The euro crisis and the new impossible trinity

"The Euro Crisis and the New Impossible Trinity" by Jean Pisani-Ferry was published in Moneda y Credito 234/2012. This external paper draws from the Bruegel Policy Contribution The Euro crisis and the new impossible trinity released on 15th January 2012.

Introduction

Since the euro crisis erupted in early 2010, the European policy discussion has mostly emphasised its fiscal roots. Beyond short term assistance, reflection on reform has focused on the need to strengthen fiscal frameworks at European Union and national levels.

The sequence of decisions and proposals is telling:

• In 2011, the EU adopted new legislation, effective from 1 January 2012, that reinforces preventive action against fiscal slippages, sets minimum requirements for national fiscal frameworks, toughens sanctions against countries in excessive deficit and tightens up enforcement through a change in the voting procedure.

• On 26 October 2011, the euro area heads of state and government decided to go further and committed themselves to adopting constitutional or near-constitutional rules on balanced budgets in structural terms, to basing national budgets on independent forecasts and, for countries in an excessive deficit procedure, to allowing examination of draft budgets by the European Commission before they are adopted by parliaments. A few weeks later, in November 2011, the European Commission put forward proposals for new legislation (the "two-pack") requiring euro area member states to give the Commission the right to assess, and request revisions to, draft national budgets before they are adopted by parliament.
• Speaking in the European Parliament in early December, European Central Bank President Mario Draghi asked for a “new fiscal compact” which he defined as “a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made”, so that these commitments “become fully credible, individually and collectively”.
• On 9 December 2011, EU heads of states and government, with the significant exception of the United Kingdom, committed themselves to introducing fiscal rules stipulating that the general government deficit must not exceed 0.5 percent of GDP in structural terms. They also agreed on a new treaty that would allow automatic activation of the sanction procedure for countries in breach of the 3 percent of GDP ceiling for budgetary deficits. Sanctions as recommended by the European Commission will be adopted unless a qualified majority of euro area member states is opposed.

The question is, are the Europeans right to see the strengthening of the fiscal framework as the main, possibly the only precondition for restoring trust in the euro? Or is this emphasis misguided? It is striking that in spite of a growing body of literature drawing attention to the non-fiscal aspects of the development of the crisis, other problems that emerged during the euro crisis have almost disappeared from the policy discussion at top level.

Credit booms and the perverse effects of negative real interest rates in countries where credit to the non-traded sector gave rise to a sustained rise in inflation were the focus of policy discussions in the aftermath of the global crisis, but these issues are barely discussed at head-of-state level. Real exchange rate misalignments within the euro area, and current-account imbalances, are largely considered to be either of lesser importance, or only symptoms of the underlying fiscal imbalances. Finally, the role of capital flows

from northern to southern Europe and their sudden reversal, are merely discussed by academics and central bankers, although the sudden reversal of north-south capital flows inside the euro area is fragmenting the single market and creating major imbalances within the Eurosystem of central banks.