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

CHAPTER 2: Unsteady foundations

The roots of the crisis

25.  The initial cause of the crisis in the euro area may have been the global banking crisis in 2008, but the severity with which it impacted upon the euro area exposed shortcomings in the existing architecture of the Economic and Monetary Union (EMU). We consider first the role the financial sector played in creating the crisis before looking at the structural problems of the EMU.


26.  Mr Mark Cliffe, Chief Economist at ING Group, drew our attention to the clear connection between Member States' current fiscal difficulties and the problems of the financial sector in the banking crisis.[23] The root cause was that "the financial crisis has forced European governments to step in to support their banking systems".[24] Ireland's current debt crisis, for example, is a direct result of its government's decision to offer a blanket guarantee to depositors. Many other countries also bailed out or supported their banks, escalating the level of public debt across Europe dramatically. In some cases this led to concerns that countries would not be able to service their debt, which in turn would then result in losses for banks holding the debt. Dr Marco Annunziata, Chief Economist at Unicredit Group, expanded on how this threatens the EU as a whole:

"Part of the concern that we have about the current situation in Ireland, Greece, and Portugal, is that the sovereign debt issued by these countries is being held in significant amounts by banks in other member countries—in the Eurozone ... but also outside the Eurozone, as in the UK. This implies that shocks and instability in one member country can no longer be isolated and contained to that country; they spill over".[25]

27.  Dr Daniel Gros, Director of Centre for European Policy Studies, argued that this was a key issue and noted that "many people ... did not put enough emphasis on strengthening the banking system".[26] He would "trade the entire van Rompuy package on economic governance against a couple of things on the banking side".[27]

28.  Mr Costello noted that the Commission was working to create "a competitive banking system, one which avoids a recurrence of where, in countries such as Ireland, their share of the banking system goes beyond their capacity to support it".[28] Supporting this goal was its work on a financial package of supervisory regulations and bodies to control the behaviour of the banking sector. Financial supervision lies outside the remit of this inquiry.[29] We note, however, that improvement and reform of financial supervision will be a vital part of measures to support the euro area in the long-term, for example the need to remedy the under-capitalisation of certain European banks. The connection between financial supervision and the wider economic governance framework covered in this report will take place through the European Systemic Risk Board (ESRB). We consider the ESRB in more detail in chapter 4.[30]

29.  The interconnection of the sovereign debt and banking sectors was one of the principal elements that contributed to the current crisis. Recent events have demonstrated the debilitating effect on public finances of transferring private debt to the public sector. Mechanisms must be put in place to control the behaviour of banks and to ensure that the public sector does not end up carrying the cost of failing banks. These must be effective. We also note the risk of a vicious circle whereby a sovereign debt crisis puts pressure on banks, including UK banks.


30.  While the banking crisis may have triggered the current crisis in the euro area, our witnesses pointed to a series of structural failings in the construction of the EMU which explain the severity with which euro area countries were affected. The first is an asymmetry at the heart of the EMU; that while monetary policy is centralised, fiscal and supply-side[31] policies are left to the discretion of Member States. This can mean that the collective decisions of euro area countries do not necessarily add up to a coherent whole. Professor Goodhart told us that "the Eurozone is a difficult and fragile halfway house because it combines monetary centralism while leaving fiscal and indeed wider political issues to the individual nation states".[32] Since political and fiscal centralisation had not followed monetary union, "the current crisis that we see is a natural, indeed almost inevitable, result".[33]

31.  In unitary states (a nation governed as a single unit where all sovereignty lies with the central government, for example Britain), as in federations (where the central government shares sovereignty with sub-national units, for example the USA), the central government typically has a large budget and fiscal policy acts in tandem with monetary policy to maintain macroeconomic stability. Typically, the central budget takes the strain in a downturn and budget deficits increase because tax revenues fall and public expenditure rises. A central government budget can also redress regional imbalances within a country: if a region encounters difficulties, it will raise less from national tax instruments and generally expect an increased share of national public spending. In the EU, however, the quasi-federal budget is very small as a proportion of GDP (1%, compared with the some 20% or more found in many federations), must always balance (it cannot therefore go into deficit) and is expressed in predominantly multi-annual spending programmes with little flexibility. Consequently it is unable to play a significant role either in automatic stabilisation or in redressing macroeconomic imbalances.

