Separating Fiscal and Monetary Union
Foreign Affairs, November/December 2011
Conventional wisdom has it that the eurozone cannot have a monetary union without also having a fiscal union. Euro-enthusiasts see the single currency as the first steppingstone toward a broader economic union, which is their dream. Euroskeptics do, too, but they see that endgame as hell -- and would prefer the single currency to be dismantled. The euro crisis has, for many observers, validated these notions. Both camps argue that the eurozone countries' lopsided efforts to construct a monetary union without a fiscal counterpart explain why the union has become such a mess. Many of the enthusiasts say that the way forward is for the 17 eurozone countries to issue euro bonds, which they would all guarantee (one of several variations on the fiscal-union theme). Even the German government, which is reluctant to bail out economies weaker than its own, thinks that some sort of pooling of budgets may be needed once the current debt problems have been solved.
A fiscal union would not come anytime soon, and certainly not soon enough to solve the current crisis.
It would require a new treaty, and that would require unanimous approval. It is difficult to imagine how such an agreement could be reached quickly given the fierce opposition from politicians and the public in the eurozone's relatively healthy economies (led by
Moreover, once the crisis is solved, the enthusiasm for a fiscal union may wane. Even if Germany is still prepared to pool some budgetary functions, it will insist on imposing strict discipline on what other countries can spend and borrow. The weaker countries, meanwhile, may not wish to submit to a Teutonic straitjacket once the immediate fear of going bust has passed.
But there are more than just two ways forward: fiscal union or a breakup of the euro. There is a third and preferable option: a kind of market discipline combined with tough love. Under this approach, individual states would take as much responsibility as possible for their own finances, but they would also embrace the free market more vigorously. Governments that borrowed too much money would have to be free to default. Limited bailouts for governments and banks in lesser trouble would also be required, albeit in return for economic reforms and belt-tightening. The result would be fitter economies and a
As this article went to press, the eurozone crisis was in a particularly acute phase. Markets were in a high state of anxiety,
In theory, a common currency has many advantages for the
But there is also a big disadvantage: individual countries lose the ability to tailor their monetary policies to their particular needs by setting their own interest rates. Instead, interest rates are set by the
Whether the benefits of having a common currency outweigh the costs depends largely on three factors: the similarity among the economies covered by the single monetary policy, their flexibility, and the existence of a large central budget that can be used to transfer money from flourishing regions to struggling ones. Economies with similar structures and cycles find it easier to live with a one-size-fits-all monetary policy. Even economies that are different can cope with a single currency so long as they are adaptable -- in particular, so long as their businesses can easily hire and fire employees and people are willing to cross borders in search of work.
The eurozone does not come out well by any of these measures, especially in comparison with
RACKING UP DEBT
But there is another way of living within the constraints of a one-size-fits-all monetary policy: strengthen
Many states also accumulated mountains of debt, sowing the seeds of the current crisis. Under the Maastricht Treaty, which began the process of forming the monetary union, governments are not supposed to run up debts that equal more than 60 percent of GDP, but every major economy of the eurozone exceeded that level significantly. After the world economy slowed down early in the century, supposedly virtuous states, such as
Debt grew not only because governments were breaking the rules; it also grew because governments managed to persuade investors, in particular banks and insurance companies, to lend them money. Beginning in early 2010, investors finally stopped funding Greece; then they stopped funding Ireland and
This, however, has not stopped
Some supposedly more palatable versions of this idea have been proposed. A paper published last year by Bruegel, a
Germany, the eurozone's main paymaster, has been willing to countenance the idea of a fiscal union, but only after a long process of integration once the crisis has been resolved. It is also insisting on strong new rules limiting the amount of money that individual countries can borrow and inflicting penalties on those that break those rules. Meanwhile,
But all of this lies far in the future -- if at all. So far, managing the current crisis has consisted of case-by-case bailouts. In return for low-interest loans from various different European war chests and the
As market conditions have deteriorated and more countries have been sucked into the vortex of economic collapse, there have been several different versions of these bailouts. The 17 eurozone countries have found it hard to agree on what to do, leading to zigzagging policymaking, which has undermined investor confidence and created unnecessary economic hardship.
For all its warts, however, the policy has had some successes. The weaker European governments have been forced to embrace reforms that they had shirked for decades. They are liberalizing their labor markets, rooting out tax evasion, pushing up excessively low retirement ages, slashing bureaucracies, privatizing industries, and opening up cartel-like industries, such as pharmacies and taxi services. This is happening not only in Greece, Ireland, and
THE FREEDOM TO FAIL
Still, the current crisis management has been deficient in one important respect. At least by the time this article went to press, no insolvent country had been allowed to go bust.
Companies and individuals all around the world restructure their debts. Governments outside
Yet most European policymakers have so far viewed default as anathema because they have been scared of contagion. If Greece defaulted, the banks that lent it money might also go bust. The market might conclude that other weak governments will default, too, making it hard for them to raise money. Some policymakers are frightened that the mayhem unleashed would be like, or even worse than, the chaos that followed
But the lesson of Lehman's collapse is not that banks or governments should never be allowed to go bust. It is that defaults should be controlled and that those that are exposed to possible contamination should prepare for it. But the eurozone seems not to have learned this yet. Banks stuffed with government bonds have merely been nudged to shore up their balance sheets. Whereas
But it is not too late to put the controlled-default option back on the table. Given the policy errors for which
LENDERS OF LAST RESORT
Part of the art of managing a financial crisis is distinguishing insolvent institutions from merely illiquid ones. The debts of insolvent institutions should be restructured, whereas illiquid institutions should get funding. Like a country with its own currency, the eurozone needs a lender of last resort. The key, however, will be to ensure that it does not become a lender of first resort, as that would remove the incentive for states and banks to manage their own affairs responsibly.
Having entered the 2007 credit crunch without a properly thought-out plan for how a lender of last resort would operate, the eurozone has had to make up policy on the fly.
But this has not ended the debate over which policy is best.
The EFSF will be replaced in mid-2013 by a new bailout fund called the European Stability Mechanism, a permanent facility. In one important respect, the ESM will be better than the EFSF: it will be required to distinguish insolvent from illiquid governments when it makes loans. In the case of insolvent governments, the debt held by private-sector creditors will have to be restructured so as to make the governments' debts sustainable. Too bad this mechanism will not kick in for almost two more years.
THE THIRD WAY
Given these complexities, many Euroskeptics think it would be better to abandon the euro project altogether. But this is a bad idea. The monetary union may have developed prematurely, but nobody has come up with a way of putting the toothpaste back in the tube. If
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Copyright 2011, Foreign Affairs