Before the euro was born

European solidarity, credible threats, economic policy and instrumental ambiguity

When the euro was designed, the German delegation insisted on the need of a "no bail

out" clause. They will not participate in the new currency without this clause. The Germans had some other obligatory clauses and, among them, the independence of the future European Central Bank which should be a clone of the Bundesbank. Other countries participating in the discussions warned the Germans that the "no bail out" clause just wasn't credible. They doubted that the rest of the Euro Zone would just sit and watch while one fellow country disorderly defaulted without doing anything. The Germans argued that this was a highly unlikely event since the existence of such a clause would discipline all member countries and, in practice, the clause will never have to be applied. This, according to the Germans, was a much wiser approach than trying to establish a mechanism for mutual assistance that would avoid default and contagion. If you preview it, you will end up needing it, was their final conclusion. Financial solidarity was then banned from the treaty. A set of rules would guarantee the strength of the new currency and that no country in the Euro Zone would ever put itself or the new currency at risk. To make this strength eternal and solid as a rock, the Mstricht criteria were made permanent under the "Growth and Stability Pact". However, both the Mstricht criteria and the pact showed soon their weakness. Greece was invited to join the single currency without meeting the criteria and, when Germany and France needed to break the rules of the Pact, the rules were just forgotten. It was not such a big deal at the moment but pretty soon Eurostat announced that Greece, helped by Lehman brothers, had forged its accounts and it was not a big deal either. In fact, everyone involved in the affair was conveniently rewarded with the presidency of something: Barroso, Draghi, Karamanlis, Papademos, etc, etc. The Pact limited fiscal deficits to a certain percentage of GDP but that is something no country can guarantee. Forecasted public revenues that make up your budgeted deficit and what these revenues turn to be along the fiscal year are two very different things. Unexpected events and crisis may lower your tax income and you may end up with a bigger than previewed 1

deficit to report to the EU Commission. European solidarity was banned from the common currency with a non credible threat and an impossible to follow Pact. Now we have a new version of that pact called "the fiscal compact" as if we hadn't learned anything.

Solidarity flows but... from where to where?

However, there is a lot of European solidarity. When the euro was designed the Council and the Commission agreed a deep reform of the structural funds. Capital transferred from net contributors to net recipient countries amounted to 5.3% of GDP every year in the case of Lithuania; 4.0% in the case of Estonia; 1.25% in the case of Portugal; 1.3 in the case of Greece and 0.04% in the case of Spain. These are 2009 figures, when the accession of Eastern countries diverted funds from Southern Europe. In the nineties Spain was a net recipient of EU transfers that amounted to about 1% of GDP every year. These transfers were thought as compensation to Southern Europe from increased imports from their Northern partners with more developed and competitive economies. However, when Germany faced its crisis at the turn of the century, the ECB monetary policy was tailored to the needs of this country. Money supply was too expansionary for the overheated economies of Southern Europe and trade imbalances soared to five to ten times the net transfer of funds from Northern Europe. Solidarity flew from the South to the North helping Germany to sort out its crisis. In a nutshell, there has been a lot of European solidarity but all efforts were made to separate it from the financial world and from the common currency. A non credible threat was the base of this separation and its design soon proved technically faulty. This solidarity was soon overcompensated by trade imbalances resulting from a monetary policy that suited the Euro Zone biggest country but not the Euro Zone as a whole. As a result, every country in the Euro Zone thinks now he has been a loser in the euro game. Northern Europe is more and more tired of subsidizing its lazy Southern neighbors and Southern Europe thinks that the euro is bringing them unbearable doses of misery under the financial tyranny of their Northern neighbors whose rescue plans do not save anyone but the creditor banks. If this is the state of affairs, what can we do now?

