Wednesday, 17 September 2003

European Monetary Union: Crunch Time Approaches


Can a currency union exist independently of pooled political sovereignty?
This has been one of the most contentious issues underlying the debate
between Europhiles and euro-sceptics since the establishment of the
European Monetary Union. But the question has been repeatedly finessed or
ignored? that is, until now.

We are now getting to crunch time. France, Germany, and Italy, together
comprising around 60 per cent of the euro-zone’s GDP, have been
persistently in breach of the Stability and Growth Pact’s limit on 3 per
cent budget deficits. France, in particular, has let its public finances
“run off the rails”, according to a recent censure by the European
Commission. Worse, the French government has even eschewed the normal
pretence of paying homage to the budgetary rules, as other countries have
ritually done when found in persistent breach. It has recently revised
upward its budget forecast for CY 2003 to 4 per cent of GDP, but both
Prime Minister Raffarin and President Chirac have indicated a clear
preference for growth and employment over adherence to an arbitrary budget
limit, whose economic logic has never been made clear.

To be sure, France’s position is not unique. Portugal and, more
significantly, Germany, also face similar budget problems, although the EU
has publicly excused them due to their efforts to comply with the SGP
(even though a fair reading of the pact makes no differentiation between
good faith and bad faith efforts to reduce budget deficits).

Paradoxically, if France is serious about pursuing a growth program, their
budget position will likely improve the greater, whereas the greater the
efforts by Germany and Portugal to comply, the more likely they are to
continue to breach the stability pact limits. This is the inevitable
by-product of implementing a contractionary fiscal policy in the midst of
a serious recession.

Historic examples abound to support the notion that fiscal policy is
invariably pro-cyclical, yet the European Commissioners seem to think this
inconvenient fact can be eliminated through bureaucratic diktat.
Governments can easily retain balanced budgets in good times without
unduly cutting spending on popular programs, given higher tax receipts and
lower attendant social security costs. But when an economy weakens,
invariably income tax receipts decline, social welfare expenditures
increase and budgets tend naturally toward deficit. A pact that puts too
much weight on achieving fiscal savings in this kind of environment can
risk exacerbating an economic downturn.

The absurdity of the current position is illustrated by the fact that
praise for Germany ? whose own deficit is forecast to reach 3.8 per cent
of GDP this year (not dissimilar to the French number) ? largely reflects
nothing more than a political stratagem to secure the Schroeder
government’s support if the EU is forced to take on President Chirac’s
government. In that sense, France is to be applauded for its lack of
hypocrisy, not a quality one readily associates with a country whose calls
for Third World solidarity with Africa sit uneasily alongside its habitual
agricultural protectionism.

Although the details of the French budget will not be released until later
this month, recent remarks by Alain Lambert, France’s budget minister,
make provision for tax cuts up to 3 percentage points, but no specifics in
terms of getting France back under the 3 per cent budget limits on the
deficit. The best that Mr Lambert could do was a pledge to reduce the
cyclically adjusted deficit, without mentioning specific figures.
This could prove a defining moment for Europe. Finance Ministers from 11
other euro-zone nations might effectively determine France’s future
economic fate because they will have to vote on any Commission
recommendation for Paris to cut spending or increase taxes. Yet none of
these officials have anything approaching democratic standing in France
itself, so the actual implementation of a fine has huge consequences,
particularly if (as we think likely) the sanctions continued to be ignored
by France. To us, this demonstrates the dangers of the EU’s repeated
tendency to make ad hoc improvisations of EMU’s treaty provisions, rather
than engaging in the hard job of reforming flawed treaties, which are
neither grounded in political reality, nor economic logic. A political
firestorm, which completely undermines the euro’s credibility, is
potentially in the offing.

It is worthwhile outlining the sanctions mechanism officially in place in
the event that any EU country is deemed to be in persistent breach of the
stability pact, as France is today. A country found to have been in
breach of the reference values has four months to introduce corrective
measures suggested by the Council of Economics and Finance Ministers of
the EU (ECOFIN). If the country concerned fails to take the recommended
action, then the fine is introduced. One penalty is in the form of a
non-interest bearing deposit at a European banking institution. If the
budget deficit is not corrected within 2 years, the deposit is forfeited
and becomes a fine; if the corrective action is taken, the deposit is
returned and the foregone interest becomes the penalty.

