It looks like it is to me. I believe that the EU is in the process of restructuring based upon the economic realities of a diverse Europe. I know that I’m not alone in that view. It appears to me that the European Union has been a product of the political will of its member states since its inception, and that the current state of that political will is not enough to hold the EU together, given the fragmenting effects of the Eurozone’s structural economic problems, particularly now due to the on-going effects of the global credit crisis.
The European Monetary Union is a reflection of political will since its inception.
The recent era of economic integration started in 1991 with the Maastricht Summit. The agreement that emerged from the Summit reflected the unified political will of the European leaders of the day to embark upon monetary integration to create a globally competitive Eurozone economy and currency. The Maastricht agreement’s economic convergence criteria (relating to the country’s inflation rate, government deficit, government debt, exchange rate, and long-term bond interest rate) were added to facilitate European monetary union and to form an integrated European economy, a daunting task in light of the economic diversity within aspiring member states. Upon hearing the news of the Agreement, many bond traders and portfolio managers did not believe that European economic convergence would be as possible.
During the period from the signing of the Treaty in 1992 leading up to monetary union and the establishment of the Euro currency in 1998, the convergence criteria were essential to bring aspiring member countries’ economies in-line, to be sufficiently similar to be managed by one central bank. The Maastricht criteria have always been used as important political tools for national leaders to justify unpopular reforms on their domestic agenda at home, and to justify disciplining neighboring member states of their failures to meet shared EU goals. That the Maastricht criteria are a reflection of political will has been evidenced by their use and interpretation over time, particularly when member states don’t meet the criteria. The Stability and Growth Pact was adopted in 1997 to regulate the fiscal policy conduct of member states. The Pact was refined in 2005 to make the rules more flexible and enforceable, such that the European Council determines when a fiscal deficit is “excessive.” It is clear that political will, not the economic criteria, has held the European Union together.
Is political will enough to keep the EU together?
Recently 16 members of the EU came to an agreement on how to assist Greece manage its finances. It is a complicated agreement, lacking on details, that is meant to give Greece time to implement fiscal austerity measures. In the coming weeks and months, market mechanisms will continue to determine if the agreement succeeds in instilling investor confidence. The extent to which Greece’s financing problems are solved will be determined in the bond market over time by quantifying how much Greece will pay to service its debt. The bi-lateral loans would also be at market levels of interest.
In some ways the new mechanism and IMF support has clearer implications for Greece than it does for other European countries. The new mechanism may bring Greece a respite of relief, and a possible solution. The new bail-out mechanism is also meant for use by any other Euro country that may need it, Portugal, Spain, and Italy being the likely candidates. Each has a larger economy than Greece and a fiscal deficit problem. However, Southern Europe’s challenges are not simply managing deficits through financing and fiscal discipline, cost-containment and austerity programs, but also inherent to the structure of the Eurozone itself.
What are the Eurozone’s structural economic problems?
The Euro has created capital flows and current account deficits in Southern Europe. The German export sector has thrived under the Euro. Not coincidently, Germany’s current account surplus is mirrored by southern Europe’s current account deficit. This is a structural imbalance inherent to the differences between economies within the Euro.
Southern European countries are hampered in their ability to bring their deficits into line by the Euro zone. They can’t depreciate their currencies so that their goods and labor can become more competitive. Nor can they lower interest rates to stimulate their economies. The country with the largest current account deficit, Spain, has had some improvement recently, but primarily due to the recession weakening domestic demand which has slowed imports. The weaker Euro, stimulating exports, also provides relief.
What can a government do to solve the economic problems?
The global crisis has wreaked havoc around the world in a familiar pattern. With interest rates abnormally low, consumers incurred too much debt, home builders over-built, banks under-estimated the risks and the banking crisis ensued as an outcome of the real estate crisis. It is not unique to the current era that a banking crisis will follow a real-estate crisis, one that would lead to a government bail-out to some degree. The problem is that not all governments can afford the bail-out.
The governments of Southern Europe appear to fall into the category of those that cannot afford the bail-out. These governments have been criticized for the actions that they have taken, as well as for actions that they haven’t taken. The recent sovereign credit downgrade of Portugal was attributed to the fiscal shock of the economic crisis on the country’s weak economy, the large current account deficit, and the lack of a credible government plan to manage the problems. The situation is difficult for any government to manage, particularly when weak economically.
