Wolfgang Munchau: How to rescue the eurozone

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The International Monetary Fund projected last week that eurozone output would regain momentum in the second half of this year.* If true, this would be unquestionably good news.

Unfortunately, most forecasts for the eurozone economy have pointed towards a second-half recovery every year since 2002. The forecasters were usually too optimistic. In fairness, the IMF acknowledged this time that “the fog surrounding the state of the recovery has not been lifted”.

Why does the eurozone economy continue to disappoint? Why do the forecasts fail to capture anticipate this? The sudden rise in the oil price and the euro’s trade-weighted exchange rate clearly had a negative impact on growth in the first half of this year. But this cannot explain the eurozone’s persistently poor performance for over such a long period.

Could the explanation be a lack of structural reforms? This is hardly plausible. A structural problem cannot explain what seems to be a cyclical phenomenon why the economic cycle has failed to turn upwards. Furthermore, eurozone member states have implemented a few of reforms. such as welfare reforms in Germany, pension reforms in Italy or the recently announced relaxation in the hiring-and-firing laws in France. Germany has started to overhaul its welfare system, Italy has tackled its pensions regime and France has recently announced a relaxation of its hiring-and-firing laws. The number of reforms is, in fact, impressive.

Conservative politicians and businessmen often explain the eurozone’s problems in terms of a loss of competitiveness. This, too, is hardly plausible. seems unlikely. How can the eurozone be lacking in competitiveness when it runs persistent current account surpluses with the rest of the world? Germany was the world’s largest exporter last year. It is a furiously competitive economy. Germany’s problem consists of is weak domestic consumption and investment.

One plausible reason for the extraordinary weakness in consumption is that badly implemented structural reforms have created uncertainty among the public. There is no transparency about how long the reform process will last, what will be reformed changed and what will be left unreformed. It is should come as no surprise that people build up precautionary savings not only as insurance against bad luck and old age, but against further reforms.

What policy advice should one give? Certainly not the advice to follow the Maastricht treaty’s fiscal rules to the letter. If the Christian Democrats (CDU) were to win the German general elections in September and immediately tried to consolidate the federal budget, the eurozone economy would be in trouble. This is not a completely far-fetched scenario, since their election manifesto includes a commitment to raise value-added tax by 2 percentage points.

The most optimistic statement one can make about the eurozone economy is that some of the conditions for a recovery are in place. The eurozone has been through a long period of wage moderation. Corporate profits are strong. There is a lot of pent-up demand for consumer durables. Many investment decisions are just waiting to be implemented. But to ensure that the recovery happens, the macroeconomic policies have to be right.

Ideally, this these policies should be carried out in a co-ordinated. manner. The contribution by of Angela Merkel, the CDU leader and Germany’s most probable likely next chancellor, should be to postpone the planned VAT increase. Italy, for example, could contribute with a strategy for labour market reform. This could help prevent a further acceleration of unit labour costs, which would damage Italy’s competitiveness.

The ECB European Central Bank should cut interest rates as early as possible. I would put its room for manoeuvre at It could do so by between one-quarter and as much as half of a percentage point without any serious risk to its inflation target.

Finally, all member states of the eurozone member states should formulate a joint economic strategy and explain it to their electorates in great detail: how to secure stronger growth, employment and a decent standard of living; where they will take the reform programmes; how they intend to secure ensure the liquidity of pension systems; and how to maintain fiscal solvency in the long run.

What the eurozone should not do is to follow bad advice. It should not follow bow to the ECB’s persistent admonitions calls for it to adhere to the deficit rules. Nor should it follow the IMF’s recommendation to that it continue focusing to focus on the Lisbon agenda, a once-hyped and now largely defunct process to improve approach to improving the European Union’s competitiveness. The IMF report states that this was the way forward “as long as it is appropriately prioritised and undergirded by credible peer pressure, including the use of benchmarks”. The content of this advice is even worse than its language. What the IMF conveniently ignored is that all this has been tried with no success.

The underlying trouble with the eurozone is not lack of reforms in general, but a lack of the right kind of reforms. This, in turn, is due to the fact that the eurozone has not yet made the transition from a monetary to an economic union. Its reforms need to be co-ordinated. This process cannot be left to the European Commission and national finance ministries because of their too over-narrow focus on deficits. There is simply no alternative but to anchoring the responsibility for the eurozone economy at the highest political level, the heads of government.

Otherwise Without such a change, we will face the depressing prospect of many more second-half recovery forecasts in the futurerecoveries that fail to materialise.

*Euro Area Policies, IMF Staff Report, August 2005, www.imf.org

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