The EMU must move a step further
9-3-2009 | Economic news
I am a strong supporter of the euro. The European currency has made a substantial contribution to our prosperity over the past ten years. Even though the current financial crisis has caused widespread damage, the level of destruction has nonetheless remained limited thanks to the euro. All you have to do is look at what has happened in Iceland and shiver with fear. And then consider the benefits of the euro and count your blessings.
Euro integration
It must be noted that the euro still continues to be an incomplete currency in a number of respects. While Europe is one entity monetarily, the process of European integration has still not been completed by far from a political standpoint. This has financial repercussions considering that liquidity in the European financial markets is a good deal below the desired level. When we add up all the outstanding government debt of all the EMU (Economic and Monetary Union) countries, the total amount is much larger, and potentially considerably more liquid, than the market for American Treasuries. Investors, however, rightly recognise that German, French and Dutch government bonds have less default risk than Italian and Greek government bonds. This means the market for German bonds, as in the years prior to the introduction of the euro, continues to be the most homogenous and liquid market for European government bonds.
Differences within the EMU
This difference incidentally only emerges during an era of uncertainty like the one we are currently facing. Until recently the markets made virtually no distinction between the different kinds of government debt within the EMU. This resulted in an excessively minimal difference and the countries with the poorest government finances were the ones that profited the most from this development. As a result some countries felt less of a sense of urgency to put their government finances in order than they should have. But in the midst of the current crisis, in which markets have become extremely nervous on account of all the shocking developments, we now suddenly see a rise in the differences between interest rates within the EMU. This once again reveals the fact that markets almost always exaggerate. First they structurally underestimate the risks and then go overboard in the other direction. The poor functioning of the financial markets within the eurozone constitutes one of the euro’s weaknesses.
A step forward
There are analysts who predict that these developments will ultimately lead to the demise of the euro. This is clearly not in the cards. But the time does seem ripe for the process of European integration to take a step forward. Having all government debt plus all issues of European institutions financed centrally from now on by a new fund, could quickly lead to the creation of a homogenous and liquid market for government debt. This would eliminate the financial markets’ last possibility for speculating against the continued existence of the euro. It would mark a huge step forward.
The consequences of a step of this magnitude would, however, have to be thoroughly considered in advance. The step would not result in a large European budget, nor would it cause countries to lose their fiscal autonomy. While the latter is a possibility, it is not necessary. The only essential condition is that governments from now on can commit to issuing their government debt via the new fund. And that is all the autonomy they would have to forfeit.
Central financing of government debt also does not necessarily undermine the budgetary discipline of the member states. However, it is a danger that is easy to overcome. The central fund will naturally in turn channel the funds it raises to the different countries that have deficits and can employ a system of mark-ups and mark-downs. This system must be based on the quality of the government finances in the related countries.
This is not a new idea and I refer to an article I wrote that was published in the Intereconomics magazine in early 2005 in which I spelled out this proposal in detail. European integration is a matter of taking numerous small and a few large steps forward. In my opinion the time has come to take one of the larger steps in the right direction.
Dr. Wim Boonstra, Chief Economist Rabobank Group
Dr. Boonstra has published numerous articles on banking, financial markets, international economics and business cycles.
