[Yves Mersch] Preventing the euro area’s next crisis

LUXEMBOURG ― Much dedication and energy are currently being devoted to institutionalizing a crisis-management mechanism for the euro area. This is a good and important goal. But a far more significant challenge ― largely covered in the accompanying debate ― is the need for crisis prevention.

At the European Union’s pre-Christmas summit, European heads of state and government agreed in principle to replace the Luxembourg-based European Financial Stability Facility (EFSF), which was thrown together practically overnight in May 2010, with a new, permanent European stability mechanism in 2013. That decision ― and the speed with which it was reached ― reflects the insight that the euro area’s institutional framework will remain incomplete until there are clear rules for handling financial crises.

But, while it is clear that the euro area will have solid and well-equipped quarantine wards should it once again be afflicted by financial contagion, a vaccine to prevent the infection would be far more effective. Unfortunately, developing one is receiving too little attention in the political arena.

The starting point should be the weaknesses of the euro area’s rules and regulations. The monetary union’s distinctive feature is the absence of a common state, despite the single currency. The euro’s architects were well aware that the participating states’ maintenance of sound public finances was a vital precondition for the new currency’s stability. A compromise was found with the Stability and Growth Pact and its provisions for adhering to the Maastricht criteria, which sought to quantify the fiscal soundness of sovereign states without actually interfering with their budget and tax policies.

Today, we know that this was a poor compromise. There has been a lack of political will to make a clear commitment to a stability-oriented fiscal policy, illustrated by the weakening of the SGP at the instigation of Germany and France in 2005. And individual euro-area members have since neglected to observe even the discipline required under the weakened version of the pact. Indeed, there have been nearly a hundred violations of the SGP’s deficit ceiling (3 percent of GDP) since the euro was introduced ― and all have gone unpunished.

Given these repeated breaches of the SGP’s deficit requirements, together with a similar lack of commitment to the pact’s debt limit (60 percent of GDP), it is hardly surprising that punishment for some states has come from the markets. The debt crisis in the euro area has highlighted the unwillingness or inability of politicians to maintain a fiscal policy consistent with the stability requirements. Instead, both long-term objectives and sustainable public finances have been sacrificed for the short-term promise of electoral success.

This implies the need to separate national debt management in the euro area from short-term electoral constraints. What is required is a stronger emphasis on automatic sanctions for fiscal profligacy and excessive debt than is contained in the EU Commission’s current proposal for reform.

It is all well and good to counter undesirable economic developments at an early stage, as the Commission’s plan promises, but the time to begin is not when fiscal distortions actually threaten. Such distortions are generally preceded by a buildup of macroeconomic imbalances. For a while, booming or overheating real-estate markets and a thriving, but oversized banking sector can disguise a gradual loss of competitiveness and risks to fiscal sustainability, as occurred in the euro area. Only when it was too late did seemingly solid national budgets come under substantial pressure.

Effective prevention must start when undesirable economic trends arise. An independent body of experts that publicly calls for member states to correct their macroeconomic course ― based on objective and comprehensible indicators, such as unit labour costs ― could make an important contribution in this regard.

Of course, Europe’s political class doesn’t like suggestions like this, because they entail surrendering some degree of national sovereignty. After all, public finances are a major competency of politics.

But wouldn’t that loss be offset by greater solidarity in case of a crisis? It is worth noting that sovereignty’s defenders never complained when the euro brought their countries the low inflation and interest rates of the euro’s most stable predecessor currencies in exchange for handing over their monetary-policy competencies to the European Central Bank. A stable currency and sound public finances are two sides of the same coin ― that’s just how it is.

Recent experience offers us an opportunity to extend EU institutions in a way that markedly reduces the likelihood of a new crisis. That means improved rules and regulations that place greater emphasis on crisis prevention than on crisis management.

Those unwilling to pay the price of handing over national sovereignty in some areas tacitly accept that the eruption of a new crisis is only a matter of time. When it does, better-equipped quarantine wards will be poor consolation.

By Yves Mersch

Yves Mersch is governor of the Central Bank of Luxembourg and a member of the Governing Council of the European Central Bank. ― Ed.

(Project Syndicate)