The truth is that "the euro is incomplete, and cannot last without major reforms". Thus did candidate Emmanuel Macron warn a German audience. As French president he must persuade Germany to accept the changes he thinks essential.
His view raises three questions. Is he right to be alarmist? Has he identified necessary reforms? Will he be able to bring them into effect?
The answer to the first is “ yes”; to the second “yes, but to a limited extent”; and to the third “probably not”.
Jean Pisani-Ferry, an adviser to Macron, justified the alarm in an article last year. “The euro’s survival currently hinges more on the fear of the dire consequences of a break-up than on the expectation that it will deliver stability and prosperity. This is not a stable equilibrium.”
Fear is powerful: it is why Greece is still in the euro zone. But reliance upon it destroys belief in European integration.
Furthermore, national elections then become clashes between defenders and opponents of an unpopular status quo. Sooner or later one of the latter is likely to be elected in a big country. The euro zone is far more stable today than a few years ago. But the fragility remains.
Remedies
This leads us to Macron’s proposed remedies. He has suggested deeper fiscal integration, with a euro zone budget, finance minister and parliamentary oversight, along with completion of the banking union.
Would such a federal agenda work? The answer is that even if it were achievable, it would be neither a sufficient nor a necessary solution.
Federalism is not a sufficient answer because even federations break up. More important, within federations depressed regions may end up living on handouts forever. That would be dire for the euro zone.
Federalism is indeed necessary, but to a limited extent. To appreciate that we need to consider the euro zone’s underlying defects. There are three: inadequate risk-sharing; inability to pursue appropriate macroeconomic policies; and asymmetric internal adjustment.
When losses occur it is necessary to allocate them between creditors and debtors. The best way to do so is via market mechanisms, notably euro zone-wide financial institutions and equity financing. That is largely why planned banking and capital market unions matter. Also important are better mechanisms for writing down unpayable debt.
The best way to cushion temporary country-specific negative shocks is via national fiscal policy, supported where necessary by emergency funding. We have learned from the euro zone crisis that the central bank must be willing to act as lender of last resort in the public debt markets of crisis-hit countries. Otherwise illiquidity can cause unnecessary defaults.
We have also learned that monetary policy may fail to offset negative shocks throughout the euro zone. Active fiscal policy may also be needed.
Cushioning shock
Where does fiscal federalism fit in? Martin Sandbu, my colleague, argues that it plays a modest role in cushioning shocks, even in the US. The degree of fiscal integration required to manage risk-sharing is quite modest: support for deposit insurance and a limited quantity of unimpeachably safe bonds.
Meanwhile, the federal budget needed to stabilise the euro zone seems unrealistically large. An alternative is to use national budgets in concert. Alas, German opposition to countercyclical fiscal policies seems to rule all such ideas out.
However, the biggest missing piece in the euro zone is neither active fiscal policy nor long-term fiscal support, but symmetric adjustment.
A recent paper from the Bruegel think-tank notes the scale and significance of the shifts in competitiveness among the euro zone’s three most important economies – Germany, France and Italy – since creation of the single currency.
It shows the huge improvement in competitiveness of Germany in the form of falling relative unit labour costs. These shifts occurred because compensation of workers grew more slowly than productivity in Germany, at much the same rate in France and faster in Italy.
As a result, the share of labour in the incomes of the German business sector fell sharply, while it rose in France and Italy. The combination of improving competitiveness with high profits (and so savings) led to the huge German current account surpluses.
Since the crises these cost divergences have ceased to grow, yet not reversed. This means that if domestic demand in the French or Italian economies were to be strong enough to eliminate that part of unemployment due to deficient demand, their current accounts would go into significant deficit.
Private sectors
If they are also to run balanced fiscal positions their private sectors must also run substantial financial deficits (excesses of spending over income). But the French and Italian private sectors have run persistent surpluses, even at low interest rates. Thus substantial fiscal tightening is likely to cause significant domestic slowdowns.
Germany’s proposed solution to divergences of competitiveness is for everybody to follow its own model. It has succeeded: in 2016 all members of the euro zone bar France ran a current account surplus. The euro zone’s current account shifted from a deficit of 1.2 per cent of gross domestic product in 2008 to a surplus of 3.4 per cent in 2016.
If France is driven into prolonged competitive deflation, Marine Le Pen might become president next time. Macron must ask Angela Merkel whether the German chancellor is willing to risk this.
Reform in France is essential. So is development of risk-sharing institutions. But the euro zone also needs a big jump in relative German wages. Will that happen? I fear not. – Copyright The Financial Times Limited 2017
