What future for the euro area?

Its incoherent makeup will have to be refashioned

2016-12-23

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A recent paper by France Stratégie tackles the persistent questions surrounding the future of the Economic and Monetary Union, in particular as pertains to the institutional framework underpinning the euro.¹ The document comes at a critical juncture, with elections in France and Germany in the horizon and the expectation that much will start happening towards the end of 2017.

Moreover, it provides much needed stimulus—and cogent arguments—to the overall debate about the future of the EMU about a year and a half after the European Commission published its so-called “Five Presidents’ report”.² Not much has happened to date, at least not insofar as the incoherence of the present system is concerned. This paper is unlikely to alter that trend in and of itself. That is not its purpose anyhow. Though it does at least provide a perspective as to what a new French government (and others influenced by those views) could potentially aim for.

The paper, which I consider essential reading, examines three realistically applicable models for the future of the euro. In the following sections I proceed to consider each case. That granted, I strongly recommend you read the original publication. What follows is either me paraphrasing or elaborating on my own interpretations and opinions.

Maastricht 2.0

The first option would be the most politically feasible in the sense that it would require few deviations from the EMU orthodoxy: a renewed commitment to the tenets of the original architecture of the euro. There would once again be a system of clear rules determining major aspects of fiscal policy, reinforced by an explicit (and this time credible) “no bail out” clause.

Where this system would differ from its predecessor is on the implementation front. In the buildup to the euro crisis it became readily apparent that the provisions of the Stability and Growth Pact were not enforceable. It is for this reason that in the aftermath of the crisis European policy-makers introduced the European Semester, the two-pack, the six-pack, and the fiscal compact. Their zealous commitment to a perhaps misguided approach notwithstanding, they wanted to address what we may refer to as the enforceability deficit that the EU all too often suffers from. The reforms make the rules-based system of economic governance more enforceable at least on the face of it, though again that is a subject of contention given the discretion of the European Commission to provide for exceptions.

To further address the flaws of the original design, the Maastricht 2.0 would redefine prudential policy as pertains to the perverse incentives that reinforce the feedback loop between banks and sovereigns. Banks would be encouraged to diversify their portfolio as public debt holdings would no longer be assigned zero risk (for instance, Greece’s debt used to be considered risk free, as if such a thing truly exists, which is obviously preposterous and a bad policy). Presumably, this would provide much-needed vigour to the expected corrective function of market agents. Indeed that is what Maastricht intended through its rules-based model: frivolous spending would be punished by rational markets.

Lastly, a new set of procedures would be introduced to the effect that sovereign debt restructuring would be possible coupled with a liquidity facility. This practically means a ‘troika’ mechanism that is known in advance. Such a role would naturally be performed by the European Stability Mechanism, though one would have to seriously reconsider its current decision-making structure which is strongly biased in favour of large economies, Germany in particular.

Given the evidence of the euro crisis, a renewed commitment to a system that failed so spectacularly is not advised. Markets proved to lack the overarching consistency and rationality expected of them to provide for system-wide macroeconomic stabilisation. Furthermore, financial institutions have been repeatedly encouraged to engage in practices that enlarge their ‘footprint’ so that their status as “too big to fail” forces authorities to bail them out, essentially rewarding their mischief and perpetuating the problem.

Proponents of the Maastricht model, including its possible refashioned alternative, would argue that its major upside is the scope it provides for national fiscal sovereignty. They would suggest that there is such a prerogative within an otherwise outer constraint enforced by the relatively generic rules. To the present author such claims are incorrect for they conflate the actual phenomenality of fiscal sovereignty with the genuine capacity of a government to formulate a context-specific economic policy.

Effective sovereignty is intimately linked to politics, manifesting in the capacity of the polity to exercise control over the means of governance and to adjust to evolving circumstances.³ The rules-based model as well as the various ex ante restrictions assume a constancy of parameters and prevailing conditions. They treat politics as a perfectly predictable, linear exercise in management, rather than the cyclical and occasionally erratic process it actually is, especially in times of crisis where needs fundamentally differ from times of ‘normality’.

In short, the Maastricht paradigm is a relic of the 1990s. It is finished.

Supranational economic governance

EU policy-makers are well aware that the original design of the EMU or some variant thereof is unsustainable. The integration process has been heading in an altogether different direction, which combines elements of a rules-based system with economic coordination.