The problem with this process is that it lays down conditions within a
political and economic vacuum. There are circumstances in which
macroeconomic shocks are quite severe and require offsetting stimulus far
in excess of the 3 per cent level of deficit laid down by the stability
pact. What happens if a government is elected under these circumstances
and proceeds immediately with an aggressive fiscal policy in direct
contravention of the pact?

Consider the position of the Chirac administration today, which campaigned
on the promise of a large package of tax cuts last year to accelerate
economic growth. It is also the current position of Chancellor
Schroeder’s new coalition government, which is in the process of
implementing significant tax reform, a major provision for which are deep
cuts in marginal rates. In the circumstances in which these two countries
find themselves today, their respective governments cannot reduce interest
rates to stimulate the economy, because they are subject to the interest
rate policy of the ECB (which is itself circumscribed by global capital
market conditions). Neither can devalue the currency, because they no
longer have one of their own. Neither can increase their respective budget
deficits, because they are already in breach of the Stability Pact and
facing financial penalties they cannot afford. They cannot raise taxes
without committing political suicide.

Among the few remaining courses of action for either government, perhaps
the least offensive is to sell its national assets: its gold, its US
dollar reserves, its public buildings, its land, and so on. The economist
Peter Warburton has likened these circumstances to the reparations a
nation must pay when defeated in battle.

And in the midst of a serious recession, the de facto reversal of a
program which formed the basis of a national mandate could be political
dynamite. Most rules, regulations, and diktats emanating from Brussels
are deemed by the national electorates to be annoying and occasionally
inconvenient. But they are the object of ridicule and satire, not the
stuff of revolution. Rulings, like this past August’s that chocolate may
contain vegetable fat, might offend certain chocolatiers in Belgium or
France. But for the most part, the European Commission is seen as
something distant with little day to day relevance in the lives of most
citizens living within the European Union. The implementation of a policy
which has profound economic consequences, however, could change
everything.

Politically, the interpretation of the euro-zone’s stability pact is
largely left in the hands of unelected bureaucrats, operating out of
institutions which are devoid of any kind of democratic legitimacy. In
such circumstances, it becomes difficult to envisage how a recently
elected government such as that of France, armed with a fresh mandate,
could be compelled to delay implementation of a key election promise,
without ultimately creating huge popular backlash in a way that
potentially compromises the long-term viability of monetary union. We had
a brief sense of that last year in France, as it was precisely this kind
of backlash that produced Jean-Marie Le Pen’s surprisingly successful
candidacy in last year’s French Presidential election.

Anti EU parties of the sort that Le Pen represents are on the rise across
continental Europe. To be sure, at this stage, they largely represent
disaffected (albeit significant) minority votes. But an externally
imposed fine by a bunch of Brussels bureaucrats could engender significant
mainstream political backlash. Voters for the Front Nationale in France,
or Vlams Blok in Belgium, are symptomatic of a growing body of opinion
which sees the European Union and its attendant institutions characterised
by a huge democratic deficit. This in turn has led to an increasing sense
of political alienation and a corresponding move toward extremist parties
hostile to any kind of political and monetary union in other parts of
Europe. Under politically charged circumstances, these extremist parties
might become the mainstream.

Should the EU technocrats persist in their current obstinate refusal to
respond realistically to these pressures, we can anticipate rising anger
at the inability of establishment politicians to pursue economic policies
in the national interest. There will be increased opposition towards
interest rates being set by “outsiders”. There will be increased anger at
Brussels bureaucrats in the event that vital development funds are
withheld from needy countries such as Portugal (which is already
technically in breach of its fiscal borrowing limits), or if financial
penalties are imposed. Politics might become even more polarized and
extreme as a consequence and the European Monetary Union itself will be
put at risk. At a time when both the dollar and yen display serious
vulnerabilities, the global economic system hardly needs a third major
currency going down the spout.

Which brings us to the European Union’s dirty little secret: for a
genuinely credible fiscal policy to succeed, it is essential to accelerate
a greater degree of political pooling. This notion is political dynamite
in some of the more euro-sceptical countries, such as Sweden (where
opponents of the single currency in the upcoming referendum ? Green party
activists, conservative politicians and some cabinet members ? have
exploited misgivings about federalist instincts in Brussels and have
claimed the country’s social security system is under threat), and the
United Kingdom (where any discussion of the political implications of the
euro is virtually taboo).

