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Reforming the Eurozone

Interviewee: Marc Levinson, Senior Fellow for International Business, Council on Foreign Relations
Interviewer: Roya Wolverson, Staff Writer, CFR.org
May 10, 2010

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The Greek debt crisis has raised serious doubts about the ability of eurozone leaders to manage fiscal crises among weaker member countries. Following the European Union's nearly $1 trillion bailout plan announced May 10, questions remain about what kind of EU reforms could mitigate the financial risks associated with the union's disparate political and economic systems. CFR's Marc Levinson says while EU limits on member states' budgets have been largely ignored, a common fund for restructuring debts, similar to the International Monetary Fund's, might encourage member countries to rack up large debts. Heavily indebted countries like Spain and Portugal should push forward with severe budget cutbacks, despite the political battles and social unrest that may ensue, he adds. Ultimately, the eurozone project should continue, he says, because "for all its messiness, European integration has brought tremendous benefits to Europe."

What long-term reforms are needed to solidify the EU's response to fiscal crises in future?

The EU and the European Central Bank were not set up to handle this sort of situation. This was clear even before the euro was inaugurated. There are a couple of changes that could enable the EU to deal with problems such as this. One would be effective EU control over member countries' fiscal policies. That is likely to be a non-starter for political reasons--the EU's limits on member states' budget deficits have been widely ignored. The other would be to set up an organization within the EU, analogous to the International Monetary Fund. Member countries would pay into the European Monetary Fund, which would then be able to finance the restructuring of a member country's debts. This is feasible in a political sense, but whether it would command resources sufficient to deal with large problems is anyone's guess. And of course there is a risk that the very existence of such an organization could make member countries less concerned about racking up large debts.

Is propping up other fiscally risky eurozone countries ultimately affordable for the EU?

In the case of Greece, the IMF basically kicked the can down the road, and almost everyone expects that another debt-restructuring program will be required three years from now.

Of course. If the IMF's member countries decide that more money is needed to address debt crises in other countries, then the money can be raised. Whether the money would solve the problems is another question. In the case of Greece, the IMF basically kicked the can down the road, and almost everyone expects that another debt-restructuring program will be required three years from now, when the IMF loans run out. There would be much reluctance to make such an arrangement with Spain, which has a far larger economy.

There is a lot of talk about the benefits of individual countries being able to control their own monetary policy in these situations. What are the pros and cons of having this be centrally determined?

Countries cannot have it both ways. Either they're in the eurozone or they're out. If they're in, they have no control over their monetary policies, period. If they want to leave, fine, but then they will probably have to leave the EU as well, and to remain out of the EU and the eurozone for a very long time. And leaving the eurozone, by itself, will solve none of their economic problems. Their interest rates will be much higher than they are today. And either their citizens will face large declines in their living standards as the new currency falls against the euro or they will be demanding to be made whole by large wage increases, which implies high inflation. There is no easy way out of excessive indebtedness.

What EU rule changes can prevent the moral hazard of eurozone countries driving up deficits--through overspending and uncompetitive wage boosts--given that these countries may now expect bailouts?

The EU can't do much about private-sector labor costs in any member state. Its focus needs to be governments' fiscal balance, in which public-sector labor costs may be a factor. As I mentioned, the EU already imposes a limit on national-government deficits. A protocol to the Maastricht Treaty of 1992 says that national governments should have deficits no larger than 3 percent of GDP and that countries' budgets should be roughly balanced, when averaged across the business cycle. In principle, the EU could fine violators, which of course would make the deficit of a deficit country even larger. In practice, the EU has found enforcement impossible.

There is concern that needed budgetary cuts in other eurozone countries--Portugal, Italy, Spain, Ireland--might cause economic stagnation by stoking severe unemployment and social unrest. Should the EU's fiscal rules and austerity packages be more accommodative of this?

Countries cannot have it both ways. Either they're in the eurozone or they're out. If they're in, they have no control over their monetary policies.

The need for budget cuts goes far beyond the countries you've mentioned. When the world economy began to slump badly in 2008, many countries acted simultaneously to stimulate their economies through deficit spending. In my view, this was absolutely the correct policy, and it helped to avert a worldwide depression. But now we're at the point that governments have to start withdrawing that stimulus. This doesn't mean that budgets should swing into balance this year; that would be catastrophic. But governments do need to show credible plans for bringing their budgets into balance over a four- or five-year time frame. This goes for the United States, Japan, and the United Kingdom just as much as for the most highly indebted countries in the EU. Unfortunately, it's hard to think of any countries that have made serious progress in this respect. What's true in the United States is just as true everywhere else: Politicians love to bang on about cutting budget deficits, but actually doing so is extremely painful.

Germany's Angela Merkel--who faced public ire in regional elections--has made somber comments about Germany's future role in Europe. Is a eurozone breakup a legitimate threat?

I don't think so. For all its problems, the euro has been hugely important to the project of European integration. European leaders of any political party are unlikely to turn their backs on it. If the eurozone were for some reason to break apart, the European Union would probably break apart along with it, and there are very few people in Europe who want to see that happen.

Ultimately, should the eurozone stay together?

This is a political question much more than an economic question. For all its messiness, European integration has brought tremendous benefits to Europe. Every EU country and every country that aspired to join the EU is a democracy; the dictators who used to run countries such as Greece, Spain, and Portugal are gone. No EU members have gone to war with one another. The EU has addressed issues from environmental protection to human rights to the free movement of workers in ways that individual member countries would not have been able to do. And on the economic side, the creation of the single market has been a boon to European businesses. There is no doubt that the euro is not an ideal currency arrangement, at least as it's structured now. But one shouldn't look at the currency in isolation from the many other efforts to bring Europe closer together.

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