The European crisis and the challenge of efficient economic governance by Juergen B. Donges

The European crisis and the challengeof efficient economic governance

* Professor emeritus of economics at the Faculty of Economic and Social Sciences of the

University of Cologne (Germany). From 1969 to 1989 he managed several economic

analysis departments at the Kiel Institute for the World Economy, in which he was the

Vice-chairman for the previous six years until he took the chair in 1989 in Cologne. He

is currently a Senior Fellow of the Cologne Institute for Economic Policy. He was the

Chairman of the German Council of Economic Experts (the so-called “Five Wise Men”)

and the German Commission on Economic Deregulation. He is an economic advisor in

several academic institutions and foundations in Germany, Spain and in other coun-

tries. He is also a member of the Supervisory Board of several multinational companies.

He is the author of several books and articles published in academic journals on inter-

national economy and public policies in the field of macro and micro economy.

/JUERGEN B. DONGES*/

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1. Introduction; 2. The root cause of the problem: too much economic diver-gence; 2.1. A suboptimal monetary area; 3. Attempted governance in anindirect manner; 3.1. Breach of the fiscal rules; 4. Governance as activismagainst the crisis; 4.1. Constituent principles, violated; 4.2. Financial assis-tance, a never-ending story?; 4.3. Political pressure to impose discipline,insufficient so far; 4.4. Financial markets, with capacity to persuade; 5. Newgovernance design: own responsibility as the key; 5.1. The euro Plus Pact, itis not binding on anyone; 5.2. The Fiscal Stability Pact, a test of nine; 5.3.The Macro-economic Governance Pact, with vague parameters; Conclusion

The European Crisis and the challenge of efficient economic governance

1. Introduction

The purpose of this article is to focus the current discussion on the

need for economic governance in the European Union (EU) and, in

particular, in the euro area, in the context of the political reality.

This is not such an easy task, as it may seem; in practice the rela-

tions between national governments, on the one hand, and these

and the European Commission and the European Parliament, on

the other, end up being profoundly redefined, with more European

powers and less national sovereignty.

This topic is not new; it has been on the table at the mee-

tings of the European Council of the Heads of State and

Government since the formation of the European Single Market 25

years ago (1986 Single European Act). We can interpret agreements

leading to a coordination of economic policies, as the initial step

towards “smooth” European economic governance, specifically to

(i) promote employment (1997 European Summit of Luxembourg),

(ii) apply structural reforms conducive to flexibility in the product

and factor markets (1998 Cardiff Summit), and (iii) institutionalise

macro-economic dialogue among the governments, the European

Central Bank (ECB) and social partners (1999 Cologne Summit).

Apart from the above steps we should add (iv) the agreement of the

European Council in 2010 to launch a strategy of structural reforms

that would make the EU at the end of that decade the most dyna-

mic economic area in the world.

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The Future of the Euro

These agreements which were then celebrated as a landmark in

the European integration process have not given the desired results.

The reason is very simple: over and above the rhetoric, the govern-

ments were not willing to co-operate if the alleged or true national

interests indicated otherwise. Such governance installed in the

European Council, the Ecofin and in other councils of ministers

involved, lacked any kind of power of management and supervi-

sion of the economic and fiscal policies of the member states.

At the current debate the great hope is that in the future

national interests will come second, giving way to the “More

Europe”, as the new political logo reads. The aim is to reach gre-

ater and efficient intra-European co-ordination of the economic

policy of the member countries. This aim was raised in 2011-

2012 in three basic agreements: (i) the Euro Plus Pact (to strengt-

hen the competitiveness and growth capacity of the economies),

(ii) The Fiscal Stability Pact (Fiscal Compact to guarantee in all

the countries the sustainability of public finances in the medium

and long term) and (iii) the Macro-economic Governance Pact

(Economic Governance Six Pack, to ensure economic and fiscal

policies compatible with the internal and external balance in the

economies). Now, the declarations of intent are one thing, put-

ting them into practice and applying the appropriate economic

policies, is quite another. Why should what politicians promise

today be believable, if in the past (and today, as many of them

are still around) did not fulfil their commitments?

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I will now analyse governance in its past and present dimen-

sions. The following section emphasises the significant fact that

the euro area is not an optimal monetary area. In the third and

fourth sections the forms of governance relied on until now are

analysed. The fifth section deals with the new approach for

European governance. The last section concludes the analysis in a

tone of moderate hope.

2. The root cause of the problem: too much economicdivergence

The crisis of the sovereign debt in Europe has shown a serious

fault in the formation of the single currency: trusting that the

governments of the member countries would apply quality econo-

mic policies in accordance with the common interest of all the

partners, as set forth in the EU Treaty (articles 2 and 121), was

naive. In Germany, I together with many other economists noticed

this fault then, but political leaders took no notice or it was labe-

lled as “academic” and, therefore, irrelevant to take great historical

decisions. The leaders simply invoked the criterion of the so-called

supremacy of politics over economics, as they do today when they

run from one summit to the next to rescue certain countries from

bankruptcy and try to stabilise the euro area.

