Debunked myths

Peter A. Hall is the Krupp Foundation Professor of European Studies at Harvard University.

The crisis of the euro is dismaying, not least for those who have lost jobs in the wake of efforts to resolve it. For those efforts, the European Union deserves some credit. However, its successive steps have been too little, too late to halt the speculation eating away the capacities of states to fund their debts. The unexpected proposal for a Greek referendum magnifies these difficulties.

To some extent, the problem can be attributed to the cumbersome decision-making of the EU. The euro crisis is a crisis of confidence. On economic fundamentals, countries such as Italy and Spain are in relatively good shape. Their difficulties stem from the self-fulfilling prophecies made by markets. To make such prophecies unrealistic requires a decisiveness and fiscal firepower the member states were initially unable to assemble.

Why did the EU not take bolder action earlier? Most answers cite a lack of political will, but that turned on misperceptions of the problem. Many northern Europeans initially treated the crisis as if it were a problem of fiscal profligacy. Only later did they realize it was a crisis of the European Union.

Economic myths

Equally important were the economic myths on which the European Monetary Union (EMU) was founded. Plans for it were laid in the early 1990s, when the doctrines of monetarist and rational expectations economics superseded the Keynesian contention that active fiscal policy stabilizes the economy in favor of the view that fiscal policy is not stabilizing and monetary policy has few real effects.

The design of EMU mirrors those doctrines. Since monetary policy was supposed to be targeted on inflation and based on monetary rules, it could be operated by a central bank entirely independent of political authority.

There was no need to endow the new Union with a capacity for medium-term fiscal coordination, since that was seen as unnecessary. A few simple rules about debts and deficits, enshrined in the Stability and Growth Pact, would suffice. Economic growth would be generated by structural reform on the supply side of the economy.

Bursting bubbles

Over the short history of the euro crisis, these myths have begun to fall, one by one, and the crisis is unlikely to be resolved until all are rejected. The first to go was the myth that the European Central Bank should be concerned exclusively with inflation. Under Jean-Claude Trichet, the ECB stepped in to support banks and governments under the guise of maintaining financial liquidity. Like the American Federal Reserve, it did what governments found it politically too difficult to do.

The myth that EMU does not need a capacity for fiscal coordination is now in tatters, although not rejected by all. Some believe that better enforcement of stiffer rules is all the Union requires. But draconian fiscal austerity which imposes most of the adjustment costs on Europe's periphery is unlikely to work economically, and Greece is now showing that it is unsustainable politically.

The alternative is a more balanced adjustment strategy, marrying reflation (stimulating the economy by increasing money supply or reducing taxes - the ed.) in northern Europe to a softer fiscal stance in the south. But to operate such a strategy, EMU must have institutions with the political capacity to negotiate and operate a flexibly coordinated fiscal policy. A strengthened Ecofin (Council of EU Finance and Economics Ministers - the ed.) might initially suffice until new institutions are devised.

Structural reform an empty mantra

However, two other myths still stand in the way of a resolution to this crisis. The first is the view that the eurozone can survive without a central bank capable of purchasing, and monetizing, sovereign debt. Only the firepower of such a bank can stem speculation in the eurozone.

There are ways to do this that preserve the letter, if not the spirit, of the European treaties. If the relevant confidence trick is done adroitly, it might not be costly. The question is whether the long learning curve of the member states will bring them around to this view soon enough to avert disaster.

The last myth is the idea that economic growth in southern Europe can be achieved via "structural reform." Structural reform has become central to the demands placed on southern Europe. It sounds good, but it is an empty mantra. At most, it means reducing state intervention and intensifying market competition.

Sustainable growth strategy

Over the long run, that may improve the efficiency of an economy. But making competition in labor or product markets more intense will not create the export markets or consumer demand these countries need now. To emerge from this crisis, they need to reduce their fiscal imbalances and secure economic growth.

Structural reform is conveniently compatible with fiscal austerity but it does not constitute a growth strategy. Until something constructive replaces it, no light will be visible at the end of this tunnel.

Editor: Michael Knigge/Rob Mudge