14 January 2016

OMFIF: Why Europe needs to resolve euro trilemma

[...] A paper by Maurice Obstfeld, now chief economist of the International Monetary Fund, published by the European Commission in April 2013 when he was an academic at the University of California, is relevant here. ‘The euro area must confront a financial-fiscal trilemma: countries in the euro area can no longer enjoy all three [desired characteristics] – financial integration with other member states, financial stability, and fiscal independence – because the cost of banking rescues may now go beyond national fiscal capacities.’

Unless the British people see this euro area ‘trilemma’ resolved very soon, as well as recognition of the need to safeguard the interests of non-euro countries within the EU, Britain is likely to vote to leave when it holds a referendum on EU membership, most likely in June or September this year.

Since 2009, the US Treasury has been making determined representations to the euro area to act to disentangle the euro crisis. The message from Europe has been that the time is not yet right for substantive action. But when will it be right? As Obstfeld reminded us in 2013, ‘Most of EMU's first decade was passed in a singularly benign global environment. That allowed EMU to skirt the biggest potential challenges identified before its 1999 launch.’ According to Obstfeld, ‘the EU imposed the euro on a linked system of national economies with well-known structural rigidities in labour and product markets. Within each country, powerful national vested interests protected existing distortions’.

This EU unilateralism is now spreading to the EU ‘five presidents’, headed by European Commission chief Jean-Claude Juncker, who – we are told in leaks from Brussels – is discussing plans for a substantial new treaty, with a proposed timetable due to be published in early 2017. This has a significant bearing on British Prime Minister David Cameron's negotiating plans.

This creates an opening for a British referendum in November or early December 2017, a year later than currently planned. This would take into account possible treaty changes involving the European Economic Area, something I have long championed. But the UK is instead preparing for a referendum in 2016. Juncker and Cameron would be better served by bringing together their separate negotiations, and extending them to the end of 2017. It is not too late to negotiate for an expanded non-integrated European Economic Area to continue alongside an integrated euro area. [...]

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