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Viktor Katona

RIAC Expert

Against the backdrop of the drawn-out migrant crisis that took place during the second half of 2015, the issue of improving pan-European mechanisms has been gradually pushed off the agenda. However, this hiatus offers Europe’s expert community an ideal opportunity to assess and rethink the main outlines of the European Union’s policies. The report “We Don’t Need No Federation. What a Devolved Eurozone Should Look Like” by Christian Odendahl, Chief Economist at the Centre for European Reform, offers an original way out of the difficult situation that has developed within the EU single currency area.

Against the backdrop of the drawn-out migrant crisis that took place during the second half of 2015, the issue of improving pan-European mechanisms has been gradually pushed off the agenda. However, this hiatus offers Europe’s expert community an ideal opportunity to assess and rethink the main outlines of the European Union’s policies. The report “We Don’t Need No Federation. What a Devolved Eurozone Should Look Like” by Christian Odendahl, Chief Economist at the Centre for European Reform, offers an original way out of the difficult situation that has developed within the EU single currency area.

Odendahl believes that today’s Eurozone is the epicentre of what Turkish economist Dani Rodrik terms the “trilemma of the world economy.” By this, he means that the three vectors of the world economy, namely, democracy, globalization and the political self-determination of peoples, cannot all exist together. At best, states succeed in pursuing two out of the three. By delegating to a supranational body the power to develop a united political orientation and adopt regulatory measures, a state thereby loses its right to self-determination, but retains democracy and globalization. Countries can also adhere to the rules of democracy and globalization without taking into account the interests and demands of their own peoples. The third way is to curtail globalization processes (free movement of goods, capital and people), but to retain democracy and political self-determination.

Odendahl believes that the Eurozone, with its current orientation toward the integration of economic policies and its excessive emphasis on budget consolidation, together with a political structure that does not reflect the national interests of several states and does not act on democratic principles, is essentially in need of a radical rethinking of its own foundations.

Odendahl believes that the Eurozone, with its current orientation toward the integration of economic policies and its excessive emphasis on budget consolidation, together with a political structure that does not reflect the national interests of several states and does not act on democratic principles, is essentially in need of a radical rethinking of its own foundations.

Odendahl believes that the Eurozone, with its current orientation toward the integration of economic policies and its excessive emphasis on budget consolidation, together with a political structure that does not reflect the national interests of several states and does not act on democratic principles, is essentially in need of a radical rethinking of its own foundations.

Theoretically, when a state joins a monetary union, it voluntarily relinquishes the right to have a monetary policy determined by its national bodies. When it comes to implementing the best economic policy, such a state has at its disposal a smaller range of measures pertaining only to fiscal and regulatory areas. Regulation implies creating conditions in which the financial sector is not subject to overheating and financial flows cannot undermine the stability of the economy. When it comes to fiscal measures, states can change governmental expenditures, tax rates or introduce economic stimulation programmes.

Counter-Cyclical Policy as the Key to Success

First of all, Odendahl proposes conducting a permanent counter-cyclical fiscal and regulatory policy in all the countries of the Eurozone. The essence of counter-cyclical policy is that during economic growth, governments should “cool down” the economy through fiscal and regulatory measures, and in a crisis, they should stimulate economic activities. Odendahl notes that, before the start of the economic crisis, some countries (Greece is never named, but it is implicitly referred to) attempted to mitigate economic disproportions through low interest rates and further “warming up” of the economy. Spain, for instance, did attempt to conduct a counter-cyclical policy and rein in its housing boom, but the measures proved to be insufficient.

Spain’s pre-crisis economic growth was based on expanding loan emissions and capital influx, which led to the growth of consumer spending and wages. When the crisis began, the population’s spending dwindled drastically, and the country’s economic situation deteriorated due to Spain’s debts and its rigid labour market structure. If the crisis lasts for too long, consumer demand and investments will continue to decrease, and the real interest rate will continue to grow. In this situation, the state inevitably begins to rely on foreign demand, thus exacerbating the debt problem even more. The European Union’s economic and political establishment viewed this phenomenon through the prism of the poor management of loans. Strict austerity was intended to correct the problem. Odendahl believes, though, that the problem has deeper roots and can be traced back to the absence of an overall counter-cyclical policy at the pan-European level.

Odendahl claims that when implementing a counter-cyclical policy, attention should be paid to several factors, for instance, to the fact that transactions between banks make up the bulk of financial transactions in the Eurozone. As a rule, banks are to some degree connected with the governments in their home countries – they may hold government bonds. The taxes banks pay are part of the state’s budget. Therefore, the weakening of the banks directly leads to the deterioration of the country’s economic situation, and governments have to settle for massive bailouts instead of debt restructuring.

Before the start of the economic crisis, some countries (Greece is never named, but it is implicitly referred to) attempted to mitigate economic disproportions through low interest rates and further “warming up” of the economy.

Before the start of the economic crisis, some countries (Greece is never named, but it is implicitly referred to) attempted to mitigate economic disproportions through low interest rates and further “warming up” of the economy.

Attention should also be paid to the fact that within a monetary union, there is a risk that the negative consequences could spill over. If investors begin to dump government bonds of a country, believing its debt load to be unsustainable, the economy of the Eurozone as a whole will suffer significant damage due to speculation concerning the possibility that the affected state may leave the Eurozone. It should be noted that the European Central Bank (ECB), the only lender of last resort for the Eurozone members, played a key role in preventing Greece from defaulting. However, the author argues that the ECB should have a much stronger mandate, which is further proved by the financial regulator’s inability to achieve the target rates of inflation and demand.

