The European crisis and the challenge of efficient economic governance by Juergen B. Donges

/JUERGEN B. DONGES * /

The European crisis and the challenge
of efficient economic governance

1. Introduction; 2. The root cause of the problem: too much economic diver-
gence; 2.1. A suboptimal monetary area; 3. Attempted governance in an
indirect manner; 3.1. Breach of the fiscal rules; 4. Governance as activism
against the crisis; 4.1. Constituent principles, violated; 4.2. Financial assis-
tance, a never-ending story?; 4.3. Political pressure to impose discipline,
insufficient so far; 4.4. Financial markets, with capacity to persuade; 5. New
governance design: own responsibility as the key; 5.1. The euro Plus Pact, it
is not binding on anyone; 5.2. The Fiscal Stability Pact, a test of nine; 5.3.
The Macro-economic Governance Pact, with vague parameters; Conclusion

* Professor emeritus of economics at the Faculty of Economic and Social Sciences of the
University of Cologne (Germany). From 1969 to 1989 he managed several economic
analysis departments at the Kiel Institute for the World Economy, in which he was the
Vice-chairman for the previous six years until he took the chair in 1989 in Cologne. He
is currently a Senior Fellow of the Cologne Institute for Economic Policy. He was the
Chairman of the German Council of Economic Experts (the so-called “Five Wise Men”)
and the German Commission on Economic Deregulation. He is an economic advisor in
several academic institutions and foundations in Germany, Spain and in other coun-
tries. He is also a member of the Supervisory Board of several multinational companies.
He is the author of several books and articles published in academic journals on inter-
national economy and public policies in the field of macro and micro economy.

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The European Crisis and the challenge of efficient economic governance

1. Introduction

The purpose of this article is to focus the current discussion on the
need for economic governance in the European Union (EU) and, in
particular, in the euro area, in the context of the political reality.
This is not such an easy task, as it may seem; in practice the rela-
tions between national governments, on the one hand, and these
and the European Commission and the European Parliament, on
the other, end up being profoundly redefined, with more European
powers and less national sovereignty.

This topic is not new; it has been on the table at the mee-
tings of the European Council of the Heads of State and
Government since the formation of the European Single Market 25
years ago (1986 Single European Act). We can interpret agreements
leading to a coordination of economic policies, as the initial step
towards “smooth” European economic governance, specifically to
(i) promote employment (1997 European Summit of Luxembourg),
(ii) apply structural reforms conducive to flexibility in the product
and factor markets (1998 Cardiff Summit), and (iii) institutionalise
macro-economic dialogue among the governments, the European
Central Bank (ECB) and social partners (1999 Cologne Summit).
Apart from the above steps we should add (iv) the agreement of the
European Council in 2010 to launch a strategy of structural reforms
that would make the EU at the end of that decade the most dyna-
mic economic area in the world.

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The Future of the Euro

These agreements which were then celebrated as a landmark in
the European integration process have not given the desired results.
The reason is very simple: over and above the rhetoric, the govern-
ments were not willing to co-operate if the alleged or true national
interests indicated otherwise. Such governance installed in the
European Council, the Ecofin and in other councils of ministers
involved, lacked any kind of power of management and supervi-
sion of the economic and fiscal policies of the member states.

At the current debate the great hope is that in the future
national interests will come second, giving way to the “More
Europe”, as the new political logo reads. The aim is to reach gre-
ater and efficient intra-European co-ordination of the economic
policy of the member countries. This aim was raised in 2011-
2012 in three basic agreements: (i) the Euro Plus Pact (to strengt-
hen the competitiveness and growth capacity of the economies),
(ii) The Fiscal Stability Pact (Fiscal Compact to guarantee in all
the countries the sustainability of public finances in the medium
and long term) and (iii) the Macro-economic Governance Pact
(Economic Governance Six Pack, to ensure economic and fiscal
policies compatible with the internal and external balance in the
economies). Now, the declarations of intent are one thing, put-
ting them into practice and applying the appropriate economic
policies, is quite another. Why should what politicians promise
today be believable, if in the past (and today, as many of them
are still around) did not fulfil their commitments?

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I will now analyse governance in its past and present dimen-
sions. The following section emphasises the significant fact that
the euro area is not an optimal monetary area. In the third and
fourth sections the forms of governance relied on until now are
analysed. The fifth section deals with the new approach for
European governance. The last section concludes the analysis in a
tone of moderate hope.

2. The root cause of the problem: too much economic
divergence

The crisis of the sovereign debt in Europe has shown a serious
fault in the formation of the single currency: trusting that the
governments of the member countries would apply quality econo-
mic policies in accordance with the common interest of all the
partners, as set forth in the EU Treaty (articles 2 and 121), was
naive. In Germany, I together with many other economists noticed
this fault then, but political leaders took no notice or it was labe-
lled as “academic” and, therefore, irrelevant to take great historical
decisions. The leaders simply invoked the criterion of the so-called
supremacy of politics over economics, as they do today when they
run from one summit to the next to rescue certain countries from
bankruptcy and try to stabilise the euro area.

