For each of these trilemmas there appears to be an optimal, EMU-friendly solution; deviations from this optimal solution would imply trading-off indispensable policy objectives against each other.
Structural reforms to safeguard European welfare systems
A first inconsistent trinity exists between conducting sound fiscal policies and achieving sustainable welfare systems while pursuing unambitious structural reforms that will keep EU economies locked in a ‘stagnation trap’. It is not possible to have fiscal discipline and at the same time maintain the European welfare model on a sustainable basis without structural reforms that are able to deliver job creation and generate growth in order to finance those welfare models. An ambitious agenda of structural reforms should be pursued with policies focusing on competitiveness gains within sustainable and inclusive growth models. Balanced growth will require an acceleration of reforms in the core and semi-core countries, not only in the vulnerable countries which have shown greater ‘reform responsiveness’.
Reclaiming macro-economic policy space for greater adjustment symmetry
The eurozone faces a fundamental challenge to support the nascent recovery and deal with macro-economic vulnerabilities. Modest real growth – partly resulting from ongoing and inevitable adjustment in private sector balance sheets after such a major financial crisis – will be compounded in its effect on nominal GDP growth by slowing eurozone inflation, which is forecast at around 1.5 per cent for 2014 and 2015. Besides ensuring debt sustainability in a low-inflation environment, eurozone members face a simultaneous challenge in ensuring a rebalancing of competitiveness and external accounts.
The objectives of debt sustainability and external rebalancing in the eurozone may conflict, as long as actual eurozone inflation remains persistently low – well below the 2 per cent inflation target of the ECB. This conflict is particularly acute for highly indebted countries in the eurozone, which tend to have greater competitiveness adjustment needs, notwithstanding their progress made to date. So this conflict of policy objectives and economic realities can be represented as a second inconsistent trinity – that vulnerable countries cannot simultaneously reduce their high debt burdens and gain competitiveness in an environment of persistently low eurozone average inflation.
As both debt sustainability and competitive rebalancing lie at the very heart of macro-economic stability in the eurozone, the EMU-friendly resolution of this trilemma, therefore, is to reject inflation being persistently below ECB target. Doing so would widen the range of possible inflation differentials between the core and periphery that would still ensure non-deflation in the periphery. Crucially, this is not to argue for a change in the ECB’s inflation target, but rather to argue in favour of the ECB’s continued efforts to meet its mandated target. Ensuring different inflation rates in a diverse economic region consistent with aggregate price stability such as the eurozone is also about ensuring appropriate demand conditions in both the core and periphery. Tremendous reform efforts are already underway in vulnerable countries at a particularly weak point in the business cycle. Part of a durable resolution of this trilemma will also involve core countries undertaking reforms to boost domestic sources of growth resulting in higher domestic demand, in particular by supporting public and private investment. This balanced approach to eurozone macro-economic policy may also be thought of as a more symmetric form of adjustment that would make tackling the main vulnerabilities in the eurozone less onerous to deliver.
Effectively combatting systemic financial sector vulnerabilities
The third challenge, closely connected with the two previous ones, relates to the eurozone’s highly integrated financial system in the context of large banking sector vulnerabilities and limited national fiscal space. Many banking systems are both fragile and too large for any sovereign state to comfortably backstop. This is the root of what has been termed the ‘deadly embrace’ between banks and their sovereigns. A related problem has been the fragmentation of the eurozone’s financial systems. Credit conditions have become highly divergent across the eurozone, thus constraining recovery, especially in the more vulnerable economies, and impairing monetary transmission channels.
Overcoming the policy conflicts
The current economic and political realities suggest a need for policymakers to reflect on a new paradigm for economic integration in Europe. Resolving the three aforementioned inconsistent trinities through EMU-friendly solutions can achieve a superior outcome that benefits all eurozone members.
Slow growth would be tackled by bold structural reforms both in the core and the periphery, which in turn would allow for maintaining sustainable welfare systems.
Appropriate structural reforms would also increase domestic demand in the core, which would in turn have a positive effect on internal demand in vulnerable countries through exports, and would facilitate rebalancing.
Higher demand would help bringing overall eurozone inflation closer to its target and, hence, provide room for higher inflation differentials between the core and the periphery, giving margin for competitive gains in vulnerable countries, and at the same time alleviating debt sustainability problems.
If coupled with a full and effective Banking Union, financial fragmentation would recede, and credit conditions could support growth and reforms through spurring investment, while important fiscal and financial risks would be reduced by severing sovereign-bank links.
What does this imply in concrete policy terms? Vulnerable Member States have recently pushed through impressive structural reforms, which can be expected to deliver growth dividends in the medium term. Early signs of economic revival are visible already. These achievements notwithstanding, further progress is needed to rebalance their economies. Meanwhile, some other Member States, including those with current account surpluses, show signs of stronger domestic demand. Bolder reform efforts will help spurring domestic demand and will enhance the overall rebalancing process. Measures to encourage public and private investment would also not only help in rebalancing the EU economy but also increase potential growth in the medium term.
Finally, a genuine Banking Union would help break the vicious link between the sovereign and the banks. A critical step towards repairing the financial system is cleaning up and strengthening bank balance sheets. The asset quality review and stress tests, ahead of the agreed launch of the single supervisory authority (SSM), will be instrumental in this respect. It will have to be complemented with a Single Resolution Mechanism (SRM) and a Resolution Fund. The completion of a fully-fledged Banking Union remains critical to reverse the process of financial fragmentation and restore the flow of credit to the corporate sector, not only through its effect on fragmentation and the cost of borrowing, but also by providing a more stable, transparent, and predictable financial environment.
This ‘consistent trinity’, whose elements gradually start to materialise, could be the basis for a new contract for the eurozone.
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