Economic Imbalances and Institutional Changes to the Euro and the European Union

Rajmund Mirdala, Rosaria Rita Canale, Rajmund Mirdala, Rosaria Rita Canale

• Publisher: Emerald Publishing Limited
• Year: 2017
• ISBN:
  9781787149540
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

This book offers a criticalperspective from which to observe evolution of the Euro Area and the EuropeanUnion in these times of growing economic and political conflict. Keyimplications of design failures in the Euro Area (i.e. incorrect diagnostics ofthe public finance crisis, single monetary policy failure, heterogeneousmacroeconomic environment, asymmetry in macroeconomic policies, obstacles forpolicy coordination) and their contribution to the excessive external andinternal economic imbalances will be critically discussed from the economic, policy and institutional perspectives. This critical insight is used to examineboth institutional asset and economic performance of Europe after the crisis, moving from the authors' shared perspective that the crisis revealed the weakaspects of the whole architecture of the European Union.

The economic crisis revealed theexistence of different forms of imbalances inside the Eurozone and highlightedthe flaws of the institutional architecture of economic policy in Europe. Thegreater fragility of some countries in respect to others has triggered abackward process in which national interests have started to prevail over thoseof both the currency area and the entire European Union. In turn, this hasfuelled a progressive decline in confidence in the European institutions and iscreating growing questions of interpretation both in terms of economic theoryand institutional asset. This book focuses on these issues and on the degree oflegitimacy of the European institutions resulting therefrom. It aims toinvestigate the nature and validity of the European integration processemphasizing limits and challenges arising from it.

PART I
INSTITUTIONAL AND POLITICAL ISSUES IN THE POLICY FRAMEWORK OF THE EUROZONE

THE EUROZONE POLICY MODEL AND THE INSTITUTIONAL CONSOLIDATION PROCESS IN THE LONG-RUN

Mariangela Bonasia and Rosaria Rita Canale

ABSTRACT

The aim of this chapter is to show the limits of the European policy model and to support the existence, through straightforward empirical analysis, of an inverse relationship both in the short run and in the long run between trust in institutions and unemployment. The empirical methodology relies on dynamic panel data techniques allowing measuring in a single equation both the long-run relationship and the short-run speed of adjustment among variables. This connection appears to be valid both in the Eurozone considered as a whole and in particular in peripheral countries, where the macroeconomic dynamics have been, under this respect, much more divergent from the average. This outcome allows proofing that to consolidate the European process of integration in the long run, institutions should have as main objective not only inflation but especially unemployment.

Keywords: Economic policy; Eurozone; institutions; trust

JEL Classifications: E02; E63; C23

INTRODUCTION

The European Monetary Union (EMU) is the goal to which came the difficult integration process started after the Second World War. The crisis, born in United States in 2007 and arrived in Europe in 2009 as a sovereign debt crisis, weakened the economic structure of many Eurozone member countries and undermined the institutional architecture of the Monetary Union. The increased fragility of some countries in respect to others has been triggering a backward process, in which the national policy authorities’ targets have been in contrast with those of the supranational institutions.

Some countries after having used, in the aftermath of the crisis, fiscal policy as a stabilization instrument, were forced to implement fiscal retrenchments to respect EMU policy rules. Some others in the fear of a greater inflation opposed to the European Central Bank (ECB) policy strategy accused of being too ease toward peripheral countries. The prevalence of the approach based on the compliance to the existing rules caused an institutional stalemate that hindered the objective of a wider and deeper integration.

As a matter of fact the Eurozone policy prescriptions appear to take care mainly of the sustainability of national fiscal accounts in the strong theoretical belief that this is the precondition of low inflation. In turn, low inflation is the sufficient and necessary condition for a long-run stable growth. However, despite the measures implemented to target and preserve a sound public balance, it has been evident that growth declined and that the majority of countries have been experiencing ever increasing rates of unemployment (Canale & Liotti, 2015; Canale, Liotti, & Napolitano, 2014). In the 12 Eurozone countries, unemployment in 1999 was on average 9.5%, 7.5% in 2008, and 12% in 2013. The recent reduction of 0.4% (11.6% in 2014) seems to be too poor to compensate the uneasy conditions of some peripheral countries (in 2014 unemployment in Greece was 26.5%, in Portugal 14.1%, in Italy 12.7% and in Spain 24.5%).¹

At the same time an ever increasing distrust in the three main European Institutions – (1) the ECB, (2) the European Commission (EC), and (3) the European Parliament (EP) – can be observed, revealing that citizens believe that these three bodies are not capable to serve their interests.