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2.1. A suboptimal monetary area

The architects of the euro area, from the 1989 Delors Report,
knew that a monetary union would not be feasible in the long run
without a fiscal union, not to mention political union. The history
of the different monetary unions in Europe in the 19th Century
had left an unequivocal message: all of them failed because of
incompatibilities among the budgetary policies of the member
countries. However, during the negotiations of what would become
the Maastricht Treaty (of 1992) the prerogative of national budge-
tary policy was sealed. The then two main characters of the
European project, the German Chancellor Helmut Kohl and the
French President François Mitterrand, fascinated their counterparts
with their vision of the euro as a pacemaker to accelerate and to go
into greater integration. More than one will remember the famous
statement of the French Finance Minister, Jacques Rueff, ‘Europe
shall be made through the currency, or it shall not be made’ (1950),
and they took it literally. The French statesman could never have
imagined such a deteriorated environment of public finances as we
have today in many European countries.

It was also clear that the five convergence criteria set forth in the
Maastricht Treaty, even if they could be fulfilled (something that
not all countries have done), did not guarantee an optimal mone-
tary area (in terms of the theory of Robert Mundell and others). In
Europe, it would have been essential for the countries to be quite
homogeneous in terms of economic development and functioning

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of the institutions or the prices and salaries in the various countries
should have been flexible enough (especially downwards in coun-
tries with weak growth and great structural unemployment), or for
European mobility of labour to be high (from backward regions
with high unemployment rates to dynamic regions with shortage
of workers). These conditions for an optimal monetary area did not
happen twenty years ago and do not happen today. The difference
between Europe and the United States in this is significant.

Only a group of countries in the euro area (in central and nort-
hern Europe) at least met then and meets now the condition of
homogeneity. The countries in the southern periphery were not,
strictu sensu, ready for their accession in 1999 to the monetary
union and, therefore, to waive a monetary and exchange rate
policy as adjustment facilities of internal imbalances (inflation)
and external imbalances (current account deficit) and to under-
take tax regulations that would restrict government deficit and
the level of government debt. It is not a coincidence that these
countries have had for the past two years a risk of insolvency (not
to have the capacity to re-finance the debt in the capital market
under affordable conditions), as only sovereign countries have, if
the State may not resort to the Central Bank to secure financing
and must get it by issuing bonds in a foreign currency. Greece
may be the most illustrative example of having done what the
German Council of Economic Experts has classified as an “origi-
nal sin”, in other words, having rushed into accessing the mone-
tary union in 2001, forced even through deceit (hiding the truth

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of their fiscal statistics): the country is now at the mercy of the
international financial markets (rating agencies), after having
revealed the serious structural deficiencies in the economy and
the public institutions, which has led to a low growth potential
and low levels of productivity and competitiveness clearly insuf-
ficient at this time (globalisation of competition).

3. Attempted governance in an indirect manner

It was conceptually logical that with the creation of the single
currency the powers on monetary policy would be transferred
from the National Central Banks to the new ECB. However, as the
budgetary policy would carry on being a national responsibility,
two principles constituting the euro area were established in
order to guarantee the sustainability of the public finances in the
member countries and to ensure that the monetary union would
work as a price stability union.

• The two principles proclaimed in the Maastrich Treaty are the
prohibition to bail out insolvent partners, on the one hand,
and the prohibition imposed on the ECB to finance govern-
ment deficits (no monetisation), on the other hand. These
clauses are contained in the most recent version of the Treaty
on the European Union (the Treaty of Lisbon of 2007) in arti-
cles 125 and 123, respectively.

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• The two provisions were supplemented with the Stability and
Growth Pact (SGP) approved in 1997 at the European Summit
in Amsterdam; in it a ceiling for national budget deficits (3%
of GDP) and government debt (60% of GDP) were established
under the assumption that the growth rate of the nominal
GDP in the euro area would be 5% in the medium term.1

With all this, indirect governance elements were created, in
other words, formally maintaining national powers in budgetary
policy, but controlling the use of the powers that could destroy
the feasibility of the euro area.

The monetary union was not designed to pay debts jointly and
generate financial transfers from certain States to others, as many
today think that that is the case, appealing to solidarity among
peoples. There was already solidarity, and there still is, in the
good sense of the concept: the more developed countries of the
EU must help the least developed for these to advance in real
convergence; the various European Structural Funds are for this.
But it is not compatible with the concept of solidarity; it rather
constitutes a “perversion” (Issing) of it, having to rescue a society
that underestimates saving, tends to consume ostentatiously,
tolerates waste by the public authorities, does not fulfil tax obli-

1 For a profound analysis see A. Brunila, M. Buti and D. Franco (ed.), The Stability and
Growth Pact: The architecture of fiscal policy in EMU. Houndsmills/Basingstoke (United
Kingdom): Palgrave, 2001 – Círculo de Empresarios (ed.), Pacto de Estabilidad y
Crecimiento: alternativas e implicaciones. Libro Marrón 2002. Madrid (December).

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gations and claims social benefits beyond the means of the
country, given its own resources.

