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Inherent Structural Weaknesses of the Eurozone and the Crisis

The Eurozone countries together form one of the largest economies in the world. The economic integration of the Eurozone was not an impulsive decision but rather a long process. It was a calculated step by the nations with a series of negotiations held for a long period of time. It included a series of treaties being signed and finally, one currency ‘Euro’ came into being that symbolized not only their economic integration but also their political dominance.

In 1951, countries including France, West Germany, Italy, Belgium, Luxemburg and the Netherlands signed the Treaty of Paris and founded the European Coal and Steel Community with the aim to remove import duties and quota restrictions on the import of coal, iron ore and steel between the member countries. In a meeting in 1955, they further encouraged trade between member states through the removal of tariffs and quotas. Later in 1958, two treaties of Rome were signed and European Economic Community (EEC) came into being. The treaty set out free movement of capital, workers and services across borders to harmonise policies on agriculture and transport. In 1993, a single European market came into existence – tariffs were scrapped and duty-free shopping remained. In January 1994, European Monetary Institute was established to oversee the coordination of monetary policies of individual national central banks. Setting up of a European Central Bank (ECB) marked Stage 3 of the economic integration which took place in June 1998. The ECB together with national central banks of the 15 member states was to be responsible for setting the monetary policy and managing the foreign reserves of member countries. In the subsequent year, 11 countries adopted a single currency- ‘Euro’ which came into circulation in 2002. The single currency was hoped to bring stability in the markets coupled with low inflation rates.

Economic benefits of the integration included reduced costs of the transaction of all cross-border economic activities, including trade in goods and services. An added incentive was, investment in ‘peripheral’ countries on favourable terms because of the stability provided by a single currency and free capital flow reduced the risk. For a long time, the apparent stability in the Eurozone caused the economists to question the possibility of growth led by a monetary union without fiscal federalism across the region.

As predicted, the integration came at a cost. There was varying productivity and structural differences within the Eurozone countries and the economies were not at a level playing field. Germany had a lower rate of unemployment as compared to peripheral nations of Greece and Portugal. This proves the fact that there was not much labour mobility as was envisaged. Unemployment remained relatively higher in peripheral economies and it was only France and Ireland that were comparable to Germany on this pretext. The cross-border expenditure rose drastically with the advent of a common currency. There was a large share of public debts held across borders with European banks. Most of the policies of the ECB were dominated by large economies like Germany and France. Therefore, most of the decisions favoured their economies and not the smaller ones.

The governments lost the control of their monetary policy and the exchange rate. These were two macroeconomic instruments that could have been used by the government to prevent the economy from collapsing. This could be seen in the example of Greece when there were imbalances created in its economy. The government could not devalue the exchange rate nor lower interest rates to provide an impetus to domestic demands, thereby, reducing unemployment and increasing income. These policies were being controlled by the ECB and all the nations were tied with a common currency. Any step in this regard would affect not only the nation who wants to devalue their currency but all the other members as well. Although this measure would not make Greece certain of the benefits, it could have put a stop to prices going down to match the German prices, adding to unemployment, reduced income and increased budget deficit.

The “Stability and Growth Pact” (SGP) added to the misery. Public finances were a reflection of the country’s historical, institutional and social development of each country. It was not possible to generalize the welfare system in this regard. The ability to collect taxes differed in every nation. Nonetheless, SGP imposed certain common fiscal trends on the Eurozone countries. It required the nations to coordinate even the fiscal policies to achieve the objectives of the integration and laid down limits for the fiscal deficit that could be incurred by a nation. However, these were mere recommendations and not binding. Its value was therefore as good as non-existent. The monetary policies were being coordinated by the ECB and the central banks. However, fiscal policies remained in the hands of individual nations. This is considered as one of the major reasons for the Euro crisis.

France had been persisting Germany to accept a stronger European Governance by coordinating the fiscal policy in the Eurozone. However, Germany has always rejected the proposal on the pretext that if governments of so many countries come together to form a fiscal union and start taking decisions on economic policies related to the government expenditure, the ECB will altogether lose its central position. To make their stance stronger, in summer 2009, the German Constitutional Court passed a sentence declaring any European federal governance as unconstitutional.

The impact of non-acceptance of this proposal was hardly contemplated and as long as there was growth, nobody paid attention to the fiscal capacity of the member nations. This led to fiscal free riding as was in the case of Greece. In late 2009, Greece admitted that its fiscal deficit was understated 12.7 % of GDP, as opposed to 3.7 % stated earlier. In late 2009, its public debt was over 113% of the GDP, far above the Eurozone limit of 60%.

Public expenditure started declining in the 1990s but not in Greece, where it remained relatively same. When the global crisis hit in 2007, the states attempted to support the aggregate demand and rescue financial resources. However, Germany did not increase its expenditure. Greek reduced the taxes on the rich as a result of which the public revenue declined. The revenue increased later, but not enough to make up for the losses incurred earlier. Ireland’s revenue also decreased despite the attempts in the 2000s. This falling revenue and rise in expenditure were inevitably creating public debt as the government had to borrow to finance their expenditure. Certain peripheral countries borrowed large volumes of funds particularly in case of Greece, Spain and Portugal. The ratio of national debt to GDP started rising. Since member states could not legally use exchange rate adjustments to mitigate the deflationary impact of shocks, the operation of the SGP and the EMU locked the Eurozone economies into a politics of disinflation and competitive deflation.

The fiscal requirement of the convergence criteria was being constantly violated. In addition, the Stability Growth Pact did not have any credibility in the absence of an enforcing body. On the top of it, was the belief that the ECB would bail out any countries that got into debt trouble. However, what the world did not know was that the design of the ‘independent’ European Central Bank precluded the necessary coordination of fiscal and monetary policy, and disabled the central banking system from providing sufficient support to national governments and their budget deficits. As a result, there was increased lending to the member nations and the government was spending mindlessly as long as its needs were being met. This led to a debt build up. A financial crisis in the peripheral economies like Greece translated quickly into zonal monetary and financial crisis, without the central monetary authority’s ability to act as the lender of the last resort. The ECB was expressly prohibited from buying the government’s debt. Had there been a fiscal union, with a system of horizontal transfer and controls, the deficit and debt ratio of the peripheral economies may have been contained.

The scope of EMU membership did not meet the standard neoclassical criteria for a common currency zone (indicating that less competitive economies would sooner or later be forced into recession and deflation) and there were no credible institutional arrangements to enforce long-term fiscal discipline, compensate for uneven development and economic performance or co-ordinate crisis management in a situation where conventional crisis responses such as devaluation were ruled out.

The crisis continues to affect the member nations even today and threatens the stability of lender economies as well. As Professor Jayati Ghosh mentioned in one of her interviews with, there are two ways out of this situation. One way is to dismantle the Eurozone by letting the weaker economies leave the Euro and depreciate their own currency. Second is really large fiscal transfers to the regions in distress, for which, the strong political will and commitment is required.



Chinar Gupta is a fourth-year student of law at the Jindal Global Law School.


Featured Image Source: Politico

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