REVITALIZING THE SPIRIT OF BRETTON WOODS

50 PERSPECTIVES ON THE FUTURE OF THE GLOBAL ECONOMIC SYSTEM

The Bretton Woods Committee

Keynes (left) chats with Dr. H. H. Kung, China’s Minister of Finance, in the dining room of the Mt. Washington Hotel on July 2, 1944.

Source: Bettmann/Getty Images

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EVOLVING GLOBAL ECONOMIC AND FINANCIAL ARCHITECTURE

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THE FUTURE OF THE EUROZONE

LORENZO BINI SMAGHI Chair of the Board of Directors, Société Générale and Italgas, and former Executive Board Member, European Central Bank

AN UNPRECEDENTED PROJECTThe creation of the euro in 1999 was one of the most influential changes in the international monetary system since the Bretton Woods agreements. Although many countries were bound by a fixed exchange rate system during the first two decades after World War II, never before had so many advanced econo-mies—initially 11, grown currently to 19—decided to share their monetary sovereignty to give birth to a monetary union with a single currency, managed by a single central bank. The creation of the euro is no doubt a unique project in modern monetary history.

The project was nevertheless contro-versial from the start, being criticized by many academics on the basis that the European Union did not qualify as an optimal currency area. It was rejected by some member states, in particular the United Kingdom and Denmark, which obtained opt-out clauses. It

experienced several shortcomings, in particular as a result of the great finan-cial crisis that erupted in 2008 and lasted longer in Europe than elsewhere. The eurozone slid into a second recession in 2012/13, while the international econ-omy was continuing its recovery. The International Monetary Fund (IMF) was asked to intervene on several occa-sions, in particular to contribute to the design and financing of the adjustment programs of countries such as Greece, Ireland, and Portugal, which had lost access to financial markets.

The request to access IMF resources was difficult to understand, especially for less-developed constituencies, since the eurozone is one of the world’s most advanced economic areas and should, in principle, be able to deal with its inter-nal problems. As Jean-Claude Juncker, president of the European Commission, recently stated in front of the European Parliament, US authorities would cer-tainly not request the help of the IMF

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if California had budgetary problems! Rather than asking for external help, shouldn’t European countries fix those parts of the monetary union that do not work properly? For how long can the eurozone rely on external help to address its internal problems, and for how long will other constituencies be willing to provide such help? Given the size of the eurozone, these questions are of interest to the whole international monetary system.

The future of the eurozone will depend on three main capabilities. The first is the ability to complete the neces-sary monetary and financial architecture to ensure that the union is capable of countering major shocks, such as that experienced during the Great Recession of 2008. The second is the ability to restore strong and sustainable growth so as to address the consequences of global-ization, in particular on the inequalities that are fueling a widespread dissatis-faction with European institutions. The third is the ability to contribute to a more stable international financial and economic order.

STRENGTHENING THE EURO ARCHITECTUREIt is widely recognized that the euro-zone has been built on the assumptions that there would be no crises and that if all the members behaved properly, there would be no need for major pol-icy adjustments. These ideas were the basis for inserting provisions such as the

no-bailout clause, which prohibits gov-ernments from supporting each other’s debt, and for preventing the central bank from purchasing public debt on the primary markets. The assumption of a crisis-free world was obviously an illusion. Crises do happen and policy makers do make mistakes.

During the 2012/13 crisis, the euro-zone took measures to improve the institutional architecture of the mone-tary union and make the system more resilient. To cite just a few of these mea-sures, the European Stability Mechanism was created to help finance countries that lose access to capital markets. The European Central Bank adopted the Outright Monetary Transactions pro-gram to protect countries that abide by adjustment programs from speculative attacks in the financial markets, which can drive borrowing costs to unsus-tainable levels. The banking union was created, and the European Central Bank was given responsibility for supervising the EU financial system under the Single Supervisory Mechanism. The Single Resolution Fund was set up to resolve failed banks.

