The EMU Problem is North vs. South. But not the Way Mrs Merkel Thinks

For observers of EMU woes, it came as no surprise that Wednesday’s summit in Brussels ended in a low-key compromise that leaves the eurozone fragility untouched.

In part this is due to the decision making process in the EU, intrinsically incapable of reaching quick and bold decisions. But there are more substantial reasons that lie in the interpretation of the crisis, the “blame game”; a blame game that has no particular interest, were it not that understanding what went wrong should constitute a guide for designing a durable and effective solution.

The narrative adopted by EU institutions and German leaders is well known: It is fiscal profligacy in Southern countries that has weakened the EMU; therefore, the medicine is fiscal consolidation and the tightening of rules to avoid future slippages. The cost to virtuous countries should be kept to a minimum. This narrative has been supported by fraudulent behaviour of previous Greek governments, and today by the weakness of the Italian Premier, that provided timely scapegoats.

But, at a closer look, the tale lacks solid foundations; it is unable to explain why, before the crisis, the countries that are today under fire had very different (and some, like Spain, healthy) fiscal positions.

All these countries shared, on the other hand, large current account deficits, hinting that the real cause of the crisis is the non-optimality of the EMU as it was designed by the Maastricht Treaty. The integration of heterogeneous capital markets in 1999 ineluctably led to flows of capital from capital-rich (core) to capital-poor (peripheral) countries, and to the corresponding current account surplus of the former. While fiscal responsibility and structural reforms could have slowed down the process, there was nothing that the Greek or Spanish government could do to avoid it.

The imbalances could have been compensated through some sort of “fiscal pooling”, ranging from a light insurance mechanism (effectively, this is what Eurobonds are), to a fully- fledged fiscal union. Unfortunately this did not happen.

These difficulties were compounded by the Treaty provisions forbidding the ECB to purchase sovereign bonds; this was justified at the time by the need to establish the reputation of a young central bank, but led to the catastrophic result that today the eurozone is the only large economy in the world lacking a lender of last resort. This is what leaves governments at the mercy of speculation.

This explanation leads to radically different solutions for a durable exit from the crisis than those currently being pursued by the EU.

First, external imbalances are symmetric, so that the burden should equally fall on deficit and surplus countries. Fiscal consolidation in the periphery should be matched by domestic demand expansion in the core, thus making the adjustment less painful, and leading to more balanced long-run growth. Second, the ECB should be allowed to purchase sovereign bonds directly, not only on secondary markets, in order to provide a guarantee for illiquid governments. This would immediately defuse speculation and increase transparency. No financial engineering, however smart, would allow the EFSF to act as a lender of last resort. Only the ECB can play that role.

Finally, a mechanism for transferring substantial fiscal power to the European level needs to be designed. This could only be done through a corresponding transfer of democratic accountability. An elected “European government” remains the most effective tool to unleash the enormous potential of the European economy. Perhaps today, on the brink of the abyss, Europe will find the resources to transform a crisis into an opportunity, and to make a substantial jump in the process of integration.

(Written with André Grjebine and submitted as an Op-Ed)