This article is divided in three sections. The first briefly describes the governance instituted with the creation of a European monetary union. The second section provides an overview of how monetary union has functioned over eleven years, highlighting its strengths and weaknesses and vulnerabilities. Finally, the third section analyzes the impact of the crisis and the reaction of European authorities, which finally introduced significant changes in the economic governance system.
The Greek crisis has caused an upheaval in the entire European monetary union. It has brought into question the viability of this project, eleven years after its birth. This state of affairs has highlighted the shortcomings of the European economic governance system and the need for improvement. The question is how to manage and prevent crisis in the Euro Area, and adopt the most appropriate economic policy.
■ ONE EUROPEAN CURRENCY: A COMPLEX PROJECT
During the late eighties and early nineties, the European Union witnessed a period of great progress in its economic integration process. The Single Act passed in 1986 prompted the creation of a unified market in Europe. After the Maastricht Treaty adopted in 1992, the project of a European single currency was launched as a complement to the single market. This project was certainly complex. Historical experience highlighted the difficulties of creating a monetary union unsupported by political union. Furthermore, academic literature did not seem to fully bless the project either.
Thus, Mundell’s theory of Optimum Currency Areas (OCA) showed that without greater labour mobility, greater flexibility in prices and wages and a common fiscal policy, the project of European monetary union was likely to fail. The basic reason was that in the absence of these mechanisms, the loss of monetary policy and exchange rate at the national level could involve high social costs if the diverse countries experienced asymmetric shocks.
However, other academic contributions, such as those by Rose and Frenkel, endorsed the monetary union project, because this can encourage increased trade, produce more cyclical synchrony between partner countries and reduce the possibility of asymmetric shocks, facilitating the functioning of a single monetary policy. In other words, an area which is not an optimum monetary zone a priori can become one later due to the dynamic forces generated by the project itself; an optimistic view that encouraged the single European currency project to be pursued.
The formula employed was as follows: First, the Maastricht Treaty set restrictive access conditions for monetary union in terms of convergence of certain nominal variables (inflation, interest rate, public deficit, public debt, exchange rate stability). While these are relevant variables, according to some economists like Paul de Grauwe, they could not ensure the project’s success, as they did not include other real variables considered by the OCA theory. Secondly, a system of EU governance was set up which comprised two key parts: a single monetary policy (centralized) and fiscal policies at the national level (decentralized) that had to be coordinated.
With respect to the single monetary policy, the European Central Bank (ECB) was created, which is totally independent of governments and EU institutions, with the primary objective of ensuring price stability. Concerning the coordination of tax policies, there have been two main regulations. On the one hand, control of public finances to avoid excessive deficit and unsustainable debt dynamics, through the implementation of a Stability and Growth Pact. And secondly, the «no bail-out» clause that prevented the ECB or any Member State to assume the debt of another Member State, so that all countries remain subject to market control (which imposes different risk premiums in terms of individual behaviour). Finally, to ensure consistency between the single monetary policy and economic policies at national level there is an «open coordination policy» that has been perfected with practice.
■ ELEVEN YEARS OF MONETARY UNION: FROM SUCCESS TO CRISIS
In 2009, to mark the tenth anniversary of the euro, several reports were prepared (by the European Commission, IMF and OECD) reflecting a very positive balance of the European monetary union. In fact, during this period the euro had established itself as an international reserve currency, the Eurobond market had developed, trade and economic growth had increased in the Euro Area (with slight stagnation in early 2000 that culminated in the reform of the Stability Pact in 2005) and the monetary policy of the European Central Bank had successfully achieved the goal of price stability.
Conversely, however, other reports (such as that conducted by the Bruegel Foundation) indicated that the European monetary union had failed to promote major political integration (as demonstrated by the failure of the draft European Constitution), or significant economic integration (as evidenced by a lack of progress in the improvement of the internal European market). In fact, it has hardly been possible to apply certain structural market reforms necessary for monetary union to function properly (such as those related to the labour market, aid and public procurement, network industries and energy).
The lack of progress made in these reforms, and generally in the implementation of structural policies, led to divergent trends in the competitiveness of European countries, bringing about different positions in the current account balance. Thus, while Germany, Finland and Austria have won in competitiveness (in prices or costs) and have experienced a favourable current account balance, other countries such as Greece, Portugal and Spain have become less competitive and have attained high external deficits (greater than 5% of the GDP over several years).
Enduring over time, these differences reflect domestic adjustment problems, productivity losses, excessive growth in credit and, even, the existence of a financial or real estate bubble. Countries with a steady external deficit have experienced a massive influx of capital, leading to an unsustainable accumulation of private debt, which has been exacerbated in countries, like Greece, that have also applied an inappropriate fiscal policy.
All this brought with it a state of vulnerability on entering an economic crisis, as indeed happened later on. The financial crisis began in the United States in the summer of 2007 and became noticeable in Europe in 2008. Then the authorities reacted in an appropriate way. On the one hand, a coordinated international response through the G-20 prevented the use of trade protectionism and pursued certain financial and regulatory cooperation. On the other hand, countries launched Keynesian economic policies, increasing public spending in an attempt to replace and boost weak private spending.