This brings us to the second scenario for the future of the euro area: economic governance. The notion of national fiscal sovereignty is discarded in favour of shared responsibility (sometimes falsely referred to as “shared sovereignty”) in the enforcement of macroeconomic rules. Liabilities on sovereign debt are mutualised, to the effect that taxpayers of one country effectively pay for the excesses of another state. Meanwhile, national parliaments lose significant powers to scrutinise their government, as economic governance unfolds at the supranational level—in practice intergovernmentally—under the oversight of the European Parliament or, in the case of a further reform, some euro-area-specific legislative institution.

The system can be provided with a pseudo fiscal capacity at the centre, which would consist of transfers from national budgets. Such fund would only be used as a means of bailing out a Member State in times of duress, in exchange for the ever stricter enforcement of fiscal discipline.

What this scenario describes is essentially where we currently stand. Liabilities are mutualised through (i) the ‘activism’ of the European Central Bank, (ii) the existing bailout programmes, (iii) the very presence of the European Stability Mechanism. The latter also doubles as the fiscal backstop of the euro area, the pseudo budget that is, which provides for marcoeconomic stabilisation in exchange for harsh austerity.

Further, the European Parliament is already performing the role of checking the implementation of economic governance through the European Semester as well as the monetary dialogue with the ECB (whether the EP has any major impact is subject to examination). National parliaments, meanwhile, have lost much of their power over their respective executive, for economic policy is now considered a matter of shared competence and, hence, excluded from the typical loop of national policy initiation and parliamentary confirmation.

Reforms to improve democratic legitimacy could only be in the form of an altogether new legislative entity that would operate at the same level as the emergent executive, i.e. at the intersection of national and intergovernmental politics. To that end, it would have to be an ad hoc parliament consisting of MEPs as well as national deputies. It would in effect be a platform for policy coordination between national parliaments and the European one.

Whatever the specifics, I personally find this formation to be largely suboptimal. Even in the case where the European Parliament or a bespoke legislature would have enhanced powers to scrutinise the process, it would fall short of its objective. The reason, albeit a nuanced one, is that the executive is not a body, but an intergovernmental process. Economic coordination happens between governments. It is not defined by an EU-level government. To this end, the model of economic governance now in place, or with some suggested alterations on the margins of its institutional order, reinforces the existing sovereignty mismatch of the EU by failing to provide for an identifiable executive that is accountable and dismissible as a body.⁴

This model requires a rigid framework of fiscal and macroeconomic rules, an intricate arrangement for coordinating national policies, all while removing the normative questions of economic policy from where they are mostly relevant: the national/local milieu. The system as a whole is believed to be more stable, though I would argue that this is a feature of its obscurity and complexity, not a genuine type of robustness to economic shocks. The lack of a system-wide stabilisation function that does not reinforce the debt-deflation spiral is a major weakness.

Neither the ESM nor the ECB, each for its own reasons and mandate, can be a suitable substitute for possible EU-wide economic policy initiatives. Besides, the politics of bailing out other states with national taxpayer money have proven highly controversial and potentially toxic. The rise of ultra-conservative and overtly nationalist political forces across Europe can to some extent be explained as the longer-term effect of the vociferous reactions to such bailouts (remember those “lazy PIIGS” and the pseudo-morality disguised as economic analysis coming out of commentators from the eurozone ‘core’?).

If I were to make a modest prediction, this is the direction the EU will continue to pursue for at least another five years. In large part that is due to the space allowed by the current Treaties, coupled with the willingness of European leaders to provide for certain necessary instruments outside the proper EU framework (such as the ESM). It also is a convenient model for national governments that prefer intergovernmental arrangements for European policy formation and implementation. Moreover, it is considered easier to proceed with business as usual than engage in an open-ended consideration of serious alternatives. Institutional inertia of such sort should not be underestimated.

Fiscal federalism

In the third and final scenario considered in the France Stratégie paper, the makeup of the EMU would be thoroughly reformed so that the supranational level would have the fiscal capacity (common budget, borrowing powers through the issuance of debt instruments) to provide for system-wide macroeconomic stabilisation, with Member States being fully responsible for their debts in exchange for a wider scope for national economic initiatives. The rules-based, quasi-automatic paradigm of Maastricht would be deprecated in favour of a more politics-driven and relatively decentralised institutional order.