It is easy to fault a government for not taking measures to liberalize a market, or instill productivity measures and those criticisms have been voiced. However, reforms that restructure an economy, such as labor market reforms, productivity enhancing measures, and pension reform are difficult to instill during the bubble economy of recent years and all the more difficult during the period of crisis that followed. The current economic situation is what it is for a lot of reasons, and there is no easy solution for any government to implement a remedy. What is clear is that the solution for Southern Europe isn’t simply allowing the governments more time and to push through unpopular fiscal austerity measures to manage their fiscal deficits. It is probable that neither time nor austerity will solve the problems. In fact, fiscal austerity could add to the problem, as cutting government spending can push an economy deeper into recession.
Can a country leave the Eurozone?
Economists’ views vary but leaving the Euro would be costly and complicated to do. The economic negatives would include higher financing costs on issuing debt, the trade impediment of currency risk being re-introduced to international trade, the operational costs of issuing a new currency, speculative attacks on the new currency, less mobility of the labor force within European labor markets, and greater isolation, in general.
A certain devaluation of the new currency would have mixed effects, both positive and negative. Devaluing the new currency would immediately lower the standard of living of those earning the new currency, as it would decrease the purchasing power of residents by making all imported goods more expensive. Exports would increase an economic stimulus. Real estate would be cheaper, attracting capital flows. Domestic banks would find it easier to sell their burdensome real estate holdings, but likely not at levels favorable to the balance sheet. National current account deficits would decrease.
As the costs of leaving the Eurozone appear to far outweigh the benefits, a country would likely only leave the Euro when there was no other choice, if it were forced out. That no country is going to leave the Euro voluntarily in spite of the problems within the Eurozone makes the Euro problem bigger still for the member states to manage under current agreements.
Is the Eurozone “dis-integrating”?
It is not a surprise that the global credit crisis and ensuing global economic recession have wreaked havoc on European political unity. During times of economic uncertainty and contraction, nationalism and protectionism are sure to rise and they have. Although European history and context support keeping the Eurozone together, Europe is currently de-converging economically for structural reasons accentuated by the global economic crisis. The Maastricht criteria may now become a footnote in European history, as meeting the economic variables at one point in time did not create a unified Euro economy given that the economic disparities within the member states are still too great to be managed with the constraints of one monetary policy. The Euro has not created economic growth to the degree that it has created current account deficits, capital flows, and structural problems. Countries are finding that their deficits can’t be resolved by discipline and austerity measures. Inherent to the structure of the Eurozone, governments cannot resort to the usual tools of independent interest rate policy nor currency devaluation. As both the banking sectors and the governments have unsustainable levels of debt, the crisis is still underway. Some economists have speculated that the inter-relationship of the Euro economies could result in contagion within the Euro region.
For the moment, a new bail-out mechanism is meant to hold the Eurozone together, and Greece is the experiment. The financial markets will continue to test the new mechanism in measurable ways. Greece faces the near term test of re-financing and issuing debt, and also the longer term test of remaining solvent. Greek funding costs will likely continue to rise in spite of the IMF promise. It will be a critical test to see how the IMF backing actually functions when it is implemented, and how financial markets react to it when it is. The Euro is vulnerable to further weakening.
Although the new mechanism is meant to be a template to be used by other countries, as needed, those countries in need will be in competition with one another to get the financial support that each needs. The competition may expedite a failure to maintain Europe together. It is possible that the introduction of the new mechanism will likely eventually be seen as the beginning of a transitory phase in the political management of the reconfiguring of the Eurozone. That the IMF is involved adds credence to that viewpoint, as the IMF would normally only be involved when imposing austerity measures on non-EU member states. Though a European member state’s deficit problem would normally be considered Europe’s problem to solve, Germany has been adamant in expressing the view of limiting the EU financial bailout of troubled Greece and that any bi-lateral loans be at market levels, not subsidized by member states. Perhaps Greece is already being managed out of the Eurozone.
It may be that a new Agreement is on the way, one that will reflect the new realities of a fragmented Europe. There is currently no EU agreement that spells-out a procedure for a member either to withdraw or be expelled from the Euro. New agreements will likely emerge that are meant to manage the exit of a country from the Euro, a non-discriminatory policy to facilitate an exit of any country which isn’t managing to meet its Euro-responsibilities. A country may be put on a type of probationary status that would renew full membership status only when the country had its fiscal house in order, or stipulate a process of withdrawal from the Euro if it did not.
Political processes are difficult to predict and can take time. Investor confidence and the magnitude of global capital flows could expedite a country’s departure from the Eurozone as well as make the political process more difficult to manage. What is certain is that political will is not enough to keep the EU from being reconfigured given the economic realities, and that the Eurozone is sure to look different within the next few years.