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After the Crisis, Much Still at Stake for Eurozone

(Version in ελληνικά)

What a difference a year makes. January 2009 marked 10 years since the introduction of the euro. That anniversary fell in the midst of the worst global financial crisis in the past half century.

The euro—and the European Central Bank—proved important safeguards against the spread of the crisis. Countries whose currencies would likely have been subject to severe market gyrations had they not been part of the eurozone held their ground. And the ECB used innovative approaches, along with central banks around the world, to help provide liquidity and calm markets.

But as the crisis progressed, it became clear that the eurozone countries were affected in very different ways.

Markets took notice and the premia charged on sovereign bonds diverged. This month, as the euro turns 11 and even as the crisis is receding and an economic recovery is underway, prominent commentators—including Martin Wolf and Paul Krugman—are concerned that the strains within the eurozone are serious, and will need serious attention.

Divergences within the eurozone

The problem is clear. As we all know, the global economy enjoyed an unprecedented expansion just before the crisis hit, which saw countries within the eurozone growing  at widely different rates, with diverging inflation rates. Calculations by the OECD show that applying the so-called Taylor Rule to individual countries would have implied very different interest rates in the different countries. Underlying the divergence in economic performance were a variety of factors operating in varying combinations: rapid growth in property prices, insufficient supervision of financial sectors, and long-standing structural weaknesses.

Markets tended to ignore these differences and risk premia on sovereign bonds were remarkably small and stable through to the start of the crisis in July 2007. Presumably, the view was that the internal mechanisms of correction, through national and European policy measures, would bring the eurozone economies back into alignment. But once the crisis hit, the differences in countries’ projected public debt levels, the state of their financial sectors, and their overall competitiveness  made the presumption of self-correction increasingly tenuous. Today, while the spreads are off their peak levels, as my colleagues Ashoka Mody, and separately Silvia Sgherri and Edda Zoli, have pointed out in recent papers, market differentiation has clearly increased and is likely to stay.

Tackling regional imbalances

Looking ahead, then, what are the policy challenges? Clearly, the scope for changes in monetary policy is limited. The monetary policy framework has worked well and is regarded as credible. Changes on the margin are, in any case, not likely to influence the major underlying source of the problem: differences in country policies and structures. Some important changes are already in train. The lessons learned from the crisis have led to an emerging global consensus on how best to regulate and supervise financial systems.

The European Union is closely involved in this debate and is committed to instituting more stringent financial policies across its member countries. Within the EU’s single financial market, a system of cross-border arrangements is needed to assess and manage systemic risks. I am encouraged that an EU Financial Stability framework is emerging. This is a key initiative.

As Paul Krugman has pointed out, even in the United States, a national crisis is felt with varying force in different parts of the country. But two important features of the U.S. economy mitigate these inevitable regional imbalances. First, the movement of people from weaker to stronger economic regions promotes adjustment over the medium term. Second, federal fiscal transfers help reduce the distress of depressed regions.

In Europe, labor mobility has increased over time—and has been important in some countries, such as Ireland and Spain—but it remains limited even as trade and capital move seamlessly across borders. Portability of pensions and healthcare are among the structural policy measures that could encourage labor mobility. But important barriers remain.

Federal fiscal transfers do not really exist in the European Union, but the combination of large automatic stabilizers attuned to country-specific circumstances and borrowing in a single currency should mimic them to some extent, provided overall fiscal discipline is preserved. As such, a central premise of European policy—embodied in the Stability and Growth Pact (SGP)—has been that national fiscal discipline will discourage imbalances from emerging in the first place.

Today, just when the challenge of realigning countries’ economic prospects is greatest, the challenge of restoring fiscal discipline is also unprecedented. With eurozone economies shrinking in 2009 and the crucial need to inject fiscal stimulus, deficits have increased and public debt is headed higher for a number of years.

The SGP provides the benchmarks to which countries must return—a deficit less than 3 percent of GDP and a public debt-to-GDP ratio less than 60 percent. But underlying these targets is the SGP’s goal of a close-to-structural balance in each country. These targets will present a huge challenge. No doubt, an unreasonable pace of consolidation may do more harm than good. But the flexibility that the SGP likely will be forced to accommodate may call its credibility into question.

Developing a broader framework for fiscal governance

To be fair, the SGP was not designed to deal with fiscal challenges of a large common shock in the context of constraints on the effectiveness of monetary policy or with individual euro area members running into financing difficulties. In my mind, this raises the key question of whether the euro area needs a broader framework for fiscal governance.

One idea, healthy for its own sake, would be for individual countries to credibly commit to fiscal self discipline by adopting, for example, fiscal targets and supporting institutions that create momentum in favor of fiscal restraint. But recent experience has also shown that the tendency to shade the fiscal numbers produces rude surprises. A more vigorous effort at the European level to monitor these numbers in a consistent and preemptive manner is therefore essential.

In addition to the stronger preventive surveillance that is possible now that the Lisbon treaty is in effect, other aspects of a broader framework for fiscal governance could also be explored. For example access to central resources, either from common bond issuance or increased federal transfers, could be introduced and conditioned on good behavior.

Much is at stake

The ECB has established a sound monetary framework and has proven itself responsive to the enormous challenge we have recently faced. The relatively benign global economic conditions in the euro’s first decade helped allay concerns about divergent economic performance within the eurozone.

That reprieve no longer exists. The ECB and the European Union are in the process of establishing new institutions and rules to create a stronger Europe. The success of these efforts will determine Europe’s course and the role of the euro in its next decade and beyond. Much is at stake.