By Guntram B. Wolff ≈
As the euro zone’s economic crisis continues, unemployment rates have reached record levels in several EU countries. Guntram Wolff, director of Europe’s leading economic think tank, Bruegel, argues that the system can work, but only with more transnational supervision.
A project as ambitious and idealistic as the European Union is bound to attract its share of skeptics, and many have pounced on the economic woes of the past several years as proof of their doubts. While we cannot deny the depth and complexity of the current crisis, we should acknowledge that important institutional changes are on the way, and that such reforms will lead to a stronger union. That said, the euro zone remains fragile, and attempts to restore confidence and stability are still underway.
Over the past decade, we’ve seen significant and unhealthy price divergence, combined with a build-up of high levels of private and public debt. Unfortunately, it is extremely difficult to reduce relative price levels and debt levels simultaneously: Reducing the ratio of debt to gross domestic product (GDP) requires more nominal GDP growth, while price competitiveness can only be restored by lower inflation rates, which reduces nominal GDP growth in the short term. It is a paradoxical situation.
To solve this problem, the average inflation rate in Europe should be stabilized at two percent. The fact that it has instead been falling since the beginning of 2012 suggests that the relative price adjustment is occurring in an asymmetric way.
Another major issue concerns the creation of an appropriate institutional framework for monetary union. The current setup is a precariously incomplete institutional framework, especially where the financial supervisory structure is concerned.
Even before the adoption of the euro, there were economists who argued that monetary union needed to be accompanied by a truly European financial and banking system. Essentially, they were saying that a currency union can only be stable if the banking system is European and supervised and regulated at European level. And they were correct.
During the euro zone’s economic crisis, there was a dire lack of transnational supervision. National supervisory agencies overlooked the degree to which banks throughout the euro zone had become integrated in the wholesale market, and how they were fragile to “sudden stop” phenomena. Risks were accumulated and there was no international supervisory agency to sound the alarm. Then, when the crisis hit, financial institutions retreated along national borders. The resulting financial fragmentation has undermined growth, and is extremely difficult for affected economies to overcome.
We need the proper infrastructure for truly European financial and banking systems, with real supervision and banking resolution mechanisms. There is broad acknowledgment of this now, and a plan has been launched to create a banking union, but it is a slow process – it is like trying to get fire insurance when the house is already burning.
A complex political environment overarches these problems. The European Union is made up of sovereign nations, so what might from an economist’s supranational standpoint seem the logical way out of the crisis is vitiated by political considerations at the national level, where democratically elected leaders can only go so far before they encounter resistance to reforms. While public spending, for instance, needs to be constrained, many euro zone nations are struggling with high unemployment rates, made worse by austerity measures. Meanwhile, Germany has in effect become the veto player in the euro zone, which naturally creates international political tensions.
Once we have a sound, effective monetary union built on a strong foundation of international regulation and supervision, economic improvements will follow. But it will be a slow and challenging process. It will have to be accompanied by structural reforms, including reforms in labor market institutions, as well as growth-supportive reforms in Germany.
The process of adjustment cannot be rushed. There has to be some cushioning through the transition, and nations that are struggling fiscally may need outside support to make the necessary labor market reforms.
Despite the current situation, there is hope for the future. But we need to make sure the monetary union works properly. We need to upgrade the infrastructure, achieve adjustment, and implement reform. Only then will the economic situation begin to improve.
Guntram B. Wolff has been the director of Bruegel – a leading, Brussels-based think tank specializing in economics – since June 2013. A member of the French prime minister’s Conseil d’Analyse Economique, he previously worked for the European Commission on the macroeconomics of the euro area and the reform of its governance.