We have long known that financial market stability cannot automatically be achieved. There is historical evidence aplenty (Kindleberger 1989; Galbraith 1993, 1995), and adequate theoretical explanations of the phenomenon1. Scholars have long debated the costs and benefits of financial openness (Bordo et al. 2001; King and Levine 1993; Demetriades and Hussain 2006) and/or possible systems of regulation and supervision (Steil 1994; Barth et al. 2006). As I argue in a recent CEPR Discussion Paper (Underhill 2010), the writing was all over the library walls.
A well-deserved crisis
Often enough, cautionary messages in the literature emerged that should have served as ample warning that global financial market integration was potentially destabilising and might unduly constrain the policy space available to governments (Rodrik 1998, Bhagwati 1998, Stiglitz 2000, 2002, Cohen 1993, 1996). This was especially the case for developing countries and emerging markets (Lucas 1990, Prasad et al. 2007) but a number of warnings can also be found in the EU. Such difficulties would likely require something well beyond the “governance lite” of the international financial architecture (Underhill et al. 2010). Neither national nor global institutions were up to the job and remedial action was required at great public expense and risk. Banks were bailed out and bonuses preserved.
The euro: Global finance, the ‘stability culture’ and institutional pot holes
EU financial integration and the Eurozone were very much part of the adventure of global financial integration. Eurozone architecture made similar assumptions that “governance lite” was a workable option and that monetary and financial stability could be automatically achieved, given the correct rules and proper application by governments and financial institutions alike. This combination of intense integration into the liberal financial order coupled with the weak institutional fabric rendered the EU and single currency in particular vulnerable to either monetary or financial crises.
In 2002 I labelled this blithe optimism “the political economy of the stability culture”, making four observations at the birth of the Eurozone (Underhill 2002).
- First, there was and remains a central paradox concerning the place of the Eurozone as an economic unit in the structures of global monetary and financial system.
The EU is relatively self-sufficient in terms of international trade, but is deeply integrated into the structures of global financial markets and investment flows. Capital flows, not trade pressures, mediate between the Eurozone and the rest of the world. Capital mobility should have been the focus of policy effort.
- Second, while there is a clear legal institutional mandate in terms of managing the Eurozone’s monetary policies, it is unclear how other policy domains are to be managed.
In particular there is a dearth of collective EU machinery for managing internal or externally-induced crises. This situation tends towards a reliance on rules and macroeconomic standards which are easily and perhaps necessarily breached under pressure. The theory was that of the German Bundesbank – if policy remained resolute and free of political interference, a “stability culture” could be achieved quasi-automatically.
This was an unfortunate misinterpretation of post-war German economic success2, but the case appeared well-grounded in experience and was anyway politically unassailable if the German government were to agree to the Union in the first place.
- Third, financial integration and the euro confront members with considerable pressure for policy convergence, but does not change bottom-line pressures of domestic political legitimacy.
The primacy of political legitimacy in terms of social policies, national (and other) identities, and the role of national democracy remain despite the increasingly integrated economic supranational unit. This is often perceived as the “sovereignty issue”, though the debate is probably better characterised as one concerning identity and policy autonomy, which are not the same as sovereignty.
- Fourth, following from the third point, the Eurozone can be seen as a radical extension of the Single Market in financial services.
The euro enhances the cross-border market forces already at work and was explicitly intended to do so. Yet, this integration process is juxtaposed on what remain distinct political systems with their own internal dynamics. The economic development and adjustment process associated with the single currency would furthermore prove highly asymmetrical with the greatest adjustment pressure on the weaker economies (Padoan 1994, Feldstein 1997, 2000)3. The Eurozone was consequently likely to encounter its share of disagreements among its members as the asymmetrical distributional consequences of integration became clear. As we now know, it did, and crisis made this worse.
The euro suffered from institutional pot holes which would make the collective management of these problems a serious challenge. The unknown factor in the eventual success of the stability culture would likely be external to the Eurozone itself – the periodic eruption of monetary and financial crisis at the global level. There was insufficient attention to this problem when the euro was created; officials I interviewed at the time were baffled by the very question I posed.
