Como se combate o populismo? "Com eleições", responde Fukuyama

[Karamba]

Euroland: Euro at Risk

Joachim Fels (London)

Dark clouds gathering over Europe
Recent data from the euro area suggest that the rebound in production and demand around the turn of the year was short-lived and that the economy has probably fallen back into the stagnation that already prevailed in the second half of last year. The recently downwardly revised GDP projections by the ECB, the EU Commission and the IMF, now uniformly at 1.6% for 2005, thus still look overly optimistic. However, growth disappointments have become the norm in Europe by now and are therefore hardly alarming. Far more worryingly, the European Union (EU) appears to be heading for a serious political crisis, which could, eventually, even put the single currency at risk. The currency markets may have started to smell these risks: the euro failed to rally against the dollar last week despite a larger-than-expected US current account deficit and accumulating signs of a slowing US economy. Yet, bond investors have been unfazed by the brewing crisis: euro area bond yields have eased back close to their historical lows reached in February, with the 10-year Bund yield breaking below 3.50% as investors have fled riskier assets such as equities and high yield. In my view, bond markets are far too complacent about the risk of an E(M)U break-up.

Revisiting ‘euro wreckage’
I have worried about Europe’s emerging political fractures and the apparent erosion of the fiscal stability consensus for some time now. When I pointed out the potential risks to the euro’s future emanating from such currents a little more than a year ago (Euro Wreckage? 22 January 2004), the typical reaction I encountered was a polite smile but very little buy-in. Bob Mundell, a Nobel prize winner and staunch euro enthusiast, wrote a response reminding me that Rome, too, was not built in a day (reprinted in Debating “Euro Wreckage?” 9 February 2004). He was, of course, right but forgot to mention that the Roman empire eventually did fall apart! More than a year after this exchange, the cracks in Europe’s political compound have clearly widened. As I see it, there are at least three developments with potentially lethal implications for European integration: (1) the surge of protectionism, especially in Germany, against perceived ‘wage dumping’ from Eastern member states; (2) the probability of a rejection of the EU constitution in France and the Netherlands; and (3) the prospect of much larger fiscal deficits in coming years now that the Stability and Growth Pact has been watered down beyond recognition.

Protectionism on the rise
Europe’s economic successes in the past fifty years have derived from dismantling tariffs and other barriers of trade between the members states and promoting the free flow of labour and capital. While economic integration has proceeded way beyond initial expectations, two recent developments suggest a growing intra-European opposition to further integration. One is the likely failure of the EU Commission’s proposed services directive, which was aimed at opening up national (non-financial) services markets to competition from other member states. Business lobbies and trade unions in several large member states have persuaded their respective governments to block this liberalization of the service sector, which could have promoted productivity growth and raised consumers’ welfare. The other telling example for a rise in protectionist sentiment is the German government’s recent decision to impose the lowest wage levels negotiated by trade unions and employers associations in each sector as statutory minimum wages in order to stymie outsider competition from the influx of workers from the Central and Eastern European member states (see E. Bartsch, German Economics: Putting a Floor below Wages, 14 April 2005). These protectionist tendencies reflect a widespread view amongst many Europeans that European integration and globalisation have gone too far.

An early death of the EU constitution?
The second challenge to the EU is the strong possibility of a rejection of the EU constitutional treaty in the French and/or Dutch referenda, which both take place within the next two months. Non-ratification by any one of the 25 member states would mean that the draft constitution cannot take effect. If so, important changes in the voting system that were aimed at making the larger union more efficient would be blocked. The EU would then be back to square one, which is the current voting system that due to its peculiarities and the widespread application of veto rights makes it virtually impossible for the 25 member states to come to decisions in major policy areas. While a no would not be “the end of the EU”, as German foreign minister Joschka Fischer claimed this week, it would likely spell prolonged paralysis on important policy decisions and difficult negotiations on the future course of the EU.

Opening the fiscal floodgates
The most serious challenge to the future of the euro, however, emanates from the watering down of the Stability and Growth Pact last month. Given the many new escape clauses for fiscal sinners in the reformed pact, it will be virtually impossible to punish governments for their fiscal profligacy. It appears likely that at least some governments will use the new-found freedom to relax fiscal policies and run larger budget deficits over the next several years. The two most obvious candidates are the EU’s two largest growth laggards Germany and Italy, which are both scheduled to hold national elections in 2006. With the euro economy slowing and deficits already at or above 3% and flattered by several on-off measures, I can easily see deficits in these countries widening to 5% and above in 2006 if economic growth fails to pick up. Such an increase would very likely spell more conflicts between the more virtuous and the less virtuous countries, as well as between profligate governments and the ECB.

End of ‘stability culture’ could lead to secession
How could EMU break apart? As I see it, the most likely break-up scenario entails a weakening of the ‘stability consensus’ within the union, with sharply rising fiscal deficits in some countries and increasing political pressures on the ECB to create higher inflation in order to erode the real value of government debt. Naturally, the ECB would likely put up a tough fight initially, but eventually it is difficult to see how it could stem against a loss in the stability consensus that we assume in this scenario. High fiscal deficits and rising inflation could then lead to a wave of protests in countries which have historically had a high preference for price stability, such a Germany. One or several political parties could then jump on the issue, promising to lead the country out of the ‘instability union’ by introducing a New Deutschmark, which would be internally and externally more stable than the euro. Of course, a credible threat of a large country to withdraw from the euro might already bring about a change in policies in the union at large. However, depending on the political constellations elsewhere at that time, some other governments or parties could well choose to embark on a ‘national-interests-first-campaign’ as well, spelling the end for the single currency. As I spelled out in more detail in the Euro Wreckage? piece last year, the technical and legal hurdles to re-introducing national currency are fairly low, in any case.

Break-up risk underestimated
Don’t get me wrong: I’m neither advocating a break-up of EMU, nor am I saying that this is the most likely outcome. But I strongly believe that most analysts and market participants are too complacent about the risk of such an outcome. Put simply, the motives behind the introduction of the euro were first and foremost political -- the euro was seen by its founding fathers as a big step towards a political union in Europe. But today’s reality is one of a very large and diverse EU-25 where political interests are far less well aligned than in the smaller union of the old days. Political conflicts are almost inevitable in the wider union, especially now that the stability pact has been softened beyond recognition. This poses a rising risk of negative repercussions for the single currency, too. Against this backdrop, the euro’s status as a serious contender to the US dollar as a reserve currency is highly questionable, in my view. And bond investors in the long end of the yield curve are currently not being compensated for the break-up risk. As a consequence, I look for a weaker euro and higher long-term bond yields as the political and fiscal policy events unfold over the next several months.