How to Save the Euro-and the EU: Reading Keynes in Brussels

Henry Farrell & John Quiggin. Foreign Affairs. Volume 90, Issue 3. May/June 2011.

The European Union is in danger of compounding its ongoing economic crisis with a political crisis of its own making. Over the last year, crises of confidence have hit the 17 EU members that in the years since 1998 have given up their own currencies to adopt the euro. For the first decade of this century, markets behaved as though the debt of peripheral EU countries, such as Greece and Ireland, was as safe as that of core EU countries, such as Germany. But when bond investors realized that Greece had been cooking its books and that Ireland’s fiscal posture was unsustainable, they ran for the door. The EU has stopped the contagion from spreading-for now-by creating the European Financial Stability Facility, which can issue bonds and raise money to help eurozone states. Together with the International Monetary Fund, the European Financial Stability Facility has already lent Greece and Ireland enough money to cover their short-term needs.

But such bailouts are only stop-gap measures. Portugal and Spain, and to a lesser extent Belgium and Italy, remain vulnerable to pressure from bondholders. Portugal is likely to receive 50-100 billion euros over the next few months. But should Spain also need a bailout-which could cost as much as 600 billion euros-the 750 billion euro European Financial Stability Facility would soon be exhausted. In that event, the main euro creditors, primarily British, French, and German banks, might have to accept so-called haircuts, substantial cuts in the principals of their loans. (The banks’ tax-avoidance strategies might inflate this total, but the Bank for International Settlements has estimated that the exposure of British, French, and German banks to the group of vulnerable debtor states referred to as the pigs-Portugal, Ireland, Greece, and Spain-amounted to more than $1 trillion in mid-2010.) Encouraged by Germany, some of the states in difficulty have sought to placate bond markets by making ruthless cuts in government spending. But as many economists have pointed out, these measures are hindering growth without satisfying bondholders that their money is safe; bondholders worry that these measures are not politically sustainable. In fact, they are likely to undermine Europe’s political union.

Nevertheless, Germany has been pressing European countries to institutionalize more stringent cuts in spending. In February, it, along with France, proposed that members of the eurozone introduce “debt brakes,” inflexible limits on deficit spending. Germany had already incorporated such a cap into its own constitution, one that severely restricts any government deficit spending, including the kind that might benefit the country’s long-term growth. In early March, the other 16 eurozone states agreed to introduce such debt brakes or some equivalent into their domestic laws and to make them as durable and binding as possible, for example, by incorporating them into their national constitutions.

But institutionalizing austerity will badly damage European economies in the short term-and the long-term consequences will be even worse. European politicians worry about the economic consequences if their attempts at fiscal stabilization fail. They should be far more worried about the political consequences. Even if these strict spending limits do calm bond markets somehow, they will destroy what little is left of the EU’s political legitimacy.

Bad as Gold

The EU is now drifting toward a thinly disguised version of the gold standard, which wreaked economic havoc in the 1920s and led to a toxic political fallout. Under that system, European states had fixed exchange rates. During economic crises, they refused to increase government spending because of a failure to either understand or care that monetary disturbances and shocks to demand could lead to joblessness. The result was generalized misery. Governments responded to economic crises by allowing unemployment to go up and cutting back wages, leaving workers to bear the pain of adjustment. As Golden Fetters, Barry Eichengreen’s classic history of the period, shows, the gold standard began to collapse when workers in Europe gained the power to vote out of office the parties that supported austerity.

The measures that the eurozone states have recently decided to adopt will be even harsher, if they make the mistake of following Germany’s example. Germany’s debt brake, which at first Berlin implicitly proposed as a model for other European countries, turns austerity into a constitutional obligation. In theory, it provides some flexibility during hard economic times, but in practice it makes deficit spending as difficult as possible: only the vote of a supermajority of German legislators can relax it. And it rules out debt-financed investment, such as in infrastructure, even though that can spur long-term growth.

As they begin to adopt Germany’s model, or something along those lines, the other eurozone states will find it nearly impossible to use fiscal stimulus in times of crisis. And with monetary policy already in the hands of the dogmatically anti-inflationary European Central Bank, their only means of adjusting to crises will be to stand by as wages fall and unemployment soars. Ireland-with its collapsed tax revenues, massive cuts in government spending, shrinking wages, and skyrocketing unemployment-is the unhappy exemplar of rigid austerity measures in the new Europe.