It also suggests that today’s fashionable tendency to expand the euro-zone
ought to be put on hold. Pooled political sovereignty and a concomitantly
more cohesive supra-national fiscal policy are far more difficult to
implement in a larger currency zone with countries at disparate stages of
economic development and correspondingly different political/historical
traditions. Europhiles should worry less about whether Sweden chooses to
embrace the euro on September 14; more attention should be devoted to
getting existing institutions working properly, so that the euro’s longer
term success is permanently entrenched.

Why is fiscal policy reform so important? Most single-currency zones
involve a central or federal government with a tax and public expenditure
program of substantial size relative to national GDP and the ability to
run significant deficits. A tax and public expenditure program generally
involves redistribution from richer regions to poorer ones, whether as an
automatic consequence of a progressive tax and social security system or
as specific policy acts. The redistribution acts as a stabilizer with
negative shocks, leading to lower taxation and higher social security
payments in the region that is adversely affected. In the absence of such
a mechanism, it could be expected that economies would adjust to
differential shocks and uneven economic performance through a variety of
other routes. In response to a negative shock, these would include
declines in economic activity, reductions in living standards, and outward
migration. There is thus a need for the development of a larger EU tax
base and redistribution of tax revenue from richer regions to poorer ones
in order to have a genuinely proper functioning fiscal policy at the
supra-national level. This is more politically feasible with a smaller
zone of nations with common economic and political philosophies.

This contentious issue has been finessed so long, but it appears that
developments in France and Germany are forcing it on to the table. This
is a debate that must occur because the European Monetary Union and its
attendant institutions ultimately cannot succeed in the absence of open,
public discussion and acceptance, in lieu of bureaucratic imposition. It
is said that politicians in particular and the democratic process in
general cannot be trusted with economic policy formulation because they
lead to decisions that have stimulating short-term effects (for example,
reducing unemployment via higher government spending) but are detrimental
in the longer term (a notable example is a rise in inflation). But the
formation of the euro has now shown us the limits of pure technocratic
economic management that takes place in a complete democratic vacuum.
Surely now is the time to find some happy medium before it is too late?

Can a currency union exist independently of pooled political sovereignty?
This has been one of the most contentious issues underlying the debate
between Europhiles and euro-sceptics since the establishment of the
European Monetary Union. But the question has been repeatedly finessed or
ignored?that is, until now.

We are now getting to crunch time. France, Germany, and Italy, together
comprising around 60 per cent of the euro-zone’s GDP, have been
persistently in breach of the Stability and Growth Pact’s limit on 3 per
cent budget deficits. France, in particular, has let its public finances
“run off the rails”, according to a recent censure by the European
Commission. Worse, the French government has even eschewed the normal
pretence of paying homage to the budgetary rules, as other countries have
ritually done when found in persistent breach. It has recently revised
upward its budget forecast for CY 2003 to 4 per cent of GDP, but both
Prime Minister Raffarin and President Chirac have indicated a clear
preference for growth and employment over adherence to an arbitrary budget
limit, whose economic logic has never been made clear.

To be sure, France’s position is not unique. Portugal and, more
significantly, Germany, also face similar budget problems, although the EU
has publicly excused them due to their efforts to comply with the SGP
(even though a fair reading of the pact makes no differentiation between
good faith and bad faith efforts to reduce budget deficits).
Paradoxically, if France is serious about pursuing a growth program, their
budget position will likely improve the greater, whereas the greater the
efforts by Germany and Portugal to comply, the more likely they are to
continue to breach the stability pact limits. This is the inevitable
by-product of implementing a contractionary fiscal policy in the midst of
a serious recession.

Historic examples abound to support the notion that fiscal policy is
invariably pro-cyclical, yet the European Commissioners seem to think this
inconvenient fact can be eliminated through bureaucratic diktat.
Governments can easily retain balanced budgets in good times without
unduly cutting spending on popular programs, given higher tax receipts and
lower attendant social security costs. But when an economy weakens,
invariably income tax receipts decline, social welfare expenditures
increase and budgets tend naturally toward deficit. A pact that puts too
much weight on achieving fiscal savings in this kind of environment can
risk exacerbating an economic downturn.