This is detectable through the Eurobarometer, a biannual survey monitoring public opinion trends in European institutions within the Member States.² This biannual survey covers a wide range of topics, including questions ascertaining to what extent European citizens tend to trust in their main decision-making bodies, thus monitoring the process of integration and legitimacy. This degree of legitimacy, however, after an initial enthusiasm lasting more or less until 2008, seems to have declined in recent years. According to data collected in the whole European Union from the birth of the Eurozone to the present day (1999–2013), 43% of citizens were prepared to place their trust in the ECB in 1999 and 50% in 2008, declining to 34% at the end of 2013, while those who stated they distrusted the ECB increased from 29% in 1999 to 49% in 2013; those confident in the EP decreased from 53% in 1999 to 39% in 2013, and those lacking confidence increased from 28% in 1999 to 48% in 2013. Finally, trust in the EC decreased from 50% to 35% while distrust increased from 29% to 47% in the same years (in all three cases the percentage of those who responded “I don’t know” decreased).³

The aim of this chapter is to show the limits of the European policy model and to support the existence, through straightforward empirical analysis, of an inverse relationship even in the long run between trust and unemployment. This connection appears to be valid both in the Eurozone considered as a whole and in particular in peripheral countries, where the macroeconomic dynamics have been, under this respect, much more divergent from the average.

The whole sample contains 11 Eurozone countries – Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, and Spain most of which joined the Euro from the beginning (only Greece joined the Euro in 2001)⁴ – and goes from 1999 to 2013 with biannual observations. To achieve this objective, unemployment and inflation, widely recognized in the literature as determinants of the institutional consolidation process, are considered as the two main explanatory variables of the net trust.⁵ The empirical methodology is a dynamic panel data allowing measuring in a single equation both the long-run relationship and the short-run speed of adjustment among variables. This approach, using the error correction form, delivers results considered to be consistent even in presence of different dynamics in each country and despite the reduced number of explanatory variables.

The overall results show that respondents, in evaluating the institutional performances and their ability to reach the policy goals, take into account not only the rate of inflation, but especially the unemployment rate. This conclusion is particularly evident for peripheral countries and in a long-run perspective. This outcome allows proofing that to consolidate the European process of integration in the long run, institutions should have as main objective not only inflation targeting but especially the rate of unemployment. This is especially true if the aim is to not leave behind countries most in need and to preserve the institutional unity of the whole currency union.

The chapter is organized as follows: the next paragraph recalls the theoretical underpinning and the main pillars of the European policy model; the third paragraph reviews the literature about trust in institutions and the economic outcomes. The fourth paragraph presents the empirical strategy and results. These are presented separately for the whole Eurozone and for the peripheral countries. Finally the fifth paragraph draws conclusions and provides reflections on the institutional steps for the future of the integration process.

THE EUROPEAN POLICY MODEL: THEORETICAL UNDERPINNINGS AND FLAWS

The policy model, the European Union was built on, represents the most faithful implementation of the theoretical conclusions reached by the prevailing economic paradigm. The main idea is that monetary policy can be efficient only if there are rigid rules in single state interventions. The result is a subordination of fiscal policies to the wider objective of the stability of the Euro. This stability is the necessary condition for long-run convergence toward the natural unemployment rate.