This approach cannot be sustained for long. The EU has never had much popular legitimacy: many voters have gone along with it so far only out of the belief that their politicians knew best. Today, they are more suspicious. And if they come to think that further European integration is causing more economic hardship, their suspicion could harden into bitterness and perhaps even xenophobia. Ireland’s new finance minister, Michael Noonan, has told voters that the EU is a game rigged in Germany’s favor; editorials in major Irish newspapers warn of Germany’s return to racist imperialism. As economic shocks hit other EU countries, politicians in those states will also look for someone to blame.

If the EU is to survive, it will have to craft a solution to the eurozone crisis that is politically as well as economically sustainable. It will need to create long-term institutions that both minimize the risk of future economic crises and refrain from adopting politically unsustainable forms of austerity when crises do hit. They must offer the EU countries that are the worst hit a viable path to economic stability while reassuring Germany, the state currently driving economic debates within the union, that it will not be asked to bail out weaker states indefinitely.

The short-term solution is clear-even if the European Central Bank, which is still fighting the war against the inflation of the 1980s and 1990s, refuses to recognize it. The solution is a one-off combination of market purchases of bonds and other financial assets, temporarily higher inflation, and fiscal support with the issuance of a common European bond. Quantitative easing and higher inflation would help ease the pain of adjustment, and a European bond would allow the weaker eurozone states to raise money on international markets. All of this would shore up the euro long enough to allow for further-reaching reforms down the road. The major euro bondholders would have to bear some of the costs-as they should, since they lent excessively during the first years of this century-through either explicit haircuts (in effect a discount of their bonds’ value) or inflation. Germany might not enjoy experiencing temporarily higher inflation, but if this were a one-time cost, it could probably live with the results-as long as it was also reassured that the long-term gain would be stability in the eurozone.

In The Best of Times, For the Worst of Times

Instituting effective long-term reforms will be a harder sell. Germany adopted its own large-scale fiscal stimulus in 2009, but it returned to its traditional anti-Keynesian stance as soon as the danger of total systemic collapse had passed. Yet Keynesianism, at least properly understood, is the only way forward.

Contrary to the beliefs of nearly all anti-Keynesians-and, regrettably, some Keynesians, too-Keynesianism demands more, not less, fiscal rectitude in normal times than does the orthodox theory of balanced budgets that underpins the EU. John Maynard Keynes argued that surpluses should be accumulated during good years so that they could be spent to stimulate demand during bad ones. This lesson was well understood during the golden age of Keynesian social democracy, after World War II, when aided by moderate inflation, the governments of the countries in the Organization for Economic Cooperation and Development greatly reduced their ratios of public debt to GDP. This approach should not be confused with the opportunistic support for large budget deficits evident, for example, among advocates of supplyside economics. If anything, “hard” Keynesianism suggests that the problem with the macroeconomic rules governing the euro is not that they are too tough and too detailed but that they are not tough or detailed enough. States in the eurozone should not be allowed to run moderate budget deficits in boom years, the Keynesian argument goes; instead, they should be compelled to run budget surpluses. The surpluses could then be saved in rainy-day funds or used to pay down government debt or, if the country had reached a satisfactory debt-to-GDP ratio, spent as a fiscal stimulus in the event of a crisis. Unlike the kind of budget management advocated by the German government, this approach does not seek to eliminate or minimize governments’ leeway to conduct fiscal policy. It gives governments up-front the means to manage demand whenever they might need to.

Resorting to hard Keynesianism to deal with the euro crisis would require making far-reaching changes to the rules and practices of the EU’s economic and monetary union. It would mean both toughening the requirements of the Stability and Growth Pact, which governs the euro, and strengthening the enforcement of these rules. As they stand, the Stability and Growth Pact’s bylaws require the eurozone states to maintain budget deficits under three percent of GDP and debt-to-GDP ratios under 60 percent. The system does not provide enough flexibility during downturns: even German politicians ignored these requirements a few years ago, when Germany was suffering from a recession-much as they prefer not to remember this today.

