Abstract
Over the last half-century, economic integration in Europe has, despite some legitimate flaws, been tremendously successful in creating a situation of peace and prosperity. The success we enjoy today, however, has not always come easily. At many points along the path of European integration, policymakers were forced to make difficult choices that demanded political courage and foresight. Now is just such a time. As Europe emerges from the crippling worldwide economic crisis, it is imperative that policymakers unite on key measures to re-capitalise Europe's banks, provide proper regulatory oversight and control public debt. Europe's future economic vitality depends on it.
Keywords
European economic integration—including the adoption of the euro—has its roots in the post-war era. From the earliest stages, the overarching aim of integration has been peace and stability in Europe, and on the whole this project is succeeding. The euro has promoted stability by keeping inflation low and providing exchange rate stability, which has been positive for Europe's exporters. Companies and consumers have benefited from increased trade among Eurozone countries. And businesses and individuals have benefited from the increased availability of credit, while travellers have seen lower costs and less inconvenience.
All of this has been possible because throughout the history of European integration, EU leaders have generally been able to find solutions—sometimes late in the day. Without these solutions, Europe would not be where it is now. In fact, one has only to contemplate what Europe would have been like during the last 30 years if there had been a series of competitive devaluations of national currencies. Had that occurred, the common market might not have survived and the tide of rising prosperity Europeans have experienced might not have begun.
Despite Europe's many accomplishments, this has been a pragmatic project at every step and has involved much trial and error. At certain times the errors have been considerable. For example, the Stability and Growth Pact has proven insufficient, especially in terms of controlling fiscal imprudence in the larger Member States. In addition, the European Central Bank (ECB) failed to use its Article 14 powers to rein in national central banks in countries developing credit-fuelled bubbles, which contributed significantly to the recent financial crisis. Finally, Europe is still struggling to devise a credible plan to recapitalise its banks in the aftermath of the crisis. In hindsight, some of these problems were not foreseen and others were not addressed quickly enough. But it is not too late to look at history, learn from its lessons and correct past mistakes. To that end, European leaders must act—and act soon—to form a stronger banking policy for the future.
The long road towards European monetary union
In 1957 six countries forged the Treaty of Rome, thereby establishing the European Common Market. This landmark treaty set the goals of ‘ever closer union among the peoples of Europe’ by ‘strengthening the unity of the economies’ of the Member States. It was not until 1969, however, that the leaders of the six Common Market countries, chaired by then–Prime Minister of Luxembourg Pierre Werner, met in The Hague to commission a study on a possible economic and monetary union with a common European currency. When Werner's study was finally presented in 1971, it described a three-stage path towards a single European currency. The first step would involve the free movement of capital between intending members; the second step would entail a system of coordination between the central banks of the intending members; and in the third stage member countries would fix exchange rates before ultimately issuing a single currency.
The report was quite explicit that membership in the Economic and Monetary Union would mean European-level involvement in domestic economic policy. In fact, the text specifically stated: To facilitate the harmonization of budget policies, searching comparisons will be made of the budgets of the Member States from both quantitative and qualitative points of view. From the quantitative point of view the comparison will embrace the total of the public budgets, including local authorities and social security.’ It was therefore clear that European-level scrutiny would extend beyond just public finance and would impact the broader economy. Moreover, the report stated, ‘It will be necessary to evaluate the whole of the fiscal pressure and the weight of public expenditure in the different countries of the Community and the effects that public receipts and expenditure have on global internal demand and on monetary stability. It will also be necessary to devise a method of calculation enabling an assessment to be made of the impulses that the whole of the public budgets impart to the economy.’
It is also important to note that the Werner report served to inform prospective members of the direction in which Europe was heading. Indeed, the report appeared before either Britain or Ireland joined the Common Market, and the leadership in both countries therefore had ample opportunity to understand the aims of the body they intended to join. Both were free not to join at all, if indeed they did not accept what membership entailed. Neither Britain nor Ireland made that choice.
The next big step in European economic integration was the Single European Act of 1986, which sought to introduce majority voting on a range of matters in order to remove barriers to intra-EU trade in goods and services. The Act also made economic and monetary union an explicit goal of the EU treaties. To help countries prepare for the extra competition they would face in such a union, regional funds were also introduced at this time. Once again, both Ireland and Britain stated their implicit support by accepting these funds.
