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Two features of the European Parliament elections in May left little doubt that not all is well in the 28-nation club. Only four in 10 eligible voters cast a ballot, and of those, nearly a quarter voted for Europe-sceptical parties. Europeans’ apathy toward their common parliament and the rise of anti-establishment parties within it are symptomatic of genuine social, financial and economic problems.
The eurozone’s problems have diverse causes and origins, yet the solutions to them proposed by anti-establishment parties converge on two common themes: exiting the euro, or the European Union (EU) in the UK’s case, and curbing immigration.
Voices of discontentIn the case of the latter, curbing immigration reflects how post-industrialised Europe is struggling to compete with lower labour cost and more productive workers in an increasingly globalised world. Proposals to reinstate legacy euro currencies reflect the uneven distribution of welfare derived from membership in the monetary union.
Where anti-establishment parties have a point is that there is no historical evidence of monetary unions enduring without either breaking up or forming political and fiscal unions. The Scandinavian (1873–1914), Latin (1865–1927) and Austro-Hungarian (1867–1919) monetary unions eventually dissolved, owing mainly to divergent fiscal paths taken by member states.
The two monetary unions that endured, the UK (still to be determined as Scotland prepares to vote on independence this fall) and United States, formed political and fiscal unions. Unless this time is different, these historical precedents suggest the eurozone’s citizens ultimately will have to choose between returning to a regime of flexible exchange rates or retaining the single currency and deepening political and fiscal integration.
Eurozone federalists support pooling political resources because individual member states will be too small in the future to have a seat at the international table. While such action makes sense for geopolitical reasons (defence and energy policies also lend themselves to centralised structures), they are not necessary to make a monetary union work. To identify the minimum requirements needed to make a monetary union work, we first need to understand what is suboptimal with the current one.
The pastWhat is suboptimal with the current setup is that it generated high unemployment, high uncertainty and was founded on a rules-based system that in practice could not be implemented.
Persistently high unemployment is socially unsustainable. The cost of regaining international competitiveness in the eurozone’s former current account deficit countries was a doubling of their unemployment. While current accounts swung from a deficit of 5% of GDP in 2007 to positive territory by the beginning of 2014 (see Figure 2), unemployment in these countries rose from 7 million to 15 million.
High unemployment was the natural consequence of correcting large external deficits via internal devaluation induced by front-loaded, anti-cyclical fiscal policies. And it was accentuated by an overvalued exchange rate relative to domestic conditions.
In contrast, countries with large external surpluses enjoyed an undervalued exchange rate relative to their domestic conditions and greater flexibility to use fiscal policy anti-cyclically. Variations in external balances among member states and the process of correcting large imbalances led to an uneven distribution of the welfare derived from eurozone membership.
The threat of sovereign default and reversibility risk of the euro generated uncertainty; this may be holding back long-term investment in the eurozone, especially foreign investment. When European Central Bank (ECB) President Mario Draghi stated that “the euro is irreversible” in August 2012, his reassurance helped to stabilise the region’s escalating debt crisis. But because government – not the ECB – determines a country’s currency and exchange rate regime, uncertainty endures today and it certainly will not diminish with an increasing number of political parties in the newly elected European Parliament wanting to exit the euro.
What use are rules and treaties if they cannot be implemented?In 2010, Greece proved too interlinked with other eurozone banks and vulnerable sovereigns for policymakers – after weighing the potential costs – to risk allowing its government to default. Bailing out the banks saved the euro, but the long-term cost was to undermine support for it: The bailout was seen by many as a way to usher in the mutualisation of debt and to foster moral hazard.
The presentNearly six years after Lehman Brothers defaulted in September 2008, the eurozone’s governance structure is stronger. Legislation in the so-called Two-Pack, Six-Pack and Fiscal Compact enable enhanced surveillance of public finances and macroeconomic imbalances that give eurozone finance ministers de facto veto power over individual countries’ budgets. The European Stability Mechanism provides a financial backstop to sovereigns threatened by loss of market access. The ECB – via the newly formed banking union – will supervise the largest eurozone banks and a single resolution mechanism will preside over winding down insolvent banks with new rules defining the hierarchy for creditor bail-in. Also, the new process for electing the European Commission’s president – Jean-Claude Juncker is currently President-elect – pays more tribute to voters’ preferences.
