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Published by Brian Sebastian Xu

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Published by: Brian Sebastian Xu on Jan 22, 2012
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ISSUE 2012/01JANUARY 2012
The search for solutions to the euro crisis is based on a partial diagnosis that over-emphasises the lack of enforcement of existing fiscal rules. Europe’s leadersshould rather address the euro area’s inherent weaknesses revealed by the crisis.At the core of euro-area vulnerability is an impossible trinity of strict no-monetaryfinancing, bank-sovereign interdependence and no co-responsibility for publicdebt. This Policy Contribution assesses the corresponding three options for reform:a broader European Central Bank (ECB) mandate, the building of a bankingfederation, and fiscal union with common bonds. None will be easy.The least feasible option is a change to the ECB’s mandate; changing marketperceptions would require the ECB to credibly commit overwhelming forces, andthe ECB is simply not in a position to make such a commitment. The building of abanking federation, meanwhile, involves reforms that are bound to be difficult.Incremental progress is likely, but a breakthrough less so.This leaves fiscal union. It faces major obstacles, but a decision to move in thisdirection would signal to the markets and ECB a commitment to strongerEconomic and Monetary Union. One possibility would be to introduce a limited,experimental scheme through which trust could be rebuilt.This Policy Contribution draws on presentations made at the
 XXIV Moneda y CréditoSymposium
, Madrid, 3 November 2011, at the Asia-Europe Economic Forumconference in Seoul, 9 December, and at De Nederlandsche Bank in Amsterdam on 17December. I am very grateful to Silvia Merler for excellent research assistance. I thankparticipants in these seminars and Bruegel colleagues for comments and criticisms.
+32 2 227 4210info@bruegel.org
1. These provisions are partof the so-called ‘six-pack’, aset of legislative acts result-ing from proposals made bythe European Commissionand from the report on eco-nomic governance in the EUprepared by Herman VanRompuy, the president of the European Council. The‘six-pack’ was adopted bythe European Parliamentand the Council on 16November 2011.2. See the ‘Euro SummitStatement’ of 26 October2011.3. Speech by Mario Draghi,1 December 2011.4. Statement by euro-areaheads of state and govern-ment, 9 December 2011.5. Interestingly, the Euro-pean Commission report onthe first ten years of EMU(European Commission,2008) emphasised theerrors resulting from theneglect of non-fiscal dimen-sions such as competitive-ness, credit booms andcurrent-account deficits. Forthis reason the six-pack leg-islation introduced a newprocedure called the
Exces-sive Imbalances Procedure
to address external imbal-ances. However subsequentpolicy discussions haverefocused on fiscal issues.
Since the euro crisis erupted in early 2010, theEuropean policy discussion has mostlyemphasised its fiscal roots. Beyond short-termassistance, reflection on reform has focused onthe need to strengthen fiscal frameworks atEuropean Union and national levels. The sequenceof decisions and proposals is telling:In 2011, the EU adopted new legislation,effective from 1 January 2012, that reinforcespreventive action against fiscal slippages, setsminimum requirements for national fiscalframeworks, toughens sanctions againstcountries in excessive deficit and tightens upenforcement through a change in the votingprocedure
.On 26 October 2011, the euro-area heads of state and government decided to go further andcommitted themselves to adopting constitu-tional or near-constitutional rules on balancedbudgets in structural terms, to basing nationalbudgets on independent forecasts and, forcountries in an excessive deficit procedure, toallowing examination of draft budgets by theEuropean Commission before they are adoptedby parliaments
. A few weeks later, in Novem-ber 2011, the European Commission put for-ward proposals for new legislation requiringeuro-area member states to give the Commis-sion the right to assess, and request revisionsto, draft national budgets before they areadopted by parliament.Speaking in the European Parliament in earlyDecember, European Central Bank PresidentMario Draghi asked for a 'new fiscal compact'which he defined as “a fundamentalrestatement of the fiscal rules together with themutual fiscal commitments that euro-areagovernments have made,” so that thesecommitments “become fully credible,individually and collectively”
.On 9 December 2011, EU heads of states andgovernment, with the significant exception of the United Kingdom, committed themselves tointroducing fiscal rules stipulating that thegeneral government deficit must not exceed0.5 percent of GDP in structural terms. Theyalso agreed on a new treaty that would allowautomatic activation of the sanction procedurefor countries in breach of the 3 percent of GDPceiling for budgetary deficits. Sanctions asrecommended by the European Commissionwill be adopted unless a qualified majority of euro-area member states is opposed
.The question is, are the Europeans right to see thestrengthening of the fiscal framework as the main,possibly the only, precondition for restoring trustin the euro? Or is this emphasis misguided?It is striking that in spite of a growing body of literature drawing attention to the non-fiscalaspects of the development of the crisis, otherproblems that emerged during the euro crisis havealmost disappeared from the policy discussion attop level
. Credit booms and the perverse effectsof negative real interest rates in countries wherecredit to the non-traded sector gave rise to asustained rise in inflation were the focus of policydiscussions in the aftermath of the global crisis,but these issues have largely disappeared fromthe policy agenda at head-of-state level. Realexchange rate misalignments within the euroarea, and current-account imbalances, are largelyconsidered to be of lesser importance, or meresymptoms of the underlying fiscal imbalances.Finally, the role of capital flows from northern tosouthern Europe and their sudden reversal, aremerely discussed by academics and centralbankers, though the sudden reversal of north-southcapital flows inside the euro area is fragmenting
Jean Pisani-Ferry
the single market and creating major imbalanceswithin the Eurosystem of central banks
.To address the issue I start in section 2 by brieflyreviewing the evidence on the link between fiscalperformance and market tensions. I then turn topresenting in section 3 why the crisis hasrevealed a more fundamental weakness in theprinciples underpinning the euro area. In section4, I discuss options for the way out. Policyconclusions are presented in section 5.
