Deliberations of the political economy continue to trump macroeconomic considerations in resolving the euro area crisis. Germany's strategy of using crisis panic and market pressure to forge consensus increases the economic cost day by day. In the last two months, the broad based withdrawal of overseas institutional investors marks another milestone. This follows of the heels of European investors cutting cross border exposures reinforced by national supervisors (such as the Austrians capping credit expansion to foreign markets) and even European bodies (such as the European Banking Association's stress tests).
Shall this trend implications on how the solution of the euro area crisis should look like? Unfortunately, yes. It seems national borders are getting reestablished in an effort to put Gini back into the bottle. But how can a joint currency make sense if capital mobility came to an end? By letting this crisis fester, solving it will become more difficult.
Previously, it was thought that three essential ingredients are sufficient to rectify the currency union. First and most importantly, structural reforms have to be implemented to allow the convergence towards an optimal currency area. These should lead to comparable levels of competitiveness, implying a long-run equilibrium of balanced current accounts. Second, a transfer mechanism has to be established that facilitates the convergence process and helps individual members cope with asymmetric, temporary shocks. Eurobonds are one possible way to effect transfers by softening the intertemporal budget constraint imposed by markets. Third, an enforcement mechanism must prevent moral hazard arising from transfers. To this end, fiscal restraint is imposed through the European semester and a possible treaty change. However, it remains to be seen whether these measures have enough bite.
Unfortunately, these ingredients are no longer enough. Enforced fiscal restraint is unlikely to bring the different euro area members towards the same level of economic strength. The festering of the crisis has damaged policy credibility and unanchored fiscal expectations. The thrust of the Maastricht Treaty can be interpreted as an implicit contract between the national authorities and the EU private sector. As long as the former guarantees stability the latter provides capital across borders to finance investments necessary to enhance productivity and level out living standards across the euro area. Protecting bond markets from the precedent of a default on senior bonds in Ireland was part of this implicit contract.
Both counterparts, the private sector as well as the public sector, have violated this contract, leading to its termination. Banks fuelled consumption and housing booms instead of productive investment. After an initial attempt to save the contract (through fiscal stimuli and generous bank interventions in the aftermath of the subprime crisis), the public sector failed to hold up its commitment under the contract and entered into a protracted crisis. Politicians started to demand a restructuring of Greek sovereign debt.
Enshrining fiscal stability through the three essential ingredients above will solve the problem only in part. Capital allocation through market forces in the euro area has lead to a boom-bust cycle. Lack of confidence may not allow to renew the contract. And even if renewed, it remains doubtful that capital flows on their own bring about convergence. Additional ingredients are needed. Most importantly, structural reforms will need to make labor markets (whose liberalization lagged the liberalization of capital markets) much more flexible. What may be needed is a social contract within and between the electorates of member countries that brings the European people closer together, catalyze greater labor mobility and make Europe truly European. Politicians may find it harder to achieve this than a contract with the financial sector. Sadly, they don't even try.
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