Can the Euro Be Saved?

It has been seven years since the EU was hit with its version of the global financial crisis. Even though Europe’s economy is growing again after two recessions, the eurozone’s GDP volume has not fully recovered yet and many of the original crisis symptoms persist. While the UK referendum to leave the EU surprised many people, Britain’s economy has been performing better than many European countries. As the UK is not part of the currency union, it is stronger economically than many of its EU counterparts. 

Greece’s rescue program moves ahead but is hampered by disagreements between Europeans and the IMF about fiscal policy and debt sustainability. The Greek central bank itself is at odds with the country’s government on whether to retain the IMF as a partner. Meanwhile, the European Central Bank (ECB) is beset by internal strife about monetary management. The disagreement is partly about the legal remit of what is allowed under statutes and partly about economic philosophy of what is efficient in money and finance. At the same time, many banks remain in a precarious state following regulatory forbearance on the part of national authorities early in the crisis. Attempts to rectify this weakness through EU-level banking supervision, resolution, and deposit insurance have yielded half-baked results so far.

Against this backdrop, it is fair to ask whether the Economic and Monetary Union (EMU) has a future as a going concern. The EMU has survived multiple tests of resilience, including the crises and rescues of Greece, Portugal, Cyprus, Spain, and Ireland. But wide divergence persists in fiscal and external accounts among economies. These divergences are exacerbated by disagreements about policy response that run so deep that the common currency might yet break apart if sufficiently strong turbulence were to hit it again. As if all these strains weren’t enough, the vote in the UK referendum to leave the EU will eat away at the cohesion of the European Union, inflaming fissiparous politics and making tough compromises even more difficult.

In this report, I assess the chances of reforming the EMU so as to keep it whole by evaluating several policies and their probable timeframes of implementation and likelihood of success. The upshot is that the euro as a common currency faces long odds of survival beyond 2025 under proposals currently in place.

The Union at a Crossroads
One of the problems of the monetary union is that it did not alleviate fiscal and external imbalances. If anything, it exacerbated them. Germany’s current account surplus is slated to rise to 9.2% of GDP in 2016, up from 8.6% in 2015. Germany’s net foreign assets rose to 49% of GDP at end-2015 compared with 3% in 1999, according to Eurostat databases. By contrast, the respective net foreign liabilities of Greece, Portugal, and Spain were 126%, 109%, and 91% of GDP in 2015, respectively. Mario Draghi, president of the European Central Bank (ECB), seemed surprised by this turn of events: “No one ever imagined that the Monetary Union could become a union divided between permanent creditors and permanent debtors, where the former would perpetually lend money and credibility to the latter.”

Chronic payments imbalances turned out to be but one of the many sources of financial stress in the eurozone. Unsustainable fiscal deficits led to sovereign debt crises in Greece in 2009 and Portugal in 2010 while banking woes forced Ireland in 2010 and Cyprus in 2011 to seek IMF assistance. Regulatory forbearance cost Spanish taxpayers tens of billions of euros in addition to a bailout through an EU rescue fund in 2012. Slovenia narrowly avoided a bailout during 2012-2013 in a case of wobbling banks that then severely weakened government finances.

Options for the Future
The boldest set of proposals invokes a full federation. As in existing federations, the EU federation would boast a federal treasury that manages revenue and can issue debt. The parliament is empowered to tax and spend on social security, public investment, defense, etc. A federal-level government can then engage in anti-cyclical fiscal policy, supplementing the monetary policy of a central bank already in place. Such a federation would largely eliminate payments or fiscal crises at the state level because federal-to-state transfers, federal insurance schemes, and central supervision of banks would limit state-level financial stress.

A less ambitious proposal sets out goals of tight policy coordination among existing governments that would substitute for the lack of a federal state. Drawn from the The Five Presidents’ Report, this blueprint foresees four “unions” of policies: economic, fiscal, financial, and political. The eurozone would be able to absorb shocks (such as the crises described above) because of resilience instilled in the individual economies through these unions. For example, excessive fiscal deficits would largely disappear through rules-based automatic adjustments to spending and revenue raising. Persistent external payments deficits would be comfortably financed thanks to a fully integrated and open union-wide capital market. Structural policies agreed upon by all members would narrow rather than widen income and wealth gaps and thus contribute to economic convergence.

