The future of economic governance in the the EU - European Union Committee Contents

Memorandum by Dr Marco Annunziata, Chief Economist, Unicredit Group (EGE 9)

  1. The recent fiscal crisis in Europe has exposed a number of flaws in the existing system of economic governance. The most simple and fundamental is that the smooth functioning of Monetary Union requires a much greater degree of centralization or coordination in macroeconomic decision making, especially as regards fiscal policy. It has often been argued that divergences across Eurozone member countries are no greater than across US states. This is both misleading and enlightening. Misleading, because unlike the Eurozone, the US federal government accounts for the largest part of taxes levied and public services provided, and of government bonds issued. Enlightening, because it underscores that divergences will eventually require fiscal transfers—something that in the Eurozone is now materializing in the form of emergency rescue plans for crisis-hit members.

  2. Greater coordination of economic policies is highly desirable, as otherwise the single monetary policy will continue to create destabilizing imbalances. There is already evidence that with Germany's economy growing much faster than the "periphery" (Italy, Spain, Portugal, Greece, Ireland), monetary policy might have to choose between allowing overheating in Germany and causing stagnation in the periphery. Since the issue is the common monetary policy, coordination could be confined to the Eurozone, as opposed to the EU; the UK can maintain a higher degree of independence as long as it keeps its own currency, which allows an extra mechanism of adjustment.

  3. Economic governance could be guided by either political discretion or by rules. However, for governance to be effective, the following should hold: (a) if it is political discretion, than this should be exercised by stronger Eurozone-level or EU-level policy bodies; (b) if rules, than these should be enshrined into national legislations to ensure they can be enforced.

  4. The direction taken by the Commission and by the Van Rompuy task force go in the right direction; specifically: (a) it is essential to give greater weight to the level of public debt; the emphasis on the fiscal deficit was aimed at preventing public debt from reaching excessive levels, but after the recent crisis debt to GDP ratios in most EU countries can already be considered excessive, and a new governance system should foster a gradual reduction; this should include the level of unfunded liabilities related to aging; (b) it is equally important to foster convergence in competitiveness and to broaden macro surveillance to private indebtedness and to external current account balances, which have proved to be potentially destabilizing; (c) in this regard, surveillance should be symmetrical, in the sense that large current account surpluses should be seen as undesirable as large deficits; (d) to effectively fister macroeconomic convergence and balance, surveillance procedures should also monitor progress on structural reforms, especially as regards rigidities in labor and product markets as well as aging-related reforms.

  5. While current proposals go in the right direction as concerns the broadening and focus of surveillance, insufficient progress is being made as regards the ability to enforce sanctions. The key weakness of the existing Stability and Growth Pact is the fact that sanctions can easily be blocked by member states, as in the case of Germany and France in 2002-03. This is the toughest issue to resolve, but the crux of the matter is the following: sanctions will unavoidably infringe on national sovereignty, as they have to impinge on decisions on taxes and expenditures which are, and should be, prerogative of the elected representatives of the people; therefore, for the rules and sanctions to be enforceable they should either (a) be entrusted to new EU-level institutions with a greater degree of political legitimacy, which in essence will require progress towards a more genuine political union; or (b) set in stone in national legislation, preferably at the level of the Constitution, so as to tie the hands of national governments in a way which is recognized as desirable by the elected national legislature. Unless enforceability of rules is ensured, changes to the rules themselves risk being irrelevant. In this regard, current suggestions that sanctions should be quasi-automatic, in the sense that once recommended by the Commission they would be automatically imposed unless they are blocked by a majority-decision of member countries, are insufficient.

  6. There appears to be a consensus that the changes should not require a renegotiation of the Treaty; but this lacks the ambition which the current crisis instead calls for. The ECB itself has indicated that ideally, reforms would now not be constrained by the current Treaty; indeed, given the magnitude and seriousness of the challenge, member governments should consider a renegotiation.

  7. Whether a permanent crisis resolution mechanism is needed is debatable. Such a mechanism already exists: it is the International Monetary Fund. It would seem most wasteful to duplicate the features and expertise of the IMF by setting up a European Monetary Fund. If a EU-specific mechanism is deemed desirable for political reasons, it should consist of a financial reserve backed by pooled tax revenues, and come together with a significant strengthening of EU-level political institutions. Even then, it would still be desirable to involve the IMF both to tap its considerable expertise (hopefully the staff at the Commission or a possible EMF would not be confronted with crises on a regular basis) and to ensure greater objectivity and independence in the assessments and recommendations.

  8. A permanent crisis resolution mechanism, whether it is the IMF or a EU-specific mechanism, would be helpful in limiting the risk of systemic instability. The best way to limit moral hazard would probably to co-opt private financial markets, which could exercise a disciplining role by driving sovereign bond yields spreads wider at an earlier stage as macroeconomic policies in a country begin to drift in the wrong direction. This would most likely require agreement on a sovereign debt restructuring mechanism or orderly insolvency procedure, to signal to private investors that should a country experience a debt crisis, they would stand to suffer a loss on their investments on the sovereign bonds of the country.

  9. The UK's national interest lies in a strengthening of macroeconomic governance along the lines described above: these would reduce the risk of systemic instability in the Eurozone, which has proved damaging for the UK as a whole. To the extent that some of the new mechanisms and institutions that would be set up would be at the level of the Eurozone rather than the EU, reflecting the fact that the common monetary policy is the main issue, the UK would risk being excluded from this particular aspect of integration and deepening of EU institutions, which might reduce its weight in the overall decision making process. This should be weighed against the fact that the current crisis has clearly underscored the value of having a national currency as an additional rapid adjustment mechanism. Incidentally, it should be noted that with fiscal policy mobilized to underpin confidence in public debt sustainability, a national currency does not become a factor of instability. From a UK perspective, it might therefore be best to encourage greater centralization and coordination of decision making processes at the Eurozone level while considering whether future participation in the Eurozone might be beneficial. This would depend on whether more centralized economic governance at the Eurozone level moves consistently with long-established UK principles of economic management, often reflected in a greater degree of flexibility than those prevailing in the Eurozone. A legitimate question is whether the UK could exercise greater influence from the inside than from the outside. At this stage, however, it would seem more prudent to seek to influence the process from the outside, without committing to membership before there is a greater degree of comfort that the institutional reforms have moved sufficiently far in the right direction.

October 2010

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