The Eurozone crisis is becoming ever more complex and cutting through the chase is becoming more and more difficult. My broad analysis of overlapping structural, political and democratic crises seems to hold up reasonably well but it is time to expand on these categories following a series of conversations I had with a variety of economists. The different crisis strands are coming together in a toxic mix and there is still a significant amount of confusion about the causes of the predicament. This needs to be clarified.
The Structural Crisis
The structural crisis we are facing is a mixture of the design flaws of the Eurozone itself, the construction and functioning of the financial sector and the results these design flaws have had in several areas. The Eurozone design flaws mean that one country after the other can be picked out and there can easily be contagion and self-fulfilling prophecies of insolvency across the currency union even though the underlying economic fundamental look sound. These issues have been extensively discussed and are reasonably well understood.
The deep competitiveness problems in some crisis countries are the result of massive inner-Eurozone capital flows that should not have occurred in the first place. There was a failure of macroeconomic oversight and regulation to prevent these capital flows and the incentives for banks were to abuse their too-big-to fail status and engage in risky activities. The buildup and bursting of economic bubbles and the deep trouble some of the Eurozone banks are in are the result of this situation.
These structural flaws of the Eurozone and their consequences converged with a second source of economic distress – the financial sector induced global economic meltdown set off in the United States – which led to governments initially propping up economies by stimulus spending and stabilising the financial sector with bank bailouts. So in many important ways it is still the structure and incentive system of the financial sector that are in urgent need of reform.
Related to this are sovereign debt issues. Current sovereign debt levels are composed of three elements: First, the pre-existing debt levels before the crisis, which in most countries were unproblematic. Second, new debt accumulated as a result of necessary economic stabilisation measures in the first crisis phase after the London G20 and the loss of tax revenues as well as higher social costs as economic activity deteriorated. And third the rather widespread socialisation (beyond the initial bailout measures) of private risks (which affects yields) and debts. The fact that it is financial players currently exploiting the structural flaws and putting excessive pressure on countries caught in debt traps – with no regard to their own crucial role in driving them into this situation – is again an indication that deep structural reform and proper regulation of the sector is long overdue.
The Political Crisis
The political crisis has made the overall situation worse still. Apart from the fact that we still don’t have a full blueprint for a sustainable Eurozone architecture, only individual measures that don’t seem to add up to a coherent strategy, political leaders have also failed in stabilising the crisis. They have also been reacting to events rather than shaping developments. This is to a large extent driven by the mistaken analysis that the sovereign debt problems were the cause of the crisis rather than the result of the deeper structural issues described above. The resulting policy of austerity has driven European nations apart and pushed crisis countries into debt traps making the necessary reforms and a sustainable reduction of debt to GDP ratios impossible to achieve.
It is true that the economic bubbles in the South should not be re-inflated and that the restoration of competitiveness also means pursuing a difficult process of adjustment. But this adjustment process needs to be symmetrical by having higher wages and also higher inflation in the core countries. An asymmetrical adjustment achieved only by deflation in the South is economically and politically unviable. It is also an often-heard argument that pushing up wages in the core would make the Eurozone uncompetitive vis-à-vis the rest of the world. But this tendency could be addressed by devaluing the Euro so external competiveness does not suffer along the way.
Some people argue that a shock adjustment is the way to go. But I don’t think that such an approach is either politically viable or socially acceptable and it is also incompatible with a symmetric approach as there won’t be high enough wage rises in places like Germany over night. The levers of conditional credit can force measures in crisis countries. Comparable levers for upward adjustment in the core countries are, however, missing. It is therefore utterly important to set a credible path for symmetric adjustment.
What needs to be done? I think four steps are necessary. First, there needs to be growth to make structural adjustment and the medium-term reduction of debt to GDP ratios possible. This requires a move away from austerity and the decoupling – as much as possible – of competitive adjustment from fiscal policy. Competitive adjustment primarily needs to take place in the private sector and governments should support this difficult process by growth-enhancing measures, not austerity.
