EMU’s Future: 20 Years After Maastricht

Speech by the EBRD President Thomas Mirow at the Official Monetary and Financial Institutions Forum (OMFIF), 26 April 2012

20 years ago, European leaders agreed on a vision for Europe’s future: Economic and Monetary Union. The place was Maastricht, at the south-eastern tip of the Netherlands, and in the heart of Charlemagne’s old empire. Following a long history of conflict and a shorter but hopeful period of peace and convergence, a common currency would give the European project new impetus. It would guarantee price stability in all member countries, end exchange rate risk, promote trade and a free flow of capital, and through all these channels unleash a process of convergence that would eventually equalise living standards across Europe – ensuring prosperity for all.

Alas, the European reality today is very far from this vision. To be sure, price stability was exported to the periphery countries, intra-European trade grew rapidly, and capital flowed from the centre to the periphery. Between 1995 and 2006, convergence did indeed pick up. Greece’s per capita GDP, for example, rose from about 45 per cent of German GDP to about 56 per cent. Spain started at 47 per cent and ended at 55. But for 2012, the IMF predicts that Greek’s GDP per capita will be back at 47 per cent and Spain’s at 48 per cent of Germany’s – almost wiping out the gains of a dozen years of convergence.  

So, was it all a mistake? Was the vision fundamentally flawed? Does it need to be replaced or could it be rescued? If so, what would it take?

The Maastricht design

Let me start with the beginning: the Maastricht design. You have all heard the basic argument for why the Maastricht vision was a mistake: it put the cart of monetary union before the horse of political and fiscal union. This worked for a while, when the road was smooth; but when the incline became too steep – or the first pothole appeared – both the cart and the horse went into the ditch. What Europe should have done is to achieve a high degree of political and fiscal union first, and then try monetary union.

This argument, while popular with many distinguished commentators and policymakers – including maybe some in this audience – is, I think, not convincing. It is – to some extent – wrong economically, for reasons that I will explain in a minute. But, most importantly, it is wrong politically. The degree of political union that it would take for Europe to achieve full fiscal union is so ambitious that, had we put political and fiscal union before monetary union, neither the cart nor horse would have moved in the first place.

The ostensible reason why fiscal union is a necessary complement of monetary union is that when countries lose the ability to run their own monetary policy and devalue their currency, they will require fiscal transfers to offset bad shocks or policy mistakes. These transfers, the argument goes, must be so large that they are conceivable only in a political union – for example, through a common European tax coupled with a single European system of social or infrastructure spending.

True, countries do lose an important policy instrument when they give up monetary independence. But they retain another one: fiscal policy. When there are shocks that require a boost to aggregate demand, they can cut taxes or increase spending. When there are shocks that threaten competiveness, this can be restored by lowering benefits and payroll taxes, as well as through structural reforms.

There is, of course, an important caveat. The mechanisms I described work as long as a government has ample access to credit. But in periods of fiscal adjustment and structural reform, a lack of access to credit can force adjustment that is so abrupt as to trigger a recession, and create formidable political and social problems. This is the situation we see in some Mediterranean countries today.

The fathers of Maastricht knew this. They also realised that if a country in EMU did indeed run into economic problems that could not be dealt with through fiscal policy, the economic and political spillovers for the rest of Europe would be very severe. Hence, fiscal policy would need to be kept in good shape. This was the rationale for the debt and deficit rules enshrined in the Maastricht treaty, and the excessive deficit procedure developed to enforce them.

What went wrong?

So, what went wrong? Part of the answer is that the Maastricht rules did not work as intended. Their legal and political anchors were not sufficiently strong, and when Germany and France decided to flaunt them in 2004, they became unstuck. But this is not the whole story. Two other factors also played an important role.

First, one element of the vision of Maastricht – the idea that EMU would stimulate capital flows and investment in poorer regions – worked, if anything too well. With no exchange rate risk, and perceptions of diminished sovereign risk, real interest rates in the European periphery countries declined to historic lows. The result was a large credit and asset price boom. The debt accumulation made it much more difficult to adjust to falling asset prices and output, particularly in countries where investments were concentrated in the housing sectors.