Where fiscal federalism differs from the previous two is in its entire conception of crisis management. The others aim at the prevention of sovereign debt crises, while fiscal federalism is more concerned with the amelioration of the effects of such crises by easing the asymmetries of an economic shock. As experience shows, the focus on prevention requires a great deal of effort to enforce decontextualised and ‘apolitical’ rules on the fiscal front, coupled with a firm belief in the capacity of the markets to cancel out any irregularities.

Maastricht clearly failed in its intended goal of preventing a major crisis, while it remains to be determined whether the present model of economic governance will prove more robust, especially when faced with a major political crisis arising from the conflicting agendas of governments involved in economic coordination who also wield considerable power at the ESM board.⁵

With the kind of federalism here considered, the deleterious effects of austerity would not be felt at the local level, as fiscal transfers would partially arrest the downturn. Transfers would come in the form of welfare benefits, thus easing the pressure on state budgets, making the process of running a small deficit or primary surplus less painful for the real economy. Personally I consider this the superior option, provided a fully fledged EU fiscal capacity led by a clearly identifiable political body that can be held accountable by the European Parliament.

Once again, if I were to make a prediction, I would suggest that there is no chance that fiscal federalism will gain any traction in the current political environment. The idea that the EU would have the power to raise taxes, issue debt, and direct funds where necessary would not be of much appeal across national governments, as it would, among others, imply a redistribution of competences as pertains to taxation. Furthermore, it would require the further politicisation of the European Commission, or some major rethink of the EU executive, which should, inter alia, reduce the powers of the European Council (and intergovernmentalism more generally).

Fiscal federalism would be in the interest of the EMU as a whole, though it is clearly not in the individual interest of at least some of its parts. It is this very phenomenon, this ever present disconnect, that will keep the EU confined to a path of incremental adjustments to the model of supranational economic governance, at least until another major crisis proves the shortcomings of such an approach.

A much-needed debate

What I particularly appreciate about the paper of France Stratégie, apart from its obvious analytical qualities, is that it contributes important ideas to a pertinent debate. Ideally one would expect every government to entertain similar notions, think through the various issues and arrive at the most coherent position. One may even imagine open proposals for public consultation or parliamentary discussion, in an effort to gather as many views as possible on the future of the EMU.

The timing of this debate is also important, for it comes prior to major elections. It is typical for EU-related issues to be put on the sidelines for consideration after election cycles. In part this is due to a concern that citizens could ask for a change in the supranational status quo, though there also exists a perception gap between national lifeworlds and the [absence of a] European public sphere. With such papers, stakeholders have the chance to review important questions in advance and to adapt their platform accordingly.

The design of the EMU is of paramount importance for the life of every citizen. The technicalities should not obscure the fact that much of the specifics of economic policy—and the relevant EU distribution of competences—hinges on the kind of negotiated result that European policy-makers will arrive at in their deliberations over the future of the euro.

The material implications will also vary depending on what their choice will be. A rules-based system means more [nominal] power to the national level in exchange for potentially more painful austerity. At the other end, fiscal federalism promises a more holistic view of systemic issues and an arguably more efficient way of tackling challenges as they emerge. Whereas the model that currently takes shape, that of supranational economic governance, seeks to satisfy all national sensitivities, hence its intergovernmentalism, at the expense of democratic legitimacy and, arguably, sound economic policy for the interests of the system at-large.

1. France Stratégie paper published on December 20, 2016: What model for the future of the eurozone?. [^]

2. The Five Presidents’ Report: Completing Europe’s Economic and Monetary Union. Published June 22, 2015. [^]

3. For more about my views on sovereignty, refer to my free book: Essays on Sovereignty. Published November 14, 2016. [^]

4. For more about my overall analysis of the EU, refer to my free book: Little Guide to the European Union. Published May 9, 2016. [^]

5. The kind of intergovernmental setup that characterises economic governance and the European Stability Mechanism’s decision-making platform has a major side-effect. It contributes to the creation of a [dynamic] two-tier setup for Member States that can more broadly be described as a divide between situational creditors and debtors. These two groups battle over the prevalence of each side’s interests, rather than both working to promote the good of the system at-large. [^]