The stakes facing the eurozone after the pandemic

12.01.2021 6 min
Editorial published on Telos on 29 November 2021

 A monetary union is, in principle, very effective when growth is facilitated by the fact that the financing capacities of certain countries in that union allow the financing needs of others to be met, thus pushing the external constraint to the boundaries of the monetary zone and not the borders of each of its constituent countries. This is the case, for example, in the United States of America for the various States that make up the United States of America. Sustained stronger growth in California, for example, would not be hampered by the weaker growth in other States, even if this would lead to an increasing current account deficit of the first State vis-à-vis all the other States, because the only relevant current account balance is that of the United States as a whole and not that of each of the States. It is therefore necessary for capital to flow efficiently within a Monetary Union. And in order for this movement to take place without hindrance, we need a transfer union, i.e. elements of budgetary solidarity between the States.

 The eurozone crisis, which began in 2010, was a “sudden stop” crisis, specific to this area, and not the mere development of the previous great financial crisis. Until then, the financial markets had properly matched the financing capacities of the Northern countries to the financing needs of the Southern countries within the eurozone. However, ever-increasing divergences between the current account balances of the eurozone countries, namely the growing deficits and surpluses of the various parties, had emerged since the creation of the euro. And when the markets realised that there was in reality no solidarity mechanism between the eurozone countries, they suddenly stopped allocating the financing capacities of the Northern countries – i.e. their current account surpluses – to the financing needs due to the current account deficits of the Southern countries. The crisis therefore happened suddenly, as always when the financial markets suddenly discover, and often belatedly, reality as it is. Countries that are structurally more importers than exporters, seeing their external financing cut off by the markets and not benefiting from solidarity from other eurozone countries, were obliged to immediately curb their demand, thus their imports, by reducing investment, wages, social benefits and public spending. As a result of strong austerity policies, the Southern countries quickly brought their current account balances to near-zero levels. Northern countries, with continued high current account surpluses, began to finance the rest of the world, including US current account deficits, but paradoxically not the other countries of the eurozone itself. This, strictly speaking, does not correspond in any way to an efficient allocation of capital within a Monetary Union.

 Therefore, it is now important to ask how we can build an efficient monetary zone through a real solidarity project in the Union. The expected “technical” improvements to both the European capital market and the Banking Union cannot alone achieve it.

 Since the idiosyncratic crisis in the eurozone, the only elements that have helped partially intermediate the financing capacities of one party with the financing needs of other parties have come from the European Central Bank, through its relations with the national central banks in the eurozone (Target 2).  It is therefore the central banks that have actually encouraged capital flow, but independently of the markets. Then, the emergence of the COVID-19 pandemic resulted in the Next Generation EU plan and the Community loan, which now make it possible to enter a new dimension because they create clear elements of solidarity and a better flow of capital. For the first time in the history of the region and in reality of the European Union, Community expenditure, through donations, mobilises amounts that are incomparably higher than previously, while not split according to the relative weight of each country but according to their needs.  On condition, however, that they undertake the necessary reforms. And the financing of these donations is done through a Community loan. These are obvious demonstrations of solidarity.

 Of course, the issue that arises is that of the European Union’s future resources, which are essential to repay these loans. The challenge is then whether European countries will reach an agreement on common taxes, such as on plastic, CO2 or digital technology. And whether this Community budget and loan will be sustainable. Europe’s “Hamiltonian moment” will only be a real one if there is long-term common expenditure of large amounts, a Community debt and resources specific to the European Union, and not only in response to the pandemic. Will solidarity be sustainable or will it, as many Northern countries are already saying, be a one-off, an isolated operation, specific to the pandemic?