These changes have strengthened the eurozone and enabled it to recover after the second recession, in 2012/13. However, they are not sufficient to ensure that the union would not be severely hit in the face of a new crisis. Further strengthening is required. The key problem is the ability of the monetary union to face a shock, either symmetric or asymmetric, the latter of

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which may produce a different impact across countries. The different room for maneuvering that each country may have in addressing the shock, as a result of a different budgetary or cyclical posi-tion, may tend to widen divergences and fuel snowball effects as well as self-ful-filling expectations that can destabilize financial markets.

Improving the eurozone’s resilience requires action in various areas. The first is to complete the union’s capacity to absorb shocks through the financial markets, which in turn requires com-pletion of the banking union. Building a true pan-European banking system would ensure that regions or countries that are hit by a shock can continue to be financed thanks to the geographic diversification of banks’ balance sheets. The biggest obstacles to a full-fledged banking union are the persistence of national exceptions in European regu-lation, which allow national authorities to require banks to maintain national liquidity and capital constraints, and the lack of a common deposit insur-ance scheme.

Another requirement is the creation of a true capital market in the euro-zone that can distribute the effects of shocks evenly throughout the area. The project that has been launched by the European Commission falls short of ambition and has been implemented in relatively small part. A revitalized approach is needed. A more integrated financial market also requires the avail-ability of a truly European “safe asset,”

denominated in euros, that can be used by market participants to manage their liquidity and to serve as a benchmark for pricing risky assets.

There is also a need to create the foundations of a more coherent policy response to shocks, based on a common instrument. This step would require a European budget to finance inter-ventions across the union so as not to overburden national budgets. Such a budget could initially finance spe-cific policies, such as unemployment compensation, subject to adherence to common standards. The issue is not simple politically, however, because of the reluctance to create mechanisms that could lead to the permanent transfer of resources across countries, potentially fueling moral hazard. Nevertheless, several proposals have been put on the table that could be experimented with and broadened over time.

RESTORING SUSTAINABLE GROWTHThe second factor that will determine the future of the eurozone is its ability to generate policies to foster sustainable growth and reduce unemployment, especially youth unemployment, which is one of the main reasons for the disaf-fection people express toward European institutions. During its first 20 years, the eurozone largely relied on world trade as the main engine for growth, in particular after the second recession, in 2012/13. The eurozone’s current

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account moved from an overall balance at the start of the euro to a surplus of around 4 percent of GDP. Most euro-zone countries are actually in surplus, with the exceptions of France, Greece, and Cyprus.

International trade might not con-tinue to be as dynamic as in the past, especially if protectionist pressures con-tinue to mount and retaliations between major trade blocs escalate. If Europe wants to strengthen its growth perfor-mance in a sustainable way, it needs to rely more on domestic demand. Such reliance requires a rebalancing in the growth model, with greater emphasis on consumption and investment, both public and private.

Consumption can be boosted through faster increases in purchasing power, in particular real wages. Such increases can be achieved only through higher productivity growth, which in turn requires stronger investments in technology and innovation. Making the European economy more attractive for investment is the key challenge in the years ahead, and it will require a stronger effort in research and development to create a more stimulating environment for entrepreneurship. It will also require structural reforms in the product and labor markets to allow new companies to emerge and develop without being hampered by barriers to entry.

The excess of savings over invest-ment in Europe also needs to be channeled through a better-function-ing capital market. The implementation of a capital market union is aimed not

only at better absorbing shocks that affect the eurozone but also at financ-ing a more dynamic economy.

To implement these policies, the eurozone largely relies on policies enacted at the national level. The budget available at the EU level is limited. The new budget for the 2020–2027 phase needs to stand up to the challenges faced by the world economy. To do so requires a stronger capacity to invest in research and development, as well as in common defense and security. Negotiation on a new financial plan should start following the May 2019 European elections, with a view to being completed by the end of 2019.