32.  Other witnesses described further problems flowing from the very limited form of fiscal union in the euro area. Dr Mayer argued that a central bank alone could not ensure stability in a financial crisis—it needed help from fiscal authorities. A collective fiscal response to crisis can only be achieved by coordinated action by all the members of the euro area. Such coordination is very difficult to achieve, especially when rapid action is required.[34] Professor Willem Buiter, Chief Economist at Citigroup, suggested that by giving up monetary autonomy Member States had lost the ability to provide a lender of last resort able to supply liquidity to its financial sector. Traditionally, this function was assigned to national central banks at the discretion of the national government, but the power of Member States to demand such lending has gone because the European Central Bank is far more independent of political authorities than any national central bank could hope to be. He suggested that this meant that "no national government, with the possible exception of Germany ... will ever be able to compel the ECB very easily into providing the liquidity that it needs to prevent a potential default".[35]

33.  In short, there is an asymmetry in the EMU between a powerful and centralised monetary policy and a fragmented and inadequately coordinated fiscal policy.


34.  Other witnesses pointed to a different problem: a growing disparity in competitiveness between different states within the euro area. Dr Dadush, for example, told us that "The fundamental cause of the Eurozone crisis ... is the build-up over a decade of large macroeconomic imbalances and the loss of competitiveness of stricken countries".[36] As Mr Leandro explained, "competitiveness imbalance means, for example, big divergences in current account balances" where Member States were "importing more than they were exporting and were losing competitiveness".[37]

35.  There are two main reasons for these macroeconomic imbalances. Firstly, a single currency has meant a single base interest rate across the euro area. This in turn permits private credit to be available in relatively inflation-prone economies like Greece at the same nominal interest rate as much stronger economies such as Germany where inflation rates are lower. This leads to credit bubbles and unsustainable levels of private borrowing. Dr Dadush explained: "the competitiveness loss was made worse ... by a common monetary policy that was too loose for fast-growing and/or higher inflation countries in the European periphery and too tight for Germany and other countries in the European core".[38]

36.  Secondly, when Member States became relatively less competitive "euro membership prevented these countries from devaluing their currencies to regain competitiveness".[39] The European Trade Union Confederation (ETUC) described the other side of the equation, telling us that when Germany started a process of competitive disinflation (i.e. deliberately holding wage increases below the rate of inflation), "whereas in the past, the gains ... were simply neutralised by an appreciation of the national currency ... this was no longer the case under monetary union".[40]

37.  Dr Buiter felt that there was nothing inherently worrying about some countries remaining uncompetitive in the sense of having lower productivity than their peers. The result would be "they will simply be poorer".[41] For others such as Open Europe, these "chronic gaps in competitiveness" are the "most critical shortcoming of the euro area",[42] while Dr Annunziata stated that in addition to stricter fiscal rules "it is equally important to foster convergence in competitiveness".[43] Professor Jean Pisani-Ferry, Director of Bruegel (a European think tank), explained bluntly: "a number of countries in the euro area have lost competitiveness in a major way ... These countries will have to regain competitiveness. That is an imperative for everyone. If they do not, they will be permanently in a situation of high unemployment and struggling with growth. That is a dangerous situation for everyone".[44] It would mean a sizeable number of countries depressing demand in the euro area as a whole.