3.1. Breach of the fiscal rules

The architecture of indirect governance crumbled when it had to
pass the first real test, in 2002/03. In those days, Germany
(Schröder) and France (Chirac) violated the the fiscal rules of the
game. In Germany, government deficit had reached 3.7% of GDP
in 2002 and 3.8% in 2003; in France, it was 3.2% and 4.1% respec-
tively. In both cases, most part of the deficit was structural. The
European Commission had activated, according to the SGP, the
supervisory mechanism for ‘excessive government deficit’ against
these two countries. The German Chancellor explicitly rejected the
intervention from Brussels, the same as the French President. They
both imposed their criterion at the European Council in November
2003, which suspended the process (against the votes of Austria,
Spain, Finland and Holland). The then President of the European
Commission, Romano Prodi, had described the SGP in an inter-
view (on 18/10/02) as “stupido”, which is highly surprising coming
from the custodian of the European Treaties.

At the European Summit held in March 2005, the SGP was
amended, watering it down a great deal: with new exceptions for
breaking the rules, an assessment of the budgetary situation on a
case-by-case basis, considering the special circumstances of each
country, relaxing the periods to take the necessary adjustment

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measures, the differentiation among countries as regards the goal
of budgetary consolidation in the medium-term and some com-
plex and non-transparent supervisory mechanisms.2 We must
remember this in order to understand the reason for the current
proposals to depoliticise (“automate”) the decisions on sanctions
in case of an infringement of the fiscal regulations.

With the erosion of the SGP, the factors that determined the cri-
sis of the current sovereign debt, put down roots, a crisis which
would have happened anyway, if the 2007-09 global financial and
economic crisis had not have appeared. If the governments of the
two main countries of the euro area are skipping the Treaty of
Europe and the SGP, why wouldn’t the rest do the same if this is
what is best for them and open the tap of non-productive public
expenditure? Structural government deficits increased conside-
rably and with this the volume of the government debt. With this
precedent, the supervision of national budgetary policies by the
European Commission was reduced to merely a rhetorical exercise
that did not scare the rulers much. Economic governance in an
indirect manner had failed. The ECB, however, fulfilled its role and
its first president, Wim Duisenberg, did not allow political leaders
to tie his hands, despite their attempts.

2 For this purpose, the European Commission adapted the original regulations No
1466/97 and 1467/97 of 7/7/1997; see COM (2005) 154 and COM (2005) 155 of
20/4/2005.

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4. Governance as activism against the crisis

The threat of Greece’s suspension of payments two years ago
showed lack of efficient European economic governance. Instead,
a rare and disconcerting political activism appeared. The nume-
rous measures taken since May 2010 in Europe seem more like an
exercise of muddling through than implementation of a consis-
tent and long-term strategy.

4.1. Constituent principles, violated

It all started in the worst possible manner: the Governments eli-
minated in one fell swoop the two principles establishing the euro
area mentioned above.

The lifting of the non-rescue clause created the problem of
moral hazard for Governments with a tendency to excessive public
expenditure and for reckless banks when it comes to buying
government bonds. The Governments could pass the cost of exces-
sive indebtedness to taxpayers from other countries (who had no
right to speak or vote when the budgets of the State in question
were drafted). The banks started a tremendous communication
campaign to warn of the danger of the euro area (systemic risks) if
indebted countries were not rescued, efficiently concealing to the
public opinion that their true intention was to protect their share-
holders.

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Under the presidency of Trichet, the ECB was under pressure to
undertake a new role: the role of being a “repair shop” for the
faults in the fiscal and growth policies. It acquired in the Securities
Markets Programme, big sums of Treasury bonds from countries in
trouble which nobody wants. Here lies the difference with other
relevant central banks (the Federal Reserve, the Bank of England,
the Bank of Japan), they also buy government securities in the con-
text of their non-conventional monetary policies, but these are
assets with considerable profitability. Furthermore, the ECB
currently grants unlimited liquidity to banks for three years, at a
symbolic interest rate (1%) and it accepts low quality securities as
guarantee. But it is not in its hand to lead banks to proper granting
of credit to companies or households in the country under affor-
dable conditions; the ECB must resign itself to banks choosing
more profitable business in the short-term, as purchasing the debt
of the State; therefore, there is not much change in the scenario of
credit restriction in the private sector in several countries, like in
Spain. The European monetary entity is not only “a last resort len-
der” anymore, which in situations of financial emergency is justi-
fiable, but it has also become “a public debt buyer of last resort”,
which is more questionable, because it delays the fiscal adjust-
ments of the Governments (and it caused in 2011 the resignation
of two German senior members of the monetary authority bodies,
first the resignation of Axel Weber, President of the Bundesbank
and ex officio member of the ECB Governing Council and, subse-
quently, the resignation of Jürgen Stark, member of the Board of
the ECB and its chief economist). The role that the ECB is playing,

108


for the moment also under its new president (Draghi), may dama-
ge its reputation as an institution independent of political powers
and commited to price stability, which is what it has been entrus-
ted with in the European Treaty.

An additional problem is that the same standards of asset qua-
lity, which are used as collateral in the re-financing of commercial
banks by the National Central Bank itself (and, as such, part of the
Eurosystem), do not govern in the whole of the euro area anymo-
re. In several countries in trouble, especially with persistent current
account deficits which (already) do not finance in a conventional
manner import of capital or through financial assistance from
abroad, the respective National Central Banks, with permission
from the ECB, accept low quality securities as guarantee of loans,
more than what is allowed for emergency liquidity assistance. It is
as if they were using the money printing press. This somewhat
undermines the monopoly of the ECB to create money. What is
questionable from an economic perspective is hidden behind the
enormous increase in the amount of these operations in the
Eurosystem Target 2 in the past years, which has been vehemently
warned by the Ifo Institute of Munich for the last year.3 The
Bundesbank has become a gigantic creditor of hundreds of millions
of euros for the National Central Banks of the other countries, wit-

3 See H.-W. Sinn and T. Wollmershäuser, “Target Loans, Current Account Balances and
Capital Flows: The ECB’s Rescue Facility”, NBER Working Paper, No 17626 (November).
CESifo, “The European Balance of Payments Crisis”, CESifo Forum, Special Issue, January
2012.

