The excessively gloomy headlines about the imminent demise of the euro currency have at least temporarily receded as European Union (EU) politicians and central bankers play out their sequenced games of political quid pro quo. Progress is being made.
Prime Minister Mario Monti has presented a new fiscal package for Italy, which will likely be approved in some form by parliament. Monti's package has gained support because it seems to distribute the fiscal pain among different parts of Italian society. Who among Italy's political bigwigs will want to take the blame for pulling the plug on the new prime minister and losing the opportunity for Italy to be taken seriously again in Europe? Failure to approve the package would hardly help the ousted prime minister, Silvio Berlusconi, in court either!
A New Fiscal Compact for Europe
Of equal importance, Mario Draghi, the new European Central Bank (ECB) president, making the bank chief's official annual appearance before the European Parliament, departed from custom and delivered a surprisingly clear commitment to stepping up the ECB's role in the short term, provided that euro area leaders first do their homework.
That speech reflected the ECB's circumscribed "political accountability," and it was among the most important policy addresses delivered to the EU Parliament in 2011. It is an embarrassing scandal that hardly any members bothered to show up and ask questions. A clearer example of why the EU Parliament does not deserve additional political powers is hard to imagine.
Draghi stated to a largely empty EU Parliament: "What I believe our economic and monetary union needs is a new fiscal compact—a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made…We might be asked whether a new fiscal compact would be enough to stabilize markets and how a credible longer-term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility. Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right…A new fiscal compact would be the most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration. It would also present a clear trajectory for the future evolution of the euro area, thus framing expectations…It is time to adapt the euro area design with a set of institutions, rules, and processes that is commensurate with the requirements of monetary union."
The implication seems clear. The ECB will do more to defend a Euro Area 2.0 adhering to "compact fiscal rules," as the central bank has called for since the launch of the common currency. The quid pro quo is fairly obvious. The ECB demands a curtailing of fiscal sovereignty by member state politicians before it will commit to more forceful measures. It seems almost certain that the ECB will lower rates by another 25 basis points at its next policy setting meeting on December 8. But what will matter are the additional non-standard measures that Frankfurt might then implement. As discussed on this blog last month, the ECB has several options, including unlimited liquidity for banks beyond one-year expansions of its covered bond program and further changes to its collateral policies.
The ECB (or its constituent central banks) could even lend to the IMF to finance a financial assistance package to Italy and/or Spain. This would be a constructive development. It would guarantee direct IMF involvement in the structural overhaul and oversight of larger EU economies, adding to market confidence. It would also effectively mobilize euro area financial resources—one of the backbones of the IMF—to help solve a euro area problem. Thus Europe, one of the richest regions in the world, would in essence be bailing itself out, rather than relying on the savings of poorer countries that would be tapped by the IMF. From a moral standpoint—and without thinking about the implied loss of euro area political sovereignty from being bailed out by the rest of the world—this would seem the right thing to do. Hopefully, relying on the IMF as a mechanism would also alleviate the ECB's concerns about its own independence. Because the IMF is not itself a government, Frankfurt could still claim to be outside euro area government influence.
The last main political deliverable at the EU Summit on December 9 will likely follow the policy demands of Germany and the ECB in favor of enhanced enforcement of euro area fiscal rules, including changes to the EU Treaty. Thus Chancellor Angela Merkel of Germany and President Nicolas Sarkozy of France have stumbled toward something reasonably close to what has been predicted on this blog. Such a step will likely satisfy the calls by Draghi for a new euro area fiscal compact.
The Standard & Poor's Stumbling Block
A no less interesting development has been the Standard & Poor's decision to put 15 euro area members on "Credit Watch with Negative Implications." This was in some ways not unexpected. In August, after all, S&P downgraded the United States from AAA-status with the reasoning that it "reflects our [S&P] view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges." What was true for US policymaking then would seem to have to be true for the euro area in the last 18 months.
In its decision, S&P states how "In addition to the protracted debate about the nature of the euro zone's systemic stress and the needed remedy, we see the consistency, predictability, and effectiveness of policy coordination among euro zone institutions as potentially unsupportive of euro zone sovereign ratings at current levels." The reasoning behind the earlier and most recent steps is actually quite similar: it's the "effectiveness and predictability of political institutions," stupid!
S&P is careful to note that its actions do not take into account the outcome of the coming EU Summit. Accordingly, a strong deliverable there might change the rating agency's mind, especially if combined with accelerated implementation of reform programs by national governments. This shot across the bow of all euro area members—having been leaked by someone with prior knowledge—provides a further incentive for all 17 members to reach agreement on December 9. This is unsurprisingly the approach taken by German Finance Minister Wolfgang Schäuble, who is already pushing for a Summit breakthrough.1
The S&P decision essentially applies a collective credit rating to the euro area and the European Financial Stability Facility (EFSF), just as it did to the US federal government this year. The agency's action is either a breakthrough or unfair, depending on your point of view. European federalists should applaud the decision. Moreover, the financial markets seem to be taking European fiscal integration seriously enough to suggest that no member of an allegedly dysfunctional currency union deserves an individual AAA rating!