38.  These structural problems were exacerbated by a failure by the markets, and Member States themselves, to understand the construction of the euro area. The markets treated all Member States within the euro as if they posed the same risk, which given Germany's economic strength meant that the spread on sovereign bonds was extremely limited. The result, as Professor Goodhart noted, was that until late 2009 "the general belief was that there was really no sovereign risk in Eurozone countries".[45] The markets assumed that the construction of the euro area would lead to responsible fiscal behaviour (through the Stability and Growth Pact) and a bail-out for any Member States which did encounter financial difficulties.[46] As Professor Buiter explained, "the markets got it radically wrong in the run-up to the financial crisis ... they underpriced credit risks generally and they undoubtedly will get it wrong again".[47] Inflation-prone economies were able to access market funding far too cheaply, and without a spread in sovereign bond rates the market did not play its usual role in restraining irresponsible government behaviour. We consider the role of the market as a means of disciplining governments in chapter 3.[48]

Looking to the Future


39.  The two structural problems we identify above (paragraphs 30-37) remain sources of destabilising pressures in the euro area. This led some witnesses to ask "whether monetary union among sovereign states requires some sort of fiscal union".[49] The term "fiscal union" is a generic term, and there have been a range of suggestions as to what such a union might entail. The suggestions range from a limited fiscal union where a euro area institution coordinated individual nations' fiscal policies, to a full fiscal union, which Dr Annunziata described as "a central authority in Brussels [that] would to a large extent run fiscal policy for the whole of the euro area, in a system similar to that of the US".[50] This would involve cross-border transfers of tax-payers money to pay for public services, but would also create a system of stabilisation that would mitigate regional imbalances.

40.  Many witnesses felt that this would be beneficial; Dr Annunziata called "full fiscal integration" the "simplest solution",[51] while Mr Cliffe talked of the "fiscal transfers and burden sharing that would make it [the euro area] sustainable in the long run".[52] Professor Goodhart said that "it would be a lot easier for all, in terms of the operation of the system, if the centralised monetary system was coordinated with a much more centralised fiscal policy".[53] The ETUC went even further, stating that "you need a European fiscal policy, or as you call it a closer fiscal union, to get the single currency to survive".[54] Mr Mats Persson of Open Europe agreed and stated that to overcome the difference in competitiveness "you really need a full-blown fiscal union with continuous transfers".[55]

41.  Although it seems that, from an economic point of view, full fiscal union might be desirable, our witnesses were strongly of the view that this would be politically impossible to achieve at present, or at any time in the near future.[56]

42.  An intermediate form of fiscal union might be to enhance the scope for collective borrowing by the euro area, so as to make it easier for fiscally vulnerable euro area countries to finance their deficits at an acceptable cost. This would imply accepting joint liability for a certain level of sovereign borrowing. Recent proposals for jointly issued eurobonds move in this direction. In practice, this is what the EFSF offers as a short-term expedient, but proposals to issue eurobonds that could be used to finance sovereign debt of all Member States have met considerable resistance. We consider these proposals further in chapter 5, but conclude that they are likely to represent a greater degree of fiscal integration than Member States are willing to accept at present.[57]


43.  It seems clear that a full fiscal union is unfeasible, and a more limited version unlikely. The direction taken by the Commission and the governments of the EU since the crisis has therefore been to propose new mechanisms, and to strengthen existing ones, to coordinate economic policies more closely to lessen the difficulties created by the absence of a fiscal union and a build-up of competitiveness imbalances between Member States. Mr Mark Hoban MP, Financial Secretary at HM Treasury, illustrated this when he stated: "it is clear from this crisis that there needs to be much greater coordination between states in the Eurozone than there has been in the past".[58]

44.  We heard scepticism from some witnesses that mere coordination, as opposed to union, would be sufficient. Mr Persson, for example, told us that "fiscal coordination ... might help a little bit, but it can only take you so far"[59], while Professor Christos Gortsos, Panteion University of Athens, felt that "in a long-term perspective ... the only viable solution" is a "single fiscal policy ... which could efficiently support the monetary unification".[60] Others, however, were supportive. Ms Barysch felt that "a monetary union can work if the constituent nations agree on very close economic policy coordination and the enforcement of very strict rules".[61] Dr Annunziata agreed[62] and endorsed the direction taken by the Commission and by the van Rompuy taskforce.[63]