In 1989, a second report emerged with the aim of reviving the process towards a monetary union. This report was prepared by a group chaired by Commission President Jacques Delors and was represented by Maurice Doyle, Governor of the Irish Central Bank, and by Robin Leigh Pemberton of the Bank of England. This report was even more specific than the Werner report was nearly two decades before, as it envisaged the potential dangers that could arise through inconsistent economic policies within a single currency area. The text warned that ‘Monetary union without a sufficient degree of convergence of economic policies is unlikely to be durable and could be damaging to the Community. Parallel advancement in economic and monetary integration would be indispensable in order to avoid imbalances.’ As it turned out, the report predicted exactly what was to go wrong in Ireland. Recalling that financial markets are very bad at predicting crises and that lending in such markets usually continues long after it should have stopped, the report stated: ‘Experience suggests that market perceptions do not necessarily provide strong and compelling signals and that access to a large capital market may for some time even facilitate the financing of economic imbalances. Market forces might either be too slow and weak or too sudden and disruptive. Hence countries would have to accept that sharing a common market and a single currency area imposed policy constraints.’ Britain and Ireland were both very well aware of these realities.
The lack of a proper response during the recent crisis
Unfortunately, the Delors report of 1989 was all too prophetic. Markets, along with their handmaidens, the rating agencies, were initially too weak and slow in penalising excessive borrowing and lending in parts of the Eurozone beginning in 2000, and when they did eventually recognise the problem, they were, exactly as Delors predicted, ‘sudden and disruptive’ in their response.
The logical response to this development should have been the formation of a common European banking policy with tight supervision from the centre—especially in those parts of the Union with an inappropriately low common interest rate for local conditions. Granted, the Maastricht Treaty gave the independent European Central Bank the responsibility to ‘keep under review’ the monetary policies of Member States and the capital movements among them, as well as the right to ‘deliver opinions’. Furthermore, Article 14 of the statute of the European System of Central Banks states clearly that ‘the national central banks are an integral part of the European System of Central Banks and shall act in accordance with the guidelines and instructions of the ECB.’ However, the ECB made no use of Article 14 when it saw a disproportionate increase in the size of the banking sector in countries like Ireland and Spain beginning in 2000.
From 2000 on, British, German, Belgian and French banks, as well as those of several other EU countries, lent irresponsibly to Irish banks in the hope that they too could profit from the Irish construction bubble occurring at the time. These banks did so notwithstanding the fact that they had ample information about spiralling housing prices in Ireland. Moreover, these banks were supervised by their home central banks and by the ECB, all of which had the same information. Nonetheless, there was little objection to these lending patterns. Of course, primary responsibility rests with the Irish authorities, who did not supervise their own banks properly. But there were other major failures of supervision, including on the part of other national central banks and at the wider European level. There is a tendency in some quarters to gloss over that fact and to present the problem as the fault of Ireland. However, it is the Irish taxpayer, who in 2008 assumed the private liabilities of Irish banks to other European banks, who is now helping to stabilise the situation in the whole of the European banking system.
One must also place some responsibility on the Stability and Growth Pact, which was drafted at the Dublin EU Summit in 1996. In this case, the error lay in focusing exclusively on government finances while neglecting the possibility that difficulties could emerge from private sector excesses. In order to avoid those difficulties, stricter European banking supervision was needed. Interest rates that were suitable in Germany as it went through the difficult post-reunification phase were too low for Ireland and Spain. And with local inflation taken into account, these interest rates were actually negative—a situation that leads to procyclical bubbles in the economy, which occurred in Ireland and Spain. Of course, these are problems that have become clearer in hindsight.
Europe's way forward
On 25 March 2011, EU leaders came together to agree on a new treaty-based fund to assist countries in need, which was underpinned by a competitiveness pact prepared by President Van Rompuy of the European Council and President Barroso of the European Commission. Despite some work that remains unfinished, the pact focuses on specific goals to be met by Member States, including reducing labour costs in countries with competitiveness problems; decentralising wage bargaining; opening up professions and energy networks to competition; achieving less expensive legal systems; raising the retirement age; introducing a constitutional or other legal limit on government borrowing; and creating a single consolidated base for corporation tax. Most of these proposals are sensible as long as the European Commission monitors the situation going forward, including by proposing changes in policy when Member States depart from the pact.