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2.1. A suboptimal monetary area

The architects of the euro area, from the 1989 Delors Report,

knew that a monetary union would not be feasible in the long run

without a fiscal union, not to mention political union. The history

of the different monetary unions in Europe in the 19th Century

had left an unequivocal message: all of them failed because of

incompatibilities among the budgetary policies of the member

countries. However, during the negotiations of what would become

the Maastricht Treaty (of 1992) the prerogative of national budge-

tary policy was sealed. The then two main characters of the

European project, the German Chancellor Helmut Kohl and the

French President François Mitterrand, fascinated their counterparts

with their vision of the euro as a pacemaker to accelerate and to go

into greater integration. More than one will remember the famous

statement of the French Finance Minister, Jacques Rueff, ‘Europe

shall be made through the currency, or it shall not be made’ (1950),

and they took it literally. The French statesman could never have

imagined such a deteriorated environment of public finances as we

have today in many European countries.

It was also clear that the five convergence criteria set forth in the

Maastricht Treaty, even if they could be fulfilled (something that

not all countries have done), did not guarantee an optimal mone-

tary area (in terms of the theory of Robert Mundell and others). In

Europe, it would have been essential for the countries to be quite

homogeneous in terms of economic development and functioning

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of the institutions or the prices and salaries in the various countries

should have been flexible enough (especially downwards in coun-

tries with weak growth and great structural unemployment), or for

European mobility of labour to be high (from backward regions

with high unemployment rates to dynamic regions with shortage

of workers). These conditions for an optimal monetary area did not

happen twenty years ago and do not happen today. The difference

between Europe and the United States in this is significant.

Only a group of countries in the euro area (in central and nort-

hern Europe) at least met then and meets now the condition of

homogeneity. The countries in the southern periphery were not,

strictu sensu, ready for their accession in 1999 to the monetary

union and, therefore, to waive a monetary and exchange rate

policy as adjustment facilities of internal imbalances (inflation)

and external imbalances (current account deficit) and to under-

take tax regulations that would restrict government deficit and

the level of government debt. It is not a coincidence that these

countries have had for the past two years a risk of insolvency (not

to have the capacity to re-finance the debt in the capital market

under affordable conditions), as only sovereign countries have, if

the State may not resort to the Central Bank to secure financing

and must get it by issuing bonds in a foreign currency. Greece

may be the most illustrative example of having done what the

German Council of Economic Experts has classified as an “origi-

nal sin”, in other words, having rushed into accessing the mone-

tary union in 2001, forced even through deceit (hiding the truth


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of their fiscal statistics): the country is now at the mercy of the

international financial markets (rating agencies), after having

revealed the serious structural deficiencies in the economy and

the public institutions, which has led to a low growth potential

and low levels of productivity and competitiveness clearly insuf-

ficient at this time (globalisation of competition).

3. Attempted governance in an indirect manner

It was conceptually logical that with the creation of the single

currency the powers on monetary policy would be transferred

from the National Central Banks to the new ECB. However, as the

budgetary policy would carry on being a national responsibility,

two principles constituting the euro area were established in

order to guarantee the sustainability of the public finances in the

member countries and to ensure that the monetary union would

work as a price stability union.

• The two principles proclaimed in the Maastrich Treaty are the

prohibition to bail out insolvent partners, on the one hand,

and the prohibition imposed on the ECB to finance govern-

ment deficits (no monetisation), on the other hand. These

clauses are contained in the most recent version of the Treaty

on the European Union (the Treaty of Lisbon of 2007) in arti-

cles 125 and 123, respectively.


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• The two provisions were supplemented with the Stability and

Growth Pact (SGP) approved in 1997 at the European Summit

in Amsterdam; in it a ceiling for national budget deficits (3%

of GDP) and government debt (60% of GDP) were established

under the assumption that the growth rate of the nominal

GDP in the euro area would be 5% in the medium term.1

With all this, indirect governance elements were created, in

other words, formally maintaining national powers in budgetary

policy, but controlling the use of the powers that could destroy

the feasibility of the euro area.

The monetary union was not designed to pay debts jointly and

generate financial transfers from certain States to others, as many

today think that that is the case, appealing to solidarity among

peoples. There was already solidarity, and there still is, in the

good sense of the concept: the more developed countries of the

EU must help the least developed for these to advance in real

convergence; the various European Structural Funds are for this.

But it is not compatible with the concept of solidarity; it rather

constitutes a “perversion” (Issing) of it, having to rescue a society

that underestimates saving, tends to consume ostentatiously,

tolerates waste by the public authorities, does not fulfil tax obli-


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1 For a profound analysis see A. Brunila, M. Buti and D. Franco (ed.), The Stability and

Growth Pact: The architecture of fiscal policy in EMU. Houndsmills/Basingstoke (United

Kingdom): Palgrave, 2001 – Círculo de Empresarios (ed.), Pacto de Estabilidad y

Crecimiento: alternativas e implicaciones. Libro Marrón 2002. Madrid (December).

gations and claims social benefits beyond the means of the

country, given its own resources.

