Monday, 5 September 2011

A Sick Old Man?

The economic case against Europe is well rehearsed. The longer term case against Europe is one of demographics. The population of Europe is ageing, and, if nothing changes to the contrary, the dependency ratio of workers to non-workers is likely to fall to the point where a severe shortfall of workers (and their tax receipts) occurs. So far, the discussion has focused upon reducing the fiscal impact of an ageing population, without considering other remedial measures that could be taken.
In the short term, the Eurozone has become a monetary union without an effective mechanism to deliver fiscal co-ordination. As a result, the weaker economies of Portugal, Ireland, Greece, and Spain have been allowed to borrow way beyond a prudent level with very little adverse consequences. Equally, the Euro provided a vehicle whereby the stronger Eurozone economies – particularly those of Germany and the Benelux nations – could power ahead faster than they otherwise would have done. An imbalance was created between the stronger and weaker Eurozone economies that has now become unsustainable.
The present situation in Europe needs greater fiscal discipline on the part of the weaker Eurozone economies and a greater fiscal transfer system on the part of the stronger Eurozone economies. Over the course of the summer, we have been inching towards this solution. We can hope that the process will continue, but perhaps with greater speed than we have seen to date. Interestingly, this could have two important long term consequences. First, we could see an inner core to the EU that has a high degree of monetary and fiscal integration – the ‘two speed Europe’. Second, that inner core could emerge as quite a strong economic force in the global economy, particularly when compared to America. After all, the Eurozone as an economic unit has a GDP to rival that of the US, the Eurozone is more of a trading force in the world economy, and, despite all of the adverse comment in the press, the Eurozone as a whole has a lower debt to GDP ratio than the US. A more integrated European economy would be a welcome result from the present malaise.
For this to happen, a number of institutional innovations need to be devised. Presently, Europe is relying upon the ECB to purchase the sovereign bonds of the Eurozone nations – a form of European wide quantitative easing. It is difficult to see how this could go on into the long term without the re-capitalisation of the ECB (the ECB has reserves of about €0.5 trn, whilst some commentators suggest that €1.5 trn to €2.0 trn might be needed to effectively stabilise the Euro). There is a case for such restructuring to be accompanied by the issuance of Euro-Bonds. In effect, this would create a fiscal union to parallel the monetary union within the Eurozone. It could, if constructed properly, actually force the weaker Eurozone nations to adopt greater levels of fiscal discipline. For example, if the issuance of Euro-Bonds were to be limited to the Stability and Growth Pact limit of 60% of GDP – an idea first floated by the Bruegel Institute – with the excess being raised under the present conditions, then it would allow nations such as Greece to have about half the sovereign debt guaranteed by the collective Eurozone nations, with about a further half to be raised under the credit-worthiness of Greece as a sovereign nation. As things currently stand, this is a move expected by the bond markets but resisted by the national politicians of the stronger Eurozone nations at the behest of their voters.
This disparity between market expectations and the willingness of politicians to act is nudging events along the course outlined above. The last final step – the issuance of Euro-Bonds – is looking ever more likely if the Euro is to remain as a currency. If the threshold of Euro-Bond issuance is not crossed, then it is difficult to see how the Euro would remain as a currency. If Euro-Bonds were to be issued, then the Eurozone would be free to concentrate upon the fiscal impact of ageing European populations. Much of this discussion has been the result of straight line thinking. It has been concerned with the shrinking of the tax base and the expansion of the welfare base. This approach, however, might be a bit premature.
Across Europe, governments have been taking steps to make their future pensioned populations less of a fiscal burden. Retirement ages have been increased, contributions to retirement schemes have been increased, and less generous entitlements have been devised. All of which act to lessen the impact of future pension spending upon the public purse. The argument about the dependency ratio is also unlikely to ring true. When faced with labour scarcities, Europe has traditionally imported labour,  rather than relying upon the natural growth rate of the population. This helps to maintain the tax base. It can be achieved in one of two ways – the first is to increase the number of young people in the EU through the accession of nations with relatively young demographic profiles. The case of Turkey is one to watch in this area. The second way of increasing the number of young workers is to attract them as ‘guest workers’ through schemes such as the ‘Blue Card Scheme’. This may well inform EU policy towards North Africa in the near future. Together, the redefining of retirement combined with an influx of young workers are likely to reduce the fiscal impact of an ageing population.
In all of this discussion we must remember that it is entirely possible that the Euro could still collapse. Equally, we must not under-estimate the political will to keep it afloat. That political desire to keep the Euro afloat is nudging the Eurozone towards a closer fiscal union to match the current monetary union. As a result, Europe of the future could become much stronger commercially than it is today. At that point, those EU nations that are outside the Eurozone, such as the UK and Denmark, may come to regret the decision to stay out.
© The European Futures Observatory 2011

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