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hout protection and right to any kind of compensation if there is
any significant bankruptcy of banks and savings banks or if the
euro area collapses. The Governments of debtor countries have in
reserve a powerful argument to manage to get from others, espe-
cially from Germany, concessions in the negotiations over finan-
cial assistance.

4.2. Financial assistance, a never-ending story?

Political leaders believed, and some of them still do, that the
creation of a common rescue fund is the solution to the problems
of countries in trouble and it eliminates possible spillover effects.

The first rescue mechanism was created with the European
Financial Stability Facility (EFSF).4 This fund is provisional (three
years, until 2013) and at the beginning had a provision of 440,000
million euros in loans guaranteed by the euro countries; as the
Fund wanted to place their issues with the highest ranking ‘AAA’
to get attractive profitability, the real lending capacity would be
lower than the allocation, about 250,000 million euros. Ireland
(87,500 million euros) and Portugal (78,000 million euros) had to
resort to this Fund. Subsequently, in July 2011, the European
Council decided to increase the real lending capacity of this rescue
fund to 440,000 million euros and, in addition, increase their

4 EU Council of Ministers (Ecofin), EFSF Framework Agreement, 9/5/10 and 7/6/10.
Web page: http://www.efsf.europa.eu (Legal documents).

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powers and relax the conditions for granting the loans to countries
in trouble. It even received leverage instruments (with a 4 factor)
and the so-called ‘special purpose vehicles’ (off-balance); such ins-
truments, applied by private banks, were exactly the ones that trig-
gered very harmful effects for the global financial crisis to break in
2008.

In mid-2012, six months in advance to the original schedule, a
new permanent rescue fund will come into force, the ‘European
Stabilisation Mechanism’ (ESM).5 This fund will have a provision
in nominal terms of 700,000 million euros (with capital contribu-
tions from the member countries amounting to 80,000 million
euros); the real lending capacity of this new Fund is 500,000
million euros. Provisionally, the amount of available resources may
amount to about 800,000 million euros, by transferring the unused
EFSF resources. The IMF, the OECD, the United States and China,
among others, recommend a higher firewall (up to 1.5 billion
euros).

In parallel with these events, a special treatment has been given
to Greece. After the initial financial assistance plan approved in
May 2010 (110,000 million euros, of which 30,000 million euros
came from the IMF), of which politicians said that it would enable

5 European Council, Treaty Establishing the European Stability Mechanism (ESM), 25/3/11.
Internet: http://www.efsf.europa.eu (Legal documents). – European Council, Treaty sig-
ned by the 17 euro area Member States, 2/2/12. Internet:
http://www.european.council.europa.eu.

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the country to return to the capital market in 2013, in February
this year a second package was agreed (130,000 million euros,
including a contribution from the IMF, to which a further amount
of 24,400 million euros of the first package pending payment will
be added). The latest thing is that private creditors will undertake
(about 85.8% voluntarily and the rest will be obliged by law) a
deduction of 53.5% and will agree for the rest of their securities an
exchange for new Greek long-term treasury bonds and of the EFSF
Fund at a moderate interest rate (which will reduce the Greek
public debt in about 107,000 million euros of a total of 350,000
million euros). Greece’s main public creditor, the ECB, has escaped
this operation and the asset losses derived from it, by means of a
trick, quickly exchanging their former Hellenic bonds, which
would have undergone a reduction, for new exempt bonds under
the same condition.

The official aim is to get the public debt to be reduced from the
current 160% of GDP to about 120% of GDP in 2020. The Ecofin
believes that this level is sustainable, which is quite surprising for
three reasons: firstly, this level was what Greece had in 2008/09,
already in the increase and considered unsustainable then;
secondly, the tax authorities must improve a great deal in order to
promote the capacity to collect taxes and stop tax fraud and capi-
tal flight; and thirdly the IMF’s estimates of 2-3% economic growth
per year from 2014 must be fulfilled, which implies that the neces-
sary structural reforms must be quickly implemented and the eco-
nomy must reach considerable gains in international competitive-

112


ness by substantial salary and price reductions (according to the
estimates, about 50%). All of these points are question marks. The
most probable thing is that the announced aim of debt reduction
will not be attained and that the European governments sooner or
later will again have on the negotiating table Greece’s request for
further financial assistance.

4.3. Political pressure to impose discipline, insufficient so far

The European form of governance since the sovereign crisis star-
ted in Greece has always been “more of the same”: to want to solve
a problem of excessive indebtedness with more debt. The critical
public opinion, as in Germany, was calmed down by saying that no
cash was going to be paid from national budgets and, therefore,
from taxpayers (although there will be in the ESM), but that each
government “only” had to provide guarantees (distributed among
the countries according to the holdings of the national central
banks in the share capital of the ECB). As if guarantees could not be
enforced at the demand of the creditors, in other words, buyers of
the securities issued by the EFSF/ESM! The expectations to calm
down the markets, restore confidence and stabilise the euro area
were not met. The markets had noticed that, in the countries badly
affected by the sovereign debt crisis, progress in fiscal consolidation
and structural reforms that raise the potential of growth and com-
petitiveness, which there are, were too slow and incomplete.