But the business cycle continues. The prospect that the next crisis will likely generate more unemployment and uncertainty, together with the fact that banks and sovereigns remain interlinked and, therefore, that insolvent sovereigns are likely to be bailed out, portend poorly for the euro’s longevity.
The futureThe eurozone will test its new enhanced surveillance tools for the foreseeable future, and probably until they demonstrably no longer work. To survive crises of existential magnitude, the eurozone’s future governance structure should improve four of today’s key weaknesses:
Philippe Legrain from the Centre for European Reform suggests in his report, “How to finish the euro house”, four possible futures for the eurozone: a Germanic, a technocratic or a decentralised future, all of which resemble the status quo, as well as a fiscally federal one. Of the four potential outlooks, only a fiscally federal eurozone would resolutely address the existing governance structure’s weaknesses; politically, however, it would be the most ambitious option to implement.
A credible roadmapAs with those who want to abolish the euro, ignore for a moment the realpolitik of system change and instead ask what a minimalist federal fiscal structure might look like and how it would be implemented. In the spirit of former European Commission President Jacques Delors, whose 1989 “Report on economic and monetary union in the European Community” was instrumental in creating the euro, the journey and destination might take the form of a Fiscal Delors Report:
Phase I: Initiation of the process (years 1-5)
Phase II: Political institutions (years 6-10)
Phase III: Fiscal tools (years 11-15)
Good relationships are based on trust, and deeper political integration requires increasing trust among governments. Trust can be achieved by upward convergence to higher common standards of public sector and labour market efficiency. Indicators produced by the World Bank, World Economic Forum, Transparency International and the University of Linz that quantify public sector and labour market efficiency show considerable variation among eurozone member states (see Figure 5). Phase I would focus on upward convergence to higher levels of public sector and labour market efficiency.
No taxation without representationUnder current arrangements, the eurozone has little representation relative to the inherent mutualisation risks accruing to taxpayers. However, were the eurozone to make these risks more transparent and confer legislative initiative to a central organ with its own resources, the collective members of the eurozone would need to create a political chamber whose voting structure fairly represents the area’s citizens. The distribution of votes in the European Parliament is too skewed toward small countries, which would contribute less to a common budget relative to large countries, to be suitable for a eurozone parliament. And the European Parliament, along with the Council of the European Union and European Council, are too focused on EU-28 issues to be suitable for the smaller 18-member eurozone. In Phase II, and only after Treaty changes, the eurozone would create its own parliament, president and cabinet before taking the final step.
Fiscal tools should come in Phase III. Ideally, fiscal policy runs counter to the business cycle, producing surpluses during booms and deficits during recessions. Expenditure from a central budget could be directed toward unemployment, which rises during recessions and falls during booms. Eurozone member states’ expenditure on unemployment varies from 0.5% of GDP in Malta to 3.1% of GDP in Spain (according to Eurostat as of 2012). Common unemployment insurance would spread the benefits and hardships of participation in a monetary union more fairly among member states.
Creating a credit-risk-free asset, i.e., an asset issued by the federal fiscal authority to which the ECB is subordinate, would break the bank-sovereign link. Banks could hold this security in place of securities issued by their own government, thereby enabling an insolvent government to default without tearing the euro apart.
The unfinished projectAnti-establishment parties have voiced their vision for the euro’s future, a future that implies uncontrolled sovereign defaults, economic depression and turning the clock back on European integration. Today’s relative tranquillity in eurozone financial markets owes largely to the ECB’s willingness to hold the single currency together.
But monetary policy has its limits; other visions for the future of the euro are needed for it to endure. From an investment perspective, that implies shaking hands with the ECB for now, but do not put all your eggs in the eurozone basket.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.
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