Have the post-euro-zone crisis reforms solved the crisis, and are they applicable to the GCC?
During the euro zone debt crisis, the central authorities took emergency stabilising measures and adopted a series of preventive reforms. To understand them, one has to go back to the Nobel Prize winner Robert Mundell’s theory of optimal currency areas.
As we explained two weeks ago in this series, when a country has its own currency, if it is fiscally irresponsible, then financial markets will doubt its creditworthiness and begin to sell its debt and its currency, initiating a self-correcting process.
Under a single currency, this process is significantly retarded: the currency’s value depends upon the actions of all member countries, and so the fiscal ill-discipline of one country has a proportionately smaller effect on the value of the currency. This drastically diminishes the cost borne by the perpetrator of fiscal irresponsibility, thereby increasing its likelihood.
A useful analogy is settling a restaurant bill. Separate currencies are like separate bills for each diner, whereas a single currency is like “going Dutch” (sharing the bill equally): it creates an incentive for people to order more than they would if they were paying for themselves exclusively. Economists refer to this as the “moral hazard” problem.
Anticipating this, Mr Mundell laid down “convergence criteria,” which help to prevent single currency moral hazard in debt. The two most important criteria are that total debt should not be too high (capped at 60 per cent of GDP in the case of the euro), and neither should budget deficits (capped at 3 per cent of GDP). Enforcing these rules largely eliminates the moral hazard problem.
The euro zone got off on the wrong foot by violating these rules at the euro’s launch, then continued to violate them, especially after the global financial crisis, when many countries were egregiously exceeding the budget deficit cap, including France, a supposedly anchor member. This happened for two reasons.
First, despite the public rhetoric, the euro was never really about economics; it was about political integration, and the empowerment of the European Commission. Thus, exacting criteria were an impediment to the covert mission, and were ignored.
Second, fiscal discipline is politically unpopular, especially during economic recessions of historic proportions, such as 2008. The situation quickly resembled going Dutch, with extravagant diners about to break their fast.
The euro-zone reforms were an attempt to rehabilitate these criteria, but with convoluted extra conditions and penalties that would overcome the inevitable tendency for members to cut each other slack as they grapple with their own recessions. So, have the European Stability Mechanism and the European Fiscal Compact done the trick?
In the short term they have worked, but in the long term, even the European Central Bank’s former (and first) chief economist, Otmar Issing, has described the system as a house of cards that will inevitably collapse.
The problem is that the system involves implausible commitments by member governments. When the next crisis arrives, the penalties will be politically unacceptable to the people of the violating country, as they will be perceived as external interference in critical internal affairs. As before, politics will trump economics, and the cycle will repeat itself.
That is why some claim that the only viable solution is to convince the countries to surrender their fiscal policy just as they surrendered their currencies under monetary union. We will see why that is a bad idea in next week’s article, and we will also see why fiscal union may be a good idea in the case of the GCC.
The other key lesson for the GCC is to keep governments in the driver seat, and power-hungry bureaucrats at bay. Economics must always trump politics in single currencies, a lesson that the European Commission obstinately refuses to learn.