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This was caused from outside. The aided governments have not
forgotten the political messages launched from the beginning of
the crisis from Brussels/Paris/Berlin. The messages that are least for-
gotten and carry on being repeated with slight variations, are the
following: (i) “We will rescue the euro, no matter what it costs”
(Barroso); (ii) “We will not allow anyone to fall into insolvency”
(Sarkozy); (iii) “If the euro fails, Europe fails” (Merkel). There could
be no better invitation for irresponsible governments to blackmail.
That is how a government in trouble is tempted not to consistently
take pure and hard measures, therefore reducing the cost of loss of
political support, which any severe fiscal adjustment plan (with
unnavoidable cuts in salaries and social benefits and necessary rise
of taxes) would imply. In Greece it is already normal for the Troika
(the European Commission, the ECB and the IMF), each time that
it visits Athens to verify if Greece’s government has implemented
its commitments, to confirm that there is lack of forcefulness in the
policies applied, especially in relation to the structural reforms. But
as the President of the euro group, Juncker, and the Ecofin finally
have given the green light for new aid tranches to be given, the
government (after Papandreou, Papademos) could, after long nego-
tiations, according to the demands of his European partners, and
once at home, do half of it. He could even reject the proposals made
by his partners (Germany, the first) to provide administrative advi-
ce in situ, for instance, in order to create an efficient tax agency and
to design and manage infrastructure investment projects.

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If with the aid programmes the idea was to buy time to imple-
ment structural reforms in the real economy, as the political leaders
repeatedly emphasised, time was not used productively in all the
countries involved, and Spain was no exception during the last
part of Zapatero’s government, when the crisis was not officially
denied anymore: fiscal and economic consolidation policies arri-
ved late and lacked consistency and force.

4.4. Financial markets, with capacity to persuade

One way of overcoming the reluctance of the governments to
inexorable political and economic changes in their respective
countries comes from the market, specifically the spreads of the
risk premiums included in the interest rates where the Treasury
may place their issues.

As mentioned above, the risk premiums of ten-year bonds, with
reference to the German bond, “bund”, reached rocket prices in
Greece in 2011 and also considerably in the other peripheral coun-
tries with debt problems, including Spain, where the interest rates
reached all-time highs of several hundred basis points. The same
happened with the credit default swaps (CDS) premiums. No mat-
ter how much the governments criticised financial agents for this,
not to mention also the three main rating agencies (Fitch, Moody’s,
Standard & Poor’s), we cannot understimate its deterrent effect
when it is intended to go into greater debt. The increase in price of
the debt convinced political leaders in the countries in trouble that

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the time of spending happily had gone and that they had to be
prepared for a future characterised by austerity. The new govern-
ment of Spain (Rajoy) is an example of strict action to modify
unsustainable habits in society and restore the economy. In Italy
there was a big change of direction since a government of techno-
crats (Monti) started in November last year. Ireland had already
started in March 2011, after early parliamentary elections and the
formation of the new government (Kenny). Three months after
that, the same happened in Portugal (Passos Coelho).

Therefore, any decision to artificially reduce the interest rates of
government bonds, as it has already been taken within the context
of rescue packages and as some governments claim, is counterpro-
ductive. Eliminating the mechanisms of the market that act, wit-
hout political interference, in favour of the quality of public finan-
ces, is pointless. Mutualisation of the sovereign debt, no matter
how much it is proclaimed by certain political circles (also Spanish,
irrespective of ideologies), as well as academic (including German,
Keynesian ideas) and financial (especially the most important
banks which are anxious to operate in capital markets with great
liquidity, comparable to the U.S. market) circles, is also pointless.
There is no reason why we should think that issuing eurobonds
would improve the quality of the economic policy in the euro area.
On the contrary, a reduction in the price of credit in the countries
in trouble, which the eurobond would entail, would deteriorate the
estimates of low cost, which all categories of public sector outlays
and any decision by the public authorities on loan finance, would

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be subjected to; furthermore, it would be impossible to put pressu-
re on a government from outside to control expenditure and opti-
mise tax collection; and, in addition, restructuring processes in the
real economy, which are so important to raise the potential of
growth, would be postponed. It is far better for the financial mar-
kets to deploy their penalising effects and thus complement the
relevant mechanisms planned by the SGP and the coming Fiscal
Stability Pact.

5. New governance design: own responsibility as the key

It seems that European leaders got it into their heads that the euro
area needs another kind of governance different from what we have
had until now.

We will have to carry on thinking in the need for official assiss-
tance for certain countries, not only for Greece. As regards Greece,
maybe we must think of two options: one, exiting the euro, in
principle on a provisional basis (until the fundamental problems
have been solved) and continue as a EU member; two, exiting the
Economic and Monetary Union, also for a certain time, but kee-
ping the euro as dual currency circulation with their own currency.