On the other hand, it is arguably unfair to rate the "political decisiveness in a fiscal crisis" of a currency union of 17 members states using the same guidelines as those applied to a single federal government. The coordination problems among 17 sovereign member states are obviously more severe than those of a single democratically elected Congress, even though the US Congress right now is not exactly a model of effectiveness.
At least the justification for the downgrade was disarmingly honest. As S&P stated: "[I]f the response of policymakers is not viewed by investors as robust, we believe market confidence could take another,
possibly steep, drop downwards, meaning higher refinancing costs for banks and governments, further deceleration of credit and demand, and an even greater required fiscal consolidation effort to arrest deteriorating credit dynamics."
In other words, S&P's rating call is a lagging indicator of financial market responses to the EU Summit. It hardly adds any new information of any value. Indeed it reflects existing market attitudes that if a bond does not trade like an AAA instrument (e.g., without high volatility), then it is not worthy of an AAA rating. Obviously, these rating decisions will be highly pro-cyclical. Since they reflect market anxieties more than fundamentals, one must question the wisdom of relying on them for any kind of financial regulatory purposes.
In a manner similar to its earlier action on the United States, the S&P ratings make an explicit determination about what summit meeting deliverables it believes will satisfy the financial markets. S&P sheepishly states that: "The details of this fiscal compact are for government officials to determine, but to be considered credible, it would likely need to imply, for example, a greater pooling of fiscal resources and obligations as well as enhanced mutual budgetary oversight."
Standard & Poor's wants more fiscal rules for the euro area, noting: "As the European economy slows, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand shrinks in line with citizens' concerns about job security and disposable incomes, eroding the revenue side of national budget. We believe that a strong and credible commitment to a balanced reform agenda by governments whose bonds have come under particular pressure will furthermore likely be an additional prerequisite for the ECB to engage in a more aggressive intervention policy."
Whether the ECB is likely to be swayed by such policies is debatable. But make no mistake. This is a political demand from S&P, raising the issue of metrics used to evaluate euro area institutions and economic policymaking and performance. I have argued that it is a mistake to evaluate the ECB's performance based on the model of the Federal Reserve acting under vastly different political circumstances in the United States. This argument can be verified (figure 1) by the recent export performance of selected EU members. Whether or not a country is a member of the euro area does not actually determine that country's ability to increase its exports in the current economic environment.
Figure 1 shows, for example, that the EU-15 country with the largest export increase recently is supposedly doomed Greece! Its export volume has increased by 30 percent since early 2011. This unfortunately does not ensure much national economic growth for that country, because Greek exports are a very small share of GDP. But this small export ratio would pose the same problem even if Greece left the euro area and adopted a "new drachma." Would Greek export performance have been better if it had had its own currency? Judging from the constant price export performance of the United Kingdom —which has a worse export performance recently than that of the peripheral countries "trapped inside the euro"—this is not the case. Unit Labor Cost (ULC) divergences are hardly everything. External demand seemingly can play a role even in a common currency.
Even if the imminent collapse of the euro predicted by a zoo full of bearish commentators has been only postponed by the latest decisions, there is still a more generalized tendency to scorn the euro area in the long run because of various perceived elementary ailments. This kind of "optimal currency area fundamentalism" is a school of theoretical thought particularly strong among many academic monetary economists and London-based commentators. It is a view strongly overrepresented as well in the US media, where dismissal of the long-term euro prospects is rampant, so long as it has no federal US-style entity with a large central budget and cross-country labor mobility.
No doubt the euro area crisis has shown the many of the flaws in the initial euro area institutional design. But the question is whether such justified critiques permanently consigns the euro area to the dustbin even if the political will is there and there is a recognition that undoing the euro would be costly and painful. The fact is that there is a determination to make the euro area work despite the basic theoretical tenets of an "optimal currency area." The prophets of calamity should ask themselves: is there no way a "hybrid currency" like the euro can adapt and survive through a relatively constant process of institutional change and legal treaty amendments like the one that will likely be announced on December 9? It took four years after the initial ratification of the US Constitution before the Bill of Rights was adopted, after all. Faulty initial designs need not preclude long-term success.
A common currency area does not have to develop along the lines dictated by established economic theories, or be doomed to failure if it does not. Provided the political will is there, the euro can develop into its own unique and lasting supra-national hybrid currency.
1. S&P is legally required to notify governments subject to changes in credit ratings at least 12 hours before its announces such actions, so many government officials in the euro area would have had prior access to this information. One can at least speculate that a Machiavellian spin doctor in Berlin would be the "strategic leaker."