3.1. Breach of the fiscal rules

The architecture of indirect governance crumbled when it had to

pass the first real test, in 2002/03. In those days, Germany

(Schröder) and France (Chirac) violated the the fiscal rules of the

game. In Germany, government deficit had reached 3.7% of GDP

in 2002 and 3.8% in 2003; in France, it was 3.2% and 4.1% respec-

tively. In both cases, most part of the deficit was structural. The

European Commission had activated, according to the SGP, the

supervisory mechanism for ‘excessive government deficit’ against

these two countries. The German Chancellor explicitly rejected the

intervention from Brussels, the same as the French President. They

both imposed their criterion at the European Council in November

2003, which suspended the process (against the votes of Austria,

Spain, Finland and Holland). The then President of the European

Commission, Romano Prodi, had described the SGP in an inter-

view (on 18/10/02) as “stupido”, which is highly surprising coming

from the custodian of the European Treaties.

At the European Summit held in March 2005, the SGP was

amended, watering it down a great deal: with new exceptions for

breaking the rules, an assessment of the budgetary situation on a

case-by-case basis, considering the special circumstances of each

country, relaxing the periods to take the necessary adjustment


105

measures, the differentiation among countries as regards the goal

of budgetary consolidation in the medium-term and some com-

plex and non-transparent supervisory mechanisms.2 We must

remember this in order to understand the reason for the current

proposals to depoliticise (“automate”) the decisions on sanctions

in case of an infringement of the fiscal regulations.

With the erosion of the SGP, the factors that determined the cri-

sis of the current sovereign debt, put down roots, a crisis which

would have happened anyway, if the 2007-09 global financial and

economic crisis had not have appeared. If the governments of the

two main countries of the euro area are skipping the Treaty of

Europe and the SGP, why wouldn’t the rest do the same if this is

what is best for them and open the tap of non-productive public

expenditure? Structural government deficits increased conside-

rably and with this the volume of the government debt. With this

precedent, the supervision of national budgetary policies by the

European Commission was reduced to merely a rhetorical exercise

that did not scare the rulers much. Economic governance in an

indirect manner had failed. The ECB, however, fulfilled its role and

its first president, Wim Duisenberg, did not allow political leaders

to tie his hands, despite their attempts.


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2 For this purpose, the European Commission adapted the original regulations No

1466/97 and 1467/97 of 7/7/1997; see COM (2005) 154 and COM (2005) 155 of

20/4/2005.

4. Governance as activism against the crisis

The threat of Greece’s suspension of payments two years ago

showed lack of efficient European economic governance. Instead,

a rare and disconcerting political activism appeared. The nume-

rous measures taken since May 2010 in Europe seem more like an

exercise of muddling through than implementation of a consis-

tent and long-term strategy.

4.1. Constituent principles, violated

It all started in the worst possible manner: the Governments eli-

minated in one fell swoop the two principles establishing the euro

area mentioned above.

The lifting of the non-rescue clause created the problem of

moral hazard for Governments with a tendency to excessive public

expenditure and for reckless banks when it comes to buying

government bonds. The Governments could pass the cost of exces-

sive indebtedness to taxpayers from other countries (who had no

right to speak or vote when the budgets of the State in question

were drafted). The banks started a tremendous communication

campaign to warn of the danger of the euro area (systemic risks) if

indebted countries were not rescued, efficiently concealing to the

public opinion that their true intention was to protect their share-

holders.


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Under the presidency of Trichet, the ECB was under pressure to

undertake a new role: the role of being a “repair shop” for the

faults in the fiscal and growth policies. It acquired in the Securities

Markets Programme, big sums of Treasury bonds from countries in

trouble which nobody wants. Here lies the difference with other

relevant central banks (the Federal Reserve, the Bank of England,

the Bank of Japan), they also buy government securities in the con-

text of their non-conventional monetary policies, but these are

assets with considerable profitability. Furthermore, the ECB

currently grants unlimited liquidity to banks for three years, at a

symbolic interest rate (1%) and it accepts low quality securities as

guarantee. But it is not in its hand to lead banks to proper granting

of credit to companies or households in the country under affor-

dable conditions; the ECB must resign itself to banks choosing

more profitable business in the short-term, as purchasing the debt

of the State; therefore, there is not much change in the scenario of

credit restriction in the private sector in several countries, like in

Spain. The European monetary entity is not only “a last resort len-

der” anymore, which in situations of financial emergency is justi-

fiable, but it has also become “a public debt buyer of last resort”,

which is more questionable, because it delays the fiscal adjust-

ments of the Governments (and it caused in 2011 the resignation

of two German senior members of the monetary authority bodies,

first the resignation of Axel Weber, President of the Bundesbank

and ex officio member of the ECB Governing Council and, subse-

quently, the resignation of Jürgen Stark, member of the Board of

the ECB and its chief economist). The role that the ECB is playing,


108

for the moment also under its new president (Draghi), may dama-

ge its reputation as an institution independent of political powers

and commited to price stability, which is what it has been entrus-

ted with in the European Treaty.

An additional problem is that the same standards of asset qua-

lity, which are used as collateral in the re-financing of commercial

banks by the National Central Bank itself (and, as such, part of the

Eurosystem), do not govern in the whole of the euro area anymo-

re. In several countries in trouble, especially with persistent current

account deficits which (already) do not finance in a conventional

manner import of capital or through financial assistance from

abroad, the respective National Central Banks, with permission

from the ECB, accept low quality securities as guarantee of loans,

more than what is allowed for emergency liquidity assistance. It is

as if they were using the money printing press. This somewhat

undermines the monopoly of the ECB to create money. What is

questionable from an economic perspective is hidden behind the

enormous increase in the amount of these operations in the

Eurosystem Target 2 in the past years, which has been vehemently

warned by the Ifo Institute of Munich for the last year.3 The

Bundesbank has become a gigantic creditor of hundreds of millions

of euros for the National Central Banks of the other countries, wit-


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3 See H.-W. Sinn and T. Wollmershäuser, “Target Loans, Current Account Balances and

Capital Flows: The ECB’s Rescue Facility”, NBER Working Paper, No 17626 (November).