It is undoubtedly true that the euro area in its firstten years suffered from a lack of fiscal discipline,that from the standpoint of sustainability of publicfinances good times were wasted, and that thecredibility of fiscal rules was compromised(Schuknecht
et al
, 2011). Greece notoriouslymisreported budgetary data and flouted theEuropean fiscal-discipline rules. In spite of havingpromised that they would avoid ‘excessivedeficits’, and in spite of the thorough monitoringdone by the European Commission, from 1999 to2008 six countries out of twelve (excluding recentadditions to the euro area) found themselves inan 'excessive deficit' position. And the now-infamous Council decision of 25 November 2003to hold the excessive deficit procedure for Franceand Germany 'in abeyance' is rightly regarded ashaving weakened significantly the credibility of the European fiscal framework.Two observations however caution against anexclusive emphasis on strengthening fiscal disci-pline through tougher and more automatic rules.First, behaviour vis-à-vis the rules of the Europeanfiscal framework (the Stability and Growth Pact orSGP) is a very poor predictor of the difficultiesexperienced nowadays by euro-area countries.Figure 1 shows recent spreads vis-à-vis theGerman Bund against past infringements of theSGP
. It is apparent that there is no relationshipbetween the two: countries such as Ireland and
6. Recent contributions tothe literature on the non-fiscal roots of the eurocrisis include De Grauwe(2011), Gros (2011), Laneand Pels (2011), and Sinnand Wollmershaeuser(2011).7. In order to avoid theresult being biased by polit-ical weight (for example, acountry could have escapedbeing singled out as infring-ing the SGP because of political clout within theCouncil of Ministers, whichvotes on sanctions and thesteps leading to them), Itake instead the number of years between the Euro-pean Commission recom-mendation that the countrybe declared to be in exces-sive deficit, up to its recom-mendation of abrogation of the excessive deficit proce-dure. Data relating to theexcessive deficit procedureis taken from the EuropeanCommission’s website.
‘The euro area in its first ten years suffered from a lack of fiscal discipline, while from thestandpoint of sustainability of public finances good times were wasted, and the credibility of  fiscal rules was compromised.’ 
Spain that were never found to have infringed therules, suffer from large spreads, whereas Germanyand the Netherlands, which were found guilty of it,enjoy remarkably low rates. This suggests that thesimplistic view that a thorough enforcement of therules would have prevented the crisis should betreated with caution.The second piece of evidence is that several euro-area countries are experiencing elevatedgovernment-borrowing costs in spite of being inmuch sounder positions than the US, the UK orJapan. Calculations by the International MonetaryFund (2011) suggest that future adjustmentsfacing non-euro area countries are of the sameorder of magnitude as those confronting euro-areacountries in trouble. Pairwise, Japan and Irelandseem to be in similar situations, as do the US andPortugal. However, only the two euro-areacountries have experienced a rise in bond yields(Figure 2).As observed by Paul De Grauwe (2011), thecomparison between Spain and the UK isparticularly telling. Even taking into account thepotential cost of recapitalising Spanish banks, thetwo countries face broadly similar fiscalchallenges (Figure 3), yet at the end of November
Jean Pisani-Ferry
Duration of Excessive Deficit Procedure (years)
    A   v   g .    1    0   y   r   g   v    t .    b   o   n    d   y    i   e    l    d    S   e   p    t  -    N   o   v    2    0    1    1      (    %     )
Figure 1: SGP infringements (1999-2008) andcurrent bond yields (Sep-Nov 2011)
Source: Bruegel based on European Commission, Datastream.

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