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Limits of EU common approach have been sadly exposed

LAST week, Europe agreed on a package to save the euro while the president and Congress of the US failed to agree on a plan to avert a possible default. The US has a few days left to resolve its impasse and a deal will probably emerge, as it did in Europe. Both events raise fundamental questions about federal fiscal control and its limits.

Some have criticised the new euro package for lacking detail. Certainly, there is more work to do. Others have suggested that available funds be augmented and this might yet be necessary. There is a clear need for more effort to be expended on returning to growth. But there was an unmistakeable sea-change in the approach to the crisis last week, which will have a lasting impact. Will this lead to more centralised fiscal control in Europe?

Many people think a US-style central authority is inevitable -- that a set of common taxes and spending is needed to support a monetary union -- and President Nicolas Sarkozy hailed the euro package as a "historic moment" that would lead to "bold and ambitious" plans for a common treasury in the form of a European Monetary Fund (EMF). Meanwhile, the US stalemate demonstrated that a strong fiscal centre could have its own set of problems and that institutions did not have lives of their own.

The crucial question for Europe, then, is what its newly empowered EFSF -- its bailout fund and embryonic EMF -- will be asked to do and how it might evolve over time.

Mr Sarkozy proposes a "quantum leap in eurozone government" but he may have already lost the initiative. His original call for the creation of an EMF came before the involvement of the IMF in the crisis last year. Since then, the limits of his common approach have been sadly exposed.

The European response to the crisis has, until now, been overtly paternalistic. The crisis countries were treated like wayward children -- granted familial support but sparingly and at punitive terms that discouraged their errant course.

The family tradition -- the European social model -- was the preferred path; and Ireland, in particular, was reprimanded for adopting a loose, low-tax lifestyle that got us into trouble. Mr Sarkozy spearheaded an attempt to lead Ireland back to virtue and high taxes.

It is to Ireland's great credit that we resisted this pressure. It is also to Ireland's credit that we exposed the paternalistic and punitive approach that has failed this country. We are the country that fully implemented its recovery programme but still could not regain access to markets. This clearly demonstrated that Europe's approach was simply not working.

Last week's reform package may have been a response to the urgent need to save Greece but it was called forth by a documented failure in its approach toward Ireland.

The new package was probably designed at IMF headquarters. Just two weeks ago, the IMF said -- somewhat disingenuously -- that it had not considered giving more money to Greece. Last week, when the new package was adopted, it immediately promised to contribute more.

Indeed, the first draft of the summit communique included a plea for the IMF to participate, suggesting that the IMF had threatened to withhold further support unless there was a radical change in direction.

In contrast to European paternalism, the IMF approach to a crisis is more fraternal. It recognises that things go wrong sometimes and is it less judgmental as to why. It is based on the fact that everybody will benefit from a recovery and gives generous support to tough reforms.

IMF programmes are designed to ensure that countries get back to normal as quickly as possible and are adapted to the circumstances and existing social model of a country. They are designed to fix problems and to do so quickly.

Last week's surprise package has all the hallmarks of this IMF approach. Loans will now be cheaper and of longer maturity; funds will be used more flexibly and in support of existing policies; and there is no mention at all of common strategies, beyond an empty call on Ireland to talk about things. It is based on the need for joint support of national policies -- in so far as they are sustainable.

Mr Sarkozy will try to make more of the new powers granted to the EFSF when proposals on improved economic governance in the eurozone are due in the autumn. But the fund that he envisaged has now been designed by the IMF and it will not easily accommodate calls for common systems and taxes.

This pursuit has already cost valuable time and resources and Europe will now settle for a decentralised union of states, albeit a union with a large emergency fund at its disposal.

The introduction of the concept of an "emergency" also marks the crucial innovation in the euro deal. The transfer union so resisted by Chancellor Angela Merkel will be limited to clearly defined emergencies.

For all his posturing, Mr Sarkozy has already lost his bigger European government. The ECB was also forced to accept the principle of limited default and of private-sector involvement -- but again, only in "emergencies".

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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