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“Europe” is in crisis and the results will eventually be profound for the relationship of nearly 500 million people (and 22% of world GDP) with the rest of the world. The depth of the crisis is vividly reflected by the unfortunate co-incidence of the Toronto G20 Summit and final agreement on the EU’s grand social and economic strategy – “Europe 2020”.
This strategy follows on from the abject failure of the 10 year strategy that finished in 2010. The European Commission has worked on it for a long time and finally the Heads of Government agreed on 17th June "Europe 2020", our new strategy for jobs and smart, sustainable and inclusive growth”. But the new wave of market disquiet was already gathering pace and barely a week later Council President van Rompuy and Commission President Barroso said after the G20 meeting “We all agreed on the importance of a coordinated approach at global level that combines growth-friendly fiscal consolidation and following through on fiscal stimulus, tailored to national circumstances…” This bizarre policy formulation reflects the inherent conflict between the wish to achieve desirable social goals and the harsh reality of current market conditions for some EU members.
The crisis has developed well beyond the problems triggered by importing securities backed by sub-prime US mortgages. However, that did precipitate a banking crisis that required a massive back-stop of public spending, and thus debt, to prevent a slide into a lengthy recession. It is that notching up of debt that is now proving so problematic. At the onset of the first Oil Shock in the 1970’s, public debt/GDP ratios were just over 30%. Forty years later, they will have nearly tripled to 88% in 2011 – according to the European Commission. Concerns about the implications have forced EU banks to undergo stress tests that will include scenarios of EU sovereign credit losses. More than 100 banks – covering the majority of deposits in the EU – will be tested and it is that new realism amongst policymakers about sovereign debt that has calmed markets somewhat because investors fear that debt is now the real problem.
Yet EMU was founded on policies of fiscal caution that were written twenty years ago to prevent exactly this situation happening: a maximum public deficit of 3% of GDP, public debt ratios should be declining to less than 60% and there was a “no bail-out” rule precisely to remove the risk that Germany would have to pay off the debts of other countries – for example, Greece was often talked about, even at that stage!
But in mid-May, the Heads of Government felt compelled to agree momentous reforms "The Council and the Member States have decided today on a comprehensive package of measures to preserve financial stability in Europe…we have decided to establish a European stabilisation mechanism. The mechanism is based on … an intergovernmental agreement of euro area Member States. Its activation is subject to strong conditionality…euro area Member States stand ready to complement such resources … guaranteed on a pro rata basis by participating Member States … up to a volume of €440 billion…..At the same time, the EU will urgently start working on the necessary reforms to complement the existing framework to ensure fiscal sustainability in the euro area..” Six weeks later Commission President Barroso delivered the first proposals "We need to strengthen economic governance in Europe... And through an incentive system that applies sanctions further upstream, we are giving ourselves the tools to act whenever it is necessary."
Has the pressure of the crisis actually resulted in tipping the 330 million people of the eurozone (and 16% of world GDP) into a tighter union? There is much excited media discussion (especially in the UK) about the opposite result – some countries leaving the euro. Under the existing Treaty, there is simply no provision for that, so a country would have to leave the EU as well.
This is the problem that faces Greece. If the markets felt they would try to resolve the pressures by trying to leave – or be thrown out of – EMU and the EU, then anxious depositors in Greece would have plenty of time to remove their deposits from local banks. The natural consequence of a collapse of all banks in Greece (in this example) may deter politicians from going down that route. This discipline was an explicit reason why the organisers of the original changeover plan (and this author was one of them) wanted to establish a single set of notes and coins to make a departure nearly impossible in practice. Austerity may be preferable – even if unpleasant.
The heart of the problem lies in the loss of competitiveness of some euro Members who were unwilling to recognise that removing the currency constraint meant they had to conduct a wide array of policies (for example on labour market flexibility) that matched their competitors in the euro area – quite apart from globally. For countries such as Greece and Portugal, this loss of competitiveness showed up as current account deficits above 10% of GDP.
These had to be financed by both the public and private sectors taking on huge foreign – though euro denominated - debts that were bound to become unsustainable eventually. It was the bank holders of those debts who then cried out for protection in the depth of the crisis. Had those lenders failed, it could well have triggered a further credit contraction in the rest of the eurozone – and thus another downward twist of the economic spiral. The bank stress tests should root out any over-extended lenders and oblige them to increase capital.
But a watershed does seem to have been crossed as the full range of economic policies – not just fiscal - will now be subject to “structured surveillance” – and Council President van Rompuy’s Task Force seems to have secured agreement for this radical step from the Member States. (In itself, this is an interesting power play within the EU as it is van Rompuy - in the newly created role of President of the Council – who has taken the lead, rather than the Commission)
When EMU was launched, many observers argued that Europe was not an “optimum currency area”. The loss of competitiveness by some states may support that argument for now. But the EU’s response is already being made clear: develop the powers of the Eurogroup (the members of EMU) to encourage improved competitiveness so that this criticism will melt away. The stakes cannot be higher as success would re-enforce the single currency, whereas failure would undermine it - perhaps fatally.
The integration of a single financial market has emerged as a critical factor: should the EU move towards “more Europe or less”? By co-incidence, former Commissioner Mario Monti published his report on a “new strategy for the single market” in the middle of the crisis. He argued that “The single market for capital and the closely interrelated single market for financial services are critical for the efficient allocation of resources - a key driver of growth and employment - and for the stability of the economy.” He pointed out that the EU is already committed to far-reaching reform as part of the G20 process and said “It would be a serious strategic mistake if the Council… were to favour timid solutions.”
The financial crisis came at a critical juncture for the debate on regulatory reform as the proposals derived from the De Larosière Group’s report are now about to be finalised. The Commission proposal would move some regulatory powers to the European level, but the ECOFIN Council – the Member States – cut these back radically. However, the new Lisbon Treaty in now in force and gives co-legislative powers to the European Parliament. Their committee (ECON) has just voted “to beef up the financial supervisory package - well beyond Council proposals”. Both Council and Parliament must agree an identical text for it to become law, so we now add in a constitutional clash as well as an economic and financial crisis. But it is a first test of how serious the EMU countries are about this new-found commitment to act together even when it is tough.
There is a dimension to this that poses particular problems for the country that hosts the largest financial market in Europe – the United Kingdom. It is not in the eurozone and thus would be outside any of the new arrangements for the co-ordination of the generality of economic policies. After the recent election, the Coalition Agreement specified “The Government believes that Britain should play a leading role in an enlarged European Union, but that no further powers should be transferred to Brussels without a referendum.” Under such a formula, Britain may find it very difficult to accept the likely compromise on shifting some financial regulatory powers to new European level bodies.
This crisis is testing Europe as never before. The eurozone members have made a bet to draw more closely together – economically and financially – and are now filling in the detailed policies to do it. Meanwhile, the UK has re-enforced its decision to stand aside from this process. Historians will judge the outcome.