July 31, 2020
Why we have been so pessimistic, and what will need to happen to change that
We are acutely aware that our take on the future of the eurozone is radically different from that of many other commentators. As this is our last briefing before the holidays, we thought we would lay out in some detail what’s behind our thinking and the analytical method through which we assess policy. That method is not foolproof. We had our share of errors. But the method as a whole served us well in the last 13 years by helping us remain focused on the essential, and not to fall for PR coups made in Brussels.
Our concern is the sustainability of the monetary union and the eurozone’s long-term prosperity. We concluded a long time ago that a monetary union with a single monetary policy but only minimal fiscal coordination and structural convergence mechanisms cannot last. It may in theory, but not in practice. That in itself does not constitute a prediction of the eurozone’s demise, merely a conditional statement that the persistent lack of such policies would cause that calamity to happen eventually.
The story is not binary. Sustainability has a technical component we believe is largely solved. The combination of the ECB’s new monetary policy instruments and the creation of the European stability mechanism have succeeded in addressing one particular threat: death by speculative attack. To the extent the EU achieved real progress, this is where it happened.
But sustainability has other components as well. Persistent economic divergence could persuade countries on either end of the eurozone’s productivity scale to leave the monetary union in hopes of achieving a better macroeconomic policy framework for themselves. Greece had a fling with Grexit in the spring 2015. The Five Star-Lega coalition in Italy had plans for a parallel currency. There was a whiff of Nexit in recent discussions in the Netherlands. Most of us would probably agree that a convergent monetary union would be more stable in the long run than a divergent one. When the EU created the monetary union, it only recognised nominal convergence criteria as conditions for joining. This was based on the prevailing economic orthodoxy at the time. But the divergence that took place subsequently was not in inflation but in productivity and employment. There are no effective EU-level instruments that could do the heavily lifting on reforms in those areas.
Our focus on the eurozone’s sustainability also means that we disregard very common arguments, like the following:
- the recovery fund is the EU Hamiltonian moment because the EU accepts, for the first time, the principle of a fiscal transfer;
- nobody would have thought in their wildest dreams that the EU would go as far as it did;
- let bygones be bygones, Angela Merkel has secured her place in history by placing Germany outside the camp if the frugals.
One can make plausible arguments in favour of each of those statements. We do not regard them as true or untrue, but as irrelevant. And yes, that includes Merkel’s position shift. We recognise it as a symbolic moment, but unlikely to have much of an effect on Italy’s future in the eurozone. Italy’s sustainability in the eurozone will not be determined by any of this.
Doubts over sustainability are not a single person’s or a single country’s fault. We see nothing in the recovery fund, including the applied conditionality, to address Italy’s debt sustainability problem. The fiscal transfer that is inherent in the programme is not big enough to make a dent in it. And it is would naive to think that the ECB will support Italy forever. There will come a day when central bank purchases of italian bonds end, and holdings are wound down.
So, rather than focusing on the long list of things that won’t do the job, let us now focus on those that might.
- A eurozone-wide fiscal space backed by a significant increase in the EU’s own resources. The fiscal union does not have to be large. We think 5% of GDP is sufficient. But it must be large enough for the eurozone to use its own financial balance sheet as a policy instrument. It cannot do this with a €390bn grant.
- Europeanisation of structural policies, including labour markets, pensions, and regulation of services and industry. This is essential to ensure that the eurozone is not just a single market, but a single economy. This means economic divergence takes place where it should: between regions, towns, companies and individuals, not between states.
- An obligation on policymakers to strive for a high degree of economic balance over long periods, and that forces them to act if imbalances become persistent.
- Agreement that the euro is a geopolitical instrument that can and should be used in support of the EU’s geopolitical goals.
This is not intended as an exhaustive list, merely a sketch of the scale of things needed to render a monetary union of divergent and sovereign countries sustainable, and to stop it from limping from crisis to crisis. The global financial crisis left the euro’s banks and some governments weakened. So did the eurozone crisis. And so will this one. We will judge a set of policies successful if we have reason to believe that this doom loop is broken.
If you think that none of this is realistic, you owe us an explanation of what steps you think are necessary for a lasting monetary union, or whether you are prepared to accept a break-up. Remember, the unsustainable does not become sustainable because somebody has done more than others thought they would, or because someone gave a wonderful speech. When we return from our summer break, we promise to continue to look at the eurozone with our analytical polaroid filter, one that cuts through reflections and mirages.