Preventing The Next Eurozone Crisis Starts Now

13/12/2016

by Jean Pisani-Ferry

European leaders have devoted scant attention to the future of the eurozone since July 2012, when Mario Draghi, the European Central Bank’s president, famously committed to do “whatever it takes” to save the common currency. For more than four years, they have essentially subcontracted the eurozone’s stability and integrity to the central bankers. But, while the ECB has performed the job skillfully, this quiet, convenient arrangement is coming to an end, because no central bank can solve political or constitutional conundrums. Europe’s heads of state and government would be wise to start over and consider options for the eurozone’s future, rather than letting circumstances decide for them.

So far, Europe’s leaders have had little appetite for such a discussion. In June 2015, they only paid lip service to a report on the euro’s future by the presidents of the various European institutions. A few weeks later, the issue briefly returned to the agenda when eurozone leaders spent a long late-July night arguing about whether to kick out Greece; but their stated intention to follow up and address underlying problems was short-lived. Finally, plans to respond to the Brexit shock by strengthening the eurozone were quickly ditched, owing to fear that reform would prove too divisive.

The issue, however, has not gone away. Although the monetary anesthetics administered by the ECB have reduced market tensions, nervousness has reemerged in the run-up to the Italian constitutional referendum on December 4. By end-November spreads between Italian and German ten-year bunds reached 200 basis points, a level not seen since 2014.

The worrying state of several Italian banks is one reason for the mounting concern. Brexit, and the election of a US president who advocates Americanism instead of globalism and dismisses the EU, adds the risk that voters, rather than markets, will call into question European monetary integration. Anti-euro political parties are on the rise in all major eurozone countries except Spain. In Italy, they may well command a majority.

On the economic front, the eurozone has much unfinished business. The banking union, launched in June 2012 to sever the interdependence of banks and states, has made good progress but is not yet complete. Competitiveness gaps between eurozone members have diminished, and external imbalances within it have abated, but largely thanks to the compression of domestic demand in Southern Europe; saving flows from North to South have not resumed. Unemployment gaps remain wide.

The eurozone still lacks a common fiscal mechanism as well, and Germany has flatly rejected the European Commission’s recent attempt to promote a “positive stance” in countries with room to boost spending. Of course, when the next recession hits, fiscal stability is likely to be in dangerously short supply.

Finally, the governance of the eurozone remains excessively cumbersome and technocratic. Most ministers, not to mention legislators, appear to have become lost in a procedural morass.

This unsatisfactory equilibrium may or may not last, depending on political or financial risks – or, most likely, the interaction between them. So the question now is how to hold a fruitful discussion to map out possible responses. The obstacles are twofold: First, there is no longer any momentum toward “more Europe”; on the contrary, a combination of skepticism about Europe and reluctance concerning potential transfers constitutes a major stumbling block. And, second, views about the nature and root causes of the euro crisis differ across countries. Given the dearth of political capital to spend on European responses, and disagreement on what the problem is and how to solve it, governments’ excess of caution is hardly surprising.

Both obstacles can be overcome. For starters, discussion of the eurozone’s future should not be framed as necessarily leading to further integration. The goal should be to make the eurozone work, which may imply giving more powers to the center in some fields, but also less in others. Fiscal responsibility, for example, should not be reduced to centralized enforcement of a common regime. It is possible to design a policy framework that embodies a more decentralized approach, empowering national institutions to monitor budgetary behavior and overall fiscal sustainability.

In fact, some steps in this direction have already been taken. Going further would imply making governments individually responsible for their misconduct – in other words, making partial debt restructuring possible within the eurozone. Such an approach would raise significant difficulties, if only because transiting to such a regime would be a hazardous journey; but options of this sort should be part of the discussion.

To overcome the second obstacle, the discussion should not start by addressing the legacy problems. Distributing a burden between creditors and debtors is inevitably acrimonious, because it is a purely zero-sum game. The history of international financial relations demonstrates that such discussions are inevitably delayed and necessarily adversarial when they take place. So the issue should not be addressed first. The seemingly realistic option of starting with immediate problems before addressing longer-term issues is only superficially attractive. In reality, discussions should start with the features of the permanent regime to be established in the longer run. Participants should explore logically coherent options until they determine if they can agree on a blueprint. It is only when agreement on a blueprint for the future has been reached that the path toward realizing it should be discussed.