The Eurozone’s Agenda in 2013

PARIS – European Union leaders concluded 2012 with a landmark agreement that places all eurozone banks under a single supervisor. But the difficult negotiations that led to the agreement eclipsed European Council President Herman Van Rompuy’s recent report, Towards a Genuine Economic and Monetary Union, which calls for unity far beyond a banking union. Although “no door was closed,” in the words of European Commission President José Manuel Barroso, EU leaders have clearly refused, at least for now, to hold a serious discussion about deeper integration.

Van Rompuy’s report raises a fundamental question: What factors are preventing the eurozone from functioning as everyone would wish? Answering this question requires, first and foremost, comparing the dynamics at play during the euro’s first decade, 1999-2009, when the eurozone ostensibly performed well, with those of the last three years, which have been marred by crisis.

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At first, the eurozone seemed to function like a true currency union: capital-market integration was accelerated; cross-border activity increased; and the per capita income gap between member countries decreased. But, unlike in a complete currency union, such as that of the United States, eurozone members retained full financial sovereignty, meaning that they controlled all of the levers of macroeconomic policy.

Without external constraints, public and private expenditure grew precipitously in many countries on the eurozone periphery, while wages rose faster than productivity. As these countries posted current-account deficits, northern European countries accumulated current-account surpluses, exposing a widening competitiveness gap.

In a genuine currency union, wealth transfers and automatic stabilizers mean that such discrepancies do not pose a problem. With the eurozone as a whole benefiting from a relatively solid balance-of-payments position, European leaders initially failed to foresee the risk incurred by letting competitiveness differentials grow, and underestimated the threat posed by some countries’ accumulation of significant external debt.

Indeed, for ten years, north-to-south income transfers and lending financed excessive aggregate demand, making the eurozone seem stable. As markets underpriced risk in order to lend to increasingly indebted countries, pressure on interest rates diminished. (Over the course of the euro’s first decade, interest-rate spreads between ten-year government bonds nearly disappeared.)

The global financial crisis exposed the eurozone’s underlying flaw. Meanwhile, international bodies, including the International Monetary Fund and the G-20, encouraged struggling countries to implement loose fiscal policies, claiming that they were needed to overcome the crisis. But fiscal stimulus merely aggravated the problem.

Financial investors soon recognized that risk had been underestimated in some countries, causing interest rates to rise, sometimes to unsustainable levels, as in Greece, Portugal, and Ireland. While the decline in aggregate demand led to reduced imports, the combination of higher interest rates, lower public expenditure, tax increases, and wage deflation boosted unemployment and triggered recession.

Normally, by decreasing prices relative to their more fiscally sound neighbors, struggling countries can boost exports, thereby reducing their current-account deficits. But, in the case of the euro crisis, price stickiness caused inflation to increase more in debtor countries than in creditor countries, making adjustment even more painful.

In this context, Van Rompuy’s report is crucial. It maps out the architecture needed to “guarantee the minimum level of convergence required for the EMU to function effectively,” and calls for a more integrated financial, budgetary, and economic policy framework. Specifically, the report highlights the need for the eurozone to make two fundamental commitments.

First, eurozone countries must implement reforms aimed at boosting wage and price flexibility through enhanced competition and improved labor and capital mobility within and between member countries. Second, wealth transfers to peripheral countries, while controversial, are necessary.

To surmount the associated political hurdles, eurozone leaders must create a limited “fiscal capacity,” which should act as a “common but limited shock-absorption function” that would “contribute to cushioning the impact of country-specific shocks and help to prevent contagion across the euro area and beyond.” This mechanism should also provide financial support for structural reforms through “limited, temporary, flexible, and targeted financial incentives.”

But Van Rompuy’s minimal proposal may be insufficient. Currency unions require a mechanism for permanent transfers to poorer regions. The EU budget should facilitate such transfers in the eurozone, using structural funds. Tax transfers should also act as an automatic stabilizer in the case of asymmetric shocks.

Such reforms undoubtedly require a much more politically integrated, or federalized, eurozone. Facing up to that reality will be the main challenge for Europe’s leaders in 2013.