The monetary and fiscal design of the Eurozone. New ideas and old mistakes from the EC.

by
Merijn T. Knibbe
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Recently the European Commission (EC) has published a “A possible roadmap towards the completion of the Economic and Monetary Union by 2025”. It is an important report. According to the report once Britain will have left the EU 85% of EU inhabitants will use the Euro. The future of these people is at stake. The report proposes:

• to introduce at least a bit of Eurozone level fiscal policy
• to introduce a kind of Eurobonds
• to introduce a system of unemployment insurance which, during national downturns, will lead to more transfer incomes and ‘automatic’ stabilization
• to introduce a banking union (which means that bankrupt banks won’t have to be re-financed by their host country anymore)
• and it wants a more transparent political process (not the same thing as a more democratic political process) and even admits (without mentioning him) that Varoufakis was totally right about the lack of formal status of and the opaque political process within the Eurogroup.

Compared with ECB studies from some years ago as well as with the (unscientific) ideas of the EC about ‘natural’ or equilibrium unemployment this well written study is a step in the right direction. For one thing, the present rate of unemployment of 9,5% (March 2017, April was 9,3%) is still considered to be way to high. And failing macro policies which themselves were caused by flaws in the design of the Eurozone are understood to be one of the reasons for this high level of unemployment. Only a few years ago the EC promoted the idea that labor markets are, always and everywhere, basically in equilibrium (even when unemployment was, as in Spain, 23%) and it is encouraging that such ideas seem to have been ditched. Look, for some background about this, here for an article about the ‘Chicago’ inspired ideas about monetary policy which, only a few years ago, were in vogue in Europe, look here for Roger Farmer who denies the very existence of the natural real of unemployment, look here for Fioramanti and Waldmann who point out the extreme volatility of the EC estimates of ‘natural’ unemployment, look here for Hendry and Mizon who point out that unemployment rate has the tendency to be ‘sticky’ for years or even decades, regardless of the structure of an economy.

The question is, however: are these ideas sufficient or even welcome? To start with the second part of this question, and I can be short about this, the report has only marginally less so than the ‘five presidents report’, written by the presidents of the ECB, the Eurogroup, the EC, the European Parliament and the European Summit of about 18 months ago, a gaping democratic hole. Though it does agree with and addresses the Varoufakis critique that the regular meetings of the ministers of finance of the EU, the ‘Eurogroup’, are informal and opaque. And the report argues for a formal position of these meetings, based in EU law, while there also should be a full-time permanent chair. This would be a step ahead. But representative democracy means that the European parliament (or national parliaments) can vote about such institutions and people (like the chairperson of the Eurogroup) and can send them home. While the parliament should, of course, also have the power to change the rules (including the mandate of the Central Bank). Nothing about that in the report!

About the first part of the question: steps ahead are the explicit recognition of the point made by Krugman, Eichengreen, Wren-Lewis and many, many others that monetary policy (i.e. interest rate policy) is not enough to stabilize a country. Fiscal policy is, according to these authors, needed too. As the Eurozone suffers from a combination of centralized monetary policy in combination with fragmented fiscal policies by its members it’s fiscal policy is wanting and monetary policy is overburdened. This has to change. The report also stresses that government debts are not the only kinds of debts which can be problematic but that private debts can be poisonous, too, while economic downturns themselves can be the problem and lead to non-performing private debts as well as increasing government debts. This is, alas, not a banal remark. Politicians and pundits have stated, over and over again and for a time backed by institutions like the EC and the ECB, that large government deficits and high government debts were the root cause of the crisis, even in countries which had considerable government surpluses like Spain and Ireland. This led a large number of high ranking economist even to write a book which spelled out that the crisis was not a government debt crisis but a classic ‘sudden stop’ crisis, i.e. a crisis caused banks which suddenly stopped providing new credit and refinancing existing (short term) credit. But in this report even the (obvious) fact that a considerable part of the post 2008 increase of government debt is caused by transferring income to the banks is mentioned! The solutions – introducing a kind of Eurozone government bond as well as a kind of Eurozone unemployment insurance (in fact: re-insurance) are badly needed for the Euro to survive and it is a breath of fresh air that such alternatives are even mentioned. Also, a the report argues in favor of a fund which has to finance national government investments during downturns, which compared with ideas of some years ago is a double improvement as it mentions government investments as ‘productive’ and recognizes that spending on such investments maintains aggregate demand.

The report also states that, to prevent future financial crises, banks need more liquidity as well as more equity. However, one of the root causes of financial disruptions (real estate booms and busts, note that two thirds of bank credits are related to mortgages) are not mentioned though the problems of bubbles as such is acknowledged. The capital flow problem which enabled and, to an extent, caused the real estate booms in Ireland and Spain is not really addressed (the consensus view is i.e. not yet totally embraced). The ideas that central banks should not guard the (which?!) price level but should enable productive credit and discourage unproductive credit used for asset purchases are not mentioned. The idea from the General Theory of Keynes that the ‘real’ wage level should never decrease, which of course is at loggerheads with still current ideas of ‘domestic devaluation’ which aim for exactly such a decrease, does not inspire the report. The extreme current account surpluses of Germany and the Netherlands (which, in the Netherlands, did not prevent a considerable increase in unemployment and sup par growth) are not mentioned. The problem of migration to the core (which aggravates the problems of non-performing loans and government budgets) does not get attention. This list can be extended.

Despite these shortcomings and given the political circumstances the report still is, when it comes to macro-economics, about the best one could hope for. The report has (in combination with the ‘five presidents’ report) however a large and, for me, unacceptable democratic gap. Let’s compare the EZ with the USA. The USA congress has recently voted to repeal Obamacare. I don’t agree. But it does show that even large countries can have parliamentary systems which can act fast and, yes, democratic (there was a vote, the margin was thus narrow that another outcome had been feasible). At this moment democracy is, at the EU level, wanting. Steps into the direction of more federal institutions have to be accompanied by a more powerful European Parliament. And hence a less powerful and independent European Central Bank, a European Commission with members which can be voted out and a, indeed, a more formal and transparent Eurogroup. Varoufakis scores his first political points with the ideas about the Eurogroup in this report. Let’s hope that his other ideas about a more democratic EU will carry the day, too.