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Analysis
Euro: Success and vulnerability

Euro: Success and vulnerability

Constâncio on Europe's unfinished business

by Kat Usita in London

Fri 25 Jan 2019

Eight months after finishing his term as vice-president of the European Central Bank, Vitor Constâncio remains a firm believer in the euro's success. But he recognises that the next downturn (or indeed, recession) could be just around the corner, and that member states may not have done enough to prepare appropriate responses.

A veteran monetary technocrat who was the Banco de Portugal's research chief in 1975 and became finance minister in 1978 after the overthrow of the Portuguese dictatorship, Constâncio spoke at an OMFIF meeting with Lucrezia Reichlin from the London Business School and Charles Goodhart of the London School of Economics. He became Portugal's central bank governor (for the second time) in 2000, a year after the single currency started, and joined the ECB in 2010. His 18-year stint as member of the ECB's governing council has given him an acute sense of the euro's development – as well as its unfinished nature.

He points out that, according to regular Eurobarometer polling, support for the euro across member countries has recovered since the financial crisis to the highest since 2004.

Based on GDP per capita and real GDP growth rates, the euro's performance is better than often portrayed. Aggregate GDP per capita in the euro area has been growing consistently faster than in the US. Dispersion in real GDP growth rates has been reasonably low.

There is however a constant concern that, because of Europe's lack of mechanisms – for example, in the area of fiscal stabilisation – to adjust to crises in an appropriate and timely way, member states are still vulnerable to shocks from inside and outside the 19-country area.

The ECB's goals have evolved over time. As a central bank that took over the mantle of the German Bundesbank, its primary task was ensuring price stability. Post-crisis, it also needed to adopt new measures to ensure liquidity and safeguard the banking system.

After several years of global growth and relative euro calm, the ECB's next challenge is to prepare for the next downturn, which Constâncio sees coming within the next 24 months. With the right tools, it need not be the next crisis. Devising means for providing liquidity to combat upsets, while navigating northern creditor states' scruples about moral hazard, is a major preoccupation. Completing the banking union initiated in 2012 would be a major factor for building and maintaining confidence in the banking sector.

Constâncio worries about the gap between what should be done, and what will be done. As he pointed out uncompromisingly in his valedictory speech at the ECB in May 2018: 'So far the banking union project has been exclusively about risk reduction and no specific element of risk reduction has been introduced.' 

The creation of a European 'safe asset' would help integration of the European bond market and the planned capital markets union, although that might be affected by the UK's departure from the EU. The overall robustness of the single currency depends on a collective effort to follow through on these plans, some of which have languished on for years – which Constâncio can discuss now with more candour.

The ECB's other challenge is Italy. For the time being, the budget stand-off between the government and the EU has been overcome. Yet disaster could strike if the country enters recession, its banks are unable to manage their non-performing loans and its fiscal issues recur – especially if this occurs at a bad time for the world economy. Whatever happens, the financial markets seem likely to decide what happens next – which may not be to the liking of Italy's ruling politicians.

The inevitable downturn will push the ECB and wider EU leadership to consider creative ways to support vulnerable member states. The task will be to rise above the sense of general mistrust towards European and national authorities. The past decade has tested, and demonstrated, the ECB's ability to respond to crises. Yet for Italy to ask for conditional EU assistance under the ECB's untried outright monetary transactions mechanism unveiled in 2012 would probably be politically intolerable.

Innumerable challenges loom. It might take another crisis to get things going.

Kat Usita is Economist at OMFIF.

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