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Analysis
EMU’s biggest threat is political contagion

EMU’s biggest threat is political contagion

Euro authorities should show solidarity despite moral hazard fears
No preparation and no architecture for political union

by Prof. Ray Kinsella, Michael Smurfit Graduate School of Business, University College Dublin

Mon 25 Jun 2012

As a full-blown Spanish crisis spills over into Italy, developments in economic and monetary union (EMU) bear an uncanny resemblance to the collapse of the Bretton Woods system in the early 1970s. Denial is followed by delay and then by various faulty repair schemes. Finally we get an implosion leading to global contagion and instability.

Financial contagion has been primarily transmitted via short term money markets. It has infected the banking sectors of the peripheral and, increasingly, larger euro area economies.

Economic contagion is being conducted across trade linkages, seen by the renewed economic contraction across EMU. These impulses interact with each other to erode policy credibility and market confidence.

But there is an even more malign form of contagion which is now being transmitted across the euro area. In a paper to the OSCE – a political and regional security counterpart to the OECD – in 2009 I suggested that what may be termed ‘political contagion’ represented the greatest threat to the euro area and to the wider European legacy.

Political contagion has been spawned by the policy failure on the part of the euro area authorities, specifically Germany. Policy has been reactive, fragmented and, more often than not, just plain contradictory. The centrality of economic growth to help debt-burdened economies to transition to sustainability has been dismissed – at a huge economic but also social cost. Power has shifted to the centre, emasculating the smaller countries.

The overriding policy priority has been to save the balance sheets of German and French banks which, in recycling their EMU surpluses, lent neither wisely nor well. The markets have drawn their own conclusions. Downgrades have gathered momentum. 

Now political union is being pushed by Germany as the solution. This is not through any real commitment to union, but because it is the last card in the pack. There has been no preparation; there is no architecture in place; neither is there a mandate across Europe.

In the meantime, the political backlash against centre-driven economic repression in debtor countries, benchmarked against an essentially arbitrary 2014 target for conforming to Stability and Growth targets that never made sense, is gathering momentum. The proposal that Spain reduce its budget deficit to 3% from 9% by 2014 is nihilistic.

This backlash began on the streets of Greece, spread to Portugal and is now embedded in Spain. Italy is next. The most visible expression of political disenchantment in the centre of EMU was President Nicolas Sarkozy’s rejection by the French electorate. Ireland and the other debtor countries now face open-ended austerity with no indication whatever of a strategy to support the growth component of the debt/GDP ratio.

To date, the consequences in terms of political unrest have been dampened by the social and economic importance of family units in the countries that have required bail-outs. In Ireland as well as in Spain, Portugal and Greece, families have been the primary shock absorber for many millions impacted by unemployment and negative equity. Family units stand between governments and political unrest but that will not continue.

Meanwhile leaders talk about everything but the real issue. You cannot stabilise the economy on the back of 25m unemployed across Europe. Now new measures are being proposed. Talk of a ‘banking union’ undermines the new EU-wide regulatory architecture that has only just been put in place – and completely misses the point that, ultimately, a banking sector is only as strong as the economy that it serves. If summitry was the answer, the crisis would surely have been resolved by now.

The euro area authorities have been fixated on ‘moral hazard’ (e.g. ‘You can’t give them debt relief; you’ll only encourage them’) as an excuse for not making a decisive response to the crisis. But there are still options.

First, there is the need for an exit, temporary or otherwise, of member countries for which euro membership and ‘troikanomics’ are the primary threat to recovery. That is the catharsis the markets expect. Second, ESFS/ESM-type ‘firewalls’ that seek to defend a failed system need to be transformed into a proactive funding mechanism for a New Deal for vulnerable euro members, including debt forgiveness. Third, a new pan-European political engagement is required for revitalising European solidarity and preserving the Single Market from the threat of economic nationalism.

Euro area authorities may reject such initiatives on moral hazard grounds. They are mistaken. We have long passed that point. Contagion, and specifically political contagion, is by far the greater danger.

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