Politicians now understand better than in the past that, for the
feasibility of the monetary union in the long term, we need robust
and resilient foundations to prevent external shocks of offer and

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demand, both from outside and from inside (which in some way or
another will happen again). It is not enough to have a determined
common monetary policy dealt with by a competent European aut-
hority with aims of stability and orderly functioning of inter-bank
market. This is only one of the required conditions. Two further fun-
damental conditions are inexorable for the context of national eco-
nomic policies:
• On the one hand, there must be some rules on behaviour in bud-
getary and economic policy compatible with the efficiency crite-
ria in the allocation of production factors and with growth and
employment aims. The problem of “moral hazard” must be
totally eliminated.
• On the other hand, there must be unconditional willingness of
the governments to observe these rules and act according to
them. There must be a clear division of work and responsibility
between the governments and the ECB.

Indeed, efficient European governance means the transfer of the
national sovereignty to the European Union in budgetary matters
and in areas essential to the real economy. This would entail a qua-
litative leap in the process of integration.

The three pillars of the new architecture are:
• The Euro Plus Pact (approved at the European Summit of 24-25
March 2011, with immediate effect);
• The Fiscal Stability Pact (approved at the European Summit on
1st March 2012, with the exception of the United Kingdom and

118


the Czech Republic, and estimated to come into force, after rati-
fication by the national parliaments, on 1st January 2013);
• The Macro-economic Governance Pact (approved by the
European Parliament in September 2011 and ratified by the
European Council, which is in force already).

The three Pacts complement one another. Without quality of
public finances there will be no appropriate economic growth (“dis-
trust effect”), but without economic growth it will be impossible to
have organised public accounts (“tax collection weakness effect”),
and with no macro-economic balance growth will be slower (“effect
of inefficiency in the allocation of production factors”).

5.1. The Euro Plus Pact, it is not binding on anyone

This Pact is based on right diagnosis: the potention of growth in
southern countries and the capacity to create employment (to a gre-
ater or lesser extent) are low owing to the persistence of negative
national factors: non-qualified labour, insufficient technological
innovation in companies, over-regulation of the labour market and
of various services, inefficient bureaucracy, deplorable tax fraud and
corruption. For this reason, structural reforms in the economy and
the institutions are so necessary.

The governments of the countries of the euro area have under-
taken to implement it; other six countries of the EU have also

119


undertaken this commitment (for this reason the term “Plus” has
been added to the name of the Pact).6 The scope of action that the
Pact contemplates affects the labour market, the educational sys-
tem, the environment for research, the tax system and a long etce-
tera. All this is praiseworthy.

But the main problem of the Pact is that it gives full freedom to
the governments to take the measures that they deem appropriate
and not to take others that would also be necessary from an objec-
tive point of view. There is no sanction in case of lack of strictness.
Therefore, this pillar of economic governance of the euro area does
not offer security.

5.2. The Fiscal Stability Pact, a test of nine

Rightly, the inexorable key is the commitment from the govern-
ments to maintain orderly and balanced public finances in the
future.

This is no dogmatic approach (“neoliberal”, as some call it pejo-
ratively), but it is the consequence of an economic analysis, sup-
ported by theory and empirical experience. Government deficit
must be limited, owing to the “Domar condition”, according to
which, for reasons of assignative efficiency, long-term interest rates

6 European Council, Conclusions 24/25 March 2011, Annex I: The Euro Plus Pact –
Stronger Economic Policy Coordination for Competitiveness, Bruselas, 25/3/11 (EUCO 10/11,
CO EUR 6, CONCL 3).

120


must be higher than the economic growth rate. With no ceiling for
government deficit sooner or later we reach a point from which the
financial expenditure of the State (for servicing the debt) increases
substantially, which progressively reduces the room for manoeuv-
re of the government to seek its economic and social aims. The
level of public debt must be limited because of the
“Reinhart/Rogoff rule”, derived from econometric studies, which
establish a critical threshold of 90% of GDP, from which the secu-
lar economic growth rate may diminish at least half a percentage
point per year for three reasons: one, because public debt servicing
reduces the margin for productive investment of the State (infras-
tructures); two, because payment of interest to foreign creditors
reduces available national income and, therefore, the capacity of
consumption of households; and three, because the need to re-
finance sovereign debt makes financing of private companies in
capital markets difficult (“expulsion effect”).

The Ltmus test is characterised by strictness under which the
governments deepen in budgetary consolidation. Despite the fact
that in different countries of the euro area some measures invol-
ving tax adjustment have been taken already, public finances are
not consolidated at all. According to the European Office of
Statistics (Eurostat), government deficit is excessive (more than
3% of GDP) in most of the countries, also in Spain (2011: 8.5% of
GDP). Germany (1%) and four small countries (Estonia, Finland,
Luxembourg and Malta) are the few exceptions. Most of the
government deficits are structural, in other words, not cyclic but

121


permanent, and, therefore, destructive for the good functioning
of the economy. The level of public debt is also too high (higher
than 60% of GDP) in almost all the countries, including
Germany (2011: 81.2%) and France (85.8%) and now also Spain
(68.5%), for the first time since 2011, Spain (68%). Where public
debt greatly exceeds all acceptable levels according to the
“Reinhart/Rogoff rule” is in the three countries that have been
rescued (Greece, Ireland and Portugal) and in Italy. For the latter
country, however, there is a differentiating factor in its favour,
most of the public debt is internal and, thus, its servicing may be
managed directly with its own instruments (by increasing fiscal
pressure on its citizens).