A bad institutional architecture delivers bad economic policies

First of all we should correct our economic policy since without the right policy mix any solidarity scheme we may depict would be useless. When our elders at Bretton Woods drew 2

the world's monetary system they set up two institutions, the World Bank and the International Monetary Fund. The EU structural funds have played the role of the World Bank and we are tempted to conclude that Europe would not need an IMF like institution because we already have the ECB, a more powerful one. However, the ECB has not ensured financial stability in the Euro Zone. On the contrary, its obsession for price stability has destabilized our finances and created a big, big financial mess. One important issue here is the independence of the Central Bank. In the eighties, this was kind of fancy among the economists. New Zealand started a trend granting independence to its Central Bank and was quickly followed by other countries like Spain, Canada and many more. Some academic papers showed that independent central banks would reduce inflation. Freeing monetary policy from the political cycle would curb inflation. Europe banned not only dependence but also central bank's accountability from the treaty. Prime ministers happily renounced to monetary policy as long as they were permitted to play their game when it came to electing the governor of the Central Bank. Here they kept their hands free of any obligation, they could elect whoever they wanted to, he didn't have to be approved by the European Parliament and he didn't even have to be an economist. Once elected, the governor was a kind of totalitarian dictator in the field of monetary policy. Many authors, i.e. Jos Manuel Blanco, an economist, lawyer and political scientist, warned not only about the democratic quality of such an institution but also about the future dangers the lack of legitimacy of the Central Bank may bring about. These dangers finally came about. When the ECB embraced a crusade against the evils of an inflation menace that only the ECB itself and Germany's chancellor saw, there was no way nor institution capable of making them change their minds. A restrictive monetary policy, again suited more to Germany's wishes than to the needs of the Euro Zone as a whole, tensioned financial markets so much that hysteria episodes around public debt brought the euro to the verge of collapse. Even though most of the harm is already done, the ECB has changed for good its monetary policy after Mario Draghi was elected governor. At last, once again, an economist running an economic institution, ain't that nice for a change? Once our monetary house in order we need to be more realistic about the pace of fiscal retrenchment. This austerity mania Europe has suffered has created another recession that started in the end of 2011. It looks that the perspective of a Germany having nowhere to export to is going to bring more realism to fiscal policy. We have mismanaged this crisis so badly that this generation of European leaders will be remembered, and not benevolently, in the Economic History books for decades. It may sound crazy but we have applied a restrictive monetary policy and a restrictive fiscal policy during a severe crisis. We have succeeded at 3

cooling down an economy already frozen. Even though the first voices are starting to cry that we should put more emphasis on growth and that current unemployment levels are not an option for any society that values stability and social cohesion, our leaders keep thinking that labor market flexibility is all that is needed. According to their view, labor market flexibility will bring confidence and companies will increase investments and labor hiring. But, will labor market flexibility bring confidence when sales are falling because of demand shortages? Will companies increase their productive capacity when they have a lot of it idle? Would you hire another worker no matter how cheap when you have not enough workload for your current employees? An honest answer to these questions will show you that, concerning fiscal policy, we're even further to the right track than in monetary policy. The key is demand. European policy makers keep thinking that workers are just producers and not consumers. If we produce cheaper the rest of the Euro Zone will buy our products. This is an old fashioned economic school dating back to the XVII century called Mercantilism. The problem with this policy is that it cannot work for everybody at the same time. Not all countries can be net exporters to the others. It is crazy. The logic is something like this. If you depress your economy, unemployment will press wages downwards. You become cheaper than your neighbors, exports will increase and the economy will grow. The problem is that all cannot be cheaper, cheaper than who? This is also like cheating your trade partners, not a very loyal economic policy. Countries running trade surpluses and with sound economic accounts and little debt should increase their spending to correct imbalances and kick start the European economy. Germany should increase its middle class wages to balance its trade with its neighbors. Otherwise, it would always be in the permanent need to finance their partners' deficits.