CESifo, “The European Balance of Payments Crisis”, CESifo Forum, Special Issue, January

2012.

hout protection and right to any kind of compensation if there is

any significant bankruptcy of banks and savings banks or if the

euro area collapses. The Governments of debtor countries have in

reserve a powerful argument to manage to get from others, espe-

cially from Germany, concessions in the negotiations over finan-

cial assistance.

4.2. Financial assistance, a never-ending story?

Political leaders believed, and some of them still do, that the

creation of a common rescue fund is the solution to the problems

of countries in trouble and it eliminates possible spillover effects.

The first rescue mechanism was created with the European

Financial Stability Facility (EFSF).4 This fund is provisional (three

years, until 2013) and at the beginning had a provision of 440,000

million euros in loans guaranteed by the euro countries; as the

Fund wanted to place their issues with the highest ranking ‘AAA’

to get attractive profitability, the real lending capacity would be

lower than the allocation, about 250,000 million euros. Ireland

(87,500 million euros) and Portugal (78,000 million euros) had to

resort to this Fund. Subsequently, in July 2011, the European

Council decided to increase the real lending capacity of this rescue

fund to 440,000 million euros and, in addition, increase their


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4 EU Council of Ministers (Ecofin), EFSF Framework Agreement, 9/5/10 and 7/6/10.

Web page: http://www.efsf.europa.eu (Legal documents).

powers and relax the conditions for granting the loans to countries

in trouble. It even received leverage instruments (with a 4 factor)

and the so-called ‘special purpose vehicles’ (off-balance); such ins-

truments, applied by private banks, were exactly the ones that trig-

gered very harmful effects for the global financial crisis to break in

2008.

In mid-2012, six months in advance to the original schedule, a

new permanent rescue fund will come into force, the ‘European

Stabilisation Mechanism’ (ESM).5 This fund will have a provision

in nominal terms of 700,000 million euros (with capital contribu-

tions from the member countries amounting to 80,000 million

euros); the real lending capacity of this new Fund is 500,000

million euros. Provisionally, the amount of available resources may

amount to about 800,000 million euros, by transferring the unused

EFSF resources. The IMF, the OECD, the United States and China,

among others, recommend a higher firewall (up to 1.5 billion

euros).

In parallel with these events, a special treatment has been given

to Greece. After the initial financial assistance plan approved in

May 2010 (110,000 million euros, of which 30,000 million euros

came from the IMF), of which politicians said that it would enable


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5 European Council, Treaty Establishing the European Stability Mechanism (ESM), 25/3/11.

Internet: http://www.efsf.europa.eu (Legal documents). – European Council, Treaty sig-

ned by the 17 euro area Member States, 2/2/12. Internet:

http://www.european.council.europa.eu.

the country to return to the capital market in 2013, in February

this year a second package was agreed (130,000 million euros,

including a contribution from the IMF, to which a further amount

of 24,400 million euros of the first package pending payment will

be added). The latest thing is that private creditors will undertake

(about 85.8% voluntarily and the rest will be obliged by law) a

deduction of 53.5% and will agree for the rest of their securities an

exchange for new Greek long-term treasury bonds and of the EFSF

Fund at a moderate interest rate (which will reduce the Greek

public debt in about 107,000 million euros of a total of 350,000

million euros). Greece’s main public creditor, the ECB, has escaped

this operation and the asset losses derived from it, by means of a

trick, quickly exchanging their former Hellenic bonds, which

would have undergone a reduction, for new exempt bonds under

the same condition.

The official aim is to get the public debt to be reduced from the

current 160% of GDP to about 120% of GDP in 2020. The Ecofin

believes that this level is sustainable, which is quite surprising for

three reasons: firstly, this level was what Greece had in 2008/09,

already in the increase and considered unsustainable then;

secondly, the tax authorities must improve a great deal in order to

promote the capacity to collect taxes and stop tax fraud and capi-

tal flight; and thirdly the IMF’s estimates of 2-3% economic growth

per year from 2014 must be fulfilled, which implies that the neces-

sary structural reforms must be quickly implemented and the eco-

nomy must reach considerable gains in international competitive-


112

ness by substantial salary and price reductions (according to the

estimates, about 50%). All of these points are question marks. The

most probable thing is that the announced aim of debt reduction

will not be attained and that the European governments sooner or

later will again have on the negotiating table Greece’s request for

further financial assistance.

4.3. Political pressure to impose discipline, insufficient so far

The European form of governance since the sovereign crisis star-

ted in Greece has always been “more of the same”: to want to solve

a problem of excessive indebtedness with more debt. The critical

public opinion, as in Germany, was calmed down by saying that no

cash was going to be paid from national budgets and, therefore,

from taxpayers (although there will be in the ESM), but that each

government “only” had to provide guarantees (distributed among

the countries according to the holdings of the national central

banks in the share capital of the ECB). As if guarantees could not be

enforced at the demand of the creditors, in other words, buyers of

the securities issued by the EFSF/ESM! The expectations to calm

down the markets, restore confidence and stabilise the euro area

were not met. The markets had noticed that, in the countries badly

affected by the sovereign debt crisis, progress in fiscal consolidation

and structural reforms that raise the potential of growth and com-

petitiveness, which there are, were too slow and incomplete.