As mentioned above, the rules on sustainability of public finan-
ces as set forth in the Treaty of the European Union and in the SGP
have not been efficient to impose budgetary discipline. Its applica-
tion has been highly politicised. The mechanisms of penalisation
have never been implemented. The new Fiscal Pact has been arran-
ged in such a manner that it could put the screws, firstly, on the
euro countries on which the agreement is binding.7 The most
important advances as regards the SGP, for the moment only on
paper, are the following three:
• Firstly, the seriousness of government deficit is explicitly ack-
nowledged when it is structural. The explicit ceiling established

7 European Council, Treaty on Stability, Coordination and Governance in the Economic and
Monetary Union, 2/3/12, artículos 3-8. Internet: http//:eur-lex.europa.eu.

122


is 0.5% of GDP, maintaining the threshold of 3% for total defi-
cit. There is thus a large margin for the operation of “automatic
stabilisers” in the economic cycle and for discretionary govern-
mental measures if there is recession.
• Secondly, the aim of limiting the level of public debt at 60% of
GDP through a procedure which, if the debt exceeds this per-
centage, may activate the supervisory mechanism for “excessive
government deficit”, even if the deficit is below 3% of GDP. The
country in question shall be forced to reduce it at an average
rate of one twentieth per year as a benchmark (“1/20 clause”).
• Thirdly, the obligation for each member country to define its
medium-term budgetary objective (MTO), quantifying an indi-
cator for public expenditure evolution and making sure that the
estimated expenditure shall be financed by sustainable income
(“golden rule” of budgetary balance). If a country does not orga-
nise its budgets in a balanced manner it will be required by the
European Commission to submit new budgetary plans.

If the new rules are important, a mechanism to enforce them is
equally important. The most relevant three new elements are the
following:
• First, continuous supervision of the policies applied in both
summits of the euro area has been devised (two per year, at
least, called and chaired by the President of the EU, currently
Herman Van Rompuy).
• Second, there is a change in the decision process on financial
sanctions (of up to 0.2% of GDP) in case of breach and non-ful-

123


filment of the specific recommendations to remedy the situa-
tion in the sense that a proposal of the European Commission is
considered approved if the Council of the Heads of State and
Government of the euro area does not vote against it with a qua-
lified majority (until now such a majority was required for the
European Council to approve the sanction). Therefore, there will
be less room for political maneuvre to prevent the fine (as it was
normal in the past after the Schröder/Chirac precedent mentio-
ned above). The sanctions are not totally automatic as one
would like them to be, but they are moving in that direction.
Furthermore, they have a broader scope than before, because the
manipulation of fiscal statistics shall also be punished.
• Third, the obligation for each member country to transpose the
fiscal stability rule into its national legislation is established and,
therefore, be explicitly responsible for its fulfilment. The Court
of Justice of the EU shall ensure its fulfilment.

For the States to decide the medium-term budgetary stability
(equivalent to the economic cycle), the most credible formula is to
constitutionally estabish a ceiling for structural government deficit.
Germany has already done it (0.35% of GDP for the central govern-
ment, from 2016, and cero deficit for the federal states, from 2020).
Spain is moving in that direction after the reform of article 135 of
the Constitution at the end of the previous term of office and the
recent approval of the Budgetary Stability Law which will require
from 2020 cero structural deficit to the public authorities (which
could be up to 0.4% of GDP in exceptional circumstances). Other

124


countries are moving in that direction. The advantage of a consti-
tutional rule as regards de margin of debt of the government is that,
if a country incurs deficit and constitutional breach, it will need bet-
ter arguments for its society than if it only needs to be explained
before the Community authorities and take there the relevant war-
nings; Brussels is “far” and it is “under suspicion” of meddling in
national affairs.

The Fiscal Pact will only work if the euro area countries are
willing to do without most of its sovereignty in budgetary matters,
which will be transferred to Community institutions. Obviously,
this affects the main prerogative of national parliaments, which is
to shape the budgets of the State and decide how to finance expen-
diture. This will meet great opposition, in all the countries. It is not
a trivial matter that the Fiscal Pact must be institutionalised
through an inter-governmental agreement, that is to say, a level
lower than the Treaty of the EU, which reform would have requi-
red the unanimous approval of the twenty-seven, which was not
reached. This procedure has opened in the legal field a debate to
decide if the procedure chosen is compatible with Community
Law, specifically in relation to the mechanisms of sanctions for
excessive government deficit as set forth in article 126 of the
Treaty. For European leaders to have lowered the quorum required
for parliamentary approval of the inter-governmental agreement is
not a trivil matter either, to 12 of the 17 States that form part of the
euro area. Could it be that some partners are not reliable? It is true
that it has been decided that the countries that do not ratify the

125


Pact and transpose to their national legislation the ceiling of
government deficit will be excluded from possible financial bai-
lout. However, is this credible, especially if the stability of the euro
area is at risk? This being so, it would be better not to be too hope-
ful about this Fiscal Pact.