These policies were implemented during 2008 and 2009, both in the United States and Europe. Consequently the imbalances in public accounts have risen in general, although this has been more problematic in some countries than in others. The consequences have been more serious for those externally indebted countries such as Greece, Ireland, Portugal and Spain.
This has give way, in recent months, to a new stage in the crisis, which concerns the sovereign debt of countries that were unable to generate sufficient confidence. In this respect, the Greek crisis has highlighted the weaknesses and inadequacies in the Euro Area, the monetary union did not have sufficient mechanisms to prevent and manage crisis situations, nor strong coordination mechanisms or economic policies. Therefore, it has been necessary to react and adopt a new system of governance.
■ TOWARDS A NEW GOVERNANCE SYSTEM IN THE EURO AREA
Indeed, the Greek crisis has suddenly raised doubts about the soundness of the eurozone governance. The change of government in Greece in October 2009 revealed that the public accounts had previously been falsified, so the deficit was actually 13.6% of GDP (instead of 3.7%), leaving a public debt exceeding 120% of GDP. The reaction of financial markets was to force the Greek government to pay a large risk premium to finance its debt, and that spread to other countries with serious macroeconomic imbalances (for example, Spain).
The slow reaction of the European authorities threatened to convert a country’s risk (focused on the secondary market of its sovereign debt) into a systemic risk for the whole Euro Area (with more far-reaching consequences). The European monetary union’s «no bail-out» clause was to shed doubt on the advisability of giving Greece firm and resolute support, but to let Greece crash was a solution that would put the entire system at too great a risk.
Finally, EU leaders decided to take the middle path and, at the important meeting held from 7-9th May 2010, they decided to create a European Financial Stability Mechanism making available 750,000 million Euros (of this total, 60,000 million were obtained from the financial market with backing from the Community budget, 440,000 million by issuing bonds guaranteed by Member States and 250,000 million from the IMF). This mechanism is available to countries facing special finance problems in the context of the crisis (such as Greece, Spain, Portugal and Ireland), on the condition that they make a commitment to implement serious and rigorous adjustment programs.
Complementarily, the European Central Bank changed its traditional conduct and bought sovereign debt on the financial markets (as did the U.S. Federal Reserve or the Bank of England). This action, despite calming the markets down short term, has created a precedent that could compromise ECB independence from political power and create a dangerous link between monetary and fiscal policy. Therefore, and to safeguard the fundamental objective of price stability, the ECB announced sterilization operations to absorb the liquidity generated by the monetization of debt.
Eventually, all these measures seem to have prevented the collapse of the system, but have also highlighted the need to review the governance framework of the European monetary union. Accordingly, early last summer a special Task Force was set up to prepare a report on the new system of economic governance. This Task Force finally presented its report on October 28th 2010, which was later endorsed by the European Council.
The proposal puts forward five main points to strengthen governance in the European Monetary Union. Firstly, it provides for an increase in budgetary discipline from the early monitoring stages of the Stability and Growth Pact, placing greater importance on the public debt criterion and strengthening the penalties for breach by any Member State. This will create a new monitoring mechanism encompassing macroeconomic imbalances that had not previously been considered (such as unemployment, housing market developments and external imbalances). There will also be stronger and more thorough coordination through the so-called «European Semester», introduced as from January 2011, so that each spring their medium-term budgetary strategies will be reviewed and reform programs (for growth and employment) drawn up for each country. A permanent crisis management mechanism (not yet clearly defined) will be instated, a mechanism to replace the current three-year one (which will last up until mid-2013), to avoid any kind of financial contagion. Finally, more effective institutions will be integrated (both at national and European level) in the process, in particular, independent institutions to carry out the analyses and projections of fiscal policy.
The implementation of these reforms will take place after the previous steps. There are, therefore, certain issues of technical and legal type that remain open. But beyond this, it seems that the European Union is ready to improve economic governance in the Euro Area, with greater fiscal discipline, greater economic surveillance and stronger coordination of Member States.
| © Belgian presidency of the Council of the European Union
On the 1st January 1999 eleven countries adopted the euro as their currency for trade and financial transactions. Banknotes and coins went into circulation two years later. Currently the so-called eurozone includes seventeen European countries.
«A system of governance was set up which comprised two key parts: a single monetary policy (centralized) and fiscal policies at the national level (decentralized) that had to be coordinated»
«The financial crisis began in the United States in the summer of 2007 and became noticeable in Europe in 2008. The consequences have been more serious for those externally indebted countries such as Greece, Ireland, Portugal and Spain»
«The Greek crisis has suddenly raised doubts about the soundness of the eurozone governance. The change of government in Greece in October 2009 revealed that the public accounts had previously been falsified»
«The anti-crisis measures taken seem to have prevented the collapse of the system, but have also highlighted the need to review the governance framework of the European monetary union»
Aghion, P. et al., 2008. Coming of Age: Report on the Euro Area. Bruegel Foundation. Brussels.
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Cinzia, A. & Y. D. Gros, 2010. «Is Greece Different? Adjustment Difficulties in Southern Europe». Vox. Research-based Policy Analysis and Commentary from Leading Economists, 22 April.
De Grauwe, P., 2009. The Economics of Monetary Union. Oxford University Press. Oxford.
Frankel, J. A. & A. K. Rose, 1998. «The Endogeneity of the Optimum Currency Area Criteria». The Economic Journal, 108(449): 1009-1025.