Friday, 2 March 2012

Implications of the Eurozone Crisis for EU Growth and Institutional Dynamics

Hind sight is a luxury not available when amidst the maelstrom of fast-moving real-time events. Just look at the haggard nature of both EU politicians and Eurocrats and one wonders if they have time for enough kip let alone time for reflection on the strategic direction the EU is taking.

On the other hand “the action is on the tails” and we are amidst a protracted tail-event in the form of a prolonged EU downturn coupled with a synchronised global slowdown – notwithstanding signs of green shoots over the other side of the pond in the US.

If the Eurozone is to survive then we are likely looking a decade or more of flatlining and only modest growth as households, banks and sovereigns go through a macroeconomic "detox" to cleanse the EU economic body.

Before reviewing possible implications, its worth skating over a brief list of how we got to where we are.
The Sovereign debt-and-banking crisis that emerged in the EU was caused by the flaws in the design of the Euro Currency Union:

  •  A single currency but with no single national fiscal policy, let alone fiscal federalism
  • So a second-best co-ordination of fiscal stances through nominal criteria was set up via the Maastricht Criteria and the Stability Pact…best referred to as the Instability Pact
  • Free movement of peoples and capital in the EU led to flows of capital to the less developed south – in turn fuelling asset bubbles and related rise in private consumption through equity withdrawals.
  •  Southern Governments became “free riders” of EU growth, relying on lower financing cost rather than any intent to focus on supply side reforms, leading to rising gaps in productivity with northern EU-ers (eurogroup or not).
  •  In the meantime, the northern Eurozoners continued to innovate and move along on the productivity chain. Germany re-emerged from the German re-unification process successfully and like its near neighbours, showing a massive 25-30% rise in productivity over the last decade.
  • The financial crisis that stated with the sub-prime problems, voodoo financial engineering had a direct hit on European banks. That in turn filtered through to the sovereign debt.
  • QE by central banks (inc. the ECB) has helped to allay – but not resolve – a pending banking crisis by massive injection of liquidity that is now cycling back into sovereign debt, helping to lower yields.
  • But credit to the real sector remains  moribund across the Eurozone as banks rebuild balance sheets by borrowing at near-zero rates from the ECB and investing in high yielding (non Greek ) sovereign bonds of the rest of the southern Eurozone.
  • Distressed Southern Eurogroup members have been bailed out to varying degrees with further write-downs a near-certainty.

So Whence Next?

At least three themes are emerging.

The first is that the Fiscal Compact, signed off by 25 of the EU group of nations on March 1st  (except the Czech Republic and the UK) has the explicit aim to add bite to the previously well-intentioned but weakly enforced Stability and Growth Pact through deeper Fiscal Co-ordination.

Will it work? The Irish threw a spanner in the works last week which may presage increased democratic review which the Eurocratic elites would rather avoid although unlike previous EU Treaties it will not hold it up....although an Irish "no" would make things interesting, at least for what it means for Irish monetary policy and future assistance from the rest of the Eurogroup.

As with the Stability and Growth Pact in the past success will be determined in reality when Germany and France abide by the rules – these two countries broke the rules previously whilst smaller states like Portugal faced Detention through the Excessive Deficit Procedure. 

The second theme emerging and which is worth review is what this means for the existing transfer mechanisms that exist in the EU - relevant for both the southern periphery but also the new EU Member States in Central and Eastern Europe. Structural and Cohesion Financing aims to ameliorate economic imbalances across the EU. Too early as yet but the real impact of the Fiscal Compact will be the spillover into how Structural Aid is delivered and – more importantly for value-for-money  for the donor tax payers in the north EU –  in terms of where this funding goes precisely and the impact it has. I will write more of this separately, as it has possible ramifications for the future aid flows to emerging countries – particularly putative candidate countries for the EU. Hungary (now an EU Member State) is already facing the music through a freeze on Cohesion Fund payments of €0.5bn in 2013 or 0.5% of Hungarian GDP.

Thirdly, the Institutional dynamics of the EU may go in one of two directions: “convergence to the mean” in institutional power play as the Commission continues to become the Death Star that has the magnetic staying power to sustain and possibly raise its powers through an incremental step-by-step process over time; OR we may see the emergence of a French-revolution that leads to a genuine Inter-Governmental approach that effectively dilutes this “competence” from the Commission.

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