Saturday 21 April 2018

Crisis has put EMU at crossroads with no real signposts for way forward

Many doubt that the eurozone nations have capacity to adapt

IRELAND is not the only country with serious questions to answer in the wake of the global crisis. Economies and financial systems right around the world have proven far less 'robust' than we thought.

This new uncertainty is driving major debate about the future direction of the single European currency; a debate which will have significant consequences for Ireland.

Perhaps Europe's founding fathers might have expected that the single currency would have provided more shelter from the economic and financial storm. However, the events of the past couple of years have underlined the fact that the very essence of modern economic activity and financial systems is their global nature.

Judged in terms of the immediate blow to growth and jobs, the eurozone seems to have navigated the crisis as well as, or slightly better than, some other major economic areas. That said, the key lessons of the crisis will only be learned from the capacity of economies to respond and recover in a sustainable and reasonably speedy manner.

It may be some time before we can draw definitive conclusions on this score but it is clear that the eurozone faces serious challenges and it is worth examining how it has met them so far.

The response of the European Central Bank (ECB) to the crisis was both better and worse than might have been expected. It acted swiftly to support the financial system in 2007 but it resolutely refused to cut its interest rates until October 2008. So it could be argued that the ECB was relatively slow to grasp the enormity of the problem facing the global economy.

When it did act, the ECB succeeded in driving short-term rates down to exceptionally low levels and delivered some measure of stability to money markets across countries facing markedly different circumstances.

The crisis highlighted the comparatively narrow mandate of the ECB, but it also showed it to be less dogmatic than its critics might have envisaged. Unfortunately, we also learned that the ECB is overburdened because of the absence of any other significant economic authority in the eurozone.

Fault line

A clear 'fault line' in eurozone structures has been the absence of mechanisms to mimic the capacity of a federal government, such as that of the US, to implement decisive and speedy policy actions across the federal region.

In saying this, two caveats must be borne in mind. First of all, 'automatic stabilisers,' such as welfare payments, are much more important in many eurozone countries than in many states of the US. As a result, the jobs impact of the downturn was a good deal less than in the US. Second, the crisis has exposed frailties in economic systems right around the world. So, it would be wrong to suggest that the single currency is uniquely flawed.

But any union between sovereign states is fundamentally different to the relationship between regions in the same country because the distribution of pain and gain between countries matters hugely. For this reason, the policy infrastructure and instruments of the eurozone have proven inadequate.

At present, attention is focused primarily, and justifiably, on major failings in Greek economic management, but difficulties run deeper and wider. Europe needs both credible short-term solutions and radical long-term changes to the way policy is made and policed across the eurozone.

Euro membership allowed -- and possibly even encouraged -- participating countries to become unduly complacent about the domestic policies they adopted. The disappearance of exchange rate volatility, together with extremely low and relatively stable borrowing costs, boosted capital flows into a number of countries causing a corresponding deterioration in their external trade positions.

In this way, membership of the Economic and Monetary union (EMU) contributed materially to the scale of budgetary and current account problems facing several eurozone countries today. At the very least, membership of the EMU encouraged and facilitated countries' ability to run policies that would have been far less sustainable outside the single currency area.

THE crisis has also raised significant questions about the nature and degree of 'real' convergence in the euro area in the past 10 years. In political circles, it has always been suggested that membership of the eurozone would bolster a country's living standards. While economists would not regard this as an inevitable outcome, there is broad agreement that 'real' convergence is hugely important to the functioning of the currency union.

Unfortunately, large differences in the scale of adjustment needed by various countries in the wake of the crisis imply that there will be strong forces acting towards 'real' divergence for some time to come.

Of course, most of those countries requiring major adjustments would also face significant problems if they were outside the EMU.

Single currency

However, participation in the single currency did not of itself strengthen (and arguably weakened) the capacity to identify a need for tough decisions and a capacity to take them. Now these countries face an urgent need to adjust sharply, speedily and for a sustained period.

Mechanisms to deal with such problems have been found wanting. This is very obvious from the extremely painful, protracted and very public process to agree practical support for Greece.

This speaks volumes as to how limited the economic element of "Economic and Monetary Union" is. Inevitably, it also means much greater external intrusion in domestic economic policy-making, here and elsewhere, in coming years.

Correcting budget and competitiveness problems could hit activity and employment hard in several countries. Importantly, there is no mechanism in the EMU that would act in the opposite direction to cushion the blow, although much will depend on the stance adopted by the ECB.

This leaves the EMU at a crossroads. The early years emphasised the benefits of membership. Coming years promise to be different and may emphasise the costs of membership. The onus will be on countries to survive within the system rather than on the eurozone to support them.

Several countries, including Ireland, will need to adhere to policy setting which must be seen to be more Germanic than the Germans. For many, this will be a seismic shift, with possibly severe political and economic consequences.

At present, there are serious doubts that all countries will have the capacity to adapt. For this reason, the major consequences of the crisis on the euro area have yet to be felt.

Austin Hughes is chief economist at KBC Bank Ireland. This article is drawn from a forthcoming KBC study on the impact of the crisis on the European economy.

Irish Independent

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