The ECB’s New Role

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The European Central Bank plays the key role in Odendahl’s proposals for reforming the Eurozone. It is under the aegis of the European Central Bank that four principal faults of the Eurozone’s current monetary mechanism should be corrected. These faults are: dependence on bank lending, close ties between banks and governments, massive withdrawals of government bonds, and the insufficient level of aggregate demand.

The author believes that the first three factors can be corrected by improving the banking union created in 2012. Creating the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM) is the correct development, and further work should be done here. Odendahl proposes eliminating cross-links between banks and governments through a single deposit insurance mechanism. Odendahl refers to the need to guarantee the protection of resources regardless of the state’s solvency. It should be noted that in November 2015, the European Commission proposed creating the European Deposit Insurance Scheme, where deposits of up to 100,000 euros would be protected by pan-European structures, including the SSM. Odendahl believes that the dependence of states on bank lending and the interconnections between banks and governments can be dealt with by limiting the amount of government bonds that banks would be allowed to hold. He does not specify how this move will affect the competitiveness of those banks which have a very limited presence outside their home countries and are, therefore, unable to compete with Europe’s leading banks.

Odendahl’s proposals appear least feasible when it comes to stimulating aggregate demand within the Eurozone. He claims that the ECB mandate is sufficient for “normal” periods. However, the delayed quantitative easing demonstrated that at times of crisis, the ECB must take more energetic steps, such as increasing the target inflation rate to 3 per cent and starting a programme of buying higher-risk assets, not just government bonds. Odendahl also claims that should the ECB, the SSM and the SRM be granted stronger mandates, there would be no need for national central banks and governmental bodies to regulate financial markets.

Harmonization without Democracy

Odendahl claims that national financial regulators are biased and promote narrow national interests instead of acting for the greater good of the pan-European financial stability. If the current matrix is retained, “institutional inertia” will get in the way of harmonizing norms and standards. To explain his proposal of abandoning national central banks, Odendahl claims that they pursue national interests, rather than pan-European interests. Besides, their decisions are often politically tinged. Should the European Central Bank subsume all the central banks of the Eurozone, the possibility of any country leaving the Eurozone will be minimized, since a government wishing to leave the monetary union will not have the financial infrastructure to take such a step.

However paradoxical that might sound, Odendahl bases the aforementioned proposals on the need to introduce more democracy into the functioning of the Eurozone. Given that Odendahl does not mention reforming the current European Central Bank, the question arises as to how democratic that institution is. For instance, the ECB’s Executive Board includes only Western European countries: Italy, Portugal, France, Germany, Belgium and Luxembourg. In the Governing Council, which adopts the principal decisions on monetary and lending policies, members of the ECB’s Executive Board have voting rights together with the 19 central bank governors. Germany, France and Italy, for instance, have two non-rotating votes. The governors of central banks of those countries that are not among the five largest economies of the Eurozone have rotating votes, and 11 votes are divided between 14 countries within a voting rights rotation system.

Had the mandates of the ECB, the SSM and the SRM be expanded, there would have been no need for national central banks and governmental bodies to regulate financial markets.

Had the mandates of the ECB, the SSM and the SRM be expanded, there would have been no need for national central banks and governmental bodies to regulate financial markets.

Since Odendahl used to work for the Federal Ministry for Economic Affairs and Energy in Germany, such casual disdain for the smaller Eurozone countries should not be surprising. Quite often, his claims demonstrate his interest in the Germany economy flourishing, such as his tenet that a more “aggressive” mandate for the ECB would help Berlin, whose economic development is below its potential economic growth. By likening Germany to countries with excessively low prices and wages, Odendahl implicitly supports “heating up” the German economy. At the same time, he does not mention the fact that, unlike many other Eurozone countries, Germany’s GDP decreased only in 2009, and since then it has been increasing steadily. Besides, for five years running, Germany has been in violation of EU norms by having trade surplus in excess of 6 per cent. In 2016, it is expected to be 7.7 per cent.

В случае замещения Европейским центральным банком всех центральных банков еврозоны вероятность выхода той или иной страны из объединения будет снижена до минимума — у желающего покинуть валютный союз национального правительства просто не будет достаточной финансовой инфраструктуры для совершения этого шага.

Should the European Central Bank subsume all the eurozone’s central banks, the possibility of any country leaving the eurozone will be minimized, since a government wishing to leave the monetary union will not have the financial infrastructure to take such a step.

Odendahl does not support the idea of dismantling central banks entirely and proposes reorganizing them into fiscal policy committees whose role will be to ensure counter-cyclical policy and guarantee debt sustainability. Members of such committees will be elected in the same manner as governors of central banks, retaining their independence of national governments. Odendahl sees the political expediency of such a development, since discussions of fiscal policies will be conducted within a single country without outside interference. It only remains to be decided who will monitor the FPCs.

On the whole, Odendahl’s report contains several correct and timely proposals for reforming the pan-European economic policy. We can agree with his claim that, recently, too much attention has been paid to the issues of debt and the absence of structural reforms, whereas counter-cyclical measures could mitigate the consequences of the economic crisis. Intuitively, Odendahl understands that in the short-term prospects, the Eurozone member states will be able to make the greatest progress within the framework of European integration precisely through the harmonization of the banking sphere. Yet when it comes to possible solutions, Odendahl goes too far: it is highly unlikely that any state could relinquish its national bank or put a limit on how many of the home government bonds the bank is allowed to hold. However, this report is on the right track, and with less radical and more feasible measures that take into account the mind-set of national political elites, it could serve as a springboard for new breakthrough works.

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