45.  Overall, we felt that witnesses were uncertain as to whether closer fiscal coordination by Member States would be sufficient to overcome destabilising pressures within the EMU. Mr Hoban perhaps summed up the balance of the views when he stated that the Commission's proposal created "the right framework", but that "it depends how Member States react to this".[64] We discuss the Commission's proposals for greater economic cooperation in relation to fiscal policy and competitiveness imbalances in detail in chapters 3 and 4.

46.  There are flaws in the concept and design of the euro area, caused by an asymmetry between a centralised monetary policy and decentralised fiscal and supply-side policies, and by a build-up of competitiveness imbalances between Member States. The simplest solution, a greater centralisation of fiscal policy leading to a full fiscal union, is politically unfeasible at the present time. A more limited form of fiscal union consisting of collective borrowing by the euro area is perhaps more plausible. Given that there has been no general agreement on this issue among Member States, however, it is unlikely to be more than an incomplete alternative in the near future. The package put forward by the Commission and the governments of EU Member States (through the Van Rompuy task force) opts for a greater coordination of fiscal and economic policies among euro area countries to overcome these flaws. If these proposals work well, they should make it easier for Member States of the EU, and particularly the euro area, to arrive at a collective fiscal stance that is compatible with a single monetary policy.

A break-up?

47.  While the success or otherwise of these proposals will determine whether the euro area is able to survive in the longer term, some commentators have questioned whether it will be able to survive intact the immediate challenges of the financial crisis. Mr Cliffe informed us that while "the political will to sustain monetary union is still very strong",[65] "the markets now put a significantly higher probability on at least some exits from monetary union over the next few years".[66]

48.  We heard two scenarios where a Member State in financial difficulties might leave. On the one hand a state could feel it would be to its economic advantage to leave, regaining the ability to set its own interest and exchange rates. Alternatively, it might be asked to impose "potentially politically intolerable fiscal austerity measures" to remain in the euro.[67]

49.  Witnesses suggested that a voluntary exit by a country in difficulties was highly unlikely since countries were better off in the euro than out.[68] They noted, however, that the fiscally strong countries in the euro area might leave, splitting the euro area in two. Professor Buiter put this view: "The only real risk for the euro area falling apart is not the fiscally weak and uncompetitive countries leaving; they'd be mad. It is the fiscally strong and competitive countries leaving".[69] Mr Cliffe and Mr Persson told us that it had been suggested that the Germans, perhaps along with some other core euro area members, might wish to leave at some point.[70] This view, however, was dismissed by Ms Barysch: "when the initial debate [in Germany] has calmed down a bit, you will find a nation that remains very much committed to the European project because it doesn't see an alternative".[71]

50.  Sir Martin Jacomb, Chairman of the Canary Wharf Group, argued that the euro area would survive simply because "the political imperatives to keep it going are too great".[72] Professor Buiter concluded that he was "optimistic about the survival of the enterprise [the euro]", albeit "not about the elegance with which that survival will be achieved".[73]

51.  It is important to recognise that withdrawal from the euro area would not be an easy exercise. It should not be confused with leaving the exchange rate mechanism (as the UK and others did in the early 1990s), because of both practical difficulties involved in recreating a national currency and legal constraints. Professor Louis stressed to us that "the monetary union has been conceived as irreversible": there is no formal, legal process for a country to either leave the euro, or to be expelled from the euro.[74] According to Phoebus Athanassiou, Legal Counsel of the European Central Bank, "a Member State's exit from EMU, without a parallel withdrawal from the EU, would be legally inconceivable".[75]

