The challenges facing the eurozone have their origins in the Maastricht Treaty, which was prepared at the high time of market liberalism. Market liberalization and integration, together with competition between participating economies and rules (for example, governing the size of budget deficits) would make the euro a success. If governments pushed through supply-side reforms and abided by the rules their economies would grow faster and converge with one another. Political integration, without which it is impossible for the ECB to fully play the role of lender of last resort or for funds to be transferred between member-states, was deemed unnecessary. The eurozone remains a market-driven project to this day.
The architects believed that market-driven integration would come about through several mechanisms. First, by increasing trade among member-states and facilitating greater price transparency and competition, the euro would make it harder for governments to shield sectors or particular companies from competition. The integration of product markets and the development of cross-border supply chains would lead to a convergence in productivity levels, fostering economic convergence in living standards.
Second, because countries would no longer be free to devalue their currencies in the face of an economic shock or loss of competitiveness brought on by excessive wage growth, governments would be forced to encourage labour mobility as well as labour market and wage flexibility in order to facilitate adjustment, thus converging on common – liberal – labour market policies. The more flexible a country was, the less likely it would be to lose competitiveness.
Third, a single currency would hasten the development of an integrated banking and financial market, reducing the cost of capital and ensuring a more efficient allocation of resources. This would facilitate cross-border investment and help member-states with low levels of capital intensity to catch up with more developed ones. While some pointed to the potential risks of more integrated banking and financial markets, such as “hot” capital flows into already booming regions, current account imbalances within the currency union were generally considered no more of a threat than those among US states or within EU member-states, say between Bavaria and Berlin, and would not persist in any case as competitiveness levels converged.
The Stability and Growth Pact (SGP), meanwhile, stipulated that public sector deficits should be in balance over the economic cycle, that the deficit must not exceed 3% of GDP (other than in exceptional circumstances), and that outstanding stocks of national debt should be kept under 60% of GDP. These rules, it was believed, would prevent member-states from exploiting the lower interest rates to overspend, which would lead to excessive demand growth, higher inflation and lost competitiveness. There was little acknowledgement that flexible macroeconomic rules might be necessary in the absence of currency flexibility. That is, absent exchange rate flexibility and with interest rates set for the eurozone as a whole, governments could need more, not less, fiscal flexibility.
Because the architects of the eurozone believed that current account imbalances within the currency union would not matter or that market integration would prevent them from emerging in the first place, they were slow to appreciate that there could be a need for ‘symmetric adjustment’ between countries. That is, following a crisis it might be necessary for countries with large trade surpluses to stimulate their domestic economies in order to offset the weakening of domestic demand in countries attempting to bring down trade deficits. Similarly, the risk of central banks losing their lender-of-last resort function was poorly understood. In common with their counterparts elsewhere, European policy-makers did not foresee the risk of self-fulfilling panics in which investors lost confidence in the solvency of banks or sovereigns; it was assumed that market-driven integration would prevent a systematic financial crisis from arising.
The eurozone crisis, which began in 2010, was triggered when investors started to doubt the sustainability of some countries’ membership in the common currency. These fears led to the withdrawal of funds from struggling countries, including from banks and sovereign bonds, which in turn did make the membership of those countries unsustainable. A breakup of the eurozone was prevented when ECB President Mario Draghi announced the central bank’s Outright Monetary Transactions (OMT), a promise to buy as many government bonds as necessary to ensure the solvency of member-states. The announcement did enough to reassure investors, but it has never been tested and is unclear how it would work in the case of a crisis in Italy, which is the third biggest sovereign debtor in the world.
For example, the ECB can only launch OMT once Italy applies for a bail-out from the European Stability Mechanism (ESM), a European Union agency that provides financial assistance in the form of loans to eurozone countries. To receive a bail-out Italy would have to sign-up to terms governing public spending, which could prove politically impossible for the Italian government. It is also unclear how all this would play out in the heat of a crisis, when authorities need to act quickly. Or indeed whether the around €400bn the ESM now has its disposal would be enough to cope with a sovereign and banking sector crisis in Italy, or how the further large-scale increase in the stock of Italian public debt would be sustainable.
Read Part 3: Europe beyond markets: New Economy in Progress