Europe’s Economic and Monetary Union (EMU) has deep roots in post-World War II history. Created to help bring peace and stability to the continent, the EMU has brought numerous benefits to its members, from increased regional trade to low inflation. However, the treaties and agreements that helped form it also overlooked dangers—from insufficient enforcement mechanisms to weaknesses in Europe’s banking system— that contributed to the current euro crisis. EU leaders must try to redress those oversights at their summit next week.
History of the EMU
Recognizing that devaluations and protectionism aggravated the Great Depression and contributed to World War II, European leaders began moving toward economic and monetary integration shortly after the war. The Organization for European Economic Co-operation—the forerunner to the OECD—was founded in 1948, for example.
Among the most important steps towards EMU was the decision by six countries in 1957 to establish the European Common Market, which sought “ever closer union among the peoples of Europe,” their economies, and their economic policies.
In 1969, the six countries commissioned a study to examine the possibility of a single currency, which recommended a three-step process: first, free capital movement between members; then, a system of coordination between their central banks; and, finally, fixed exchange rates and the introduction of the single currency. The study also made clear that if countries joined the Economic and Monetary Union, their domestic economic policies, including their impact on the broader, European economy, would be scrutinized by the Union.
Several other important developments followed. The Single European Act of 1986 removed barriers to intra-EU trade, introduced regional funds, and made financial union an explicit goal in European treaties. In 1990, free capital movement was allowed and, two years later, the Maastricht Treaty set a timetable for the remaining stages toward a single currency. In 1996, the Stability and Growth Pact put the Maastricht Treaty into effect. Finally, in 2000, the euro was born.
Unintended Consequences
The EMU system has clearly benefitted its member countries. Just consider what a Europe marred by competitive devaluations over the last three decades would have looked like—the common market may not even have survived. And the euro has had tangible benefits: low inflation, exchange rate stability, lower costs and more convenience for travelers, seignorage revenues, increased credit availability, and more trade within the Eurozone.
Nevertheless, inconsistent economic policies across member countries created economic imbalances, and financial markets were first too slow and then too sudden in responding to them, as the Delors Report of 1989 predicted.
In addition, the Stability and Growth Pact of 1996 neglected private-sector regulation and facilitated pro-cyclical monetary expansion in some countries. The low interest rates that suited Germany while it underwent a difficult reunification process were negative in real terms in Ireland and Spain, incentivizing economic bubbles.
After free capital movement was introduced, a single European banking system emerged in reality. Without a common European banking policy, this proved dangerous.
And, while Europe technically maintained national banking systems after free capital movement was introduced, a single European banking system emerged in reality. Banks lent increasingly to one another and grew interdependent. Without a common European banking policy, this proved dangerous. Ideally, a central system of tight supervision would have monitored member countries—particularly those for which the common interest rate was inappropriately low. But the closest Europe came to a common banking policy was a Maastricht Treaty provision that tasked the European Central Bank (ECB) with reviewing member states’ monetary policies and capital movements, as well as Article 14 of the statute of the European System of Central Banks, which stated that “national central banks … shall act in accordance with the guidelines and instructions of the ECB.”
Surely if a country’s central bank was allowing its banking sector to balloon to 300 percent of its GDP, these provisions would have led the ECB to stop it. But it didn’t—not in Ireland. The ECB—which had access to information about Ireland’s spiraling housing prices—did not stop banks in other EU countries, such as Britain, Germany, Belgium, and France, from lending irresponsibly to banks in Ireland.
A Way Forward: The March 25 Summit
Next week, EU leaders will have the chance to redress some of these errors, as well as aspects of today’s euro crisis. They will agree on a new fund for vulnerable countries, underpinned by a competitiveness pact, which will focus on:
- Reducing labor costs in countries with competitiveness problems
- Decentralizing wage bargaining
- Opening up professions and energy networks to competition
- Lowering the costs of legal systems
- Raising the retirement age
- Introducing a constitutional/legal limit on government borrowing
- Instituting a single, consolidated base for corporation taxation
Most of the proposals are good, as is the monitoring and enforcement role given to the European Commission. But others are misguided, including the creation of a consolidated tax base. Ernst & Young estimates that a single tax base would increase Irish firms’ tax compliance costs by 13 percent—at a time when they can hardly afford them. Another study suggests that, though the single base would increase the tax revenues of larger countries, it would decrease those of smaller peripheral countries, thereby worsening their relative debt repayment position.