52.  The Minister refused to speculate on whether the euro area would survive in its current form, simply noting that "there is no mechanism for countries to leave the euro", and adding that "it would be quite a big step for that to happen".[76]

53.  Professor Goodhart stated that "the costs, political as well as economic, to a country voluntarily leaving the euro are huge".[77] Mr Cliffe told us that any benefits for a country leaving the euro "would come along with considerable costs" and "there would be severe transitional costs for any members leaving the monetary union".[78] In a paper for the ING Group, EMU Break-up: Quantifying the Unthinkable he concludes that "the numbers are debatable, but the impact would undoubtedly be traumatic". The trauma would be most severe for those countries leaving the Euro, but other countries in the euro area and the wider EU would also suffer, and the report finishes with a warning that "this is perhaps something that policy-makers may care to reflect upon when they blithely talk of exit from EMU as being a policy option".[79] It is perhaps worth noting that those countries currently in difficulties make up only a small proportion of the euro area's combined gross domestic product (see Appendix 6).

54.  We believe that the political imperatives holding the euro area together are strong, and we do not think it is likely that any country, whether fiscally weak or strong, will try to leave voluntarily. We do, however, recognise that it is now conceivable that a country could be forced to leave the euro, or that the euro area could separate into two parts.

55.  Any break-up of the euro area would not only be economically and politically costly for those Member States leaving the euro, but would have a damaging impact on all members of the euro area and the wider EU, not least the UK.

Governance within the euro area

56.  The role of the Eurogroup (a body composed of finance ministers of the Member States of the euro area), has grown significantly since its formation in 1998. It came into existence as an informal body, although it has since acquired formal recognition in the Lisbon treaty.[80] Its primary role has been to agree common positions in relation to ECOFIN[81] decisions that pertain solely to the euro area. However, it also offers a forum in which euro area finance ministers could review economic conditions and debate policy choices.

57.  There have been suggestions that the Eurogroup might be given a more official role among the EU institutions. We wondered whether this might create a risk of marginalisation for those Member States who are not in the euro. The Eurogroup, since it contains a majority of Member States of the EU, can effectively decide issues pertaining to the whole EU before they can be discussed at ECOFIN. This perception was strengthened by President Sarkozy's calls for a unified economic government of the Eurogroup,[82] and by recent agreement on a "Pact for the Euro" (see paragraphs 190-193).

58.  Professor Louis reminded us that Mr Blair had opposed the idea of strengthening the formal role of the Eurogroup as it would have been "a farce" to have a decision-making body without the presence of the UK. The members of the Eurogroup at the time, meanwhile, saw this move as potentially "too divisive".[83] Mr Zuleeg thought however that, since the Eurogroup was now in the Treaties, "it has an official role ... it has responsibility for coordinating Eurozone members".[84]

59.  Ms Barysch also told us that the Eurogroup already exercised a leadership role. She noted, though, that Germany was reluctant to "institutionalise" the Eurogroup since it was dominated by southern European countries, in contrast to the EU 27 where their presence was balanced by the more "liberal and fiscally responsible" northern and eastern European countries.[85] The Government were clear that "ECOFIN Council should retain its primary role as the forum for discussion of EU macroeconomic and fiscal policies". They would not, therefore, "support the creation of new euro area institutions" that could undermine its role.[86]

60.  We did not receive compelling evidence to suggest that the Eurogroup needed a more formal role and position. Such a move could have implications for the UK and for the position of ECOFIN as the ultimate decision-making body on financial and economic matters. Recent decisions by the Eurogroup to adopt a "Pact for the Euro" have brought these implications into sharp relief.

