Tomorrow's Economy

The future of the eurozone

31st March 2016

The prospects for much-needed reform are notoriously difficult, but a rare window of opportunity will open in the coming years

The eurozone is made up of 19 countries that share a common currency – the euro. It represents the most recent stage of more than 50 years of European integration. When the euro was introduced in 1999, it almost instantly became a success. The currency was stable, trade and economic growth increased. It was a good time for the bloc and the rest of the European Union. This seems like a very distant past from today’s perspective. In 2009, the shock waves of the global financial crisis catapulted the currency into its own crisis – the euro crisis. In the following years the eurozone repeatedly teetered at the brink of collapse.

One emergency meeting followed another. National governments scrambled to stabilise the currency in long night sessions in Brussels. It became increasingly clear to everyone involved that the institutional set-up of the eurozone was deeply flawed. The common currency needed reform, if it was to survive. New measures were introduced. Rescue packages were agreed, the banking union introduced, fiscal rules strengthened, and some investment programmes launched.

And while the bloc stabilised, no one today is really convinced that the reforms were sufficient. The economic crisis and especially the divergence among eurozone countries remain too deep and too persistent. More is needed if the eurozone is to have a future.

What is wrong with the eurozone?

There are at least three distinct reasons why the eurozone needs reform. I will start with the most obvious one regarding the functioning of the currency union. There is now broad consensus among policymakers and experts alike that it will be extremely difficult to preserve the euro with the current level of economic divergence among the member states. There is also the shared understanding that the adjustment capacity at the eurozone- and member state-level to adverse economic developments is not sufficient. As member states can no longer respond to economic shocks by devaluing their currencies, the brunt of adjustment is to be borne by fiscal policy.

This is an almost classic case of functional spillover between different policy areas, namely monetary and fiscal policy, and the challenges that result from different levels of integration. What is more, fiscal policy at the member state-level is constrained by the fiscal rules of the Stability and Growth Pact that limit national spending while a common fiscal capacity at the level of the eurozone is missing.

In theory, adjustment of price and wage levels could also provide for the necessary flexibility in a currency union. But it is reasonable to conclude – based, for example, on the experience of steep wage reductions in southern European countries – that this adjustment mechanism is not powerful enough to balance sufficiently economic divergence in the bloc.

The second challenge is the intergovernmental governance of the eurozone. The problem is that the Economic and Monetary Union (EMU) increasingly affects core state powers, such as budgetary policy. It is not difficult to predict that national governments – elected and responsive to national electorates – will therefore trick, truck, and barter over community rules and will be ready to break them, if necessary. The result is that the rules-based governance gets increasingly politicised until it might collapse altogether.

The last, and perhaps most important, reason why the eurozone needs to be reformed relates to the pressures created by EMU on national labour markets and welfare states. Even with a common fiscal capacity, adjustment to economic downturns through wage (and price) levels plays a significant role in any currency union. In practice, this creates pressures to deregulate labour markets and riddles collective bargaining and social partnership. Moreover, constraints on fiscal policy have led to cuts of social expenditure increasing pressures on welfare states. This undermines public support for progressives who are seen to dismantle social institutions, but it most importantly undermines many of the social institutions that make up the comparative advantage of European economies in global markets. So which reforms does the eurozone need?

The Europe we need

The starting point for a reform agenda follows from the political and social foundations on which the common currency (and the single market) is built [1]. Today, we tend to think of markets as a kind of natural occurrence. We forget that they are man-made and part and parcel of our social institutions. The introduction of the Euro uprooted social foundations underpinning national currencies. We should understand the euro crisis as the beginning of a possible counter movement. The following offers a brief sketch of different reform proposals that can re-embed the currency in political and social institutions.

Create a eurozone budget and automatic stabiliser

A common fiscal capacity in the form of a eurozone budget is one of the most prominent reform proposals. The argument is that in the absence of adjustment through national monetary policy, the flexibility provided by fiscal policy at the eurozone-level should be increased. A common budget could stimulate growth in those parts of the currency union that perform under eurozone average thus contributing to economic convergence [2]. It could also be used as a flexible policy instrument to respond to sudden economic shocks caused, for example, by global economic crises. The key advantage of the eurozone budget is that it is flexible and discretionary.

The size of the budget will depend on its exact purpose, but current proposals range from four to seven per cent of eurozone GDP. It could be financed by member state contributions or a eurozone tax. The latter is preferable as it would even further contribute to balancing divergent economic developments in the bloc and it would form a direct connection between eurozone tax payers and eurozone institutions without intergovernmental bodies diffusing political responsibility.

Another frequently discussed proposal involves insurance-based mechanisms that function as automatic stabilisers. They would also add to the necessary flexibility in fiscal policy. The basic idea is that a eurozone insurance withdraws money from economies that are over-performing and transfers them to those whose economic development is below average. Unlike the eurozone budget, an insurance mechanism would be by definition automatic and not based on political discretion.