THE EURO AS A GLOBAL PLAYERThe third factor that will determine the future of the eurozone is the role that the EU will want, and be able, to play at the global level. The rebalancing of power, in economic and political terms, has accelerated in recent years. China is emerging as the world’s largest economy, with growing political influence not only in Asia but also in Africa and Europe, notably through the Belt and Road Initiative. The United States is trying to fight the trend of a decreasing market share, with initiatives aimed at boosting military spending while at the same time reducing military presence abroad.

The issue of migration is affecting all developed areas of the world. The EU, which has limited powers in foreign and security policy because its member

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states retain most of those capacities, does not seem to have adapted to the new environment. Its process remains paralyzed by the need to make deci-sions by consensus, with any country capable of blocking a decision. These constraints explain the difficulty of effectively addressing the challenge of migration, which is particularly bur-dening some EU members and fueling negative feelings in large parts of the population. They also explain the rising tensions within the transatlantic mili-tary alliance, with European countries continuing to limit their budgetary spending on defense, relying instead on US financing.

In the economic sphere, the interna-tional representation of European interests remains fragmented. For instance, in the IMF, the Eurozone is represented not by a single chair, which would give it a weight comparable to that of the United States, but by several chairs, some in con-stituencies containing emerging markets. The European influence is thus diluted and not capable of promoting common interests. The same fragmentation pre-vails in other international forums, such as the G20 and the Basel Committee on Banking Supervision, the latter of which defines the regulatory framework for global financial markets.

Overall, what seems to be lacking, be it from the European Commission, the European Council, or the European Parliament, is a coherent view of the role that Europe should play in the world and in the economic and political dimensions of international relations,

and what measures it should promote to achieve such a role.

An interesting case relates to the role of the euro as one of the major inter-national currencies. Although the euro is currently the second most import-ant currency in the world, after the US dollar, there is no policy to extract from it any key strategic advantages. The inter-national use of the euro is left to free market choice, not encouraged, nor even required in international transactions. This is a very different attitude from that of the United States and possibly China. The United States, in particular, is taking huge advantage of the role of the dollar in international markets, in many different respects. For instance, the extra-territoriality of US legislation is claimed to apply whenever the dollar is used in transactions, even outside the United States and between non–US citizens.

The complexity of the EU deci-sion-making process has prevented Europe from being more assertive in the international environment and made it defensive with respect to the reform of the international financial system, starting with the governance of the IMF and World Bank. This situ-ation has created an imbalance between the economic size of the union and its effective ability to influence global issues. Such an imbalance may become more apparent over time, in particular with the emergence of China and other economic powers that may have dif-ferent principles and policy objectives from those of the EU. The ability of EU member states to understand that

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their relative power has decreased and will continue to do so over time, to the point of their becoming irrelevant, will be a key factor in determining their desire to share sovereignty in these areas. The European institutions, including the Council of Ministers (i.e., the Council of the European Union), the European Commission, and the European Central Bank, should be proactive in promoting a single repre-sentation within international bodies, with a view to making the latter more effective and accountable.

It is not clear what will trigger such a change. However, experience shows that Europe tends to move only in reaction to crises. Only in crises do governments realize that the prevailing institutional system does not allow them to make efficient decisions. Only in crises do

citizens realize that more rather than less Europe is needed. This has been the case, for instance, with the monetary union, which was implemented after the cur-rency crises of the 1970s and 1980s, and with the banking union, which came after the 2011 crisis.

Jean Monnet’s prediction that “Europe will be forged in crises and will be the sum of the solutions adopted for those crises” remains valid. Incidentally, it applies not only to Europe. Most of what the United States is today is the result of decisions made during crises. It is thus an illusion to think that the future of Europe can be drawn in the abstract, based on some theoretical model or copying an existing one. It will be the way in which the people of Europe react to events, including crises, that will affect the world around Europe.