5.3. The Macro-economic Governance Pact, with vague
parameters

The same caution is advisable with regards to the solemnly
proclaimed Six Pack (so called because its content has been draf-
ted through a Community directive and five regulations).
Nodoby doubts that, for the feasibility of the euro area, macro-
economic stability is a necessary condition (although not enough
if the requirements for an optimal monetary area are not fulfi-
lled). Furthermore, it is true that macro-economic stability goes
beyond budgetary balance, as it has been proven with the recent
experience of different countries (inflationary pressure, property
bubble, excessive private sector debt, competitive weakness of
companies, current account imbalance, etc.). However, the
European Commission, the European Parliament and the
European Council seem to have faith in the capacity of economic
policy to handle crucial factors in the real economy. This is
highly questionable.

An alert mechanism scoreboard was created for the appearance
of internal and external imbalances in the countries, which will be

126


managed by the European Commission based on ten parameters,
as follows: 8
• Internal imbalance parameters: evolution of unit labour cost,
unemployment rate, private sector indebtedness, credit to the
private sector, evolution of property prices and government
indebtedness.
• External imbalance parameters: surplus and deficit of current
account balance, net international investment position, change of
export market shares and change of the real effective exchange
rates of the euro.

For these parameters, critical thresholds have been established,
from which the alarm would be triggered, and this would start a
procedure to analyse the causes in order to decide from Europe if
corrective measures need to be taken or not. For instance, for unit
labour costs the threshold is an increase of 9% in three years, for
unemployment rates it is 10% of the workforce as a three-year ave-
rage or for current account balance the threshold established is 3
year backward moving average of the current account balance as a
per cent of GDP, with a threshold of +6% of GDP (surplus) and -4%
of GDP (deficit). If there is excessive imbalance, the European
Commission will make the relevant recommendations for the
government of the country in question to remedy the imbalance; in
case of non-fulfilment, a fine may be imposed (up to 0.1% of GDP).

8 European Commission, EU Economic governance “Six Pack“ enters into force,
MEMO/11/898, 12/12/2011.

127


The thresholds set are not a consequence of a detailed economic
and empirical analysis that may indicate for sure when an imba-
lance is excessive for a country and negatively affects the euro area
as a whole. The numerical values rather represent the perception of
politicians of the recent events; therefore, they are, unavoidably,
arbitrary. But the fundamental question is different: How can a
government act efficiently?

We must remember that the EU proposes an open market eco-
nomy with free competition (article 119 of the Treaty of the EU). All
euro countries have this concept of economic system, some becau-
se of the Ludwig Erhard tradition (Germany), and others with reser-
vation in favour of the government (France). In a market economy,
the government lacks the instruments to control the variables con-
templated in this Macro-economic Governance Pact. Therefore, the
governments should activate a series of interventionist measures,
with no guarantee of their efficiency and with a high risk of distor-
ting efficiency in the allocation of production factors. In a market
economy, responsibilities are distributed in a different way: for level
of employment, social partners (unions and employers); for export
development, private companies (technology); or for granting
loans, commercial banks (based on the appropriate risk estimate).
The current account balance, among other things, represents the
saving trend rooted in society and objective conditions for fixed
capital investment (as explained by the “macro-economic equa-
tion” and the “Böhm-Bawerk theorem”). Unions will not accept
government interference in the negotiation of collective agree-

128


ments and companies will not stop being creative or innovative in
organisational management and product development for which
elasticity-income of international demand is higher than the unit,
and banks will not neglect their classical business, which is to pro-
vide credit to companies and households.

This economic governance project has no clear future. In the
best-case scenario, the new Summits of the euro area would have
matters to discuss. The countries in which the economy works well
could be taken as a benchmark for the others to rectify their struc-
tural deficiencies and improve their productive and competitive-
ness levels. In the worst-case scenario, the euro area would be expo-
sed to continuous political conflicts, which would not promote
economic growth with high employment. It is so easy, and espe-
cially politically profitable in countries with domestic problems, to
look for the villain abroad, maybe Germany?

Conclusion

The sovereign debt crisis has had a healthy effect in convincing
politicians that by providing liquidity to governments and banks
the stability of the euro area will not be attained in the medium
and long term. The quality of the economic policy must improve
in the countries, there must be impeccable follow-up by indepen-
dent institutions to weigh up the economic and fiscal situation and
it must be guaranteed that national accounts and other relevant
statistics are arranged under utmost scientific accuracy at all times.

129


If in all the euro countries the governments understand that
sound public finances and application of structural reforms is their
responsibility and if they act seriously according to them, no State
will have to rescue another State because of over-indebtedness and
waste, and the ECB may stop indirectly financing States and focus
more on its task, ensuring stability in price levels in the euro area.
The ESM fund would be reserved to emergency situations caused by
external factors beyond the government’s control. The Fiscal Pact
would have fulfilled its mission and the Euro Plus Pact would be
filled with efficient contents. We would not need to resort to mar-
ket interventionism as entailed with the Six Pack.

If, on the contrary, there is no determination in the member
countries, any attempt of European economic governance would
result more from proactive intentions than harsh reality. The euro
area would have an uncertain future. The alternative of a European
Political Union, in which all necessary economic policies could be
undertaken from a Community Executive under the control of the
European Parliament, with all democratic rights, cannot be seen on
the horizon.

130

The European crisis and the challenge of efficient economic governance by Juergen B. Donges

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