Designing the Euro: An institutional hole?

The UACES Network |

“If Member States run sound public finances, as a rule, they will never find themselves in a position where they have to correct an excessive deficit,” underlined Joaquín Almunia, Commissioner for economic and financial affairs, presenting the 2007 ‘Public Finances in EMU’ report in June. “And that is why the preventive arm of the Stability and Growth Pact (SGP) is of crucial importance.”  –  European Commission (2007)

The financial crisis has shown up most dramatically the difficulties inherent in roping together seventeen different countries, each with individual tax rates, traditions, and attitudes to public finance. In particular, fears of a Greek default have consumed the media in recent weeks and months, with lurid stories of national battles fought between Berlin, Paris and Athens. But ire surrounding the issue has tended to emphasize the wisdom, or not, of allowing Greece (as a country with unusually large-scale public debt) into the Eurozone in the first place. As with many things in the Eurozone, this was fundamentally a political decision, but perhaps the more pertinent question is whether the Eurozone could have been designed better to contain this diversity?

The principal split in the Eurozone is between monetary policy, which is set collectively by the European Central Bank; and fiscal policy, which is set at the national level (with a little help from the European Commission and from subnational governments, where these have the power to tax and spend). The former is, at least institutionally, out of the hands of the member states. The latter however falls well within their purview and is subject to as much fiddling as they care to exercise. Indeed, the long-term trend since the inception of the Euro has been towards increasing current account deficits: since 1999, the Eurozone of 17 has never once collectively been in surplus.

Eurozone (of 17) aggregate budget balance, 1999-2010 (Source: Eurostat)

So what provisions exist to combat this collective slide, and are they working? When the Euro was being agreed, a frequent bone of contention was the issue of moral hazard, or how ‘bad’ countries (like Greece) could be prevented from getting ‘good’ countries (like Germany) into trouble. This led firstly to the ‘convergence criteria’, and secondly to a proposal by Theo Waigel, the German Finance Minister, for a ‘stability pact’ in 1995. Both had similar aims: to restrict membership to countries who could demonstrate and uphold sound public finances, defined as budget deficits below 3% and inflation and interest rate levels within 1.5% and 2% respectively of the best-performing countries. The actual numbers are fairly arbitrary, but the idea was to define some binding benchmark to a) restrict the countries that could join the Euro, and b) make sure they behaved once they joined. The post-accession regulation, christened the stability and growth pact, introduced two policy instruments to enforce these standards – a preventative arm, and a dissuasive arm. The aim was to guide countries towards exercising budgets that were balanced or in surplus over the medium term (four years).

“The countries which participate in Monetary Union will expressly commit themselves not only to respect the formal fiscal policy stability criteria but also while maintaining their national sovereignty in fiscal policy, to actively and permanently follow a sound fiscal policy for growth and employment both in their own interest and in the interest of Europe.”- Theo Waigel (1995)

The problem with this is that even ‘good’ countries can easily become ‘bad’ given the right circumstances. Indeed, the first sign of trouble came in Germany and France in 2002-2003, who tipped over the three percent limit following a period of sluggish growth. The pact was reformed in 2005 to offer more flexibility and enforceability, but even this has been proven inadequate to the task by the recession. Only four countries – Luxembourg, Estonia, Finland and Sweden – are currently operating deficits of less than 3%, and Ireland (the ‘Celtic tiger’, previously considered a star performer for growth and public account surpluses) has a deficit of 32.4%. This is so far beyond the bounds of what was expected that it is difficult to treat the SGP as still credible, and indeed reforms of the pact are ongoing (albeit secondary to the immediate firefighting issues raised by the debt crisis).

What could have been done differently? My own research looks at the ways in which the institutions have been designed, and how they work in practice. One of the theories often used by economists and political scientists to explain the functioning of currency unions like the Euro is optimal currency area theory (OCA), which analyses the conditions under which a currency union is the best course of action. Whilst this is mostly a theory of money, there are – as always – political and institutional consequences. In particular, Robert Mundell, the father of the theory, suggests that a currency union is only likely under conditions of political upheaval (as has taken place in the EU), and political commitment to the blurring of national boundaries that inevitably results. Other proponents of the theory such as Baldwin and Wyplosz (2006) have argued that the fiscal knock-on effects of a common monetary policy need to be balanced by co-ordinated fiscal policies (which is to say, Euro-level taxing and spending) in the institutional design of a common currency. In practice, this requires and a ‘risk sharing’ mechanism to help redistribute funds to countries suffering from economic shocks (such as the output collapse currently being experienced by countries like Spain). Both of these are notably absent in the SGP. In particular, the SGP explicitly forebade the second condition – that of risk sharing – by including a ‘no bail out’ clause. Of course, this has been de facto abandoned in practice, since the decision to inject £80bn into the Greek economy in April 2010. So why did policy makers not worry about this from the start?

My research suggests that in addition to a profound naivety concerning the likely future necessity of a bailout (with focus very strongly on prevention rather than cure), member states have been remarkably laissez-faire about the kind of governance relationships that would be necessary to sustain the common currency. In practice, the relationships between the many different bodies involved even in monetary policy can be fiendishly complex (see above). And monetary policy is considered to be more straightforward than fiscal policy! That so few of these links were defined in the SGP – which is more or less silent on the matter – ought to be of concern. Indeed, the practice of policy, in particular in the current times of crisis, has been one of creating these institutional webs on the hoof, through lobbying, ad hoc committee meetings, and emergency summits. This cannot continue if the Euro is to remain sustainable. A common economic and monetary policy is exactly that – common. It is myopic to suggest that countries could be left to deal with the fiscal fallout of a common monetary policy alone.


Holly Snaith is a PhD student in the Department of Politics, University of Sheffield. Her primary research interests lie in the paradoxes of multi-level governance and in theories of economic policy-making, although she often writes on public policy more broadly and has been involved in a number of disparate research projects under this umbrella. She can be reached at h.snaith[at]