PARIS – Heading into 2014, financial markets are quiet and Europe’s politicians are relieved, but the fundamental problems that have driven the euro crisis for the last four years remain, and now is the time to address them. That is the claim of two important recent papers, one by a bipartisan group of German economists, lawyers, and political scientists called the Glienicker Gruppe, and the other by Ashoka Mody, a former International Monetary Fund official who is now at Princeton University and the European think tank Bruegel.
Aside from the need to act, however, the authors agree on little else. The German group argues that the eurozone’s survival requires a political union equipped with a common budget. Mody says that European Union’s federalist plans have been disappointed for five decades, and that the only way forward is to abandon efforts to fine-tune national policies set in Brussels and instead pursue a decentralized union.
Their shared premise is correct: complacency about the euro crisis is misguided, the fixes adopted so far do not go far enough to ensure lasting stability, and the current respite should be used to design the bloc’s permanent architecture. Furthermore, the advent of a bipartisan government coalition in Germany, together with the appointment of a new European administration following the European Parliament election in May, creates a window for new thinking.
The two papers’ disagreement is political, not economic. The Glienicker Gruppe argues that a stable monetary union needs a transfer mechanism to help cushion severe economic downturns and a legitimate government to ensure that democracy and the rule of law prevail at all times and in all countries. Their point is that the EU has passed the integration threshold beneath which EU members could behave independently. The degree of interdependence that the euro has created calls for proportionate instruments to manage common public goods. Their idea is that the eurozone could not afford a neo-fascist government in a member country, and that preventing such an outcome requires both carrots (transfer mechanisms) and sticks (supranational powers).
Mody concurs that a political union would enhance the eurozone’s functioning. But he argues that it will not be established, because there is no appetite for it. Grand plans, he says, will only end in a muddle, so it would be wiser to accept reality and draw the right conclusions from it: Europe should abandon efforts to create a federation. Furthermore, it should rid itself of its technocratic surveillance apparatus, which lacks both legitimacy and effectiveness. It should acknowledge that, except in emergencies, international bureaucrats cannot dictate sovereign choices.
The arrangement that Mody proposes is one whereby states decide by themselves which fiscal policy they prefer and default if they become insolvent; banks know that public debt is risky and behave accordingly; and governments force banks to shrink by refusing to stand behind them and socialize their losses. In short, Europe should emulate the late-nineteenth-century United States (or, perhaps more accurately, the early-twentieth-century gold standard).
Mody’s solution is logically coherent and looks attractive. But it is not clear that it would pass the test of reality.
First, a default by a major European sovereign would be a true financial catastrophe. The state of California’s debt today amounts to about 1% of US GDP, whereas Italy’s debt represents 18% of eurozone GDP. California’s default would be a secondary event in the US, whereas in the eurozone, an Italian default would impoverish debt holders massively, bring down several banks, and set in motion a dangerous chain reaction.
To be sure, investors, anticipating such a catastrophe, would refrain from holding Italian bonds, forcing Italy to reduce its public debt. But this would happen only in the long run. In the meantime, the entire eurozone would be vulnerable, while the very transition to the new, lower-debt steady state would add to Europe’s woes.
Second, a union of the kind imagined by Mody might not be very resilient. Deprived of their partners’ assistance, member countries could choose to quit. Indeed, Greece might have exited by now, had it not received massive financial assistance.
The two papers thus advance opposite templates for the eurozone’s future, neither of which is without risks. If, as they both suggest, Europe’s preference for the middle road is mistaken, and one or the other of the proposed solutions must be chosen, a true dilemma will have to be confronted.
That would be one more reason to use the current respite to think hard, lay out options, and be candid about preferences and their consequences.