The euro: now is the time for reform

Sarah Hewin Head of Research, Europe and Americas

11 Sep 2015

The euro area should seize on this moment to press ahead with closer integration

Over the next few months, voters go to the polls in Greece, Portugal and Spain – three of the countries most affected by the euro crisis.

Given these are the first elections since Greece’s latest bailout, the future direction of euro-area integration will loom over the debate.

The elections are an important gauge for policy makers as they weigh up the next stage of monetary union. Polls suggest that support is returning to mainstream political parties, following (as in Spain and Greece) a surge in popularity for anti-establishment and anti-euro parties.

Euro-area leaders know what needs to be done to prevent a break-up

We think that the time is right for the region to press ahead with closer integration.

Euro-area leaders know what needs to be done to prevent a break-up of monetary union. And the commitment to the euro is strong:  politicians – including eurosceptics in the Finnish government – backed a third bailout for Greece when faced with the alternative.

Greece’s leaders (as with their Cypriot counterparts two years earlier) viewed the cost of euro exit as too high, despite the backdrop of bank closures and collapsing economic activity.

Important steps taken

Through the turbulence of recent years, the region has taken important steps to strengthen institutions and governance. These measures prevented a repeat of the damaging contagion seen between Greece’s first and second bailouts.

Meanwhile, credit markets have become less fragmented and lending is finally recovering. Countries have embarked on reform, with the periphery most active in improving product-market regulations (albeit from a weak starting point) and addressing labour-market rigidities. Some have made huge strides in improving economic flexibility to address imbalances and tackle weak competitiveness. Current account deficits have largely been eliminated, government deficits are manageable and economic growth is returning.

But it is not enough to ‘do what it takes’ in the heat of a crisis. Policy apathy often prevails during calmer times, yet the euro remains vulnerable to patchy integration, weak growth and high unemployment.

Policy makers urgently need to take action on the next stage of integration

Growth and productivity in the euro area have underperformed the US in most years since the creation of the single currency, and unemployment is twice as high. Doing business is far from ‘easy’ in many countries, according to World Bank indicators.

Policy makers urgently need to take action on the next stage of integration: accelerating risk-sharing measures, while raising the region’s productivity.

This means establishing a common deposit insurance fund (a feature that could have prevented bank runs in Greece) and moving ahead on capital-market union (CMU) to boost market-based financing, which still accounts for just one-fifth of lending in the euro area, compared with some 70 per cent in the US.

Reforms required

A developed capital market can play a significant role in smoothing the impact of outside shocks, lessening the need for full fiscal union in the euro area. But a partial step to fiscal integration could include a common European unemployment insurance scheme, which would help to mitigate the impact of an asymmetric shock affecting individual countries rather than the region.

Productivity will likely rise with stronger investment and better opportunities for creating businesses. In turn, this requires ongoing product and labour-market reforms and better regulation, for example, in enforcing contracts.

Such moves will be risky for governments. Risk-sharing demands a further loss of sovereignty, while economic reform challenges vested interests and the benefits take time to emerge.

Standing still is not an option, if future crises are to be avoided

The question is whether Europe is up for it.

There are clear political challenges: lowering unemployment should boost ‘Europeanism’, but in some countries support for nationalist parties is high alongside low unemployment.

That said, we think that leaders should take note of consistently solid popular support for the euro – over 60 per cent even in the throes of the 2012-13 crisis, on a rising trend in the past two years and now at close to 70 per cent.

With fiscal adjustments largely completed, ultra-loose monetary policy finally gaining traction and external factors (cheap oil and a competitive euro) supportive, now is the time to press ahead with reforms to improve the business environment and move on to the next stages of banking union, start CMU and lay the foundations for a limited fiscal union.

Standing still is not an option, if future crises are to be avoided and the euro is to survive for another 17 years.

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