113

This was caused from outside. The aided governments have not

forgotten the political messages launched from the beginning of

the crisis from Brussels/Paris/Berlin. The messages that are least for-

gotten and carry on being repeated with slight variations, are the

following: (i) “We will rescue the euro, no matter what it costs”

(Barroso); (ii) “We will not allow anyone to fall into insolvency”

(Sarkozy); (iii) “If the euro fails, Europe fails” (Merkel). There could

be no better invitation for irresponsible governments to blackmail.

That is how a government in trouble is tempted not to consistently

take pure and hard measures, therefore reducing the cost of loss of

political support, which any severe fiscal adjustment plan (with

unnavoidable cuts in salaries and social benefits and necessary rise

of taxes) would imply. In Greece it is already normal for the Troika

(the European Commission, the ECB and the IMF), each time that

it visits Athens to verify if Greece’s government has implemented

its commitments, to confirm that there is lack of forcefulness in the

policies applied, especially in relation to the structural reforms. But

as the President of the euro group, Juncker, and the Ecofin finally

have given the green light for new aid tranches to be given, the

government (after Papandreou, Papademos) could, after long nego-

tiations, according to the demands of his European partners, and

once at home, do half of it. He could even reject the proposals made

by his partners (Germany, the first) to provide administrative advi-

ce in situ, for instance, in order to create an efficient tax agency and

to design and manage infrastructure investment projects.


114

If with the aid programmes the idea was to buy time to imple-

ment structural reforms in the real economy, as the political leaders

repeatedly emphasised, time was not used productively in all the

countries involved, and Spain was no exception during the last

part of Zapatero’s government, when the crisis was not officially

denied anymore: fiscal and economic consolidation policies arri-

ved late and lacked consistency and force.

4.4. Financial markets, with capacity to persuade

One way of overcoming the reluctance of the governments to

inexorable political and economic changes in their respective

countries comes from the market, specifically the spreads of the

risk premiums included in the interest rates where the Treasury

may place their issues.

As mentioned above, the risk premiums of ten-year bonds, with

reference to the German bond, “bund”, reached rocket prices in

Greece in 2011 and also considerably in the other peripheral coun-

tries with debt problems, including Spain, where the interest rates

reached all-time highs of several hundred basis points. The same

happened with the credit default swaps (CDS) premiums. No mat-

ter how much the governments criticised financial agents for this,

not to mention also the three main rating agencies (Fitch, Moody’s,

Standard & Poor’s), we cannot understimate its deterrent effect

when it is intended to go into greater debt. The increase in price of

the debt convinced political leaders in the countries in trouble that


115

the time of spending happily had gone and that they had to be

prepared for a future characterised by austerity. The new govern-

ment of Spain (Rajoy) is an example of strict action to modify

unsustainable habits in society and restore the economy. In Italy

there was a big change of direction since a government of techno-

crats (Monti) started in November last year. Ireland had already

started in March 2011, after early parliamentary elections and the

formation of the new government (Kenny). Three months after

that, the same happened in Portugal (Passos Coelho).

Therefore, any decision to artificially reduce the interest rates of

government bonds, as it has already been taken within the context

of rescue packages and as some governments claim, is counterpro-

ductive. Eliminating the mechanisms of the market that act, wit-

hout political interference, in favour of the quality of public finan-

ces, is pointless. Mutualisation of the sovereign debt, no matter

how much it is proclaimed by certain political circles (also Spanish,

irrespective of ideologies), as well as academic (including German,

Keynesian ideas) and financial (especially the most important

banks which are anxious to operate in capital markets with great

liquidity, comparable to the U.S. market) circles, is also pointless.

There is no reason why we should think that issuing eurobonds

would improve the quality of the economic policy in the euro area.

On the contrary, a reduction in the price of credit in the countries

in trouble, which the eurobond would entail, would deteriorate the

estimates of low cost, which all categories of public sector outlays

and any decision by the public authorities on loan finance, would


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117

be subjected to; furthermore, it would be impossible to put pressu-

re on a government from outside to control expenditure and opti-

mise tax collection; and, in addition, restructuring processes in the

real economy, which are so important to raise the potential of

growth, would be postponed. It is far better for the financial mar-

kets to deploy their penalising effects and thus complement the

relevant mechanisms planned by the SGP and the coming Fiscal

Stability Pact.

5. New governance design: own responsibility as the key

It seems that European leaders got it into their heads that the euro

area needs another kind of governance different from what we have

had until now.

We will have to carry on thinking in the need for official assiss-

tance for certain countries, not only for Greece. As regards Greece,

maybe we must think of two options: one, exiting the euro, in

principle on a provisional basis (until the fundamental problems

have been solved) and continue as a EU member; two, exiting the

Economic and Monetary Union, also for a certain time, but kee-

ping the euro as dual currency circulation with their own currency.

