Reforming the Euro’s Institutional Framework

IN PREVIOUS LEVY INSTITUTE PUBLICATIONS (Arestis, McCauley, and Sawyer 2001; Arestis and Sawyer 2002b), we critiqued the underlying institutional system of the European Union (EU), including the Economic and Monetary Union (EMU). Our critique f ocused on the mandatory fiscal austerity of the Stability and Growth Pact (SGP), the undemocratic structure and lack of accountability of the European Central Bank (ECB), the separation between fiscal and monetary policy, and the paramount importance attached to price stability at the expense of other policy objectives. We proposed removing the restraints on fiscal policy at the national level and developing a coherent set of labor market, industrial, and macroeconomic policies at the EU level. Otherwise, we argued, achieving full employment or reducing inequality and regional disparities in the EU would not be possible. Furthermore, we foresaw serious negative effects on the economic performance of th e member states of the EU and the material well-being of EU citizens. Since early 2001, the eurozone has experienced rising unemployment (from 8.1 percent to 8.4 percent in November 2002), falling output (annual GDP growth declining from 2.5 percent in the first quarter of 2001 to 0.8 percent in the third quarter of 2002), and inflation higher than the ECB's target level of 2 percent, as measured by the Harmonized Index of Consumer Prices (HICP). These statistics support our earlier conclusion that the institutional and policy arrangements governing the EU are inappropriate for combating unemployment, recession, and inflation. The Stability and Growth Pact Revisited The general stance of the SGP-an overall balanced budget and a maximum annual deficit of 3 percent of GDP-is deeply flawed. A balanced budget does not allow governments to borrow to fund capital investment projects, and maintaining government deficits below 3 percent of GDP during recession will likely cause economies to slump further. There is, moreover, a deflationary bias in the operation of the SGP. In 2001, for example, the European Commission condemned Ireland for cutting taxes and raising public expenditures when its output was above the trend rate of growth. In 2002 the Commission criticized Britain, which is currently outside the EMU, for proposing public expenditure increases when its output was also above the trend rate of growth. The Commission recommended further that in the event of an economic downturn in 2002, British public expenditures should be reduced from planned levels to maintain the eurozone's target public expenditure-to-GDP ratio. Countries differ in the extent to which their output varies during the course of the business cycle and in the sensitivity of t heir budget positions to the business cycle. The European Commission found that balanced budgets were negatively linked to GDP growth (Buti, Franco, and Ongena 1997) and estimated that a 1 percentage-point decline in GDP increased the deficit-to-GDP ratio on average by 0.5 percentage po ints at the EU level. At the national level, the effect of a 1 percentage-point decline in GDP on budget deficits was different among countrie s and more dramatic (e.g., budget deficits in the Netherlands and Spain increased by 0.8 and 0.9 percentage points respectively). The SGP assumes that any level of output and employment is consistent with a balanced budget and is thus compatible with a comb ination of net private saving and trade that sums to zero. Although individuals and firms make decisions on saving, investment, imports, and e xports, it is unlikely that the aggregation of these decisions will sum to zero. Likewise, the budget deficit will not equal zero (in order t o satisfy the identity equation drawn from the national accounts). Similarly, the view that a balanced budget is compatible with high levels of employ ment cannot be justified. In the past, governments typically operated with budget deficits. The imposition of a balanced budget represents a m ajor departure from the norm.