Next down on the ambition ladder is a proposal for “minimum conditions for the survival of the monetary union.” This blueprint eschews grandstanding and focuses on basic economics. The ECB needs to become a “normal” central bank, independent of political wrangling, in order to forcefully act as lender of last resort to banks. A common currency cannot support banks chartered and supervised according to national preferences. Hence, a true banking union must be completed in order to eliminate the “doom loop” of banks underwriting sovereign state-level debt. Rather than being centralized, fiscal policy should be decentralized in this proposal because EMU members hail from differing tax and spending cultures (Figure 1). Among the necessary conditions are a write-off of debt overhang to make room for fiscal policy and a no-bailout clause that proscribes the ECB from purchasing debt of governments that get into fiscal trouble.

Figure 1 – General Government Finances, European Union

Source(s): Eurostat and MAPI Foundation

Source(s): Eurostat and MAPI Foundation

Finally, there is the nuclear option of fixing the EMU by abolishing it.1 An orderly dismantling of the common currency is possible and a return to national legal tenders is the obvious choice according to Polish economists Stefan Kawalec and Ernest Pytlarczyk. They see no feasible adjustment mechanism for imbalances within the currency union as it exists. Their key concern is the survival of the European Union itself. Political battles to defend the euro weaken the European economy and alienate the polities, sapping the cohesion of the EU along the way. The authors admonish non-EMU members, such as Poland, Sweden, and the Czech Republic, not to join the monetary union.

What Policies Would Save the Euro?
In Table 1, I evaluate the proposals by mapping out their probabilities of success.

Table 1 – Policy Proposals

* 1: low probability; 2: medium probability; 3: high probability Source(s): MAPI Foundation

* 1: low probability; 2: medium probability; 3: high probability
Source(s): MAPI Foundation

The Federalists: Instituting a Full Federation
The European “founding fathers” have no illusion that their proposal is about to air in prime time any time soon—“We are convinced that a Federation of Europe (some day) will come.” This sounds like an appropriately modest admission in the face of stiff public opposition. According to a recent Pew Research Center poll, just 51% of voters have a positive opinion of the EU (47% have a negative opinion). More pointedly, only 19% of respondents say national governments should transfer more power to the EU and 42% believe some powers should be returned to national governments. All in all, there is no public mandate for an “ever closer union.”

Whereas a federation would cure most decisively the instabilities affecting the current monetary union, such a solution faces the longest odds of success among those widely discussed.

The Idealists: Achieving Deeper Integration
The Five Presidents’ Report is more normative than positive even though it contains two sets of deadlines. In the first stage (by 2017), the EMU would have completed the Financial Union, maintained “responsible fiscal policies,” and “enhanced democratic accountability.” In the second stage (by 2025), all other unions would be fully in place. Significantly, the EMU ought to evolve from rule-based cooperation to further sovereignty-sharing within common institutions. It honestly admits that the EMU is only half-built and that it had always been more of a political project than a common currency. This proposal aims at deeper integration.

In the report, “Economic Union” means that economies have converged toward similar levels of competitiveness. This is about to transpire through the creation of “Competitiveness Authorities” and strengthened implementation of the Macroeconomic Imbalance Procedure (rules that lead to adjustments in fiscal and external imbalances). Essentially, an Economic Union will have been reached when economies can absorb shocks through internal resilience. Centralization of some policies (e.g., fiscal) will be necessary.2

The chances of all EMU states converging around similar competitiveness levels and subjecting themselves to centralized fiscal policies by 2025 must be judged remote. Competitiveness—however defined—varies widely in the EMU. It took decades and sometimes centuries for economies to narrow gaps in productivity. More recently, the cases of Korea, Japan, and China suggest that the type of economic convergence discussed in the report is way more than a decade away.

The Capital Markets Union includes a banking union and a fully open and flexible market for securities to trade across the entire EU. Beyond this elegant statement lies an array of difficult gaps that need to be bridged in the common market for securities alone. From a legal standpoint, differences in insolvency and corporate law are pronounced, as are differing regimes of property rights and securitization. Accounting rules can be streamlined but tax regimes would be very difficult to harmonize, as would distribution channels. Critically, the proposal envisions the creation of a virtual treasury—a claim on fiscal resources to bail out a bank, for example. Such a treasury would make sense in cases of bank failures only if its funding remit were unrestricted. This does not seem to be in the cards, however.

