The Euro Area at Twenty and the Need for Reform

One can identify four sub-periods in the evolution of monetary cooperation in the European Union. First, the period from the collapse of the Bretton Woods system of fixed parities in 1973, to the emergence of the EMS in 1979. Second, the period of operation of the EMS, until the creation of the euro in 1999. Third, the first ten years of the euro area, before the crisis of 2009-2010. Finally, the period since 2010, when the euro crisis broke out.

In each successive sub-period monetary integration was becoming gradually deeper, evolving from the “snake” of the 1970s, to the EMS of the 1980s, the tighter EMS of the 1990s, with infrequent reallignments, and, eventually with the creation of the euro.

All periods were characterized by significant macroeconomic and financial asymmetries among member states in the core economies of the north and the economies of the southern periphery, but also by different degrees of monetary integration.

With the deepening of monetary cooperation, in the evolution from the snake to the euro, some of these asymmetries were addressed, while others were not. When the euro was created, very little was done to address the remaining asymmetries, essentially shifting the burden of adjustment to individual euro area members and their fiscal systems. As a result, while asymmetries in inflation rates, and nominal interest rates and exchange rates were addressed by the creation of the euro, real, financial and external asymmetries widened after the creation of the euro, both before and after the euro area crisis.

In the first ten years of the euro area, the remaining asymmetries resulted in the build up of significant external imbalances, and, eventually contributed to the eruption of the euro area crisis. The main financial asymmetric shock appears to have been the creation of the euro itself, which initially brought about the convergence of nominal and real interest rates between the periphery and the core. This convergence resulted in a widening of savings and investment imbalances in the periphery, which up until then had relatively high nominal and real interest rates, the widening of external imbalances, the buildup of external debt by the countries of the periphery, and eventually a euro area financial crisis. This process was exacerbated by the “home” bias of banks in the countries of the euro area.

The euro area crisis was essentially an external debt crisis in an economic and monetary union with a single currency, but major economic and governance problem areas, such as major differences in the product mix, fragmented national labor markets, different fiscal systems, imperfect financial integration, lack of effective cross border financial regulation, an extremely low federal budget and lack of a lender of last resort to banks and sovereign governments. In this respect, the euro area crisis of the 2010s was at the end of the day no different that other regional financial crises involving indebted economies, such as the Latin American crisis of the 1980s and the Asian crisis of the 1990s.

A result of the major asymmetries and other economic and governance problems of the euro area is the fact that adjustment efforts since the crisis have shifted the burden exclusively towards the weaker economies in the periphery of the euro area, which suffered deep recessions, a significant rise in unemployment, continuous tax rises and exorbitant social costs for young workers and old age pensioners.

Although financial market integration and effective regulation of financial markets have taken a priority since the 2010 crisis, the euro area remains a single currency area with significant real and financial asymmetries, segregated national fiscal systems, weak coordination of fiscal policies and a virtually non-existent federal budget. At the same time, the European Central Bank (ECB) remains the only major central bank in the industrialized world which cannot function properly as a lender of last resort to governments and commercial banks. In addition, labor markets in the euro area remain fragmented, contributing to major differences in unemployment rates, which are exacerbated by the notoriously low degree of labor mobility in Europe.

Hence, not only does the euro area not satisfy the main criterion suggested by optimum currency area considerations, namely the absence of asymmetries and asymmetric shocks, it furthermore lacks the other two main prerequisites for macroeconomic stabilization, namely integrated labor markets and a federal budget that would act as an automatic stabilizer in the case of asymmetric macroeconomic developments. Furthermore, its response to major financial crises the Euro area is hampered by the lack of an effective lender of last resort, the creation of the European Stability Mechanism (ESM) notwithstanding.

The euro area is in urgent need for additional fiscal, financial and labor market reforms. A moderate and appropriately targeted increase in the EU budget would help smooth out the asymmetric impact of macroeconomic shocks through the operation of automatic fiscal stabilizers. It would also help countries in recession face fewer fiscal and financial consequences of such recessions, and would also partly address labor market fragmentation. A significant part of the fragmentation of labor markets in Europe is the result of the lack of a cross border system of unemployment and health insurance. This could be addressed in a reform that would allow for a moderate increase in the EU budget targeted to euro area wide unemployment and health insurance.

This proposal goes against the arguments of those opposing a transfer union, chiefly the countries that are net contributors to the EU budget. We feel that these objections are misplaced. The EU and, in particular, the EA are already transfer unions, through the operation of the single market and the monetary union. They encourage significant economic transfers from weaker and less competitive sectors and economies, to stronger and more competitive ones, as suggested by the macroeconomic performance of the core and the periphery following the creation of the Euro area. A fiscal transfer union, which would partly correct the effects of such transfers through fiscal redistribution is a logical counterpart of the single market and the monetary union. The transfers we suggest are modest, but certainly higher than the current EU ceiling of 1% of GDP. They could be concentrated in key areas such as unemployment insurance and regional aid.

The objections of net contributors to a moderate increase in the EU budget could in principle be overcome by an appropriate rules based fiscal reform that would address moral hazard and other coordination problems.

It would also help in the avoidance of future crises if there was a composite euro area safe asset and the ECB enhanced its ability to act as a lender of last resort.

From the introduction to Economic and Financial Asymmetries in the Euro Area, by George Alogoskoufis and Laurent Jacque, Fletcher School, Tufts University (November 2018).