As someone put it, there is “too much monetary union” and “too little fiscal union” in the Euro zone. The tension between the two becomes apparent when relatively weak economies experience serious downturns and people remember that exchange rate adjustments are not possible. Campa (2012) has provided a useful description of efforts underway to create more fiscal union and the challenges associated with them. He also discusses the long-run structural issues facing Euro zone economies. Campa's discussion provides a useful reference for anyone interested in related issues. Thus, rather than trying to critically comment on Campa's views, I would like to discuss some broader issues concerning the Euro area related to his analysis.
First, structural differences among Euro area countries that would normally require exchange rate changes remain significant. Figure 1 shows movements in unit labor costs for selected Euro area countries since 1999. The difference between Germany and Greece has widened by almost 30% since the start of the euro. More interestingly, Spain, Italy, and even France are much closer to Greece than to Germany. Going forward, of course, Germany will need some reflation and Italy and Spain deflation and efforts to improve the supply side of their economies. The gap between these two groups, however, seems to be too large to be closable within a short period of time. In the meantime, the gap that will remain will continue to generate pressure on Germany to transfer resources to the Southern members of Europe. This creates an unfortunate image of the disciplined North subsidizing the profligate South. Any attempts to create more fiscal union will face enormous opposition from the taxpayers in the North.
Second, the absence of a fiscal union has led to the absence of the framework to stop the contagion of systemic financial risks, as we have so painfully observed since 2010. That is, without a fiscal union, a banking union has been difficult and, moreover, severe limitations have been placed on the European Central Bank (ECB) to carry out operations that potentially have fiscal implications. As a result, the Euro area has lacked measures to contain occasional rises in investor concerns about the creditworthiness of sovereigns and/or banks in the area. This has been unfortunate because the currency unification has brought more financial integration and interconnectedness in the area. Policymakers should have at their disposal measures they could use in the case of sudden changes in investor psychology and associated reversals of capital flows.
The absence of a banking union has meant that countries have had hard time recapitalizing impaired banks for fear of generating a negative feedback loop between banking stability and the health of sovereigns.
The difficulty of purchases of government bonds on a large scale by the ECB forced the ECB to come up with the collateralized 3-year liquidity provision to banks after the European Union (EU) financial crisis became very serious in late 2011. The operation provided a boost to the markets for sovereigns, but it was a very roundabout way of doing so. In fact, as Campa points out, countries such as the UK, the USA, and Japan suffer more serious fiscal sustainability problems than does the Euro area, but have not experienced a huge sell-off of their government bonds so far. One major factor behind this has surely been large-scale central bank purchases of government bonds.
Discussions along these lines suggest the possibility that the inability of the ECB and Euro area bank regulatory authorities to act promptly in the face of stresses in the funding markets for banks and sovereigns has thrown the area into a bad contagious equilibrium since the crisis first erupted in Greece and a few other countries. It has lacked both the “lender of last resort” to avoid systemic run sovereigns and a mechanism to recapitalize banks. Efforts are underway to remedy this but will surely take a significant amount of time.