Speaking with a single voice

61.  While the euro area is a single monetary union, a multiplicity of voices have spoken on its behalf during the current crisis.[87] On occasion, different participants have given conflicting comments or made remarks on behalf of one euro area country without ensuring that they had the support of other Member States. This has had unfortunate results at times. As an example, Mr Leandro, speaking to us about private sector involvement in sovereign bonds[88] admitted that "there have been a lot of misunderstandings about this ... Some say this is one of the reasons we are seeing the turmoil in the markets".[89] Professor Buiter emphasised this point: "there is a huge communication deficit between the markets and European political leaders, especially but not only in Germany" and argued that politicians "do not communicate well with markets".[90]

62.  Mr de la Chapelle Bizot put the need succinctly: "It will be really important to show the rest of the world unity at the level of the European Union. If the markets ... could consider that there is no unity, no impetus, no consensus to go forward and tackle the financial difficulty inside the European Union or the Eurozone, we will, together, face real difficulties".[91]

63.  There is a clear need for the euro area to speak with one voice in crisis situations. It is essential that it improves the speed and clarity with which it communicates with the markets.

23   Q 62 Back

24   Q 53 Back

25   Q 127 Back

26   Q 170 Back

27   Q 171 Back

28   Q 385 Back

29   We have covered some of this material in a previous report however. See European Union Committee, 14th Report (2008-09): The future of EU financial regulation and supervision (HL Paper 106) Back

30   See paragraphs 171-177 Back

31   Policies affecting, inter alia, the labour market, social protection, research and development, and skills. Back

32   Q 82 Back

33   Q 83. See also, Q 486 (Professor Buiter), EGE 6 (Professor Gortsos) Back

34   Q 130 Back

35   Q 485 Back

36   EGE 18 Back

37   Q 244 Back

38   EGE 18 Back

39   EGE 7 (Open Europe). See also, EGE 13 (Sir Martin Jacomb) Back

40   EGE 2 Back

41   Q 500. See also Q 106 (Dr Schelkle) Back

42   EGE 7 Back

43   EGE 9 Back

44   Q 284. See also, Q 244 (Mr Leandro) Back

45   Q 86 Back

46   To date, of course, the euro area has indeed provided financing for any Member State in financial difficulties.  Back

47   Q 495 Back

48   See paragraphs 79-82 Back

49   Q 452 Back

50   Q 127 Back

51   Q 127 Back

52   Q 64 Back

53   Q 98 Back

54   EGE 2 Back

55   Q 430 Back

56   For example, QQ 489 (Professor Buiter), 98 (Professor Goodhart), 294 (Mr de la Chapelle Bizot) Back

57   See paragraphs 211-217. Back

58   Q 520 Back

59   Q 430 Back

60   EGE 6 Back

61   Q 452 Back

62   Q 128 Back

63   EGE 9 Back

64   Q 523 Back

65   Q 64 Back

66   Q 51 Back

67   Q 51 (Mr Cliffe) Back

68   QQ 55 (Mr Cliffe), 132 (Dr Mayer), 134 (Dr Annunziata) Back

69   Q 494 Back

70   QQ 51, 411 Back

71   Q 462 Back

72   Q 146. See also Q 63 (Mr Cliffe) Back

73   Q 502 Back

74   Q 350 Back

75   Athanassiou P, Withdrawal and expulsion from the EU and EMU: some reflections (2009), ECB Legal Working Papers Series No. 10 Back

76   Q 506 Back

77   Q 99. See also QQ 404 (Professor Copeland), 409 (Mr Persson) Back

78   Q 51. Back

79   ING, EMU Break-up: Quantifying the Unthinkable (2010), p 16 Back

80   Q 336 (Mr Zuleeg) Back

81   The Economic and Financial Affairs Council. It is composed of the finance ministers of Member States. Back

82   See, for example, "Czechs reject Sarkozy's Eurogroup presidency plans", (24 October 2008) Back

83   Q 348 Back

84   Q 336 Back

85   Q 459 Back

86   EGE 14 Back

87   Q 456  Back

88   See paragraphs 199-200 in Chapter 5 for further explanation of this issue. Back

89   Q 261 Back

90   Q 495 Back

91   Q 304 Back

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