The absurdity of the current position is illustrated by the fact that
praise for Germany ? whose own deficit is forecast to reach 3.8 per cent
of GDP this year (not dissimilar to the French number) ? largely reflects
nothing more than a political stratagem to secure the Schroeder
government’s support if the EU is forced to take on President Chirac’s
government. In that sense, France is to be applauded for its lack of
hypocrisy, not a quality one readily associates with a country whose calls
for Third World solidarity with Africa sit uneasily alongside its habitual
agricultural protectionism.

Although the details of the French budget will not be released until later
this month, recent remarks by Alain Lambert, France’s budget minister,
make provision for tax cuts up to 3 percentage points, but no specifics in
terms of getting France back under the 3 per cent budget limits on the
deficit. The best that Mr Lambert could do was a pledge to reduce the
cyclically adjusted deficit, without mentioning specific figures.
This could prove a defining moment for Europe. Finance Ministers from 11
other euro-zone nations might effectively determine France’s future
economic fate because they will have to vote on any Commission
recommendation for Paris to cut spending or increase taxes. Yet none of
these officials have anything approaching democratic standing in France
itself, so the actual implementation of a fine has huge consequences,
particularly if (as we think likely) the sanctions continued to be ignored
by France. To us, this demonstrates the dangers of the EU’s repeated
tendency to make ad hoc improvisations of EMU’s treaty provisions, rather
than engaging in the hard job of reforming flawed treaties, which are
neither grounded in political reality, nor economic logic. A political
firestorm, which completely undermines the euro’s credibility, is
potentially in the offing.

It is worthwhile outlining the sanctions mechanism officially in place in
the event that any EU country is deemed to be in persistent breach of the
stability pact, as France is today. A country found to have been in
breach of the reference values has four months to introduce corrective
measures suggested by the Council of Economics and Finance Ministers of
the EU (ECOFIN). If the country concerned fails to take the recommended
action, then the fine is introduced. One penalty is in the form of a
non-interest bearing deposit at a European banking institution. If the
budget deficit is not corrected within 2 years, the deposit is forfeited
and becomes a fine; if the corrective action is taken, the deposit is
returned and the foregone interest becomes the penalty.

The problem with this process is that it lays down conditions within a
political and economic vacuum. There are circumstances in which
macroeconomic shocks are quite severe and require offsetting stimulus far
in excess of the 3 per cent level of deficit laid down by the stability
pact. What happens if a government is elected under these circumstances
and proceeds immediately with an aggressive fiscal policy in direct
contravention of the pact?

Consider the position of the Chirac administration today, which campaigned
on the promise of a large package of tax cuts last year to accelerate
economic growth. It is also the current position of Chancellor
Schroeder’s new coalition government, which is in the process of
implementing significant tax reform, a major provision for which are deep
cuts in marginal rates. In the circumstances in which these two countries
find themselves today, their respective governments cannot reduce interest
rates to stimulate the economy, because they are subject to the interest
rate policy of the ECB (which is itself circumscribed by global capital
market conditions). Neither can devalue the currency, because they no
longer have one of their own. Neither can increase their respective budget
deficits, because they are already in breach of the Stability Pact and
facing financial penalties they cannot afford. They cannot raise taxes
without committing political suicide.

Among the few remaining courses of action for either government, perhaps
the least offensive is to sell its national assets: its gold, its US
dollar reserves, its public buildings, its land, and so on. The economist
Peter Warburton has likened these circumstances to the reparations a
nation must pay when defeated in battle.

And in the midst of a serious recession, the de facto reversal of a
program which formed the basis of a national mandate could be political
dynamite. Most rules, regulations, and diktats emanating from Brussels
are deemed by the national electorates to be annoying and occasionally
inconvenient. But they are the object of ridicule and satire, not the
stuff of revolution. Rulings, like this past August’s that chocolate may
contain vegetable fat, might offend certain chocolatiers in Belgium or
France. But for the most part, the European Commission is seen as
something distant with little day to day relevance in the lives of most
citizens living within the European Union. The implementation of a policy
which has profound economic consequences, however, could change
everything.

Politically, the interpretation of the euro-zone’s stability pact is
largely left in the hands of unelected bureaucrats, operating out of
institutions which are devoid of any kind of democratic legitimacy. In
such circumstances, it becomes difficult to envisage how a recently
elected government such as that of France, armed with a fresh mandate,
could be compelled to delay implementation of a key election promise,
without ultimately creating huge popular backlash in a way that
potentially compromises the long-term viability of monetary union. We had
a brief sense of that last year in France, as it was precisely this kind
of backlash that produced Jean-Marie Le Pen’s surprisingly successful
candidacy in last year’s French Presidential election.