Taxation is a national matter and preferences differ widely. The Irish and Luxembourgers favor low taxes whereas the French and Italians like to raise a lot of revenue from financial markets. Banking models in Germany and Italy are far removed from those in the UK and Ireland. It is hard to imagine that national authorities would revamp funding patterns in order to assume new common guidelines in a unified capital market. As with the Economic Union, the probability that a fully fledged Capital Markets Union would be in place by 2025 is remote.

The most common definition of a fiscal union is the power to tax and spend on behalf of a jurisdiction. This is not the case as far as the Fiscal Union is defined in The Five Presidents’ Report. This Fiscal Union essentially refers to a eurozone-wide fiscal stabilization mechanism. National budgets would be subject to coordination and joint decision-making. Subsumed here is a certain level of economic convergence and financial integration.

Some institutions tasked with policing fiscal stability already exist. They include the Six-Pack and the Two-Pack (both essentially add up to the Fiscal Compact) and the Macroeconomic Imbalance Procedure. What these facilities have in common is their uselessness in narrowing past imbalances. The Five Presidents’ Report proposes creating two additional bodies, an advisory European Fiscal Board and National Fiscal Councils, that would serve as “good cops” advising parliaments how best to achieve fiscal probity. Tellingly, the Fiscal Union must not lead to permanent transfers between countries and cannot be an instrument of crisis management, according to the report’s authors.

Fiscal centralization in the eurozone failed because it is impractical and contrary to longstanding preferences by electorates. A quick glance at the depth of fiscal redistribution by country (Figure 1) shows why centralization without a federal treasury is bound to fail: national parliaments retain the ultimate authority in matters of revenue and expenditures because they answer to national electorates, not the European Parliament (The Five Presidents’ Report defines a “treasury” as more joint decision-making on fiscal matters and need not mean federal-level revenue raising and expenditures). The Fiscal Union as presented in the report faces a scant chance of success by 2025.

The Political Union refers to democratic accountability, legitimacy, and institutional strengthening. The concepts are vague but they point to greater coordination among the EU parliament, European Council, EU Commission, and Eurogroup (a college of finance ministers).

Political legitimacy strengthens economic management in times of crises when difficult decisions about the use of public funds create losers and winners. This goodwill appears to be in short supply in the EU at the moment. That being said, it’s difficult to judge the probability of attaining a political union in the EU by 2025 when the concept itself is vague.

The Realists: Solidifying the Union
The two economists behind the proposal on minimal conditions for the survival of the euro, Barry Eichengreen and Charles Wyplosz, eschew theoretical expositions and normative wishful thinking. They realize that the EMU was a flawed construct yet they also understand the enormous cost to the future of Europe should the euro fail. They want to see salvaged what is salvageable.

They start by delineating problems. These include mutual resentment and recrimination among debtors and creditors. Large creditors suffer from low interest rates (stress on asset returns) whereas borrowers fear years of low growth and debilitating debt burdens. Limits to political integration in Europe are a fact of life, so they should not be a cause of despair. The authors rightly admit that the euro crisis will be resolved (if resolved it can be) well before full political integration takes place. Eichengreen and Wyplosz freely concede that the EU is facing a problem of trust: some constituencies refuse to pay for provision of public goods that they are unlikely to consume.

They place the ECB at the center of their concern. It is the one institution that is truly powerful, credible, and indispensable to stability. The ECB is not yet a “true” central bank in their eyes so it needs to be fixed. The bank’s goal of inflation targeting is not credible because when the remit of price control is EMU-wide, inflation cannot be of national concern, as it appears all too often now. More importantly, the ECB refuses to act as lender of last resort to financial institutions.

The authors present compelling arguments—trust needs to be restored so the ECB is not perceived as pandering to special or national interests. Actually, it is conceivable that by 2025 the ECB might fulfill its job as lender of last resort. The bank’s council is increasingly forceful in moving the debates in that direction. The current president is fully invested in restoring the bank’s credibility and independence in the financial marketplace.

The authors advise the EU to complete the banking union. The key is to devolve supervision and resolution away from national authorities. A meaningful banking union is hard to imagine without a meaningful fiscal union, which in turn is hard to conceive without a meaningful political union. A true banking union, like its cousin a Capital Markets Union, will be hard to achieve by 2025.

Perhaps the most counterintuitive argument advanced in this set of proposals concerns renationalization of fiscal policy. The conventional wisdom holds ever tighter fiscal policy coordination as essential. The authors breezily admit that efforts at centralization have failed—and for good reason. Member states hold keys to taxing and spending. Many constituencies resent pooling resources or agree to outright fiscal transfers because fiscal policy is about politics. Moreover, if sovereign bailouts introduce moral hazard, then they should be outlawed (as is the case with U.S. state finances).