The constitutional limit on government borrowing could also backfire, devolving into a political game with lawyers in the center. It will only work if carefully designed, with room left for dealing with emergencies. The Gramm-Rudman laws, a similar effort in the United States to gradually reduce deficit targets and balance the budget, could provide a useful case study.
That said, getting public debt under control must remain the Eurozone’s priority, particularly given the high levels of debt in some countries and the prospective cost of aging societies.
Missing Pieces
The competitiveness pact also overlooks several elements essential to fixing the EMU system. EU leaders must bring in these missing pieces at the summit.
First, they need to create and enforce effective penalties. Peer pressure alone will not work: small countries may submit to big countries, but the process can fall apart in reverse, as when attempts to apply the Stability and Growth Pact to Germany and France in 2004 failed. The present system of imposing fines on countries that exceed the deficit (but interestingly not the debt) limits is also insufficient. In some countries, like Ireland, the expansion of private-sector credit—not government debt—was the primary problem, and that requires its own set of penalties. Meanwhile, in countries where the deficit is already too big, enforcing fines will be like trying to squeeze blood from a stone.
For effective penalties to emerge, markets—both political and financial—must be engaged. The European Commission and the ECB should adopt a policy of regularly briefing the ratings agencies and all political parties in all member states with their candid assessments of problems emerging in competitiveness, credit growth, and public finances in each member state. This should catalyze market action.
Second, EU leaders must address the banking sector’s weaknesses. Europe’s stress tests have been highly criticized for being too weak; its banking sector now represents three-and-a-half times GDP, compared to only 80 percent of GDP in the United States; and its loan-to-deposit ratios are also considerably higher than those in the United States. Europe relies so heavily on banks because it has no alternative means of raising finance—an issue the summit should seek to resolve.
Unless Europe restores its banking system, confidence will not return to the markets, small businesses will not thrive, and credit will be too scarce to tackle large structural problems.
Third, the summit must find a way to recapitalize Europe’s banks—which, given their interdependence, is now a European responsibility. If George Soros’ proposal of using the EU’s emergency funds to recapitalize its banks is not enacted, the EU must find an alternative solution. A transfer union, through which stronger Eurozone members like France and Germany would provide financial support to the weaker ones, is not politically feasible, but relaunching Europe’s banking system could be.
Most importantly, Europe needs a banking policy. This is a logical consequence of the first stage of economic and monetary union, but it is not being tackled in any of the papers from German Chancellor Angela Merkel, French President Nicolas Sarkozy, or the EU institutions.
A common banking policy would require a European view on a host of difficult questions, from the interconnectedness of banks to the “too big to fail” problem. But, unless Europe restores its banking system, confidence will not return to the markets, small businesses will not thrive, and credit will be too scarce to tackle large structural problems. Nor can innovation occur without a properly functioning banking system that lends to entrepreneurs.
Finally, EU leaders must recognize that central bank policy was procyclical during the boom, exacerbating existing problems. But they must not overreact in the opposite direction now by insisting that all bank assets be marked to the price they could realize if sold immediately (into a market in which nobody can raise the money to buy them).
Conclusion
The EU must swear off the institutional rivalry that occasionally characterizes it and instead confront problems honestly. Ireland’s debt crisis, for example, is not purely an Irish problem; the Irish are not solely to blame, and relying on Irish taxpayers to help stabilize the European banking system blinds Europeans to lessons that must be learned at the broader level, too. Ireland—and other weak Eurozone members—must of course address their weaknesses, but the EU must also work together toward practical, imaginative solutions if it is to avoid similar crises in the future. If leaders can take steps toward that next week, the summit will be a success.
John Bruton is the former prime minister of Ireland and also served as ambassador of the EU to the United States until 2009. Additionally, he has held the posts of minister for finance and minister for industry, trade, commerce and tourism in Ireland.