However, despite the soundness of these measures, there are potential pitfalls, not the least in Ireland, which continued to be a source of uncertainty after the 25 March meeting failed to produce agreement on a revised interest rate for the country's bailout funds. The issue hinges on Ireland's corporate tax rate, which some EU leaders are pushing the Irish government to raise in exchange for more favourable bailout terms. However, as Ernst and Young has estimated, a common consolidated tax base would add 13% to the net tax compliance costs of Irish firms. Another study suggests that large countries with sizeable markets would collect more tax under a consolidated tax base, while smaller peripheral countries such as Ireland would collect less, actually worsening their relative debt repayment positions. Moreover, enforcement may prove difficult and it may not be enough to rely on heads of government simply policing one another to ensure that commitments are honoured. While small countries may submit to pressure from larger countries, there is no guarantee the process will work in reverse. The experience of trying to apply the Stability and Growth Pact to Germany and France in 2004 demonstrates exactly that. Moreover, a constitutional debt brake would bring lawyers into the centre of fiscal policymaking, which is not likely to improve matters. As a case in point, it would be useful to study the effects of a similar effort in the United States, the Balanced Budget and Emergency Deficit Control Act of 1985, otherwise known as the Gramm-Rudman Act.
Although there is room to debate the merits of particular measures, there is no question that policymakers must focus on getting public debt under control. The US Congressional Budget Office predicts that based on current trends, America's federal debt service will rise from 10% of US revenues today to 58% by 2040. Europe's present difficulties, including the prospective costs of ageing societies, have put many European governments on a similar trajectory. The greatest challenge in shaping these proposals involves determining proper penalties—beyond mere peer pressure—in case of errant behaviour. Under the present system, fines are theoretically imposed on countries that exceed the deficit limit (but interestingly not the debt limits). These rules have not worked, which raises two concerns.
First, in some countries like Ireland, government deficit was not the primary problem; the main issue was the expansion of private sector credit, a phenomenon for which there were, and are, no penalties. The second concern involves the possibility of imposing fines on countries that already cannot pay their way because of a large deficit. Such a measure would prove difficult to enforce—akin to trying to extract blood from a stone.
A new system must therefore ensure that markets function properly. The best way may be for supervisory authorities to maintain the offensive by continually reminding the markets of problems they might otherwise ignore until it is too late. Such an approach was agreed upon at the 25 March meeting of the European Council by deciding that the Commission, in coordination with the ECB and the IMF, will assess a rigorous analysis of the sustainability of the public debt of the concerned Member State. Such a policy of formally and regularly briefing the rating agencies, as well as the political parties in all Member States, would entail a candid assessment of emerging problems in competitiveness, credit growth and public finance imbalances in each Member State, all on a systematic basis. Therefore, rather than relying on cumbersome bureaucratic procedures in the European institutions to eventually put pressure on countries to address problems, more reliance would be placed on competitive financial markets and on competitive political markets to deliver the necessary policy changes. This approach should be far more effective than peer pressure within closed-door meetings in Brussels.
Any new policy measures must also take aim at issues beyond just competitiveness. Although there will be no transfer union within the Eurozone, a solution must be implemented similar to George Soros's recent call for EU emergency funds to be used to recapitalise Europe's banks. There has also been significant criticism of the stress tests carried out on Europe's banks. Europe's banking system is three and a half times Europe's GDP, whereas the US banking system is only 80% of US GDP. Loan-to-deposit ratios are considerably higher in Europe than in the US. Europe relies very heavily on banks because it has not developed alternative means of raising finance.
In order for Europe to create a new banking policy, leaders must take a European view about the size of banks, the interconnectedness of banks, the ‘too big to fail’ problem and a host of other difficult questions. But unless we restore our banking system, confidence will not return, small businesses will not thrive and we will lack the necessary credit to tackle our structural problems.
Although there are always sceptics, necessity is truly the mother of invention. The Industrial Revolution began in Britain rather than on the Continent because labour costs were higher in Britain. This gave British industrialists the incentive to adopt labour-saving machinery. Perhaps one of the main challenges of our time, the supply and high cost of imported oil and gas, will now give Europe the necessary incentive to adopt energy-saving technologies. But this cannot happen—nor can solutions to all the other challenges we face—unless Europe has a properly functioning banking system that can lend to the entrepreneurs who make such breakthroughs.
The problems the European Union faces today are challenging not only politically but also intellectually. But they are problems that others in the world will have to face sooner or later. Europeans are the world's pioneers of economic integration, and the leaders who founded the European Union had enormous intellectual self-confidence. That self-confidence must be rediscovered. There must be a uniting of minds in place of the institutional rivalry that sometimes characterises EU politics. Lessons must be learned and problems must be confronted honestly; only then can we begin to work together to find practical and imaginative solutions. But above all, in order to sustain an economic and monetary union in the long run, we need to create a true European demos and a greater sense of European patriotism. Only then will Europe realise its full potential.