Those Eurozone politicians who ludicrously claimed that the crisis was over (see quondam President Sarkozy, as recently as March) have been routed. Once again the doom merchants are in the ascendancy. Maybe the Mayans were actually predicting the end of the euro in 2012 not the end of the world. (I imagine Mayan hieroglyphs are the devil to translate.)
For my purposes here I will take it that the euro will continue (this is also what I expect). I will not discuss directly issues around crisis management and short-term fixes — instead I want to focus upon those measures and changes that would be required for a more permanent solution.
The euro’s starting conditions were not thought through. If we consider a country with relatively flexible labour markets, then any adjustment to changes in demand can be spread across employment and real wage levels even in a low inflation environment. But if a country has rigid labour markets, then low inflation — and price stability was one of the big wins intended for the euro — is a problem: employment takes the full brunt of the adjustment necessary. A country like this needs a high level of inflation to adjust real wages. A major problem then for the Eurozone is continued heterogeneity of labour markets in terms of bargaining. This also means that adjustment within the Eurozone to differing macroeconomic conditions is far from ideal. It follows that it was extremely foolish to join inflexible economies into a currency union. Needless to add many economies within the Eurozone still need deep structural reform.
To cope better with economic shocks, greater efficiency in national labour and capital markets is needed to aid price flexibility. But even in the event of substantial and long overdue structural reforms within peripheral countries it may take a very long time to work their way towards the same competitive level as the more successful Eurozone states. So, greater cross-border factor mobility is also needed: particular of labour. This would mean substantial broadening of the recognition of professional qualifications and similar measures. Germany should show leadership here.
However, even if successful enhanced cross-border mobility could create new problems. If such labour flows were bilateral (not necessarily contemporaneously but over time) then this would not be a cause of concern, but it is more likely that there will be winners and losers. Portugal could spend its resources educating its labour force only for it to spend its working life elsewhere.
Given this perhaps a system of “transfer fees” be introduced. This would involve the recipient country sharing tax revenues with the host. This would not last for ever but could act as a mechanism for achieving small fiscal transfers: countries that are booming would attract labour and therefore be obliged to pay money to its exporters. The likely consequences of this should not be overstated — I imagine that the numbers involved would be fairly small beer for most countries but may be more politically acceptable than the alternatives.
Increasing fiscal sustainability
There is a looming fiscal challenge due to the ageing of societies — and in some cases low birth rates — that puts in potential jeopardy the current basis of healthcare and pension provision.
On pensions there are a number of possible choices beyond the brute increase in retirement age (although that is likely to be necessary too). For example Sweden reformed its pensions, retaining a pay-as-you-go system — in common with much of Europe — but with features that make it akin to a notional defined contribution plan. In particular there is an automatic stabilising mechanism, such that when liabilities exceed assets benefits are reduced. This type of adjustment happened in 2010. The discipline such an approach imposes upon politicians and voters would be a benefit in other countries too (although it may be that those countries likely to benefit most may be least likely to make the change).
More ambitious would be a switch towards own account pensions, with top-ups in contribution for the low paid and, subject to some conditions, non-earners. Again this would closely define and limit the state’s role and obligations.
Ideally this could be designed such that it would facilitate cross-border labour mobility: you, your employer and the relevant government could all contribute to your account. This type of approach is critical to the promotion of bottom-up European integration, driven by (and limited by) the individual- and family-level decisions of its citizens. The Institutions for Occupational Retirement Provision (IORP) Directive seeks to reduce limitations on such cross-border pensions. This benefit has been subsumed within the (very important) debate about how prudential rules should apply.
Macro-prudential tools are now to be part of the arsenal for every central banker. The case for them is, I believe, even more pressing in the Eurozone — this would be the case even in the case of political union: the Eurozone’s economies are simply too heterogeneous to do without. The key objective would be dealing with asset bubbles, such as those experienced in the Spanish and Irish housing markets.
None of the above means that political or full fiscal union are required: but new policy strategies are required to stabilise the euro beyond anything done or described so far. Given their track record to date the idea of Europe’s leaders having the audacity to do what is necessary may be a vain hope.