A new design
Now that we have fixed our policy mix and got rid of the counterproductive fiscal compact, how should we setup an efficient solidarity mechanism? First of all, should all the details be elicited? If we do that we risk a moral hazard problem, that is, some countries, knowing how this solidarity works, will just rely on it when it comes to pay back. Before continuing we have to remark that solidarity among countries should not be envisaged to avoid crisis. A central fiscal authority should be in charge of that. Solidarity among countries would then be, if at all, a mutual help and assistance among countries sharing the euro as their currency. Since there would be an authority in charge of avoiding crisis, most countries will not 4

be compelled to rescue or bail out a partner country nor will they have an interest on it; it will be just a solidarity mechanism among governments, not among peoples. It would be completely unnecessary as a mean to support the common currency in the same way that the American Stated on the verge of bankruptcy do not compromise the US dollar. Solidarity can be then what it has always been, a capital transfer from rich to poor countries as the structural funds or any other mechanism we may think of. We should correct, however, the malfunctioning we have experienced in the European regional policy: avoiding mercantilist policies that offset solidarity mechanisms, simplify procedures, give more power to the Parliament to control how funds are spent and so on. It is a central issue of the theory of monetary integration that optimal currency areas need a central fiscal authority. A central fiscal authority will act as an automatic stabilizer. Getting more money in those countries whose economy is doing better and spending it in those ones whose economy is performing worse, this authority will redistribute demand across countries in such a way that it will soften crisis wherever there is one and it will also cool down the economy wherever do help they are not enough as we have just seen during this last crisis. When crisis comes, discretionary spending increases and expansionary monetary policy are needed to put the economy back on its track. Even though a set of rules can be envisaged, it is usually much better that it would be the Council or, even better, the European Parliament who decide when to start discretionary policies. First of all, it would be kind of arrogant and presumptuous for this generation of leaders to think that they know better than future leaders about what would be better for them and their people when time comes. There are also solid reasons to think that it would be not very democratic if one generation decides what the next one should do whether it would be in crisis time or during expansions. Also, an important issue in the coordination of economic policy is that of instrumental ambiguity. If coordination of economic policy is always necessary because of economic policy spill overs between countries, growing importance of international trade and capital flows, multinational companies and, in brief, globalization, this is even more so in Europe. From a theoretical point of view, Mundell and Fleming, Theil and Hamada have proved how welfare increases in all countries that coordinate their economic policy. However, they also point out some problems that may arise when countries engage in a coordination game. These problems arise because some countries will try to free ride the efforts by others. There is also a moral hazard problem and some countries will just try to impose on the other participants in the

coordination game the cost of providing financial stability to the area and even in their own country. Examples of both cases abound and are very close in time here in Europe. Kindleberg and Gilpin analyzed how the optimal solution would be that one country called hegemon provides financial stability but for this solution to work that country should be big enough so that his own benefit is greater than the cost of bearing himself alone the cost of an economic policy fit for the whole area. Since this is not the case in Europe we need an international institution that monitors the efforts of participating countries. In our case it is clear that it should be the EU Commission the institution that should play that role. According to Haas, Koehane and Martin, and, Frankel and Rockett, this institution will face some difficulties due to asymmetric information. Participating countries are the owners of the information about the economy of their country, so they have strong incentives to lie and avoid sanctions or to get an undeserved reward when it is the case. Since knowledge is not commonly shared we need some "instrumental ambiguity", that is, some margin when it comes to interpret an agreement in some specific situations. This is a kind of safeguard clause that will partially avoid the free riding problem since participating countries will not know for sure if their partners will come to the rescue or not.

Is Europe democratic enough?

While it is clear for me that the institution who should be call to play the role of Central Fiscal Authority is the EU Commission, it is also clear for me that it should undergo some reforms to be able to do it. The EU Commission should become (more) democratic and accountable. An appointed body is by no means a legitimate institution to hold that much power and to draw that much resources from the tax payers' pockets. Sadly there have been many unheard calls for transformation in that direction. Since this is an obvious point for any democratic citizen of the world, it's been the shortest point even though most Europeans will agree with me that it is the most important one.

One concluding comment

Our main conclusion to this short paper would be that most problems we now face in Europe could have been avoided if our current leaders and those who designed the institutional architecture of the common currency had known a little bit of international economics. It is never too late to correct an error, but this one has already caused a lot of 6

misery and unemployment all over Europe. Even more, the European project has suffered both inside and outside Europe because of it. Most Europeans think now that the Europe they used to believe in is unfeasible from an economic point of view. Outside Europe there is even a worse feeling about the goodness of the European model. Finally, and even worse, European Northerners and Southerners will need much time to forgive their neighbors and to heal their wounds. Jos A Poncela