Backtracking on the EU's monetary union will be politically very costly, but in the absence of a genuine economic and political union this stands out as the most likely scenario. What are the alternatives? Are there any?
The euro crisis has a systemic nature, linked to the structural weaknesses of an incomplete monetary union: the economic pillar of the Economic and Monetary Union was never built. Jacques Delors, one of the founding fathers of the EMU, has recently shed some light on this:
“I proposed a pact for the co-ordination of economic policies to run alongside the monetary Stability Pact. This was not accepted. Instead, it was deemed sufficient to merely add the word ‘Growth’ to the name of the Stability Pact. In reality, this was purely and simply a budgetary stability pact: no economic co-ordination; no instruments to stimulate, co-operate or regulate. (…) Everything continued without any serious disruption until the international financial crisis erupted. At that point, the inherent flaws of EMU were revealed, especially in the form of excessive debt – not only public debt, but private debt too”
Future historians will investigate the reasons for this incompletion, but it is important now to understand its consequences. The decision to pursue European integration starting with a currency union was a crucial one. Unifying monetary policy at a supranational level, giving the reins to a technical, independent institution - far beyond political control and democratic accountability - promoted an integration process more favourable to one factor, capital, over the other, labour. The removal of the exchange rate risk, the free circulation of capital, the impossibility for the central bank to act as a lender of last resort, the consequent higher interests on public debt, with accompanying limits, explicit and implicit, to fiscal policy, all determined a macroeconomic framework which constrained the margins of manoeuvre of national governments.
The second factor of production, labour, didn’t enjoy a comparable level of mobility, constrained within national borders by cultural, linguistic barriers, but also by political ones. A truly single common labour market has not yet been completed, social security systems remain national competences, mutual recognition of professional qualifications is still very partial and incomplete. The much higher mobility of capital compared to labour has generated increasing pressure on the latter over time, in the form of stagnant real wages, worsening working conditions and massive unemployment.
On the eve of the Euro, many economists highlighted the risks of pressures on labour and of compromising the European social model in case of a single currency, because it was well-known that the rigidity of the exchange rates would have deprived the member states of an important mechanism for the automatic absorption of economic shocks. In the absence of the monetary union, adjustment to shocks would happen via flexible exchange rates. In properly functioning monetary unions labour mobility and a relevant system of direct transfer from a central budget would act as automatic stabilisers. We have neither.
Moreover, a one-size-fits-all monetary policy for countries with different economic cycles, without common automatic stabilisers, has contributed to exacerbate rather than reduce imbalances. For instance, between 2001 and 2005 an abrupt reduction of interest rates by the ECB (4.5 percent to 2.0 percent in less than two years) helped countries with low growth, low inflation and contracting domestic demand like Germany and Italy avoid a recession, at the expense of fuelling a boom in countries with higher growth and inflation, like Spain, Ireland and Greece.
These increasing macroeconomic imbalances within the Eurozone have divided more than unified the member states, exaggerating differences and conflicts between surplus and deficit countries. All the weight of the adjustment has been put on the second group, by imposing tough austerity measures to pursue an internal devaluation that made social conditions nearly unsustainable. A recent study by Goldman Sachs has calculated, by weighting current account imbalances in tradable and non-tradable sectors, the extent of internal devaluations still needed in the Eurozone countries: 15 percent in Italy, 20 percent in France, 30 percent in Spain, 50 percent in Greece, implying the need for a decade-long era of austerity in Spain, a bit less in France and Italy, and no hope for Greece.
But the problem is that the Eurozone’s overall current account vis-à-vis the rest of the world is close to balance. This implies that deficit countries within the Eurozone are the main source of external demand for surplus countries. A recession in the former, it follows, is likely to drag the latter into a similar situation, sooner or later.
This is the framework in which we should assess the proposed alternative to austerity put forward by several governments, including France, Italy, and Spain. The anti-austerity group wants to negotiate a loosening of the stability pact, to allow a higher margin of manoeuvre for fiscal policies in order to boost investment and demand in deficit countries.
Unfortunately, more expansive fiscal policies in deficit countries will not reduce imbalances within the Eurozone as long as surplus countries stick to their restrictive deflationist policies. In other words, higher spending in France, Italy, and Spain will worsen their current account deficit, increase public debt as well as domestic demand, hence imports, and exacerbate existing imbalances. Their inflation differential compared to surplus countries will continue to increase.
These policies risk being counterproductive given the current macroeconomic framework of the Eurozone, in a similar way to how drinking alcohol to warm one's-self up accords a temporary relief, but dehydrates and worsens the longerterm situation. A boost of investments and demand in deficit countries may only benefit exports from surplus countries in the long run, and this is why this request by the anti-austerity group will probably run into the sand.
Theoretically it makes more sense to continue with austerity policies to address the macroeconomic imbalances at the origin of this systemic crisis of the Eurozone. Internal devaluations in deficit countries reduce their imports and symmetrically the exports from surplus countries. But unfortunately, this race to the bottom is recessionary and socially unsustainable.
What alternatives, then, are on the table?
The first and obvious one, in a genuine political union, would be a massive stimulus of domestic demand in surplus countries: this would increase imports in surplus countries and exports from deficit ones, rebalancing the current situation till equilibrium is reached. This would imply a big change in the economic policy model of some surplus countries, such as Germany.
The second option, in a genuine economic union, would require a sizeable common budget acting as automatic stabiliser. It has been calculated that in the US the federal budget covers between one-third and one-half of an asymmetric shock suffered by a state. This would imply transfers from surplus to deficit countries, in other words the long-feared, in Germany, 'Transferunion'.
The third option, in a genuine lack of economic and political union, would require re-establishing flexible exchange rates. This would provide a quick stabilisation mechanism, reabsorbing current imbalances.
The first and the second options depend on political will in the surplus countries, Germany in particular. France, Italy, Spain and the others can do very little to persuade Berlin to accept something it has always avoided so far.
The third option, in principle, is within each country’s reach. More or less so. In his “whatever it takes” speech, European Central Bank President Mario Draghi reminded European politicians of “the amount of political capital” invested in the euro. This is true for the main political parties in France, Germany, Italy, Spain and the other Eurozone members. As a consequence of the enduring euro crisis, they are all losing electoral support, with extremist parties on the rise in the polls. A backtrack on the monetary union will be politically very costly, but in the absence of a truly genuine economic and political union this stands out as the most likely scenario.
 Goldman Sachs, Economics Research. European Economics Analyst. 18 January 2013. Issue No: 13/03.