There are different technical proposals on the table. Some propose transfers among states, others advocate transfers among workers on the micro-level, for example in the form of a European unemployment insurance. The advantage of the micro-level approach is that support would go directly to the unemployed and inefficiencies of state-level distributions of lump sums would be avoided.

The major political challenge against a common fiscal capacity is that it could lead to moral hazard reducing the pressure for national governments to conduct necessary structural reforms. A way to avoid this is by combining financial support with political reform commitments – a point I will return to later on.

Establish a euro finance minister

The common fiscal capacity, in particular the eurozone budget, will need a political institution that decides over which programmes and regions are supported and monitors the compliance with the fiscal rules of the eurozone [3]. This could be achieved through a euro finance minister, something proposed recently by German finance minister Wolfgang Schäuble. The euro finance minister should have a strong role in coordinating national budgetary policies and enforcing common fiscal rules. It should also be the euro finance minister that carries the political responsibility for the effectiveness of European fiscal policy through the common budget. This means that she has to be elected and controlled, for example, by a joint chamber of members of the European parliament and national parliaments.

Towards a social union

As in fiscal policy, much more coordination of national labour market and social policies is necessary to avoid economic divergence and moral hazard in a fiscal union. Fiscal support through the eurozone budget or automatic stabiliser should be conditional on reform commitments for national labour markets and welfare states. But it is too often assumed that social institutions are a drag on economic productivity. The contrary is rarely considered: The major comparative advantage of European economies lies in the economic productivity generated by social institutions [4].

We need a reform agenda that increases the productivity of our social institutions. Take Germany’s industrial sector. How could it compete with China if it was not for dual training systems that ensure demand-tailored skill formation, short-time work allowance that lets companies hold on to their workers in times of crisis, employment regulation that forces them to invest in their workers and reduce turnover, co-determination that provides bottom-up coordination for product innovation?

True, not all social institutions are economically beneficial and many countries are currently struggling to find the right balance. But it is also true that almost all European countries have sectors that are highly competitive as can be seen in the Lombardy region in Italy, Catalonia in Spain, and Rohne-Alpes in France. A bottom-up approach to the coordination of national labour market and social policies – based on the involvement of the social partners on the sectorial level – could strengthen the comparative advantage of social institutions and move us closer to a social union.

But this will not be enough to safeguard social institutions in the currency union. The eurozone therefore has to adopt basic social rights that carry the same legal significance as fiscal rules. The adoption of European minimum standards on systems of minimum income is already feasible within the current treaties [5]. There can also be a eurozone framework for national minimum wage policy. Generally, these should be European frameworks for national minimum standards that allow for the diversity of national welfare states.

How to get there

The prospects for reforms are notoriously difficult in the eurozone and the EU as a whole. In addition to the economic woes, the refugee crisis and the possibility of the UK leaving the union has further strained the relations among national governments. In the coming years, however, a rare window of opportunity will open for reforms.

The promises made to the British government in an effort to prevent the country from leaving the EU open a window for treaty change not only for the UK, but also for the eurozone. This is not unreasonable to assume considering the recent negotiations over the British referendum. The eurozone members secured the commitment from the UK that it will not impede reforms of the bloc in return for their support of the British demands. Moreover, in the ‘fiscal compact’, adopted in 2012 and one of the central treaties that govern the eurozone, a review is foreseen by 2017. After elections in France and Germany in the same year, there will be an important chance for reform.

To use this opportunity, we need more debate on the eurozone and the European Union. The type of solution that emanates from the many expert reports commissioned by governments is mostly designed to accommodate for some technical shortcoming of monetary union, say the lack of a common fiscal capacity or the implementation of fiscal rules, while minimising political exposure (think transfer union) and maintaining the power-sharing structures that make up the EU today (think national sovereignty). This is understandable and it may be even necessary in a union where 28 member states hold veto rights.

However, it should be equally clear that this approach cannot provide answers to eminently political questions of European integration in a time when functional interdependencies among policy areas and virulent Euroscepticism are both rapidly growing. Solutions will have to come from a broad political debate about the future of the union. No doubt, the politicisation of European politics carries many risks that the traditional elite-driven approach did not know. But it may very well be the most viable option for the future of Europe and the eurozone



[1] Matthijs, M. & Blyth, M. (2015): Introduction. In: The future of the Euro. Matthijs, M. & Blyth, M. (Ed.). Oxford: Oxford University Press.

[2] Pisani-Ferry, J. (2014): The Euro crisis and its aftermath. Oxford: Oxford University Press: 153-59.

[3] Enderlein, H. & Haas, J. (2015): What would a European Finance minister Do? A proposal. Policy Paper 145. Berlin: Jacques Delors Institut.

[4] Hall, P. & Soskice, D. (Eds.) (2001): Varieties of capitalism: The institutional foundations of comparative advantage. Oxford: Oxford University Press.

[5] Van Lancker, A. (2010): Working document on a Framework Directive on Minimum Income. Brussels: European Anti-Poverty Network


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