13 January 2013

Edmond Alphandéry: The eurozone's agenda in 2013

In this New Europe article, the former French finance minister writes that Van Rompuy's report raises a fundamental question: What factors are preventing the eurozone from functioning as everyone would wish?

The global financial crisis exposed the eurozone’s underlying flaw. Meanwhile, international bodies, including the International Monetary Fund and the G20, encouraged struggling countries to implement loose fiscal policies, claiming that they were needed to overcome the crisis. But fiscal stimulus merely aggravated the problem.

Financial investors soon recognised that risk had been underestimated in some countries, causing interest rates to rise, sometimes to unsustainable levels, as in Greece, Portugal, and Ireland. While the decline in aggregate demand led to reduced imports, the combination of higher interest rates, lower public expenditure, tax increases, and wage deflation boosted unemployment and triggered recession.

Normally, by decreasing prices relative to their more fiscally sound neighbours, struggling countries can boost exports, thereby reducing their current-account deficits. But, in the case of the euro crisis, price stickiness caused inflation to increase more in debtor countries than in creditor countries, making adjustment even more painful.

In this context, Van Rompuy’s report is crucial. It maps out the architecture needed to “guarantee the minimum level of convergence required for the EMU to function effectively”, and calls for a more integrated financial, budgetary and economic policy framework. Specifically, the report highlights the need for the eurozone to make two fundamental commitments.

First, eurozone countries must implement reforms aimed at boosting wage and price flexibility through enhanced competition and improved labor and capital mobility within and between member countries. Second, wealth transfers to peripheral countries, while controversial, are necessary.

To surmount the associated political hurdles, eurozone leaders must create a limited “fiscal capacity”, which should act as a “common but limited shock-absorption function” that would “contribute to cushioning the impact of country-specific shocks and help to prevent contagion across the euro area and beyond". This mechanism should also provide financial support for structural reforms through “limited, temporary, flexible, and targeted financial incentives.”

But Van Rompuy’s minimal proposal may be insufficient. Currency unions require a mechanism for permanent transfers to poorer regions. The EU budget should facilitate such transfers in the eurozone, using structural funds. Tax transfers should also act as an automatic stabiliser in the case of asymmetric shocks.

Such reforms undoubtedly require a much more politically integrated, or federalised, eurozone. Facing up to that reality will be the main challenge for Europe’s leaders in 2013. 

Full article

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