Time for a European Political Union

Marco Annunziata, chief economist of Unicredit writes a superb piece (HT: Eurointelligence) on state of affairs in Europe.

He reviews the ongoing situation in Europe:

The financial crisis has been a humbling experience. As financial market turmoil erupted over two years ago, European policymakers reacted with almost smug confidence: It was going to be mostly a U.S. problem, while the euro zone would be shielded by its solid fundamentals and balanced external position. Now the swagger is gone: The euro zone suffered a deeper recession than the U.S. in 2009, and is set for a less dynamic recovery this year. Worse still, and most embarrassingly, the risk of a debt crisis in one or more European countries has suddenly emerged as the markets’ most acute and pressing concern.

As they struggle to stabilize the situation, European policymakers occasionally still protest that this all stems from a major misunderstanding—that investors are focusing on individual countries whereas they should be looking at the single currency area as a whole.

The European Central Bank, in particular, points out that the euro zone has a stronger fiscal position than its peers: The International Monetary Fund forecasts a 2010 fiscal deficit of about 6.5% for the euro zone, compared to over 10% for the U.S. and Japan, and over 13% for the U.K. The ECB also argues that it makes no more sense to be concerned about an individual euro zone country than about a single U.S. state: Why worry about Greece, which accounts for a mere 2% of Eurozone GDP, when California has fiscal troubles of its own and makes up as much as 13% of the U.S. economy?

He then points comparison with Greece and California are futile. California is far better off than Greece in terms of stats. And then has US treasury backing California. Who saves Greece?

But who stands behind Greece? Who has the means and authority to guarantee support and impose discipline? Europe does have the resources: Greece’s entire public debt stock amounts to just 2% of euro zone GDP. But there is no established support mechanism—partly because this was never supposed to happen. Any financial support would need to be accompanied by heavy policy conditionality, as an unconditional bailout would exacerbate moral hazard and weaken other countries’ resolve to correct their own fiscal imbalances. The International Monetary Fund has the required expertise, but its intervention would be seen as an additional embarrassment, proof that the European Union is unable to handle its own problems. The EU however has no experience in this respect, and has too much at stake to impose credible threats. As there is no separate federal debt in the euro zone, a default or restructuring by one member would quickly spark contagion across the area’s sovereign debt markets.

The main problem has been to look at Eurozone as a whole and not on specific countries. In total terms it has looked fine but individually countries have become crisis prone. There are imbalances within European countries with Germany running current account surpluses for many years with others running deficits. All these free lunches are over now.

The solution is:

There is a way out of this dilemma, and it is to make individual countries’ s imbalances truly irrelevant, really turning Greece into the equivalent of California. It would require a European federal government with substantial taxing and spending power, with the ability to redistribute resources and impose fiscal discipline across the continent.

In short, it would require a far greater degree of political union than European leaders seem willing to contemplate.

Yet the choice is now clear and inescapable: The current institutional framework does not work—neither the Stability and Growth Pact nor peer pressure can enforce fiscal discipline. Moral hazard is hard-wired into the existing incentives setup, and the result is a combination of lackluster growth and financial instability. The euro zone now needs to grow up and overhaul its institutions to keep pace with increasingly fierce global competition. Otherwise, in another ten years, it will look at itself in the mirror and think, “I could have been a contender”.

Very interesting thoughts and very well put. The political economy (also this ) always plays a very strong role in Europe.