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Since the beginning of the European debt crisis, most economists have focused on the potential consequences of a breakup of the euro zone. It’s easy to understand why. Although unlikely, a euro-zone breakup would be a potentially cataclysmic event that would leave the world economy in tatters. Economist Milton Friedman famously predicted the euro zone would fail when confronted with its first systemic crisis because it was a fair-weather construction.
The “countdown to apocalypse” frame of mind, however, misses the most important part of the story – specifically, the progress European leaders have made since the crisis started, nearly five years ago, in reshaping EMU (European Economic and Monetary Union) into a more viable currency union. Therein lies the under-reported, and more significant, story of the European debt crisis.
The strengthening of EMU into a cohesive monetary union would have been impossible to imagine in the benign context of the 1990s when the euro zone was created and its economies were growing at relatively healthy clips. The current crisis has changed the economic and political environment in Europe and provided the incentive to make progress on taboo topics, including painful abandonments of sovereignty by member states. This doesn’t mean that the euro zone has to become another US-style federal union.
As Mario Draghi, the president of the European Central Bank, declared, “those who claim only a full federation can be sustainable set the bar too high.” Rather, what’s emerging is what leaders like EU Monetary Affairs and Finance Commissioner Olli Rehn call “euro zone 2.0” The new euro zone will be an in-between, sui generis institution built on six pillars. Let’s examine the progress made on each of those pillars since the beginning of the crisis and see what remains to be done.
Firstly, the euro zone needs a deeper fiscal union with stricter budget discipline from its member states and regulatory agencies with effective surveillance and enforcement powers. Such a structure would be necessary to support debt mutualization and a dose of fiscal transfers, most probably through a common euro-zone budget. Since the beginning of the crisis, European leaders have made some real progress on budget discipline, with the European Semester for economic coordination and the so-called Six-Pack measures. But these developments remain insufficient to convince Germany to accede to a regime of debt mutualization.
This leads us to the second pillar – a political union. Since abandonments of sovereignty are required from all member states, new governance and accountability mechanisms at the level of the euro zone must be created. On the financial front, to ensure financial stability, Germany and other creditor countries, which have contributed most to the region’s sovereign bailouts, will have to relinquish control of part of their own budget by consenting to at least a dose of automatic transfers as part of their ongoing financial support of debtor countries. On the political front, debtor countries, like Spain or Portugal, will need to give up their control over core spending functions. Angela Merkel has been calling for deeper political integration, but France’s François Hollande is more cautious, and progress on this front has been very limited so far.
The third pillar supporting a stronger euro zone involves a banking union, which is crucial to breaking the vicious circle of sovereign debt crises and bank failures. The decision to build such a union, with zone-wide regulation and bank supervision by the ECB, was actually taken by the European summit of June 2012. It could be operational as early as 2013.
The fourth pillar is the provision of liquidity to the financial system in times of stress. The ECB has committed to more monetary action, and in doing so, more closely resembles traditional central banks like the US Fed or the Bank of England.
Similarly, European leaders have made good progress in creating crisis management tools for current and future sovereign debt crises, the fifth necessary pillar of a euro zone 2.0. The “no-bailout clause” of the treaties has been de facto abolished, and replaced not only by the two successive emergency funds guaranteed by all member states (EFSF and ESM, or European Stability Mechanism). One can also add to the mix the open market bond purchases by the ECB as part of Draghi’s commitment to defeat speculative attacks against weaker countries.
Progress on the sixth and last pillar – improving competitiveness and economic adjustment between euro-zone member states – has, like greater fiscal and political integration, been more modest. Labor mobility has improved somewhat, with well-educated Spaniards and Greeks migrating to higher-paying work in Germany. Germany’s higher wages have helped other countries – including Spain, Portugal or even Ireland – regain competitiveness. However, it is unclear if structural reforms, rather than the economic recession, have contributed to these improvements.
The bottom line is that the euro-zone “crisis” has already generated a lot of euro-zone “progress,” and today the monetary union is much more solid than it was at its birth. In some respects, it is hard to recognize it. What observers should monitor over the next few months is whether European leaders make good on creating the banking union and, more crucially, how they manage to crack the toughest nut, achieving much stronger fiscal union accompanied by a deeper political union.