The hidden dangers of safety nets

Civitas, 20 December 2010

With the Irish bail-out agreed upon EU leaders and Eurozone country governments have been returning to the long-term task of placing the Eurozone on a more sustainable footing. However a number of recent pronouncements highlight the difficulties in concurrently achieving short-term stability and long-term change.

The overriding rationale in creating the single-currency, for a group of national economies that, in 1999, did not fulfil the requirements of an ‘optimal currency area’, was that over time these economies would converge. The single market would facilitate this process by increasing cross-border trade, uniting the economies of Europe. Unfortunately this envisaged convergence has not been achieved, and there is now talk of a ‘two-speed’ Eurozone with fast-growing members such as Germany, the Netherlands and Finland racing ahead of sluggish nations such as Ireland, Spain and Portugal.

This talk angers proponents of European integration, France has long been one of the keener advocates of this and its President Nicolas Sarkozy recently declared: ‘We have to tackle the competitiveness gaps’ in the Eurozone. Sarkozy is right, divergent competitiveness harms the Eurozone and hampers further economic integration (despite benefitting some countries). Improving competitiveness, without the ability to devalue one’s currency, requires reform of a country’s labour market, its infrastructure and a plethora of other, interconnected, aspects of a country’s economy. Bringing about such change requires political will, and the ability to face down interests who will fight such change. Sarkozy himself knows the difficulty of implementing such reform as recent French protests over raising the retirement age has demonstrated.

One often finds that governments are only committed to such reform when it becomes absolutely necessary. Indeed Greece only began to attack its ‘competitiveness deficit’ when it was abandoned by investors and forced to implement reforms as a necessary condition of its bail-out. I think it would be fair to say that nothing stimulates action like the prospect of disaster. That’s why pronouncements by EU and Eurozone leaders that provision for future bail-outs must be enshrined in a revised EU constitution may, if not handled correctly, inhibit reform by member states that badly need to improve competitiveness. The problem, one perennial since the introduction of the single currency, is that countries have been able to dodge difficult decisions because of the protection provided by the Euro. Greece is a perfect example: it was able to borrow cheaply at rates that did not reflect the structural failings of its economy because of its links with stronger European economies. Such borrowing allowed Greece to entrench weaknesses in its economy, such as overly generous public pensions and salaries and uncompetitive, subsidised industries.

This is why poorly performing states must not be allowed to dodge difficult decisions. The creation of a stability mechanism is laudable, but must not create moral hazard whereby weaker economies are allowed to put off much-needed reforms, safe in the knowledge that the ECB will come in and save the day when things go sour. This is recognised by EU leaders, the European Council President Herman Van Rompuy, quoting a proposed addition to the EU’s Lisbon Treaty, stated ‘the granting of any required financial assistance under the (bail-out) mechanism will be made subject to strict conditionality’. Let’s just hope that this ‘strict conditionality’ is strict enough.