A sovereign currency represents the collective characteristics of the issuing nation. The single currency of the European Union – the euro – is far removed from this status. Rather than demonstrating unity, it is a continuing source of tension, debate and dispute among the euro area’s constituents.
At a time when the European Central Bank needs to go further in ‘normalising’ interest rates to counter persistent inflation, member states and the European Commission must demonstrate political will for corrective action. Unless new policies are forthcoming, sooner or later, a new euro crisis could erupt.
The euro is the second global currency after the dollar. But this success cannot hide deep internal divisions. The reasons are manifold. There are as many budgetary policies as member states. Perceptions of inflation vary widely, since northern members are less inflation-prone than southern – a state of affairs perpetuated by the ‘one size fits all’ interest rate. The EU since the 1960s has become less guided by strong structural policies in areas like industry, agriculture and energy competition. Instead, it has moved to a single market without community preferences, often overridden by powerful national trends.
Euro area growth has lagged the US. Since 1995, real US gross domestic product has increased by more than 90% against the euro area’s more than 50%. Reflecting better US productivity, the growth gap has intensified since the 1997-98 financial crisis. Eliminating the risks of fluctuating exchange rates favours product specialisation. As a result, the euro has reinforced the more industrialised euro area members at the expense of those in industrial decline. A relatively weak fixed exchange rate favours exporting countries. Germany’s real effective exchange rate is estimated to be 20% undervalued.
Macroeconomic divergence is further demonstrated by the Target-2 imbalances representing the national central banks’ intra-euro area claims and liabilities. Spain and Italy register liabilities of around 28% of GDP, while Germany has a net claim of 26%. A monetary union does not erase current account imbalances that remain, by definition, national. Public debt and deficit levels are highly divergent. Unfortunately, the single European market has not brought more economic coherence, because member states have not aligned policies on necessary reforms. Structural low ECB interest rates over the last 15 years have driven capital flight, especially to the US.
What can be done?
One way forward would be to overcome EU banking fragmentation. This would require harmonising national rules and overcoming host country ring-fencing practices. Steps are needed to drive forward capital market union, which so far remains a dream. The same is true of the need for a safe European financial asset, held back by the absence of a common tax policy.
With integrated banking and financial markets, excess savings from northern countries could finance necessary investments in the south. This would promote European growth, the international role of the euro and Europe’s strategic autonomy in finance. But this aim is impeded by growing economic divergence and lack of trust among member states.
Another basic problem has been ultra-accommodative ECB monetary policies. These have disincentivised structural reforms, particularly in France and Italy. ‘Fiscal dominance’ under near-zero interest rates has made public deficits easily financeable. The ECB’s quantitative easing helped problems caused by spreads in bond yields but heightened general indebtedness and the vulnerability of the financial system.
Eurosystem central banks now own more than 30% of outstanding public debt, casting a dark shadow over central bank independence. By setting medium- and long-term interest rates administratively, central banks have crossed a crucial limit: that of intervening in the allocation of resources and the distribution of wealth, shutting out the influence of markets.
Central banks have systematically favoured debtors over creditors. But now that interest rates are at last increasing, debt servicing costs have risen sizeably, weighing heavily on indebted countries’ budgets. Some EU member states could see their debt sustainability called into question. Failure to understand that over-indebtedness drives under-competitiveness holds back an economically and financially integrated Europe. Fiscal and economic divergence favours go-it-alone policies and prevents progress in sharing public and private risks.
Avoiding fragmentation
As the ECB continues to combat persistent inflation, how should monetary policy take into account the risks of financial fragmentation? It would be wise to start a resolute process of quantitative tightening to eliminate excess liquidity. Fears of rising European spreads must not dominate monetary decision-making. Sooner or later, structural spreads – reflecting accumulating fiscal and structural deficiencies – will reappear. The ECB wishes to moderate ‘excessive’ differences in market rates. But central banks are not obliged to erase systematically all traces of interest rate differences. That aim would be difficult to reconcile with the Maastricht treaty.
Nor can monetary policy solve structural problems. Member states must adjust their economic and fiscal policies accordingly. The revision of the stability and growth pact must be ambitious and immediately effective to prevent an imminent euro crisis. Fiscal dominance must be replaced by gradual convergence of member states’ budgetary polices. The European Commission’s proposed case-by-case framework seems a good approach. The pace of return to public debt below 60% of GDP should be specifically adapted to each country.
The macroeconomic imbalance procedure must be rigorously respected within the framework of equal treatment and multilateral surveillance, either by the Commission or by an independent budgetary authority. Current account adjustments should concern countries with both structural deficits and surpluses. It is neither possible nor honest to expect the countries of the south indefinitely to reduce economic growth to rein in deficits to compensate for northern surpluses. A symmetrical adjustment mechanism is needed where surpluses are treated in the same way as deficits.
Europe’s complex system of attempting to manage monetary union without a credible economic stability mechanism is unsustainable in the long term. European policy-makers, and above all the Commission, must assume responsibilities in respecting economic discipline. This requires independence, competence, vision and courage. At present we see a process of fiscal, inflationary and economic slippage – and the danger that the more ‘virtuous’ countries of the north end up paying for the ensuing problems. It is time Europe takes its destiny into its hands.
Jacques de Larosière is a former director of the French Treasury, managing director of the International Monetary Fund, governor of the Banque de France and president of the European Bank for Reconstruction and Development.
This is a longer version of an article published in the Financial Times.
Jacques de Larosière made a speech on this subject in Luxembourg on 4 October. Read a French-language version here.