It's abundantly unclear how the EU summit on Friday actually solved the foundational problems behind the financial crisis in Europe - if anything the implications for the future might be worse. Here are a few posts that get to the gist of the problem with the touted "fiscal union".
Let's start with this NPR piece by Chana Joffe-Walt which helpfully summarizes the recent historical data on Eurozone deficits and debt as a percentage of GDP. First, EU countries' deficits as a percentage of GDP compared to the threshold limit set by the pact on Friday, December 9.
Second, EU countries' debt as a percentage of GDP compared to the threshold limit set by the same pact.
You'll notice that Spain and Ireland were running fiscal surpluses with acceptable debt/GDP in the years immediately preceding the financial crisis - yet these countries are amongst the worst affected by the meltdown and and in the crosshairs of the ECB and austerity hawks. Slovenia had run modest deficits ahead of the financial crisis and its debt to GDP ratio was low and declining ahead of the crisis - yet, Slovenia's bond yields have been in crisis territory recently and its debt situation is worsening as the economy teeters into recession. Undoubtedly, countries like Greece made their problems much worse with very high levels of deficits and debt prior to the crisis. That said, even Germany ran significant deficits and had high debt levels prior to the crisis - yet, Germany remains relatively unscathed because it has run massive current account surpluses thanks in part to the Eurozone periphery that ran massive trade deficits that benefited countries like Germany.
This is a point that has been made by many people before: rather than fiscal profligacy, the main root cause of the current European financial crisis can be traced back to large current account deficits run by many EU members following the establishment of the Euro as a common currency, culminating in a sudden stop (in the vicinity of the Great Recession) that pummeled the economic and fiscal health of those countries. A useful chart is available from Kash Mansori at The Street Light - along with his follow-up observations:
Let's put aside the above concerns for a minute. When all is said and done, I am still amazed that the outcome of this summit is being described as a move toward fiscal union. It is not that - it is commitment to unified fiscal austerity, nothing more. Consider just a strict enforcement of the 3% deficit ceiling in light of actual deficits in the EU. Via NPR:
[See NPR deficit chart shown above]
Just on the surface, it is tough to see any commitment to fiscal austerity as credible. Germany itself exceeded the targets in 7 out of the past 11 years. Talk about the pot calling the kettle black. France missed 6 in the past 11 years. And Italy 8 times. Thus, in addition to the periphery nations, the biggest economies in the Eurozone will all need to increase government saving to meet these targets.
Such saving will be attempted in the context of a recession in which the private sector also will be increasing savings as well. In other words, the public sector will be engaging in massive pro-cyclical fiscal policy as the recession intensifies. You have to imagine the end result is a substantial deflationary environment.
In short, I think Europe is rushing full speed to a Japanese outcome, with slow growth coupled with an appreciating currency. And it is that promise of slow growth and a strong currency will be what eventually tears the Eurozone apart. And this is truly sad given that deficits are not really the problem to begin with. [more on the root causes here and here]
Why will the Eurozone fail? Because we still see nothing that addresses the internal imbalances between the core (largely Germany), and the periphery. That is the result of failing to commit to a real fiscal union. Such a union would include automatic internal fiscal transfers that are essential to maintaining regional economic stability. For example, economic distress in a US state results in an automatic relative transfer of resources via decreased tax revenue from and increased transfer payments to that state. Lacking such a mechanism, a slow growth, hard money regime will increasingly ratchet up the levels of economic distress in the periphery. And eventually the costs of staying in the Euro will exceed the costs of exit.
With this in mind, the most obvious point about the recent summit is that the “fiscal stability union” that it proposed is nothing of the sort. Rather than creating an inter-regional insurance mechanism involving counter-cyclical transfers, the version on offer would constitutionalize pro-cyclical adjustment in recession-hit countries, with no countervailing measures to boost demand elsewhere in the eurozone. Describing this as a “fiscal union,” as some have done, constitutes a near-Orwellian abuse of language.
Many will argue that such arrangements are needed to save the eurozone, but what is needed to save the eurozone in the immediate future is a European Central Bank that acts like a proper monetary authority. True, Germany is insisting on a “fiscal stability union” as a condition of allowing the ECB to do even the minimum needed to keep the euro afloat; but this is a political argument, not an economic one. Economically, the proposal would make an already terrible institutional design worse.
What is needed to save the eurozone in the medium term is a central bank mandated to target more than just inflation – for example, unemployment, financial stability, and the survival of the single currency. A common framework for regulating the financial system is also required, as is a common banking-resolution framework that serves the interests of taxpayers and government bondholders, rather than those of banks and their creditors. This will require a minimal fiscal union; a full-scale fiscal union would be better still. Yet none of this was on the summit’s agenda.
Like I said, I have no idea why the "fiscal union" announced on Friday is perceived as anything but bad news in the absence of evidence that additional, needed strong counter-cyclical fiscal and monetary policy provisions are part of any such union. Time will tell how this is going to play out.