JTW Op-Ed, George Pagoulatos*

Over the last few years, under painful adjustment policies, the Eurozone made great strides towards confronting the large deficits and excessive imbalances that contributed to the sovereign debt crisis. However, the adjustment policy mix has been too procyclical, therefore amplifying the recession, fostering debt deflation and prolonging the crisis. The lack of any significant Eurozone-level countercyclical measures that would offset the recessionary impact of adjustment has contributed to the prolonged stagnation of the European economy. The inability of the broken monetary transmission mechanism to transfer the low interest rates from the core to the economies of the periphery has further deprived healthy companies, especially SMEs, of precious capital.

As a result of poor management of the crisis, the European economy is facing a threat of fragmentation which is now more imminent than ever: fragmentation between Euro-ins and Euro-outs, fragmentation between North and South, and fragmentation within societies themselves as income inequality and poverty is growing, mainly as a result of intolerable levels of unemployment in the Eurozone South.

Since the crisis began, the growth rates of the Eurozone economy have been deplorably low. Hovering around 0.5%, the current rate of inflation in the Eurozone falls short of the ECB�s definition of price stability. Deflation or �lowflation� makes rebalancing in the Eurozone extremely difficult. The economies of the South need lower inflation, in order to restore cost competitiveness vis-�-vis the core; but against an average 0.5% they can only rebalance in deflation. A nominal GDP growth rate around 1% or below means that the debt burden, public and private, in the highly indebted Eurozone economies will further increase to the point where it eventually becomes unserviceable.

What is needed is a policy mix that would assist fiscal consolidation, economic adjustment and structural reforms in the economically weaker countries, starting from a higher average inflation rate (closer to 2%) in the Eurozone. At the same time, the Eurozone economy needs an urgent countercyclical stimulus, which should be provided via an EMU-wide investment stimulus. The �315bn Juncker investment plan is a good start, but it is not sufficient: the actual EU funds allocated by the plan (�21bn) are very small, and the plan aims to reach the said target by achieving an excessively optimistic leverage ratio of 15. Greater involvement is needed by the European Investment Bank, which should increase its capital base, supplemented by a possible issuance of bonds which could then be purchased by the ECB, as part of an extensive asset purchasing program.

At an average rate of around 12%, unemployment remains the most important concern for Europe. This is painfully acute in the crisis-hit economies, as seen in Spain and Greece where unemployment peaks above 25%. Apart from being an explosive socioeconomic and political problem, long-term unemployment is a terrible waste of human capital, undercutting the productive capacity and future growth potential of the economy. It is vital to maintain the employability of the unemployed, especially the long-term unemployed, by making sure that active support and training is extended and social safety nets are funded to avert marginalization.

Raising competitiveness, especially in the economically weaker countries, has extensively relied on wage deflation and lowering labor costs. Though the adjustment of unit labor costs since the outbreak of the crisis has been necessary, there should be stronger emphasis on other cost factors too and on raising overall productivity levels. This remains mainly a national policy responsibility, but the EU should become more active in supporting investment and providing technical assistance to the less developed regions.

The economies which prior to the crisis had relied on credit-driven growth and an overexpansion of the non-tradable at the expense of tradable sectors, will need to shift to a more export-led model. The EU should work closely with national and regional authorities, private business, research centers and other stakeholders to encourage and sustain smart growth.

It is important to promote the speedy implementation of the banking union. Without it, the Eurozone periphery could end up trapped in a permanent situation of high perceived country risk, higher capital costs, savings and investment flight, wage deflation, low growth and persistently high unemployment. This would undermine the economic and sociopolitical viability of the euro and European integration. The backstop established by the banking union needs to be strengthened. The third pillar of the banking union, a single deposit insurance system, needs to be added.

The recommendations outlined in the President�s report �Towards a Genuine EMU� and the Commission�s �Blueprint for a Deep and Genuine EMU� must be acted upon. Most important among them is the need for the Eurozone to acquire its own fiscal capacity. A Eurozone budget, funded preferably by its own resources (VAT, corporate taxation, financial transaction tax, etc), should operate as a main instrument of macroeconomic stabilization in the face of crises hitting member states in an asymmetric manner. A Eurozone budget, together with the EIB, should be able to direct investment to crisis regions, assisting their recovery. A European unemployment insurance scheme could assist the national efforts to deal with excessively high levels of cyclical unemployment, while national reforms confront the sources of structural unemployment.

There should be progress towards an investment union, as proposed by the European Policy Centre (EPC), including a dedicated investment fund aimed at delivering investment for growth in member states unable to make the necessary investments themselves. This would encompass and exceed existing initiatives such as frontloading EU budget funds, project bonds and the Connecting Europe Facility. A European Investment Guarantee Scheme would be a vital new instrument that would provide insurance against the higher country risks involved in private sector investment towards crisis-ridden economies. Such steps towards moderate mutualization, combined with greater pooling of national budgetary and economic policies, would help build a more integrated, cohesive and sustainable Eurozone. A Eurobond scheme could be employed to finance Eurozone investment in infrastructure.

The Eurozone has not tapped into the advantages of a monetary union, and especially the status of the euro as the world�s parallel reserve currency next to the dollar. This implies that Eurozone bonds, Eurobonds, should seek to benefit from the advantages of a deep and liquid global financial market, ensuring low-interest finance for major EMU projects. Such projects include infrastructure, and they can also include the process of partly substituting the national issuance of debt through joint issuance in the form of Eurobills and a Debt Redemption Fund. Thus, through reducing servicing costs, high public debt levels would de-escalate more rapidly and financial markets would be better integrated and stabilized.

The appropriate conditionality would effectively safeguard against moral hazard. Dealing effectively with the debt overhang is a crucial prerequisite for allowing the European economies to grow.

*George Pagoulatos is a professor of European politics and economy, Athens University of Economics & Business; visiting professor, College of Europe; member of the Board of Directors, ELIAMEP; academic fellow, EPC.

**Note:This article was firstly published in Analist Monthly Journals January issue, 2015