Business World

Wednesday 25 April 2018

Gary O'Callaghan: German obsession with rules could wreck eurozone

Gary O'Callaghan

TWO major speeches this week from Angela Merkel and David Cameron confirmed a stark divergence of opinion on Europe's future, but also exposed very different conceptions of how economic systems work.

These conceptual differences could well lead to greater division in Europe but are far more profound and removed from crude nationalism than is generally allowed.

The irony is that supporters of a looser association take an approach that could save the union. Meanwhile, advocates of closer union and more rules -- including Ms Merkel -- have badly misread the problems that concern the eurozone and are in danger of taking steps that could blow it apart.

The headlines focused on Ms Merkel's depiction of Europe's "most difficult hours since the Second World War" and on her call for "a breakthrough to a new Europe and . . . towards a permanent solution". She also dismissed eurobonds or shared debt, however, and made no calls for help from the ECB. Her finance minister explained that Germany wants to push through changes to the Lisbon Treaty by the end of 2012 that would set the foundation for a common fiscal policy in the eurozone.

Mr Cameron, on the other hand, dismissed talk of "grand plans and utopian visions" and called for a looser EU with "the flexibility of a network, not the rigidity of a bloc". He argued that, "for too long, the EU has tried to make reality fit its institutions . . . [whereas] you can only succeed in the long run if the institutions fit the reality." As if to confirm his diagnosis, Ms Merkel referred to the euro as "the symbol of Europe's unification" and argued for "creating a Europe that ensures the euro has a future".

So, Ms Merkel thinks the euro reflects the sum of its constituent parts and will thrive if its components are stable and support the currency -- not the other way round. And the route to securing this outcome is to help recalcitrant members make necessary reforms, including fiscal correction. Moreover, tougher rules and sanctions will ensure that members do not stray from virtue in the future.

Mr Cameron, on the other hand, sees the main value of the EU in its promotion of dynamic interaction and trade. As a result, the combined EU is worth far more than the sum of its member states.

He objects to regulation and rigidity, arguing that institutions should "help by connecting. . . members. . . rather than holding them back". He regrets that the EU has become "an abstract end in its self, immune from. . . the real world" and calls for it to embrace diversity as a source of strength.

Mr Cameron spoke of the EU but might as easily have described the eurozone; it, too, is more than the sum of its parts. And the euro system -- if properly designed -- should be intended to augment the potential of its constituent members. Its members should not become slaves to preconceived notions. These differences in economic perspective matter.

Ms Merkel fails to appreciate the full economic complexity of the eurozone and is led, therefore, to consider it largely in political terms.

Moreover, she sees the euro's difficulties as mostly political in nature and has made the dangerous mistake of thinking that politics alone will solve them; one problem at a time. But the dangers are economic in nature and apply to the whole of the system.

This week saw the promise of two more problem countries being turned around by new governments and the eurozone's difficulties should -- from a political perspective -- have eased.

Bond yields

Instead, bond yields jumped alarmingly in France, Italy and Spain -- and even began to move in the Netherlands! (Greek two-year bonds now offer an annual "return" of 110pc).

The reality is that positive developments in any one country no longer spread confidence and this is a measure of how far credibility in the eurozone -- as a system -- has eroded.

Only malaise spreads now, because there is no apparent way out for any country that gets into trouble. Meanwhile, the Bundesbank again warned against the ECB being used as a "lender of last resort" and this is more likely to have shaken the markets. It insisted, as ever, that rules be observed. But rules cannot change the past and were drawn up before the crisis hit. Meanwhile, look at what the crisis has taught us.

First, the eurozone's problems are bigger than the sum of the problems afflicting individual countries and will only be resolved by a system-wide response, like deploying ECB resources. Everything else has fallen short of the mark.

Second, that the markets will not wait for individual countries to solve their deep-rooted problems and need assurances, in the meantime, if they are to stay engaged. Therefore, the eurozone needs to create a short-term bridge to credible long-term reforms.

Germany is right to be concerned with long-term reforms but the main problem will not be resolved by changes in rules.

So forget potentially disruptive treaty changes for now and concentrate on some mechanism that will allow the ECB to put its full weight behind a solution.

Gary O'Callaghan is Professor of Economics at Dubrovnik International University. He was a member of the staff of the IMF and has advised numerous governments on macroeconomic policies.

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