EMU design failure

The impact of the Europe's sovereign debt crisis on the sustainability of the single currency had arguably become the most serious problem in the aftermath of the global financial crisis. In hindsight, the sovereign debt and single currency crisis exposed a critical design failure in the rule-based macroeconomic regime of the EMU (Eichengreen, 2010). The original idea was that prices in a monetary union, embedded in a smoothly functioning internal market, would converge across the euro area. European Union policymakers believed that belonging to a monetary union, subject to the fiscal constraints laid down in the Stability and Growth Pact, and financial market oversight by rating agencies, would produce real long-term convergence of national economies. Under this policy theory, the ECB received the singular mandate to maintain price stability, while the SGP and the Excessive Deficit Procedure (EDP) were to control fiscal sustainability, with the Maastricht Treaty explicitly proscribing bail-outs of imprudent members. These rules were believed sufficient to foster real economic convergence. In theory, threats to macroeconomic stability could come only from budgetary profligacy and monetary laxity. With the ECB responsible for average price stability across the EU, macroeconomic adjustment problems had to be dealt with by Member States individually under the fiscal constraints of the Stability Pact.

From its inception, many economists raised doubts about the viability of the single currency without some minimal form of fiscal union (Eichengreen, 1990, 1994; De Grauwe, 2009b). By narrowly targeting inflation and fiscal discipline, moreover, the EMU macroeconomic architecture completely overlooked current account competitiveness divergences across the euro area. Fiscal rules were brushed aside by the political decisions to let notoriously indebted countries such as Italy and Greece partake in the currency union. Later, deficit limits were ignored when Germany and France got into trouble in 2004.

We now know that the EMU, paradoxically, contributed to economic divergence, rather than convergence. In the first place, the EMU created the fiction that investing in government bonds across the eurozone carried no risks. As a result, too much capital flowed to too many countries that were ill-prepared to receive it. In some of these countries, capital inflow perpetuated unsustainable fiscal policies, as in Greece, while in others it fuelled private property and credit bubbles, as in Spain and Ireland. Contrary to the hopes of more or less spontaneous convergence, increasing divergences in competitiveness within the single currency became a collective European problem which the EMU architecture had no instruments to handle. The aggravated asymmetries in productivity in the tradeable sectors resulted in vast deviations in the external balances (see Fig. 9.5).

From this perspective, it is extremely important to emphasize that fiscal profligacy is not the root cause of the contagious eurozone currency crisis. Until financial markets crashed in 2008, Spain and Ireland were hailed as economic miracles, with lower public-debt burdens and healthier budgets than Germany and France. Before 2007, these two model countries ran primary surpluses while keeping public debt well within the bounds of the Maastricht criterion of 60 per cent of GDP, while Greece was running an irresponsible budgetary policy and attempting to hide it. Spanish and Irish problems were related to private sector-induced construction booms, which domestic economic policy failed to correct. From 1998 to 2007, relative production costs increased significantly, particularly in the tradeable goods and manufacturing sectors. The ultimate result was a significant current account deficit that peaked at 10 per cent of the GDP in 2007.

With diverging national economic conditions and with consistently high inflation in countries where domestic demand was strongest, a single monetary policy tended to create highly diverse macroeconomic contexts across the eurozone. In other words, one-size-fits-all ECB interest rates inevitably produced asymmetric impulses across EMU economies, with above- or below- average rates of growth and inflation, creating dangerous internal macro imbalances (Scharpf, 2011). Of the countries that lost competitiveness following the introduction of the single currency, Greece, Italy, Portugal, Spain, and Ireland stand out in particular, as illustrated in Fig. 9.6, with severe current account deficits and overvalued exchange rates, together with a strong dependence on capital inflows. Lack of judgement by the rating agencies, moreover, weakened anticipated market discipline and kept long-term nominal interest too low in countries where private indebtedness rapidly accumulated. The EMU regime's bias towards public budgetary discipline, in addition, made eurozone and domestic policymakers in Ireland, Portugal, and Spain completely ignorant of the destabilizing effects of accumulating private sector indebtedness.

In hindsight, the performances of the alleged 'miracle' countries of the Lisbon Strategy, Ireland and Spain, ultimately proved, according to Paul De

Figure 9.5. Current account positions over time. Source: OECD.

Current accounts positions, surplus and deficit countries

Figure 9.6. Current accounts positions, surplus and deficit countries.

Note: Surplus countries are Germany, Austria, Netherlands, and Finland. Deficit countries are Greece, Ireland, Spain, Portugal, and Slovakia.

Source: ECFIN's AMECO (adapted from P. de Grauwe, 2011).

Grauwe, to be the weakest links in the aftermath of the financial crisis (De Grauwe, 2010).

Given the impossibility of currency devaluation in a monetary union, these countries, since the outbreak of the crisis, have had to resort to engineering internal devaluations in trying to bring down wages and prices. And while Ireland, Portugal, and Spain pursued radical retrenchments in order to improve their competitiveness, they were subject to financial market nervousness and rating agency downgrades and disturbances in international financial markets. Hereby liquidity problems transmuted into solvency crises (Scharpf, 2011). Punitively high interest rates, following the reasoning of De Grauwe and Scharpf, pushed besieged eurozone economies into 'bad equilibria' with chronically high deficits, mass unemployment, and economic stagnation, causing in turn international financial markets to doubt sustainable debt servicing (De Grauwe, 2011).

Many leading European economists and policymakers, among whom are Jean Pisani-Ferri, Mario Monti, and Paul de Grauwe, suggested the introduction of Eurobonds to assure financial markets that the debt would be repaid, while at the same time enabling peripheral economies to borrow at manageable interest rates (De Grauwe, 2010, 2011). The Eurobonds solution, these experts argued, could have stopped the downward spiral of sovereign debt contagion and downgrades. However, European leaders, spearheaded by Angela Merkel, have thus far vetoed Eurobonds, believing that the weaker economies would not resist the temptation to continue free-riding on low interest rates rather than engage in structural economic reform.

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