The second factor was bad luck. The US-born crisis created in the autumn of 2008 the worst asset price and trade shock in Europe since the Great Depression. As output, revenues, and housing prices collapsed, public debt surged and private debt went sour. This in turn threatened banking systems, which led to more public debt. The rest is history.

Restoring the vision, correcting the flaws

The vision of Maastricht remains compelling. Europe has much to gain from further economic and financial integration, and a currency union is essential to this aim.

At the same time, we must face the reality that majorities of citizens in most European countries are wary of devolving more competencies away from national parliaments, and that voters – not just in Germany – have been reluctant to go along even with the modest transfers – compared to the United States, for example – that have been on the table during the Eurozone crisis so far.

In light of this, the European project’s best chance is to rebuild Maastricht in a way that addresses its design flaws and makes it much more resilient both to weak national policies and institutions, and to economic shocks. This requires developing institutions at three levels.                                                                          

First, the Eurozone needs strong mechanisms that constrain credit booms and reduce the risk of private debt spilling over to public debt once markets reverse. These mechanisms must allow differentiation at the national level, but the realities of cross-border banking require a strong cross-border element in both supervision and resolution.

Second, we need fiscal rules that cannot easily be pushed aside just when they become binding. This does not mean that the rules must be insensitive to economic cycles. But it must be beyond the discretion of European government, even powerful ones, to change them without a renegotiation involving all other governments.

Third, we need to accept the fact that crises may occur even if the new institutions work as intended. For this reason, Europe needs a crisis fund that will extend financing to governments that temporarily lose market access and limit contagion within the Eurozone.

The three elements of this institutional reform package are complementary. Fiscal rules will not prevent a new crisis without a parallel policy framework that contains private debt creation. Conversely, mechanisms that contain private sector debt bubbles need to be complemented by a framework that limits public sector debt, particularly if a large crisis fund is being put in place at the same time.

Progress to date -- A glass half full or half empty?

It will be clear to everyone in this room that the three fundamental areas of reform that I have just described are also the areas in which Europe has made significant recent efforts, with the creation of the European Stability Risk Board, the joint European supervisory agencies, the European Stability Mechanism, as well as the signature of the Fiscal Compact. Importantly, the ESM was modified in a way that links it to membership in the Fiscal Compact, meaning that the presence of a large crisis fund should strengthen, rather than undermine, incentives for good policies.

Hence, Europe has been making important steps in the right direction. Yet, the glass remains half full, as it is easy to find faults with the reform effort so far.

• Observers have pointed to weaknesses in the design of the Fiscal Compact, questioning whether we will be able to correctly estimate structural deficits and whether the differentiation between countries above and below the 60% threshold is substantial enough.
  
• Then, the decision to activate the ESM will be made directly by the European Council, which makes it more susceptible to political deals than arms-length institutions such as the European Commission.
  
• Most importantly, the reform of financial sector institutions needs to go further. The ESRB and the EBA both remain weak relative to national supervisory authorities. Consistent with this, the fiscal responsibility for bank resolution remains squarely with national authorities. Breaking the link from private to public national balance sheets would require common European deposit insurance and perhaps bank recapitalisation funds, possibly funded by a systemic risk charge levied on banks.
  
• Also, of course, the ratification of the Fiscal Compact is not a done deal. While it is highly likely that it will be ratified in some form, it is possible that some additional EU countries will follow the path of Britain and the Czech Republic and stay outside the pact.

The priority: to foster growth in the Euro periphery

But most crucially, it is clear that the governance reforms will not by themselves address the imbalances in the Eurozone that were created as a result of the last crisis and the boom years that led to it. The utmost priority is of course to recreate the conditions for sound growth in the countries of southern Europe, laying the foundations for a sustainable, long term growth through structural reforms, while striking the right balance between austerity and growth in the short term. In these endeavours, the tradable sector, including modern services, should be the piece of focus, with the goal of reducing structural current account imbalances.

