28 February 2013

ECB Occasional Paper: The mutating euro area crisis - Is the balance between "sceptics" and "advocates" shifting?

The aim of this paper by Francesco Paolo Mongelli is to give expression to some thoughts on the various dimensions of the crisis, without claiming to offer a coherent and conclusive view either of the crisis or the future of the euro area.

The crisis is a catalyst for change, the full effects of which is slowly becoming apparent. Understanding  the reform efforts under way will help rebalancing the views of both sceptics and advocates. The “uniqueness of EMU”– i.e. a strong single market, a strong single currency, but a modest  political union – originates from the choices and constraints that emerged in the 1950s. Back then,  functional integration prevailed over the sharing of sovereignty and a true political union (of the  type that is being discussed today). A bit later, there was too little understanding of what EMU’s  architecture – sketched in the 1992 Maastricht Treaty – can and cannot do, and what types of shock it might actually withstand after the launch of the euro. EMU scepticism came into being at the  same time as the euro: several influential economists immediately doubted that EMU would ever  work. These doubts have resurfaced and gained credence during the crisis.

The achievements during the first 10 years of the euro are linked with the severity of the crisis. The reason is that the euro had both intended as well as unintended effects. There was a dichotomy. On the one hand, trade and financial links deepened, and cross-country investments (FDIs) rose. The Single Market expanded and the “home bias” declined. On the other hand, not all these benefits proved to be sustainable as they were predicated on cheap and abundant short-term funding channelled mostly by the banking system. The financial turmoil that started in August 2007 and the global financial crisis that erupted in October 2008 shattered cross-country money markets and triggered a process of “renationalisation”. Cheap liquidity dried up, greatly contributing to the erosion of trust in the solidity of the financial system. Also the pre-EMU adjustment mechanism – national monetary and exchange rate policies were of course not available – broke down. What happened is that after the launch of the euro various imbalances grew unchecked in several euro area countries, including persistent budget deficits, rising current account deficits and feeble productivity growth. The global financial crisis and the recession of 2008-2009 were not the fault of the euro, but they exacerbated these imbalances.

The responses to the crisis emerged in a series of EU and euro summits and joint decisions: there is now realism and an acceptance of the need for changes in governance and the strengthening of institutions. This will be a gradual process that has been supported by various unplanned “insurance mechanisms”, which receive too little recognition and which have allowed the euro area partly to cushion the impact of the crisis, avoid financial meltdowns, and temper the contagion effects. As a result, a new “constitutional framework” is emerging and a new political economy is within reach, reducing future systemic risks.

The paper illustrates the effects of the euro area imbalances as well as the sovereign debt crisis using the optimum currency area (OCA) theory. This framework illustrates the need for more openness and economic and financial flexibility by each country. This will in turn raise their income correlation over time. Therefore, there is a dimension of the crisis that remains supremely national: finding a consensus on, and support for, new social contracts among national constituencies, and choosing sustainable national covenants that boost flexibility, openness and correlation. The euro area will become a different sort of viable optimum currency area than, for example, the US, but it will still be very beneficial for each euro area country.

Still, the path out of the crisis will be long and strewn with obstacles. Many commentators and pundits still fear that a break-up of the euro area is inevitable. Others are still concerned about a possible irreversible stagnation and even a financial meltdown in some countries (although such risks have partly receded since last summer). Fear and the will to survive are powerful motivators: they are certainly contributing to the radical reforms that we are witnessing. There is a challenge of transition, implementation and transposition (into national law). However, in the long-term, the integrity and prosperity of the euro area must be grounded on its intrinsic values, for example, as a catalyst for a stronger single market and deeper (and sound) economic and financial integration, and because of its long-term benefits.

Full paper

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