Ten years on

 

The European Commission’s report on the future of the euro area has not been getting the deserved attention in European newspapers, which is why we are (unusually) running a special edition summarising, and commenting on, some of its key recommendations.

 

The others big news yesterday was the now official recommendation by the European Commission that Slovakia can join the euro next January, becoming its 16^th member state. The ECB’s report on Slovakia has warned about future inflation (though the country did meet the inflation criterion). See this report in Frankfurter Allgemeine for more details.

 

Now back to the EU’s Commission report on the euro area. EMU@10 is a very substantial document about the future of the euro area – by far the most comprehensive and thoughtful report we have yet seen. It has three parts. We will ignore the first, which looks back at the first ten years, as well as the second on future challenges, and focus on the third about policy co-ordination, the most important from our point of view.

 

There are three schools of thought about euro area policy co-ordination. There are those who want a new treaty to produce genuine gouvernance economique to subject the ECB to political dictat. There are those who want to stretch the existing framework (“let’s see how far the ambiguity over exchange rate policy can take us”). And there are those who want to work under the existing framework. We should not be surprised that the European Commission – the guardian of treaty after all - is clearly among the latter.

 

Nevertheless, despite the EU Commission’s naturally conservative instincts, this report proposes some far-reaching changes of policy.  One would be mistaken to belittle its recommendations. The two most important in our view are coordination of structural reforms, and external representation of the euro area. Let’s deal with those two issues in turn – before briefly addressing the question of whether more is needed.

 

Coordination of structural reforms

This is a very significant proposal. What is remarkable is that the European Commission is departing from the previous line that economic reforms should be dealt with purely under the framework of the Lisbon Agenda. This report acknowledges that there are euro area-specific, rather than EU specific, externalities in economic reforms. And while the Commission does not favour a new Lisbon Agenda for the euro area alone, it proposes structures to deal with implementing reform policy co-ordination at the euro area level.

 

The Commission favours the euro group of finance ministers as the appropriate place where this co-ordination should take place. This group has one distinct advantage – and several disadvantages. The advantage is that it exists – and it is formally recognised by the yet to be ratified Treaty of Lisbon. This is not as trivial as it sounds. Lack of official status was a big problem for the euro group in the past. The biggest disadvantage is that finance ministers are clueless about structural reforms. (We think this is a problem that can be solved, however, by extending the euro group informally to include other ministries, and let the euro group be the formal body. This is not exactly a clean solution, but we have done worse things in the past).

 

Leaving this point aside, this is what the report says about how such coordination should work in practice:

 

For the Eurogroup to become a vocal supporter

of reforms at national and EU level, it will be

important that its discussions on structural

reforms become more focused with a particular

stress on spillovers. The objective of these

discussions would be to arrive at common

understandings. A more effective monitoring of

the implementation of reforms in response to

euro-area recommendation would have the

character of a common will. An even stronger

signal would result from euro-area Ministers'

commitment to concrete measures aiming at

removing nominal wage and price rigidities. As

stressed before, pressing towards a brisk

implementation of the Service Directive in the

euro-area Member States would be a suitable

starting point for common action by the

Eurogroup.

 

 

We are actually surprised by this. We have not heard before that the Commission wants to push ahead parts of the single market within the context of the euro area alone. This is actually quite revolutionary (and it will annoy the Brits endlessly). The suggestion to start with services is in many ways very clever. Apart from the fact that service liberalisation is the closest you can get to apply pie in structural reform policies, it is politically easier to liberalise services within the euro area rather than within the EU, as we circumvent the Polish plumber issue for the time being. The more serious point is that the euro area members are economically much closer so that services liberalisation should be less controversial.

 

Apart from assigning a formal policy co-ordination role to the euro group in structural reforms, the Commission also proposes that more attention be paid to the sequences of reforms. We are now definitely in a new post-Lisbon age here. In particular, the Commission argues that financial sector reforms are much more likely to enhance benefits of product and service market reforms. This is how the Commission defines the objective:

 

As to the sequencing of

reforms, particular emphasise should be

placed on improving the functioning of

financial markets which help 'bring

forward' the benefits of other reforms and

hence strengthen the political incentives in

implementing them.

 

 

Again, this is a very smart suggestion. Most of the economic reform debate in the EU has focused on labour markets, while the financial services agenda was dealt with under a separate process at EU level. It is unquestionable that financial market integration plays a particularly important role for a monetary union, and it is sensible that member states of EMU discuss this issue – not to create barriers to non-EMU members, but to provide leadership on this important issue for the EU as a whole.

 

 

 

Strengthening the International role of the euro

The second set of proposals was well flagged in advance, and discussed on Eurointelligence at length: improving the international role of the euro. Here is what the Commission has to say:

 

…the internationalisation of

the euro brings a number of benefits to the euro

area. These benefits, which are likely to increase

over time, range from seigniorage revenues and a

capacity to place securities among foreign

investors at lower interest rates to certain

competitive advantages for euro-area exporters

and financial institutions. However, there are

also potential costs and risks associated with

having an international currency, including a

more unpredictable money demand and a higher

exposure of the euro area's economy and its

financial system to abrupt shifts in portfolio

preferences due to the increased substitutability

between euro assets and dollar assets. Moreover,

the transition from the current situation to a new

steady state characterised by a wider

international role of the euro may not be smooth…

… The new policy challenges and

responsibilities in the international arena, notably

those related to the greater potential for financial

upheaval due to sudden changes in market

expectations, call for a clear role of the euro area

in global economic governance institutions.

 

 

In other words: The euro’s international role is large and growing, and the EU is woefully unprepared for this. This is what needs to be done, according to the Commission:

 

A consolidated representation of the euro area in

international fora can strengthen the euro area's

negotiating power and can increase its gains

from international policy coordination. It can

also reduce the transaction costs associated with

international coordination and increase the

interest of other key partners to coordinate with

the euro area. The EU's common external trade

policy demonstrates the advantages in terms of

bargaining power and influence of speaking with

a single voice

 

The European Commission wants a single euro area representative at the IMF, and at the various G-groups. We have been saying this too, but it is one thing for us at Eurointelligence to say this, but quite another for the European Commission. For example, the external representation issue has been discussed by many commentators, including Barry Eichengreen, in terms of the EU as whole, rather than the euro area. The European Commission actually favours euro area-only representation.

 

 

What should we make of these measures

If all the proposals were implemented, it would amount to a policy revolution, the biggest since the beginning of the euro area. Should the Commission have proposed more?

 

The French government reportedly favoured a euro area summit to be held during the French presidency. In our view such a meeting could be quite useful, on the conditions that it is well prepared, and that there is a genuine attempt by the main players to make progress. Neither condition is in place. President Sarkozy and some of his more thuggish advisers have left behind a trail of scorched earth on this question, leaving the Germans as close to a veto mood as it gets. According to Le Monde, the French now dropped the idea.  

 

If we take the present policy regime for the euro area as given – and we believe we should – then the Commission’s proposals would be a huge step towards improved governance. Of course, we are still in a neoclassical world, but then this is part of the setup of the euro area. The present framework provides for a high decree of monetary and fiscal stability, while adjustment to shocks is left to the real economy. This is harsh regime no doubt, but it is the regime we have, and it is not going to change. Once we accept this reality, the Commission’s proposals are actually a big step forward.

 

 

 

 

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