European institutions shared this point of view, and despite the trade-off – at least in these times – between the reduction in public expenditure and interventions required to sustain growth, they have been asserting that there is only one single strategy to achieve both goals: the free operating of market forces which, in the long run, leads to steady growth, internal convergence and sound public accounts. There is the strong belief that: (a) short-term policies are not desirable because, even if they could have positive effects in the short-run, the final result is just an increase of inflation; (b) inflation is just a monetary phenomenon; (c) in the long-run inflation is proportional to the quantity of money in circulation and does not depend on what happens in the goods market; (d) gross domestic product (GDP) and unemployment fluctuate around their long-run value. This last one is independent from active fiscal and monetary policies (Canale, 2008).

These conclusions affected almost all the advanced economies and conduced to an institutional structure based on:

1. Separation between fiscal and monetary policy.
   Until the 1970s, economic policy has been managed more or less coordinately, according to different situations. The Central Bank effectively cooperated to the Government spending strategies. The main objective was the achievement of full employment, which the injection of resources would have assured to achieve. Since the early 1970s, after the collapse of Bretton Woods and the abandonment of the Gold Exchange Standard, economic theory changed orientation. The increase in inflation accompanied by a modest increase in employment brought to believe that the injection of money could not cause permanent changes in the real macro-variables but just a worsening of the income distribution, led to keep separate the decision-making process of fiscal and monetary authorities. The two policy authorities should cooperate just in presence of shared goals.
2. Fiscal policies managed within a general criterion of spending constraint.
   The direct consequence of the separation between fiscal and monetary policy is that the public debt must be placed – unless the Central Bank decides autonomously otherwise – on the private market. The higher the debt, the higher is the amount of interest to be paid. Moreover, Government spending, as prevailing economic theory states following the seminal contribution of Barro (1974), does not produce long-term growth, and it is therefore certainly desirable that State economic intervention were inspired by the general criteria of spending constraint. In addition public spending is often subject to the consensus mechanism, rather than to effectiveness and efficiency criteria.
3. Monetary policy with the purpose of maintaining constant the price growth.
   The distrust on the governments’ role in stabilizing output and the belief that the real growth could not be permanently affected by factors with a monetary nature, brought to assign to central banks the commitment of price stability. The achievement of this goal would have allowed perfect information, efficient market working and the achievement of full employment.
   In Eurozone two elements were added:

• a. A single monetary policy
  As a matter of fact the ECB manages monetary policy for all the Eurozone member states. The principle of “one size fits all” was applied in the strong belief that the financial integration would have assured real convergence.
• b. Fiscal policy based on a strict budgetary discipline and left to the management of individual states.

As it is well known, the Maastricht Treaty signed in 1992 and the Stability and Growth Pact state that public deficit and debt ratios to GDP should stand at 3% and 60% of GDP respectively. To achieve these objectives on March 2, 2015, Member States and many Eurozone countries (excluding the United Kingdom and Czech Republic) have signed the Fiscal Compact, which commits them to a path of reduction of public spending particularly onerous. In particular, the structural deficit – that is, the one that does not depend on the cycle – should not exceed 0.5% of GDP, and those countries with a debt/GDP ratio exceeding 60% should pursue a path of reduction of an annual value of 1/20 of the GDP.

This model showed its limits in dealing with situations such as those of the 2007s financial crisis. Its underpinnings are two controversial hypotheses that in times of crisis –in particular a financial crisis – represent an oxymoron: (a) the deterministic nature of the economic system; (b) the ability of financial markets to anticipate the future trend of the economy. According to the first hypothesis, in examining the working and the adjustment mechanisms of the economic system it is not necessary to consider the case of the occurrence of systemic shocks (i.e., affecting all countries contemporarily).

Following the second hypothesis – known as efficiency market hypothesis – financial markets are considered capable of assessing the various risks in order to prevent the excessive accumulation of debt, both public and private, by anticipating the future value of assets.

The crisis denied the goodness of these two assumptions and has been spreading negative real effects throughout the world through banks balance sheets, the higher financing costs and the fall of aggregate demand. The crisis also highlighted the greater fragility of some countries in respect to others and made clear that the economic policy structure was designed unbalanced. Unbalanced with respect to some countries and unbalanced with respect to the role of monetary policy to which both the output and inflation stabilization functions could be assign...