Anti EU parties of the sort that Le Pen represents are on the rise across
continental Europe. To be sure, at this stage, they largely represent
disaffected (albeit significant) minority votes. But an externally
imposed fine by a bunch of Brussels bureaucrats could engender significant
mainstream political backlash. Voters for the Front Nationale in France,
or Vlams Blok in Belgium, are symptomatic of a growing body of opinion
which sees the European Union and its attendant institutions characterised
by a huge democratic deficit. This in turn has led to an increasing sense
of political alienation and a corresponding move toward extremist parties
hostile to any kind of political and monetary union in other parts of
Europe. Under politically charged circumstances, these extremist parties
might become the mainstream.

Should the EU technocrats persist in their current obstinate refusal to
respond realistically to these pressures, we can anticipate rising anger
at the inability of establishment politicians to pursue economic policies
in the national interest. There will be increased opposition towards
interest rates being set by “outsiders”. There will be increased anger at
Brussels bureaucrats in the event that vital development funds are
withheld from needy countries such as Portugal (which is already
technically in breach of its fiscal borrowing limits), or if financial
penalties are imposed. Politics might become even more polarized and
extreme as a consequence and the European Monetary Union itself will be
put at risk. At a time when both the dollar and yen display serious
vulnerabilities, the global economic system hardly needs a third major
currency going down the spout.

Which brings us to the European Union’s dirty little secret: for a
genuinely credible fiscal policy to succeed, it is essential to accelerate
a greater degree of political pooling. This notion is political dynamite
in some of the more euro-sceptical countries, such as Sweden (where
opponents of the single currency in the upcoming referendum ? Green party
activists, conservative politicians and some cabinet members ? have
exploited misgivings about federalist instincts in Brussels and have
claimed the country’s social security system is under threat), and the
United Kingdom (where any discussion of the political implications of the
euro is virtually taboo).

It also suggests that today’s fashionable tendency to expand the euro-zone
ought to be put on hold. Pooled political sovereignty and a concomitantly
more cohesive supra-national fiscal policy are far more difficult to
implement in a larger currency zone with countries at disparate stages of
economic development and correspondingly different political/historical
traditions. Europhiles should worry less about whether Sweden chooses to
embrace the euro on September 14; more attention should be devoted to
getting existing institutions working properly, so that the euro’s longer
term success is permanently entrenched.

Why is fiscal policy reform so important? Most single-currency zones
involve a central or federal government with a tax and public expenditure
program of substantial size relative to national GDP and the ability to
run significant deficits. A tax and public expenditure program generally
involves redistribution from richer regions to poorer ones, whether as an
automatic consequence of a progressive tax and social security system or
as specific policy acts. The redistribution acts as a stabilizer with
negative shocks, leading to lower taxation and higher social security
payments in the region that is adversely affected. In the absence of such
a mechanism, it could be expected that economies would adjust to
differential shocks and uneven economic performance through a variety of
other routes. In response to a negative shock, these would include
declines in economic activity, reductions in living standards, and outward
migration. There is thus a need for the development of a larger EU tax
base and redistribution of tax revenue from richer regions to poorer ones
in order to have a genuinely proper functioning fiscal policy at the
supra-national level. This is more politically feasible with a smaller
zone of nations with common economic and political philosophies.

This contentious issue has been finessed so long, but it appears that
developments in France and Germany are forcing it on to the table. This
is a debate that must occur because the European Monetary Union and its
attendant institutions ultimately cannot succeed in the absence of open,
public discussion and acceptance, in lieu of bureaucratic imposition. It
is said that politicians in particular and the democratic process in
general cannot be trusted with economic policy formulation because they
lead to decisions that have stimulating short-term effects (for example,
reducing unemployment via higher government spending) but are detrimental
in the longer term (a notable example is a rise in inflation). But the
formation of the euro has now shown us the limits of pure technocratic
economic management that takes place in a complete democratic vacuum.
Surely now is the time to find some happy medium before it is too late?

Marshall Auerback
September 9, 2003

This article first appeared on www.PrudentBear.com