Politicians now understand better than in the past that, for the

feasibility of the monetary union in the long term, we need robust

and resilient foundations to prevent external shocks of offer and

demand, both from outside and from inside (which in some way or

another will happen again). It is not enough to have a determined

common monetary policy dealt with by a competent European aut-

hority with aims of stability and orderly functioning of inter-bank

market. This is only one of the required conditions. Two further fun-

damental conditions are inexorable for the context of national eco-

nomic policies:

• On the one hand, there must be some rules on behaviour in bud-

getary and economic policy compatible with the efficiency crite-

ria in the allocation of production factors and with growth and

employment aims. The problem of “moral hazard” must be

totally eliminated.

• On the other hand, there must be unconditional willingness of

the governments to observe these rules and act according to

them. There must be a clear division of work and responsibility

between the governments and the ECB.

Indeed, efficient European governance means the transfer of the

national sovereignty to the European Union in budgetary matters

and in areas essential to the real economy. This would entail a qua-

litative leap in the process of integration.

The three pillars of the new architecture are:

• The Euro Plus Pact (approved at the European Summit of 24-25

March 2011, with immediate effect);

• The Fiscal Stability Pact (approved at the European Summit on

1st March 2012, with the exception of the United Kingdom and


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the Czech Republic, and estimated to come into force, after rati-

fication by the national parliaments, on 1st January 2013);

• The Macro-economic Governance Pact (approved by the

European Parliament in September 2011 and ratified by the

European Council, which is in force already).

The three Pacts complement one another. Without quality of

public finances there will be no appropriate economic growth (“dis-

trust effect”), but without economic growth it will be impossible to

have organised public accounts (“tax collection weakness effect”),

and with no macro-economic balance growth will be slower (“effect

of inefficiency in the allocation of production factors”).

5.1. The Euro Plus Pact, it is not binding on anyone

This Pact is based on right diagnosis: the potention of growth in

southern countries and the capacity to create employment (to a gre-

ater or lesser extent) are low owing to the persistence of negative

national factors: non-qualified labour, insufficient technological

innovation in companies, over-regulation of the labour market and

of various services, inefficient bureaucracy, deplorable tax fraud and

corruption. For this reason, structural reforms in the economy and

the institutions are so necessary.

The governments of the countries of the euro area have under-

taken to implement it; other six countries of the EU have also

undertaken this commitment (for this reason the term “Plus” has

been added to the name of the Pact).6 The scope of action that the

Pact contemplates affects the labour market, the educational sys-

tem, the environment for research, the tax system and a long etce-

tera. All this is praiseworthy.

But the main problem of the Pact is that it gives full freedom to

the governments to take the measures that they deem appropriate

and not to take others that would also be necessary from an objec-

tive point of view. There is no sanction in case of lack of strictness.

Therefore, this pillar of economic governance of the euro area does

not offer security.

5.2. The Fiscal Stability Pact, a test of nine

Rightly, the inexorable key is the commitment from the govern-

ments to maintain orderly and balanced public finances in the

future.

This is no dogmatic approach (“neoliberal”, as some call it pejo-

ratively), but it is the consequence of an economic analysis, sup-

ported by theory and empirical experience. Government deficit

must be limited, owing to the “Domar condition”, according to

which, for reasons of assignative efficiency, long-term interest rates


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6 European Council, Conclusions 24/25 March 2011, Annex I: The Euro Plus Pact –

Stronger Economic Policy Coordination for Competitiveness, Bruselas, 25/3/11 (EUCO 10/11,

CO EUR 6, CONCL 3).

must be higher than the economic growth rate. With no ceiling for

government deficit sooner or later we reach a point from which the

financial expenditure of the State (for servicing the debt) increases

substantially, which progressively reduces the room for manoeuv-

re of the government to seek its economic and social aims. The

level of public debt must be limited because of the

“Reinhart/Rogoff rule”, derived from econometric studies, which

establish a critical threshold of 90% of GDP, from which the secu-

lar economic growth rate may diminish at least half a percentage

point per year for three reasons: one, because public debt servicing

reduces the margin for productive investment of the State (infras-

tructures); two, because payment of interest to foreign creditors

reduces available national income and, therefore, the capacity of

consumption of households; and three, because the need to re-

finance sovereign debt makes financing of private companies in

capital markets difficult (“expulsion effect”).

The Ltmus test is characterised by strictness under which the

governments deepen in budgetary consolidation. Despite the fact

that in different countries of the euro area some measures invol-

ving tax adjustment have been taken already, public finances are

not consolidated at all. According to the European Office of

Statistics (Eurostat), government deficit is excessive (more than

3% of GDP) in most of the countries, also in Spain (2011: 8.5% of

GDP). Germany (1%) and four small countries (Estonia, Finland,

Luxembourg and Malta) are the few exceptions. Most of the

government deficits are structural, in other words, not cyclic but


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permanent, and, therefore, destructive for the good functioning

of the economy. The level of public debt is also too high (higher

than 60% of GDP) in almost all the countries, including

Germany (2011: 81.2%) and France (85.8%) and now also Spain

(68.5%), for the first time since 2011, Spain (68%). Where public

debt greatly exceeds all acceptable levels according to the

“Reinhart/Rogoff rule” is in the three countries that have been

rescued (Greece, Ireland and Portugal) and in Italy. For the latter

country, however, there is a differentiating factor in its favour,

most of the public debt is internal and, thus, its servicing may be

managed directly with its own instruments (by increasing fiscal

pressure on its citizens).