To be more effective, the system needs to be stricter. The Stability and Growth Pact should be strengthened so that it requires countries to put aside surpluses during auspicious years. Since governments are persistently tempted to squander surpluses, a new supervisory institution should be introduced at the EU level. It should be granted access to detailed budget-planning and other economic information from the eurozone states and should be empowered to sanction misbehaving states. Such a reform could be integrated into other proposals under consideration today, such as the “European semester system,” which would give the European Council the responsibility to assess member states’ budgetary policies. A new European college of budgetary supervisors, with one supervisor from each member state, could assess the budget-planning processes of the member states and provide short-term flexibility in times of real crisis. Its staff would come from the ministries of finance of the eurozone states. When states faced hard economic times, the college could decide, with a simple majority, to relax fiscal strictures on a six-month basis.

The Stability and Growth Pact, a semi-formal protocol of dubious legal standing, should also be properly incorporated into the EU’s basic treaties. That would allow the European Court of Justice to adjudicate disputes between EU bodies and member states and help with the pact’s enforcement. These arrangements would prevent national governments from unjustified deficit spending while giving them flexibility in times of real need.

Such an active use of fiscal policy requires the coordination of fiscal and monetary policies. This, in turn, means that the European Central Bank can no longer be totally independent, as it has been since the implementation of the euro. As it stands, the European Central Bank is possessive about its powers. For example, it has resisted oversight by the European Parliament even though it has begun to take on an increasingly important political role through its support for the European banking system. It has assiduously avoided mingling monetary policy and fiscal policy, focusing instead on targeting inflation. But it nonetheless failed to prevent asset price booms, and these could only have been prevented with much more direct institutional control over unsound financial innovations. As the interaction between governments and central banks is unavoidable and the role of the European Central Bank is increasingly political, it would be better to properly define the relations of authority among these bodies. The European Central Bank must be more willing to adjust its policies so that they do not undercut those of elected national governments. Even if this were not necessary economically, it would be necessary politically. Handing the power to destroy national economies to unelected technocrats is simply not politically sustainable.

Creating an active fiscal policy regime of this kind would reduce the volatility of interest rates, the result of an excessive reliance on monetary policy. Manipulating interest rates helped stabilize inflation during “the great moderation,” the era of relative economic calm between the late 1980s and the late years of the first decade of this century. But in the long term, it contributed to the growth of the asset price bubbles that almost destroyed the entire system in the global financial crisis. To be most effective, these reforms would have to go together with the creation of a limited fiscal union that would balance out the asymmetric effects of economic shocks by allowing limited fiscal transfers between member states. Managing surpluses as hard Keynesianism recommends would go some way toward providing the eurozone states with an important buffer against crises. But in hard times, imperfect monetary unions, such as the eurozone, require temporary transfers to the countries most hurt from the countries that are less affected. This is not to argue that the EU should become a “transfer union,” with the extensive fiscal transfers of a full-fledged federal system, as the German government fears. But the eurozone should allow for more short-term fiscal transfers to deal with asymmetric shocks. A common bond mechanism, for example, would help states in difficulty raise money on international markets or allow resources that are, say, earmarked for agriculture to be redirected to an emergency fund.

Room with a View

Hard Keynesianism would not solve all of the EU’s economic and political problems. But it would steer the union away from the disaster toward which it is now sleepwalking. A new set of rules based on this approach could form the basis of a solution that is politically viable for both Germany and its European partners most suffering from the crisis. With only limited fiscal transfers allowed, Germany could be further assured that it would not have to continually bail out its profligate partners. Such an approach would maximize the fiscal room that states in distress need in order to deal with economic shocks while ensuring the eurozone’s long-term fiscal sustainability. In the short term, hard Keynesianism, like enforced austerity, would impose real adjustment costs on the eurozone’s weaker economies; there is no cost-free path to fiscal balance. But if the costs were shared with bondholders and were alleviated by a one-off loosening of monetary policy, they could be politically acceptable.

By concentrating on its economic problems but ignoring their political consequences, the EU is setting itself up for failure. The case for austerity does not make sense. And if the EU fails to deal with the political fallout of its own institutional weaknesses, it is going to collapse. No political body can force voters to repeatedly shoulder the costs of adjustment on their own and expect to remain legitimate. During the gold standard, nation-states tried this and failed-and they had considerably more authority than the EU has today. Hard Keynesianism offers a means to combine fiscal discipline with flexibility in order to cushion the political costs of adjustment in times of economic stress. EU leaders must institute it in a hurry.