10 March 2011

John Llewellyn: Europe's pact is the first step to recovery

Writing for the Financial Times, John Llewellyn says that Europe's financial storm may have passed its peak, but it is not yet finished blowing. Eurozone leaders, meeting in Brussels on Friday, will announce a wave of reforms.

Plans for a Franco-German competitiveness pact will not do enough to deal with the present crisis, or prevent another. But they will be a step forward, and one that must now be followed with further moves to ensure Europe becomes more convergent and competitive.

The outlines of the deal set to emerge in coming weeks seem clear. There will be stricter oversight of national budgets by the European Commission, with more equal weight given to deficits and debt. Greater alignment of financial market, banking and regulation policies is likely, together with further reforms of cross-border bank resolution, living wills and credit monitoring. A permanent crisis resolution mechanism has already been agreed.

Europe’s competitiveness problems, however, require a more aggressive deal than that currently proposed. Rising relative costs and prices have damaged peripheral economies, deepening the eurozone’s dangerous imbalances. Markets are also rightly worried that the reforms will not go far enough, especially if it then does not prove possible for the authorities in the core countries – and Germany and France in particular – to persuade electorates of the case for an enlarged, suitably funded and flexible crisis resolution mechanism.

That is why it is vital that peripheral countries are pushed to make further structural reforms – and that these should be a precondition for continued financial assistance.

A true competitiveness strategy must also restrain wage growth – which means striking a difficult agreement with major unions. Labour and product market regulations have also to be aligned with best practice, not national vested interests.

In both fiscal and labour market policy, therefore, individual countries face difficult choices over how much sovereignty they are prepared to relinquish to become well-functioning members of the monetary union. Many will have to be persuaded and cajoled. Yet while current reforms may not go as far as markets would like, they are part of the solution. With them the eurozone will be a more robust monetary union, with stronger instruments and practices for controlling the budgets of its member states than the US federal government has in some respects.

Even with these reforms, some argue not just that further competitiveness measures are needed, but that the euro is unlikely to survive. They believe the single currency had design flaws from its inception, including an inability to contain public sector deficits or deal with regional shocks. The crisis is taken as evidence that the eurozone is so far from being an optimal currency area that it is doomed.

This view is much too pessimistic, for two reasons. First, the economic costs of abandoning the euro would be huge; much greater than negotiating a tough second round of competitiveness reforms. A safe-haven, new-DMark Germany could see its currency appreciate way beyond the point of competitiveness, damaging its exports and provoking recession. Meanwhile, depreciating southern European economies would see the domestic currency cost of their euro-denominated debt soar, provoking defaults, bank bankruptcies, a collapse of lending and recession.

The second is fundamentally political. The European Union (and the euro itself) have tied their members together and proved a magnet to emerging European nations – a queue of which still seek to join. It is true that Chancellor Angela Merkel and President Nicolas Sarkozy are under intense political pressure not to agree to any deal that gives the impression of letting the periphery countries off too easily. But in the final analysis it is hard to envisage either politician wishing to go down in history as having presided over the dissolution or fragmentation of Europe.

Thankfully, the eurozone’s original deficiencies can be fixed. The current measures go some way to doing so. In Europe, it often takes a crisis to provoke the reforms needed to prevent a crisis. And as the proposed reforms bear fruit, and structural characteristics converge, the union will become less prone to the type of problems that currently afflict it – and better able to deal with new types of shock should they occur. This crisis may therefore not be the last. But because the cost of failure is so grave, Europe, and its monetary union, will survive.

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