As mentioned above, the rules on sustainability of public finan-

ces as set forth in the Treaty of the European Union and in the SGP

have not been efficient to impose budgetary discipline. Its applica-

tion has been highly politicised. The mechanisms of penalisation

have never been implemented. The new Fiscal Pact has been arran-

ged in such a manner that it could put the screws, firstly, on the

euro countries on which the agreement is binding.7 The most

important advances as regards the SGP, for the moment only on

paper, are the following three:

• Firstly, the seriousness of government deficit is explicitly ack-

nowledged when it is structural. The explicit ceiling established


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7 European Council, Treaty on Stability, Coordination and Governance in the Economic and

Monetary Union, 2/3/12, artículos 3-8. Internet: http//:eur-lex.europa.eu.

is 0.5% of GDP, maintaining the threshold of 3% for total defi-

cit. There is thus a large margin for the operation of “automatic

stabilisers” in the economic cycle and for discretionary govern-

mental measures if there is recession.

• Secondly, the aim of limiting the level of public debt at 60% of

GDP through a procedure which, if the debt exceeds this per-

centage, may activate the supervisory mechanism for “excessive

government deficit”, even if the deficit is below 3% of GDP. The

country in question shall be forced to reduce it at an average

rate of one twentieth per year as a benchmark (“1/20 clause”).

• Thirdly, the obligation for each member country to define its

medium-term budgetary objective (MTO), quantifying an indi-

cator for public expenditure evolution and making sure that the

estimated expenditure shall be financed by sustainable income

(“golden rule” of budgetary balance). If a country does not orga-

nise its budgets in a balanced manner it will be required by the

European Commission to submit new budgetary plans.

If the new rules are important, a mechanism to enforce them is

equally important. The most relevant three new elements are the

following:

• First, continuous supervision of the policies applied in both

summits of the euro area has been devised (two per year, at

least, called and chaired by the President of the EU, currently

Herman Van Rompuy).

• Second, there is a change in the decision process on financial

sanctions (of up to 0.2% of GDP) in case of breach and non-ful-


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filment of the specific recommendations to remedy the situa-

tion in the sense that a proposal of the European Commission is

considered approved if the Council of the Heads of State and

Government of the euro area does not vote against it with a qua-

lified majority (until now such a majority was required for the

European Council to approve the sanction). Therefore, there will

be less room for political maneuvre to prevent the fine (as it was

normal in the past after the Schröder/Chirac precedent mentio-

ned above). The sanctions are not totally automatic as one

would like them to be, but they are moving in that direction.

Furthermore, they have a broader scope than before, because the

manipulation of fiscal statistics shall also be punished.

• Third, the obligation for each member country to transpose the

fiscal stability rule into its national legislation is established and,

therefore, be explicitly responsible for its fulfilment. The Court

of Justice of the EU shall ensure its fulfilment.

For the States to decide the medium-term budgetary stability

(equivalent to the economic cycle), the most credible formula is to

constitutionally estabish a ceiling for structural government deficit.

Germany has already done it (0.35% of GDP for the central govern-

ment, from 2016, and cero deficit for the federal states, from 2020).

Spain is moving in that direction after the reform of article 135 of

the Constitution at the end of the previous term of office and the

recent approval of the Budgetary Stability Law which will require

from 2020 cero structural deficit to the public authorities (which

could be up to 0.4% of GDP in exceptional circumstances). Other


124

countries are moving in that direction. The advantage of a consti-

tutional rule as regards de margin of debt of the government is that,

if a country incurs deficit and constitutional breach, it will need bet-

ter arguments for its society than if it only needs to be explained

before the Community authorities and take there the relevant war-

nings; Brussels is “far” and it is “under suspicion” of meddling in

national affairs.

The Fiscal Pact will only work if the euro area countries are

willing to do without most of its sovereignty in budgetary matters,

which will be transferred to Community institutions. Obviously,

this affects the main prerogative of national parliaments, which is

to shape the budgets of the State and decide how to finance expen-

diture. This will meet great opposition, in all the countries. It is not

a trivial matter that the Fiscal Pact must be institutionalised

through an inter-governmental agreement, that is to say, a level

lower than the Treaty of the EU, which reform would have requi-

red the unanimous approval of the twenty-seven, which was not

reached. This procedure has opened in the legal field a debate to

decide if the procedure chosen is compatible with Community

Law, specifically in relation to the mechanisms of sanctions for

excessive government deficit as set forth in article 126 of the

Treaty. For European leaders to have lowered the quorum required

for parliamentary approval of the inter-governmental agreement is

not a trivil matter either, to 12 of the 17 States that form part of the

euro area. Could it be that some partners are not reliable? It is true

that it has been decided that the countries that do not ratify the


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Pact and transpose to their national legislation the ceiling of

government deficit will be excluded from possible financial bai-

lout. However, is this credible, especially if the stability of the euro

area is at risk? This being so, it would be better not to be too hope-

ful about this Fiscal Pact.

5.3. The Macro-economic Governance Pact, with vague

parameters

The same caution is advisable with regards to the solemnly

proclaimed Six Pack (so called because its content has been draf-

ted through a Community directive and five regulations).