All of this is an ambitious task. So let us dwell upon some of the national structural reforms that we – and many others – view as essential for fostering growth in peripheral Europe.

A first priority should be to improve the functioning of labour markets, in two complementary dimensions: labour market adjustment must be facilitated, and overall labour force participation boosted. A well-functioning labour market has a clear positive impact on both the growth potential of an economy and the public finances of the country, and can act as an 'equalisation mechanism' in case of shocks – mechanism much needed in a monetary union, as we discussed earlier.

To this aim, efforts should be put into making wages more responsive to economic and firm-specific conditions, into reducing labour market dualism and barriers to entry, but also – at the other end of the age scale – into retaining older workers in the labour market through tightened conditions for early retirement – labour and pension reforms are here closely related. Also, the tax wedge on labour income should be reduced by broadening the tax base and shifting more taxation on property and – with a gradual approach – on consumption.

A second priority should be to further reduce regulatory barriers to competition and to unleash the growth currently frustrated in some sheltered sectors of the economy, such as professional services or retail trade. The administrative burden on businesses can be eased, licensing procedures simplified, closed professions opened. A new impetus could here come from the EU level.

Finally, and this cannot be underestimated, the long term growth potential of an economy ultimately depends on the quality of its education system and the level of innovation. Within national educational frameworks, we believe there is room for teachers’ careers to be more closely linked to performance, for greater independence – and accountability, its twin sister – of schools and universities. Vocational education should be promoted. On the innovation front, tax incentives for R&D can be strengthened and links between academic research and businesses improved.

In recent months, significant actions have already been taken in these three directions in Italy, Spain, Portugal and Greece. Some others are under discussion. This is all good news.

At the same time, it is clear that successful implementation of structural reform will face headwinds, particularly in the current economic climate. There is a two-way interaction between short run growth and structural reforms. Convincing structural reform improves the long-term solvency of government, thus reducing borrowing costs and the austerity required to achieve a given deficit reduction path. This can lead to a virtuous cycle. But conversely, there is also a danger that austerity depresses short term growth to the point where it destroys the willingness of the population to support structural reform.

The southern European governments need to try as hard as they can to establish the virtuous cycle. But this was not to materialise, we would need to look at solutions that spread the adjustment effort over a longer time period. This would require either more direct official financing or official guarantees over a limited time period, for instance as proposed in the “redemption fund” idea put forward by the German council for economic experts.

The Euro: still an attractive prospect?

Let me try to summarise the discussion so far. The good news is that there is a coherent roadmap for a governance architecture that can make EMU work, and that European leaders have taken initial steps on this road. The bad news is that the road is long and fraught with risk. Will Europe make it to the end of this road, or will EMU stall and reverse?

One way to answer this question is to check whether the prospect of joining the Euro remains attractive to the EU countries that a few years ago had every intention of joining – namely the new members states of Central and Eastern Europe that my institution, the EBRD, operates in. The results are surprisingly clear cut. With the exception of the Czech Republic, which was Eurosceptic even before the crisis, all new member states continue to express their commitment to joining the Euro.

To be sure, the Eurozone crisis has affected the timing of Euro-accession plans, on both sides. Poland, in particular, has made it clear that it want to see progress in Eurozone governance reform before setting itself a new timetable for Euro adoption. But elsewhere, the policy remains to seek Euro adoption in a short horizon.

Concluding remarks

Ladies and Gentlemen, it is time to conclude.

Today, I tried to convince you that the Maastricht vision remains right, even if there were gaps and design flaws in the institutional setup that it created. There is a path to restoring that vision. While not easy, this path is politically and economically feasible.

Institutional progress made in the past two years is renewed evidence that economic integration can drive political integration – the very core idea behind Maastricht. We are still – slowly but surely – moving towards a more economically and politically integrated European Union.

I very much look forward to discussing this with our distinguished panel and audience. Thank you for your attention.

Last updated 26 April 2012