EU economic reforms fall short on growth

The European Commission announced proposals for reform of eurozone governance on Wednesday, calling for closer monitoring of member states’ public finances and tougher penalties for alleged fiscal ill-discipline. Countries at risk of excessive private sector debt and current account deficits are to be named and forced to take corrective action, for example by cutting wage growth or curtailing access to credit.

The problem is that poor economic growth prospects, not just fiscal ill-discipline, lie at the heart of the eurozone’s problems. Without a sustained recovery, Europe’s public finances will remain in crisis, as the escalating problems in Ireland over the last week show. Reforms therefore must centre on removing obstacles to growth, meaning a concerted drive to deepen the single market, recapitalise banks and ensure greater fiscal union. In short, reforms must tighten economic and political integration.

Unfortunately, the actual reforms – to be discussed by member-state governments at a European Union summit in October – will fall dramatically short. The proposed eurozone governance will, in truth, be little more than a beefed-up system to ensure budgetary discipline. Serious trade imbalances within the eurozone are to be treated as a matter for the deficit countries alone; surplus countries, such as Germany, will not be obliged to strengthen their domestic demand. And there will be little push to accelerate market integration or move to greater fiscal union.

There is little difference between the European Commission’s proposals for reform and those of the European Council’s taskforce headed by President Herman Van Rompuy, which presented its findings to finance ministers on Monday. Both advocate tougher penalties for fiscally errant governments. To the extent that they acknowledge imbalances to be a problem, both recommend that action be taken to narrow differences in competitiveness.

The fact that both fail to focus on deepening market integration and making labour markets more flexible is unsurprising. Most eurozone governments still do not acknowledge that a shared currency cannot rest on a group of national markets that are insufficiently flexible and imperfectly integrated with each other. But the most glaring problem with both the Commission’s and the Council’s reforms is that they ignore demand.

Unless there is stronger demand elsewhere in the eurozone, those countries running deficits can only rebalance their economies by reducing incomes, and hence demand for imports. This implies stagnation at the very best. At the same time, a German economy where domestic demand remains chronically weak – it increased by just 3 per cent between 1999 and 2009 – will remain a drag on the eurozone. The outcome will be very weak demand across the currency bloc, heightening the risk of deflation.

Instead, policies are needed that promote stronger demand in the eurozone’s surplus economies, rather than weaker demand in the deficit ones. Germany has been able to rely on wage restraint to boost the competitiveness of its exports. But this is hardly something that all member states can do simultaneously, at least not without condemning the eurozone to a slump. A meaningful system of eurozone governance would devote as much time to German labour market policies as to the monitoring of Spain’s public finances.

In Wednesday’s proposals, eurozone policymakers seem to be assuming that they can count on demand from the rest of the world to bail them out. However, with every major economy in the world targeting export-led growth, it is hard to see how this could work. German exports to economies outside the eurozone are certainly growing strongly but the zone cannot rely on exports unless it runs an ever larger trade surplus.

There is no doubting the member states’ political commitment to European monetary union. But the markets will speculate against the euro until the underlying obstacles to economic growth are addressed. The ratings agencies will continue to downgrade the debt of eurozone economies, citing poor growth prospects. Unless there is a rethink, the eurozone risks permanent crisis with chronically weak growth across the region as a whole, and politically destabilising debt-deflation in the struggling member states.