Second, if there are stagnant or slowly increasing real wage levels in the South, matched by considerably higher wage increases and higher inflation in the core, new growth could not only help to address competitive imbalances but also the huge unemployment issues. This in turn could also help to bring social costs and public deficits under control.
Third, inequality has been identified as one of the key structural drivers behind our broken model of finance-driven capitalism. Inequality is for instance revealed by the ever-decreasing income share of wages in the face of an ever-increasing share of profits. Addressing this issue is an urgent matter for the reform of the economic system as a whole, the fairness of the adjustment process and the regaining of trust in democracy. And it goes without saying that given the arguments above the fundamental reform of the financial sector is another key political priorty.
And fourth, the refinancing costs of countries also need to be brought down. Here, the issues of debt mutualisation, ECB reform and a joint banking system, which are required for the long-term institutional sustainability of the Euro, are at the core of current discussions. There are, however, important democratic issues attached to this, which leads me to the third crisis.
The Crisis of Democracy
The democratic crisis is also worsening and might well be the fighting ground that eventually decides the fate of the Eurozone. There is first of all the situation – resulting from the Euro’s structural design flaws – that 17 sovereign fiscal decision-making procedures create policy externalities for all Euro countries because of the joint currency. Second, there are national democratic crises as the burdens of economic adjustment are currently not only unfairly distributed amongst countries but also within countries, partially because of credit conditionality and partially because of deep-seated democratic problems in some member states. Across the Eurozone, people increasingly seem to lose faith in politics and the ability of the political class to master the huge problems and at the same time maintain democratic principles. And last but not least the move towards a political union, necessary to overcome the Euro’s structural flaws in the long-run, faces several serious challenges.
It is often argued that a mutualisation of debt would create a moral hazard as it reduces the pressure to pursue necessary adjustment and break the link between decision and responsibility – similar to the same broken link in the financial sector. There are basically two options to address this issue. The first one does not involve a full political union. One basically keeps 17 national decision-making procedures in place and constrains them by generally binding rules. This is what is currently pursued. Even if the rules were right – and the fiscal compact rules are not right in my view – there is a big issue of enforcement. The only sanction for rule breaking would be penalties but could one realistically fine countries already in a financial crisis for breaking rules? This hasn’t worked in the past and is unlikely to work in the future. Seen in this light the common rules approach – even if there was a way to establish the right rules – seems unworkable.
Moral hazard has to be contained by a governance mechanism with teeth that intervenes before a spending decision is finalised (ex ante not ex post). This would mean supranationalising a large part of fiscal policy decision-making, which effectively breaches current national sovereignty rules and would be unconstitutional in Germany and I suspect also in most, if not all, other Eurozone countries. So this kind of political union would require extensive constitutional change on the European as well as the national level.
At this point the sheer scale of the task becomes clear: There are no easy solutions and there are no quick fixes. Is such a supranationalisation possible? Would citizens across the Eurozone back such a move, maybe even by referendum? If these hurdles cannot be overcome, could there be minimal integration, for instance a banking union, without a full fiscal integration? Could this work or will the Euro with such a construction inevitably fail at some point with all the huge and unpredictable political, economic and social consequences? Can such a large reform be achieved in the short-term, effectively with a gun to your head? Or can we at least set a process in motion that would transform the Eurozone in this way, maybe over the next decade or so?
Where do we go from here?
The fusion of structural, political and democratic crisis aspects is becoming more and more complex. Against this backdrop, it might well be the issue of democracy that finally decides the fate of the Eurozone in one way or the other. The European integration process driven by elites seems to have reached its limits. In the long run the Eurozone crisis can only be solved by a democratically legitimised leap forward; or by disintegration which could be a political, economic and social disaster (nobody knows!). So after all, at its core the Eurozone crisis is still a political crisis.
This column is part of the Eurozone Scenarios Project of the Friedrich-Ebert-Stiftung and Social Europe Journal. The long version of the scenarios paper can be downloaded here. A Statistical Annex is also available.