With the continuous outpouring of bleak economic data from the EU, many are expressing deep pessimism bordering on despair about the prospects for the sustainability of the monetary union. Yet in some areas at least, progress is in evidence. Compared to the reluctance of the Obama administration to address the deeper causes of the American (and mutatis mutandis) global crisis, at least some structural causes of the EU crisis have been identified. Contrary to the not-always-well-informed American press, which seems congenitally pessimistic regarding the future of EU, actions are being taken by the EU to address some of these deep problems. On September 12, 2012, a German constitutional court took a momentous decision and prepared the way for the country's participation in a new European bailout fund. So far, markets seem to have reacted positively, though it is too early to be certain. Significantly, the pro-EU party in the Netherlands has won the elections recently also. This is encouraging. Furthermore, earlier the European Central bank (ECB) had reversed an earlier policy stance and decided that it would serve as a lender of last resort for government bonds after all.
The deep underlying causes of the Eurozone crisis are the flaws in the design of the transnational monetary union. The Economic and Monetary Union(EMU) launched in 1999 consisted of the euro and the European Central Bank (ECB) for a common monetary policy. While the countries surrendered their ability to formulate and implement independent monetary policies, the fiscal and other economic disparities were not addressed. Nor was there a fiscal union, or even strong fiscal federalism and other institutional mechanisms required for coordinating structural policies to address the uneven economic development in Europe. Both the Werner Report of the 1970s and the Delors' Report of the 1980s, which served as the blueprint, had developed a three-stage roadmap comprising closer economic coordination among members, binding constraints on member states' national budget, and a single currency. The Maastricht treaty reflected these. But Krugman's inept joke at the time about the unpronounceable -- by the provincial American tongue at least -- name of the city indicating future trouble, did contain the germs of an apt economic argument and judgment. But that argument, not fleshed out by Krugman then, was far from the complacent conventional wisdom in Euro-American academe.
In hindsight it seems clear that in their eagerness to put through a full and irrevocable European unity, the treaty makers had hastily concluded that the two convergence criteria written into the Maastricht Treaty -- a 3 percent limit on annual fiscal deficit and 60 percent limit on gross public debt to GDP ratio -- would be adequate for maintaining the irrevocable European unity. In truth, this was the result of using a flawed theory -- monetarist in its origin and naïve in terms of political economy and politics during possible crisis. In fact, no possibility of a crisis was countenanced.
On the positive side, the institutional flaws have now been identified honestly and are being fixed. A key shortcoming in the design of the EMU was the absence of the lender of last resort in government bond markets. It is axiomatic that when a country issues sovereign bonds in its own currency there is an implicit guarantee from the central bank that cash will always be available to pay out the bondholders. One can call it an "implicit contract," following the insights of contract theory, a branch of theoretical economics developed vigorously in the last twenty-five years in North America and Europe. The absence of such an implicit contract in a monetary union -- where bonds are issued in a currency over which individual countries have little or no control -- makes the sovereign bond markets prone to liquidity crisis and contagion,very much like banking systems in the absence of lender of last resorts. Just as in the previous paragraph, the outcome was both the inability to use good theories that were in fact available and to use good long-term statesmanlike political judgment.
The situation was compounded by the lack of flexibility of ECB earlier. For a long time, the ECB interpreted the no-bailout clause in the EU treaty quite rigidly. The "Central Bank" was reluctant to pursue the role of lender of last resort. As a makeshift structure, the policy makers set up the European Financial Stability Facility (EFSF) as a substitute. Recognizing that EFSF was not a good substitute took some time. But finally, it looks like that a permanent 500 billion euro European Stability Mechanism (ESM) may be established by the end of 2012 or in 2013. This week's German constitutional court approval was an important milestone for this process. It should have been clear, as some observers had noted that the EFSF will run out of money. Thepresent writer made this point in several UN and other symposia from the beginning of the crisis. Others have also made the same point recently. Having bailed out Greece, Ireland, and Portugal, the EFSF is running out of steam. It is also due to expire in less than a year. Therefore, the establishment of ESM is or should be a critical item on "saving the EU" agenda.
Furthermore, it should be noted that there has been a dramatic turnaround in the ECB and that is something new and important. In July, ECB chief Mario Draghi, had promised to "do whatever it takes" to protect the euro. On September 6, he announced plans to make the ECB the lender of last resort in government bond markets. Under the new program called the Outright MonetaryTransactions (OMT), the ECB will buy existing government bonds in the secondary market without limits. The OMT will primarily benefit fiscally troubled countries like Spain and Italy which are facing difficulties financing their debt as their borrowing costs have soared in recent months. The arrangement should have come much earlier. But it could be a lifesaver for EU now. There are still issues of fiscal austerity and related to this is the crucial question: which class will bear the burden of adjustment? Internal class struggles could derail the whole effort that is underway now. It remains to be seen ultimately how technically astute and politically wise the ruling elites in the most powerful EU countries are. The fiscal compact and banking union are both steps in the right direction. Ultimately, only a more deeply democratic union based on fair class compromises can save the EU.