Some thoughts on euro area imbalances

2015-08-14

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In a July 17 article titled “Greece and Europe: Is Europe holding up its end of the bargain?”, Ben Bernanke, the former chairperson of the Federal Reserve (Fed), states thus:

[…] it’s time for the leaders of the euro zone to address the problem of large and sustained trade imbalances (either surpluses or deficits), which, in a fixed-exchange-rate system like the euro zone, impose significant costs and risks. For example, the Stability and Growth Pact, which imposes rules and penalties with the goal of limiting fiscal deficits, could be extended to reference trade imbalances as well. Simply recognizing officially that creditor as well as debtor countries have an obligation to adjust over time (through fiscal and structural measures, for example) would be an important step in the right direction.

It appears that while Mr. Bernanke may be raising a valid point, he does not note the presence of Europe’s legal framework for economic governance beyond the Stability and Growth Pact. Furthermore, he seems to remain trapped in the rationale of automatic rules covering up for the absence of a concerted Union-level economic policy.

What has been introduced as a response to the financial crisis is the European Semester: an elaborate, highly technical process for economic policy coordination. Within that framework, there exists a certain instrument for addressing trade imbalances: the Macroeconomic Imbalances Procedure (MIP).

The European Semester is a “multilateral surveillance” framework, in accordance with Article 121 of the Treaty on the Functioning of the European Union. Though never explicitly labelled as such, it is an inter-governmental arrangement enhanced by Community involvement, courtesy of the participation of the European Commission, the European Parliament, and the Council of the European Union.

Macroeconomic imbalances are supposed to be addressed in three separate phases:

1. an early warning system based on the monitoring of eleven economic indicators;
2. preventive and corrective action, with the former being presented in the Commission’s country-specific recommendations and the latter being formulated by the Member State whose imbalances are to be corrected;
3. enforcement involving sanctions.

The provisions peculiar to the MIP are part of the so-called Six-Pack, in particular Regulations 1174/2011 and 1176/2011.

Legal complexity conceals a simpler problem

To cut the longer story short, these are perfect examples of what I have repeatedly referred to as Europe’s model of “common rules without common politics”. The European Semester is a rather arcane workaround for the European Union’s or the Economic and Monetary Union’s lack of a genuine fiscal capacity.

Had there been a European Treasury in place capable of raising taxes, issuing debt, and framing the operations of the European Central Bank, economic policy coordination would be less of an issue. Instead of relying on peer pressure among governments and putting faith in the ability of each state to address economic magnitudes that may extend beyond its reach, whatever asymmetries would be decisively addressed by European-level measures in line with cyclical fluctuations.

Member States whose currency is the euro do not have monetary instruments for dealing with imbalances, while they also have no means of imposing restrictions on the free movement of capital. Add to those the rigid fiscal constraints of 3% budget deficit and 60% public debt and you get a system that is designed in such a way that only “structural reforms” can be considered, which typically result in the introduction of measures for repressing direct and indirect labour costs.

The fact is that Member States are not economically sovereign. Yet it is expected of them to act as if they were. The absence of such power would not be a problem in itself had it been sufficiently compensated by a greater, European sovereignty over economic policy. But without a European Democracy in place, governments face constraints they may not be able to overcome, inevitably leading to a reduction in the overall quality of policy, narrowing it down to a set of unidimensional provisions against the interests and material conditions of those on the lower parts of the income distribution.

I would contend that economic governance, as it is currently made manifest as a multilateral framework of coordination, is the sub-optimal and largely inadequate alternative to a “federal” approach to economic policy.

Susceptibility to abuse

What follows from the absence of a genuine federal republic, is that the inter-governmental setup necessarily hinges on inter-state relations and the situational balance of power thereof. Influential Member States such as France have already been treated with leniency, while it is not at all clear whether Germany’s macro-economic imbalances, as identified by the Commission, will indeed be addressed over the short-to-medium term. Time will tell.

Still, uncertainty over the effectiveness and credibility of the MIP should not be dismissed as a mere sentiment that arises in the mean time between the identification and correction of imbalances, or indeed the absence of economic normality. As with the original framework for enforcing the Stability and Growth Pact in the early years of the euro, the system continues to be contingent on the good will of Member States to comply with the rules. Yet if some states can enjoy preferential treatment, all while increasing the pressure for reform on the less powerful ones, then economic governance is not as robust to abuse as it ought to be.

To that end, we have this admission from the European Commission’s November 2014 review of economic governance (emphasis is mine):

As regards the question whether the procedure has been effective in identifying the relevant policy issues, contributed to deliver appropriate policy recommendations, and to their monitoring and had an impact on the policy debates in each Member State and in the EU as a whole, it needs to be pointed out that the Macroeconomic Imbalances Procedure, together with other elements of economic governance, has contributed to a shared understanding among Member States of their specific and common policy challenges and the policy response. However, there is a need to improve the implementation of the relevant policy recommendations, and find the tools that improve the incentives for Member States to adopt and implement the necessary policies.

A sceptic could point out that offering “incentives” to a government to introduce measures that might undermine its own favourable economic (and perhaps negotiating) position, is not the most prudent of approaches. If a given Member State has more to gain than lose from a certain set of conditions, it will simply do whatever it can to circumvent the rules.

It is highly unlikely that inter-governmental peer pressure—this “shared understanding”—coupled with excessive optimism will be sufficient to cover the design flaws of a stateless currency. Though empirically informed from the euro’s past, I believe it is more likely that the loopholes of economic governance will be abused with impunity once again: the overall framework will not succeed in fostering a rational approach to correcting area-wide imbalances.

Constructive criticism is necessary

As of late, there is a certain tendency to dismiss some American intellectuals and economists as “clueless”, just because they may happen to be unaware of some of the EU’s obscure particularities. This kind of cavalier attitude is directed towards those who mostly disagree with Europe’s handling of its own crisis.

As I am not a panegyrist of eurocentrism, I will resist considering Mr. Bernanke an “ignoramus” as far as European affairs are concerned. The fact that he did not reference such things as the European Semester, that he might not have known of its existence or scope, is an indication of the inherent complexity—and resulting opacity—of Europe’s methods for economic governance.

Technicalities notwithstanding, the crux of Mr. Bernanke’s argument is valid: the euro has internal imbalances that have remained unchecked. To me the solution to that design flaw is the establishment of a European-level fiscal capacity to underpin a “federal” economic policy. Asymmetries need to be addressed by a European Treasury, a Ministry of Finance, that will have the power to direct resources wherever necessary.

For the time being, there is a divide between the presence of legal instruments and the institutional framework for implementing them. Europe has rules, lots of them. What it lacks, is the European-level democratic state that owns the euro and its governance, and which has the power to conduct policy for the system as a whole, without arbitrarily favouring or discriminating against any Member State.

It is pointless to correct a system of “common rules without common politics” by merely strengthening the legal provisions. Efforts must be directed towards establishing legitimate common politics for the promotion of the general good, without having to be exposed to the vicissitudes of inter-governmentalism; an inter-governmentalism that have thus far delivered mostly sub-optimal and largely undesirable policy outcomes.