Both nationalization of fiscal policy and clauses banning bailouts appear feasible to me by 2025. Moral hazard that emanates from some rescue programs has already shifted policymakers’ opinions on this issue. It is likewise not inconceivable that severely limiting banks’ exposure to sovereign debt could be in place by 2025 as well. If a full banking union proved too controversial to legislate fully, these ancillary measures might present an acceptable compromise.

Removing debt overhang is controversial at the moment but some resolution to unsustainable obligations must be found. For Eichengreen and Wyplosz, the rationale for debt write-off lies in restoring to fiscal policy its countercyclical role.

Overall, even though Eichengreen and Wyplosz stop short of hinting at how their plans are to be implemented, their set of proposals is a level-headed, practical call to action.

The Radicals: Dismantling the Union
Kawalec and Pytlarczyk advocate an orderly dissolution of the monetary union and a return to national currencies. If an orderly dismantlement were possible, it would be an idea worthy of technical or political debates. However, there may not be much of a distinction between an orderly and a disorderly dissolution because any attempt at the former would end up being the latter.

The authors raise several pertinent arguments. One is the danger of a frail EMU dragging the EU to its demise. The second is a sober reminder to EU leaders that however unfashionable out-of-the-box thinking might appear today, it should be earnestly considered at intellectual and policy levels. This does not just touch upon the breakup of the EMU but also includes bold technical proposals, such as those discussed in this report.

The reform proposals of the federalists, the five presidents, and those advocating dissolution face a scant probability of being fully implemented by 2025. All three sets of blueprints are bold yet they enjoy little political support. Neither the college of all 28 national governments nor the EU Commission nor the European Parliament could garner the requisite backing for them based on electoral platforms of political parties and opinion polls.

By contrast, the modest designs advocated by Eichengreen and Wyplosz appear realistic against the long timeline proposed by the five presidents. There are two caveats. One, Eichengreen and Wyplosz’s paper should not be construed as the definitive gospel on saving the euro. It is a set of views by two economists that appears credible to me with one major qualification. Eichengreen and Wyplosz back the banking union as presented by the commission. This proposal is heavy on creditor bail-ins (forcing losses on bondholders and depositors) in order to avoid recourse to taxpayers’ money. However, in some cases, saving a bank through a temporary state takeover might be necessary to avoid a meltdown of the entire financial sector. For this, some form of a “virtual” treasury or an unlimited claim on the public purse would be required, particularly when the ECB does not fulfill the role of lender of last resort. The versions of the banking union proposed by Eichengreen and Wyplosz as well as the commission do not address this option. Without it, the banking union is bound to deliver less than its name implies.

The second caveat is about timing. The deadline of 2025 proposed by the five presidents is arbitrary. Another crisis may hit the eurozone well before then given tumultuous realignments of political forces or possible future referenda, to say nothing of financial shocks. Eichengreen and Wyplosz explicitly call for immediate implementation of their four conditions as the very minimum way of saving the euro. This appears to be highly optimistic.

The decision by British voters to leave the UK complicates matters. The referendum has confirmed widespread euroscepticism. The departure of the UK will sap the energy of those working within the EMU to close ranks, seek tough political choices, and hunt for compromises. It will embolden political parties hostile to further European integration. Mainstream politicians will be constrained in how daring their proposals can be.

What emerges is a monetary union that faces truly long odds of survival in the medium term. The obvious solution to save it—a federation—is excluded by politics. The clean way out of toxic economics—a return to flexible exchange rates—is barred by reflexive abhorrence of the concept by politicians. And any in-between solutions are frozen in place by fear of flailing popular support that could then wreck the European Union itself.

To survive, the EMU must find a way out of the doom loop, in which euroscepticism feeds into preference for the status quo by fearful politicians. This inaction then lowers public expectations that the EU is strong enough to fight future crises, which in turn further inflames euroscepticism. Perhaps the true minimum condition to save the euro lies in the will to break out of this cycle.

1. Stefan Kawalec and Ernest Pytlarczyk, The Euro Paradox: How to Break Out of the Trap of a Common Currency? (in original Polish), 2016.
2. "This would require Member States to accept increasingly joint decision-making on elements of their respective national budgets and economic policies," pg. 5.