European storm subsided, but damaged roof still needs fixing

Policy reflections on the future of the eurozone

By Filip Abraham, professor of international economics at Vlerick Business School and KU Leuven

On June 29-30 a high-level conference on the future of the eurozone took place in the Spanish coastal town of  Santander. The conference was co-organized by Prof Filip Abraham from Vlerick Business School and KU Leuven, together with Prof. Manuel Sanchis of the University of Valencia. Among others, the list of distinguished speakers included President Emeritus or the European Council Herman Van Rompuy, former EU Commissioner Joaquin Almunia, and EC Director General of Economics Prof Frank Smets. Sponsoring was provided by the Spanish BBVA Bank, Vlerick Business School and KU Leuven.

 

Key insights:

  • Although the sky is brightening up, the eurozone is not out of the woods yet – some important weaknesses need to be dealt with before the next potential crisis
  • A lack of economic convergence between Northern and Southern eurozone members creates a two-speed Europe
  • Several banks within the eurozone remain vulnerable to negative shocks
  • There is a mismatch between eurozone regulation and the effective decisions that national governments take
  • A debate on a sustainable fiscal union is necessary

A year ago, the eurozone was all about gloom and doom. Economic growth was low and unemployment high. The UK had just voted to leave the EU. Populist political movements  railed against the European super-state. They were demanding that “Europe” would transfer back political powers to the sovereign national member states.

Wind of change

What a difference a year makes! At this moment, the eurozone is recording solid growth rates. Countries such as Spain, that went through years of painful economic adjustments, are among the strongest performers. Brexit has thrown the UK economy and  prime minister May’s conservative government into disarray but has not undermined cohesion in the EU. On the contrary, it acted as a stark warning to other EU member states that leaving the EU is more easily voted than done. On the political front, populist parties in Austria, France and Netherlands did not achieve the electoral breakthrough that they had hoped for. Instead, the French voters elected a pro-European president. Provided that German Chancellor Angela Merkel gets re-elected in September, the revival of a strong French-German alliance that drives EU integration forward is no longer a distant possibility.

Hope is back. It is time for a new ambition in the EU. Those statements by Herman Van Rompuy nicely summarize the renewed optimism that was felt throughout the conference. But it also reflects the need to act now and deal with the weaknesses of the eurozone rather than waiting until the next crisis arrives.  As the old saying goes, it is better to fix the roof when the sun is shining.

A two-speed Europe

As a matter of fact, the roof of the eurozone construction is in need of repair. One serious problem concerns the lack of economic convergence between the Northern and the Southern members of the eurozone.  Countries such as Germany and the Netherlands realize record current account surpluses while several Southern countries suffer from structural imbalances between exports and imports. Financial capital does not flow smoothly from Northern surplus countries to Southern deficit countries, keeping interest rates in the South at a higher level. This is particularly troublesome in times of economic recovery because Southern SME’s firms cannot obtain credit at the same low interest rates as in the North. As a result, investment in the South remains below its potential, blocking the convergence process between the North and the South. Moreover, the quality of institutions and policy-making varies considerably across countries. For those reasons, better economic times do not automatically lead to economic convergence within the eurozone. This is worrisome because the theory of optimum currency areas views such convergence as one of the fundamental criteria for a successful monetary union. 

Banks are still a weak spot

The construction of a sustainable eurozone requires a functioning banking union. Although the banking sector is in a better shape than a decade ago, several banks within the eurozone remain vulnerable to several negative shocks. Reinforcing the banking union involves the roll-out of the resolution fund and an agreement on a common deposit guarantee fund.  It also requires a commitment to follow the rules that have already been agreed.

The conference was organized shortly after the take-over of the struggling Spanish Banco Popular, by the largest Spanish bank, the Banco de Santander. This take-over respects the bail-in principle of the European regulations on bank resolution because it puts the burden of the rescue package on the shareholders of the banks.  Around the same time, the Italian government saved ailing banks like Banca de Veneto with taxpayers money using a legal loophole to get around the European rulebook. This Italian approach was seriously criticized by the Spanish participants to the conference because it undermines the fundamentals of the banking union.

Too much room for interpretation?

This mismatch between the content of the eurozone rules and the effective decisions by national governments was a recurring theme throughout the conference.  According to one view, this mismatch was caused by the fact that too many national authorities from a very diverse group of members states were taking too many different decisions. If so, the solution would be to strengthen decision-making at the European level. One could for instance envision the appointment of a common EU or eurozone minister of finance. Other participants were not convinced by such proposals because they imply further European centralization in the decision process. Instead, they advocated a more effective cooperation between the European institutions and the member states with the European Council acting as the principal intermediator.

Give fiscal peace a chance

As a final topic, the prospects for fiscal union were explored during the conference. There was a general feeling that the polarized debate of the last couple of years between proponents and critics of fiscal austerity should be put to rest.  In effect, the improving economic conditions should ease the transition to sustainable public finances for highly indebted countries while at the same time leaving enough room for public investment in infrastructure and innovation. Attention was paid to topics as debt restructuring and the building blocks for a sustainable fiscal union. 

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