Lack of reforms contributes to the European debt crisis
It was clear from the start of EMU in 1999 that Member States needed to enhance the adaptive power of their economies. Within a monetary union, this is necessary for countries to absorb economic shocks where they can no longer use the exchange rate as an adjustment mechanism. In many countries, however, the rate of reform remained disappointingly slow. Whereas it was thought initially that countries would suffer most from their own inflexibility, the debt crisis showed that there were substantial international spillover effects, owing to imbalances that were the result of structural rigidity in some economies.
Lack of structural reform is thus one of the fundamental causes of the European debt crisis. In the southern euro countries (Greece, Italy, Portugal and Spain), rigid and stagnated labour markets led to persistently high wage growth and, hence, high inflation rates. This in turn caused the gradual erosion of competitiveness, adding to already high current-account deficits. During the credit crisis, the budget deficits and public debt of these countries, especially, soared far higher than those of other euro countries. The inflexibility caused by the failure to implement reforms now impedes the much-needed recovery of the southern countries' competitiveness and reduces their structural growth potential. Public debt becomes unsustainable.
Enforceability of reforms will benefit EMU as well as the Netherlands
The European debt crisis has shown that failure to reform on the part of individual Member States can affect the entire union. Therefore, stronger coordination within Europe is needed to enhance the enforceability of structural reforms in individual Member States. Europe has already taken a firm step in the form of the Macroeconomic Imbalance Procedure or MIP, and is contemplating further moves.
Many Member States show themselves reluctant when it comes to strengthening Europe’s enforcement mechanism. They dislike being forced by Europe to implement impopular measures. Yet stronger powers to enforce rules are necessary to improve the functioning of EMU on a structural basis. Without further reforms, the euro area’s problems cannot be solved quickly enough and other imbalances are likely to arise sooner or later. Therefore the euro countries must make up their minds: do they prefer, whatever the cost, to avoid ever being called to order by Europe, or do they prefer a more effective EMU that protects them from being harmed by other countries’ problems?
For the Netherlands, in particular, enforceable reforms within EMU are important. The open Dutch economy has greatly benefited from the euro. Yet conversely, we have also been greatly harmed by unsustainable developments in other euro countries. This is because the Netherlands has intense trade relations with these countries, and our high current-account surplus and large pension and banking industries mean that we Dutch hold considerable financial stakes throughout the euro area.
European policy limited to areas essential to EMU
So while a common European policy is strongly needed, it may be limited to areas that are essential for the smooth functioning of EMU. These are the areas where a lack of reforms has led to harmful spillover effects between Member States which have, for instance, contributed to distortions in the balance of payments. The area most qualified to be brought under common control is the reform of labour and product markets. Enhanced flexibility in these areas is of great importance for improving the adaptive power of countries in the euro area – the more so as low labour mobility in the euro area does little to strengthen this adaptive power. More flexibility will lead to smaller and less persistent inflation differences between countries and to more effective relative pricing. Other beneficial results will be more rapid alignment of the current-account balance and quicker correction of imbalances. Finally, flexible labour and product markets will enhance the structural growth potential of Member States, which will help to make public debt more sustainable.
Minimum standards policy cuts deepest in inflexible countries
A European policy should be based on formally enforceable best practices or minimum standards.Such minimum standards should apply to, for instance, the degree of automatic price index linking, which should be discontinued.As long as a country meets the minimum standards, it should be at liberty to pursue its own policies.
Minimum standards will be felt most keenly by inflexible countries in southernEurope.There, competitiveness lags clearly behind the EMU core countries (see the Table).Labour and product market efficiency are especially unsatisfactory and leave substantial gains to be made.The southern European labour markets are among the most rigid in the world.