Wednesday, November 26, 2014

France and the Netherlands Strike Back

BRUSSELS – In 2005, France and the Netherlands both voted no to a constitutional treaty for the European Union, derailing years of integration efforts. They seem to be poised to disrupt Europe once again.

On April 21, the Dutch coalition government collapsed, after right-wing populist Geert Wilders refused to endorse the spending cuts needed to limit the budget deficit to 3% of GDP. The next day, candidates who advocated backtracking on European integration captured one-third of the vote in the first round of the French presidential election. On May 6, France is expected to turn left and elect François Hollande, who questions the EU’s German-inspired fiscal compact, agreed last December, and has called for Europe to emphasize growth.

These are the first skirmishes in a highly significant debate for Europe. The debate revolves around two major issues: austerity and integration.

Start with austerity. The question here is not whether deficits should be reduced. They must be, given the dire state of European public finances, and also because the countries whose competitiveness deteriorated during the first decade of monetary union must tighten fiscal policy in order to deliver the necessary adjustment of wages and prices.

Indeed, it is revealing that, as eurozone countries with severe external imbalances at the onset of the crisis have benefited from the European Central Bank’s wholesale liquidity provision, they have reduced their current-account deficits much less than non-euro countries in a similar situation. Germany, the arch-advocate of austerity, is right on this point.

The problem is that austerity has perverse effects. Private and public deleveraging can hardly take place at the same time, unless trade partners generate demand for exports. Recession and price deflation reduce tax receipts and worsen the dynamics of public debt, threatening the return to sustainability. Moreover, deficit targets lead governments to respond to recessions by doubling down on austerity, generally without much regard for the adverse supply-side effects.

So there is a need to approach austerity and rebalancing strategically. And here, the EU has made three mistakes.

First, finance ministers tried to reassure markets last October by demonstrating toughness and endorsing headline, instead of cyclically adjusted, deficit targets. This may be justified for a country on the verge of losing access to capital markets, but not for a country with relatively low debt and a moderate deficit. Ministers should change course and revert to their original 2009 commitment, which was to plan consolidation efforts and adhere to them through fluctuations and shocks.

Second, the eurozone still shies away from a comprehensive approach to its internal rebalancing. Price competitiveness is a relative concept, not an absolute value, yet the policy discussion still ignores this basic fact. This is paradoxical, because the ECB’s policy framework provides clear guidance. The ECB is committed to 2% inflation in the eurozone as a whole, which implies that lower wage and price increases in southern Europe arithmetically mean higher wage and price increases in northern Europe. The wider the gap between the two, the sooner the rebalancing will be achieved.

It is time to say loud and clear that the ECB will fight hard to keep average inflation on target, and that northern Europe – especially Germany – will not attempt to counter higher domestic inflation as long as price stability is maintained in the eurozone as a whole. This would help significantly in mapping out a sensible rebalancing strategy.

The third mistake is one of omission: as ECB President Mario Draghi recently said, Europe has a fiscal compact, but lacks a growth compact. To be sure, there are no quick fixes: headline-grabbing initiatives often fail to measure up to the challenge of reviving growth. Nevertheless, serious discussion is needed concerning how to use the EU budget to enhance economic performance, rather than for redistribution only; how to foster pro-growth reforms at the national level; and how to boost investment in the periphery countries’ tradable sectors.

A credible growth compact would help to overcome immediate hurdles. After all, the post-war Marshall Plan was so successful not because of its size, but because it helped to counteract zero-sum games and self-fulfilling pessimism. That is a lesson to keep in mind today.

But austerity is not the only dimension of the debate. Developments over the last two years have exposed the weaknesses of a bare-bones monetary union based only on a single monetary policy and fiscal discipline. While reforms enacted in the wake of the Greek crisis have equipped the eurozone with crisis-management capabilities, more is needed to restore confidence, ensure financial stability, and ward off financial fragmentation.

A key characteristic of the European crisis has been the strong correlation between banking stress and sovereign distress. Time and again, banks’ woes have affected governments’ borrowing costs, and concerns over governments’ solvency have affected banks’ balance sheets.

This major potential threat to financial stability has been alleviated, but not eliminated, by the ECB’s large-scale provision of liquidity. The recent re-emergence of concerns about Spain has shown that the problem has not gone away.

Systemic reforms to resolve the problem all involve significant further integration: joint issuance of government bonds that play the role of safe asset in banks’ portfolios, a “banking union” with a common regime for deposit insurance, supervision, and crisis resolution – or both. Either one involves risk-sharing among eurozone members.

In France, the Netherlands, and elsewhere, many citizens view Europe as a threat to their way of life. Telling them that the euro is an unfinished construct that requires even more commitment is a hard call for politicians. The question for the coming months is whether European leaders will have enough political capital to embark on further reforms and make the case for them to angry publics. If not, it is to be feared that they will agree only on platitudes and hope for the best.

Read more from our "Austerity and its Discontents" Focal Point.

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    1. CommentedAldo Dias

      And that couldn't possibly have anything to do with non-eurozone countries's ability to devalue their currency and thus at the same time stimulate its exports and reduce its imports? Having entered the euro and now unable to leave it, the only way for countries who struggle with such a high euro to improve their current-accounts and begin to pay back their debt is for the economies who are able to adopt expansionary measures to do so, to foment exports in debt-ridden countries.

      More important than this, however, is the (much, much needed) creation of an European internal market, such as Mr Monti and many others currently defend. The global governance structures needed to regulate a global market do not exist - and this imperfect, unequal market place bring havock, not in the least to the environment. While the nation-state model has in many ways failed us, we shouldn't be tempted to move to the opposite extreme. Instruments of regulation and protection are essential to the creation and growth of the middle class. If we are to maintain and hopefully grow this middle class then we need to maintain and hopefully grow (perfect is perhaps a better term) the instruments that allows it to flourish in the first place, namely industrialization and protection.

      Moreover, be it either on environmental or consumer and worker safety, the EU has many a claim on which to found this legitimate re-ajustment in its trading relations.

    2. CommentedZsolt Hermann

      The problem at the present is the general attitude of the decision making layers of society.
      The politicians, and their supporting cast preparing for elections all over the globe chose their own agendas, re-election prospects, and populist promises instead of the truth.
      Those people at the top who has the widest access to general and global knowledge, very well aware that the problem is much deeper than just simple fiscal balancing or austerity.
      The reason we cannot initiate growth is that further growth is not possible, not only in Europe but all over the globe.
      Our present constant growth, expansive economic model is simply based on an illusion and is unsustainable and now we have hit the wall, or passed tipping point, that is why we are in an unsolvable crisis, or system failure.
      The problem is instead of facing the true problem, and facing the public with true revelations and information we opt for false promises hoping for quick rewards.
      But these politicians shoot themselves into the foot, since as soon as they come into power they will face the growing unhappiness, and even anger of the public, these days political honeymoons do not last long.
      We need to change our whole global socio-economic system, and create a truly functional, mutually responsible supra-national human system.
      We can forget about stimulus or austerity, the only slogan we need to keep is integration, and integration on a global level.
      It is time politicians, other leaders, and the mass media start educating people about our true situation and the system we live instead of the repeated games and lies of today.