Nodoby doubts that, for the feasibility of the euro area, macro-

economic stability is a necessary condition (although not enough

if the requirements for an optimal monetary area are not fulfi-

lled). Furthermore, it is true that macro-economic stability goes

beyond budgetary balance, as it has been proven with the recent

experience of different countries (inflationary pressure, property

bubble, excessive private sector debt, competitive weakness of

companies, current account imbalance, etc.). However, the

European Commission, the European Parliament and the

European Council seem to have faith in the capacity of economic

policy to handle crucial factors in the real economy. This is

highly questionable.

An alert mechanism scoreboard was created for the appearance

of internal and external imbalances in the countries, which will be


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managed by the European Commission based on ten parameters,

as follows: 8

• Internal imbalance parameters: evolution of unit labour cost,

unemployment rate, private sector indebtedness, credit to the

private sector, evolution of property prices and government

indebtedness.

• External imbalance parameters: surplus and deficit of current

account balance, net international investment position, change of

export market shares and change of the real effective exchange

rates of the euro.

For these parameters, critical thresholds have been established,

from which the alarm would be triggered, and this would start a

procedure to analyse the causes in order to decide from Europe if

corrective measures need to be taken or not. For instance, for unit

labour costs the threshold is an increase of 9% in three years, for

unemployment rates it is 10% of the workforce as a three-year ave-

rage or for current account balance the threshold established is 3

year backward moving average of the current account balance as a

per cent of GDP, with a threshold of +6% of GDP (surplus) and -4%

of GDP (deficit). If there is excessive imbalance, the European

Commission will make the relevant recommendations for the

government of the country in question to remedy the imbalance; in

case of non-fulfilment, a fine may be imposed (up to 0.1% of GDP).


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8 European Commission, EU Economic governance “Six Pack“ enters into force,

MEMO/11/898, 12/12/2011.

The thresholds set are not a consequence of a detailed economic

and empirical analysis that may indicate for sure when an imba-

lance is excessive for a country and negatively affects the euro area

as a whole. The numerical values rather represent the perception of

politicians of the recent events; therefore, they are, unavoidably,

arbitrary. But the fundamental question is different: How can a

government act efficiently?

We must remember that the EU proposes an open market eco-

nomy with free competition (article 119 of the Treaty of the EU). All

euro countries have this concept of economic system, some becau-

se of the Ludwig Erhard tradition (Germany), and others with reser-

vation in favour of the government (France). In a market economy,

the government lacks the instruments to control the variables con-

templated in this Macro-economic Governance Pact. Therefore, the

governments should activate a series of interventionist measures,

with no guarantee of their efficiency and with a high risk of distor-

ting efficiency in the allocation of production factors. In a market

economy, responsibilities are distributed in a different way: for level

of employment, social partners (unions and employers); for export

development, private companies (technology); or for granting

loans, commercial banks (based on the appropriate risk estimate).

The current account balance, among other things, represents the

saving trend rooted in society and objective conditions for fixed

capital investment (as explained by the “macro-economic equa-

tion” and the “Böhm-Bawerk theorem”). Unions will not accept

government interference in the negotiation of collective agree-


128

ments and companies will not stop being creative or innovative in

organisational management and product development for which

elasticity-income of international demand is higher than the unit,

and banks will not neglect their classical business, which is to pro-

vide credit to companies and households.

This economic governance project has no clear future. In the

best-case scenario, the new Summits of the euro area would have

matters to discuss. The countries in which the economy works well

could be taken as a benchmark for the others to rectify their struc-

tural deficiencies and improve their productive and competitive-

ness levels. In the worst-case scenario, the euro area would be expo-

sed to continuous political conflicts, which would not promote

economic growth with high employment. It is so easy, and espe-

cially politically profitable in countries with domestic problems, to

look for the villain abroad, maybe Germany?

Conclusion

The sovereign debt crisis has had a healthy effect in convincing

politicians that by providing liquidity to governments and banks

the stability of the euro area will not be attained in the medium

and long term. The quality of the economic policy must improve

in the countries, there must be impeccable follow-up by indepen-

dent institutions to weigh up the economic and fiscal situation and

it must be guaranteed that national accounts and other relevant

statistics are arranged under utmost scientific accuracy at all times.


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If in all the euro countries the governments understand that

sound public finances and application of structural reforms is their

responsibility and if they act seriously according to them, no State

will have to rescue another State because of over-indebtedness and

waste, and the ECB may stop indirectly financing States and focus

more on its task, ensuring stability in price levels in the euro area.

The ESM fund would be reserved to emergency situations caused by

external factors beyond the government’s control. The Fiscal Pact

would have fulfilled its mission and the Euro Plus Pact would be

filled with efficient contents. We would not need to resort to mar-

ket interventionism as entailed with the Six Pack.

If, on the contrary, there is no determination in the member

countries, any attempt of European economic governance would

result more from proactive intentions than harsh reality. The euro

area would have an uncertain future. The alternative of a European

Political Union, in which all necessary economic policies could be

undertaken from a Community Executive under the control of the

European Parliament, with all democratic rights, cannot be seen on

the horizon.


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Education

The European crisis and the challenge of efficient economic governance by Juergen B. Donges