Would the Eurozone be the island of monetary and financial stability its architects had hoped? The institutions and co-ordinating mechanisms for prudential supervision and oversight of the financial system and eventual crisis management were woefully underdeveloped at the level of the Eurozone and even after post-crisis reform still remain essentially the stuff of national jurisdiction.
The Maastricht Treaty reinforced a reliance on market forces to provide discipline and stability. The only collective mechanism for dealing with crises was the Stability and Growth Pact that accompanied the treaty. This was essentially an agreement on sovereign debt burdens, less inflexible than many thought, but the overall framework implied that governments, not financial markets, were the problem – if the rules were properly applied, stability would prevail. The Treaty thus favoured price stability and the fight against inflation over growth, employment, and social policies. Much was in the hands of the independent ECB and the markets, but political authorities (the Commission, the Council, elected national governments) would have to pick up the pieces and suffer the legitimacy shock in the face of failure.
Of course there were also substantial benefits. Those who had been subject to German monetary policy would now have a voice at the ECB table. Internal exchange rate crises would be a thing of the past, and the most competitive economies (Germany, Netherlands) would no longer suffer the devaluations of others. Member states would have better access to cheaper capital. Given that by far most EU member trade was with other EU partners, Eurozone participants would be sheltered also from global exchange rate volatility. Members would be relatively free of current-account constraints as well (Jones 2003), though less free of the need to adjust to competitive pressures in the long run. Last but not least, and in retrospect perhaps the most important, national central bank reserves and resources that might be required for adjustment or in a financial rescue would be pooled. That is, large and stable economies could, and would (it was assumed), support the weaker links hit by asymmetrical adjustment. The stability culture was a safe harbour from the winds of financial, exchange rate, and monetary instability and this was central to the compromise. What political and institutional machinery was to manage the process when push came to shove was unclear, but over time there was as much talk of solidarity as of the need for discipline.
At the very least, if one institutes an essentially federalised monetary union, then under the threat of crisis the union must act in a functionally federal manner even in the absence of sufficient institutions to do so. This means central (ECB) guarantees to the “provinces”, and adequate internal resource transfers to compensate for the fully predictable adjustment asymmetries in the absence of intra-Eurozone devaluations. During the financial phase of the crisis the EU led by the Bank behaved just so, violating its own rules to take on all sorts of dubious collateral from banks. The sovereign debt phase was more fractiously handled. At first, European “solidarity” proved non-existent, and its delayed and weak return has since most likely worsened the problem for all. Neither national nor EU institutions have seen their legitimacy enhanced as a result, and it is unclear whether the Eurozone will yet survive.
The EU appears for a long time to have been looking for some functional equivalent of the lost, mythical Gold Standard – if only the rules are the right ones, and everyone behaves properly, stability will be achieved automatically. The Eurozone hangs in the balance as a result of serious policy mistakes. Purely national solutions may yet prove the only option, leaving the European dream to wither and die. The worst is that bank bailouts turned out to be more important than fellow citizens of the Union, especially citizens in poorer economies. The poor and the “other” too frequently appear expendable in our world. There are sombre days yet ahead of us where EU governance is concerned.
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1 See among others Minsky (1975) on Keynes and also (1982) on the financial instability hypothesis; Kindleberger and Laffargue 1982; Galbraith (1993) on the psychology of speculation.
2 This stability culture version of German monetary history in the post-war period left out many factors such as successful industrial renewal and development wherein government policy played a central role, externally-supported political stability and democratic development, post-war deutschemark undervaluation, EU integration as a growing market for German export success, and the refusal to recognise the German current-account surplus as a problem for anyone but Germany’s trading partners.
3 Although, of course, these have also experienced the fastest growth. Developing economies which do well often experience severe short- and medium-term external imbalances, difficulties with public debt, and perhaps inflation. This phenomenon is well known in the literature and should surprise no one.