 A monetary union can only be sustainable if there are clear elements of a transfer union. Thus, the fundamental question is whether the interests of the various European countries are sufficiently convergent to achieve this and to agree on it over the long term. If they are not, it becomes very difficult to ensure the permanence of a Community budget and debt. However, Northern countries have significantly increased their industrial capacity while Southern countries have gradually de‑industrialised since the creation of the eurozone. Consecutively, Northern countries have gained market share in global trade (increase in their exports as a percentage of global exports), while Southern countries have diminished their share.  Countries with current account surpluses, thus the Northern countries, have accumulated net assets in the rest of the world; whereas Southern countries, with current account deficits, until the eurozone crisis, have conversely built up debts to the rest of the world on an ongoing basis. At the same time, assessments of initial education levels, as well as professional skills, are very different between the countries of the South and the North. Like youth unemployment rates and general employment rates, productivity gains also diverge.

All these factors contribute to the level of growth and the quality/price competitiveness of each country. Finally, the consequences are a growing North-South divergence in the levels of public debt to GDP.

If this situation persists, post-pandemic solidarity is likely to be short-lived. Especially since, in addition, current inflation, if not only transitory, would lead the ECB to gradually increase its rates, at the very least to neutralize its policy, if not more so. That would increase the difficulties of Southern countries that would not have sufficiently engaged in a credible policy of normalizing their fiscal policy. On the other hand, if the ECB, does not push its interest rate up, to protect them, that would significantly increase tensions in Northern countries with regard to a single monetary policy considered too accommodative for too long and would undoubtedly also cause dangerous market reactions.

 Faced with these considerable and numerous divergences, what must we build to achieve greater solidarity? How can we build mutual trust between the countries of the North and the South? Three points can be put forward here.

 Firstly, Southern countries must implement structural policies, i.e. ad hoc investments and reforms aimed at significantly reducing these divergences. These necessary reforms are not austerity policies, since, on the contrary, they increase potential growth, by increasing productivity, improving the efficiency of initial and vocational training, by better labour mobilisation, including through pension reform, as well as by optimising public spending. Only these policies will ensure that Northern countries do not have to send subsidies indefinitely to Southern countries. This will make it possible to activate the necessary elements to achieve at least some elements of a transfer union.

 While these reforms are necessary, they will not be sufficient. Structural policies alone will not make up for the increased differences in industrialisation levels between the countries of the North and the South. Hence the second point: an industrial and regional planning policy in the European Union must also be implemented, through investment and aid from Northern countries to Southern countries, in order to contribute to their re-industrialisation in certain well-chosen sectors. On this point, we can hope that the Next Generation EU plan will be able to provide answers, since this plan presents and includes major projects for the future. They should therefore be set up according to the relative specialisations, existing or desirable, so as to promote industrialisation and competitiveness in countries requiring it.

Finally, the third point is based on the necessary reconstruction of shared and realistic budgetary rules: they are no longer so today. These rules must be effective and make it possible to support these developments, while ensuring that there are no free riders in the countries of the Union.

 Individual (country-by-country) efforts by the members of the Union, and jointly transitory efforts from North to South, are needed, because they will, in a shared interest, allow the North not to finance the South ad infinitum, and the South not to experience continuous de-industrialisation with all that this implies both economically and socially. And there is a need for budgetary rules that make it possible to implement these policies effectively, but also without leaving the possibility for some countries to count indefinitely on the aid of others, by perpetually postponing the necessary reforms. Otherwise, either populism will continue to rise in the Northern countries that will not agree to pay subsidies ad infinitum to the Southern countries, or populism will continue to grow in the Southern countries, if we leave them to continually become de-industrialised without coming to their aid. Especially as this de-industrialisation is encouraged by an incomplete monetary union, i.e. in particular without the coordination of economic policies and without a transfer union. The catch-up of competitiveness differentials cannot be facilitated by devaluations, which are by the way never miracle solutions. That leads to a dynamic of increasing competitiveness divergences, with induced phenomena of industrial polarisation located in countries with the best comparative advantages. Without individual and common efforts, therefore, there will be no permanent elements of solidarity to get out of this trap. We would then suffer from this rise in populism, which would ultimately endanger the Monetary Union, which is an undeniable common good, due to the virtues of the euro, which has demonstrated its usefulness to us, especially during crises, thanks to the determined action of the European Central Bank.  But the ECB definitely cannot be the only player at the table.

Olivier Klein
CEO of BRED and Professor of Financial Macroeconomics and of Monetary Policy at HEC Paris