Time for Europe to grab more of the spotlight on world’s financial stage

Date: 28/02/02

THE three years since the start of European Monetary Union have been characterised by an extraordinary degree of financial market volatility. EU institutions have generally not been in the forefront of the efforts to stabilise global financial markets. This is partly understandable as most of the volatility originated outside the EU. But just putting one's own house in order is not sufficient when global financial stability is at stake.

11 September

The terrorist attack on the US sent shock waves through financial markets. At first it seemed there was a real danger a vicious spiral would develop of falling consumer confidence, falling demand and falling output.

This was averted by prompt action involving both monetary and fiscal policy. The Federal Reserve provided the necessary liquidity to ease any stress on financial markets, and as US fiscal policy loosened immediately, the case for more government (i.e. military) spending became compelling.

Once financial markets calmed down, it turned out that the US economy was large enough to absorb the material damage of 11 September without any problems. Labour productivity actually improved during the last quarter of 2001. Demand has also stabilised and at the time of writing it seems that the US is on the brink of a modest recovery.

What was the role of the EU in this success story? It was limited, but not unimportant. The European Central Bank (ECB) lowered its interest rates immediately in such a way that its move appeared to have been coordinated with the Federal Reserve. This helped to stabilise financial markets. Moreover, as it became apparent that weakness had spread to the eurozone, the ECB continued to provide ample liquidity to markets, overriding its own 'reference value' for monetary growth. While the contribution from the ECB to the stabilisation of financial markets after 11 September was modest, one should not forget that it was certainly much more than Japan could provide.

So far so good; but all the major imbalances in the global economic system existing before 11 September are still with us.

US imbalances

The largest imbalance in the global economy is the US current account. The US, as one of the richest economies in the world, should be a capital exporter, not an importer of capital to the tune of 4 of its GDP, or almost 25 of its own national savings.

It is difficult to see this continuing forever. It is true that the international indebtedness accumulated by the US is, so far, less than 30 of its GDP. But as exports constitute only 10 of GDP, it follows that the US has already a foreign debt/exports ratio of about 300, and this ratio is rising by about 40 every year. In any emerging market, this kind of ratio and trend would be likely to provoke a foreign exchange crisis.

An outright currency crisis is most unlikely given that foreign debt of the US is mostly denominated in dollars, and a lot of it is actually bound up in (foreign ownership of) US assets, such as real estate and shares. But the trend in US indebtedness implies that sooner or later (probably later) a large devaluation of the dollar is unavoidable.

The sluggish growth of US exports in recent years suggests that the new economy has not allowed the US to export much more than usual. There is thus a big difference between the domestic and international aspects of the new economy. Productivity growth continues unabated despite the recession.

But exports do not show signs of growing accordingly. A correction of the current account deficit thus requires a combination of lower demand growth in the US and a devaluation of the dollar. Both are likely to be accompanied by major financial market volatility.

Unfortunately, there is not much the EU can do to address this issue. In the long run the Union must influence the US imbalance by becoming more competitive itself, and thus a more attractive place to invest. However, the EU must be prepared to contribute to an orderly management of the fall in the dollar when it becomes necessary.

There is a real risk that foreign exchange markets will be made even more jittery by discordant statements from various EU institutions. In principle there is now a broad agreement between the ECB and the political authorities (ECOFIN in this case) on the distribution of competences.

It is now clear that the ECB alone decides on the implementation of interventions, and the ECB president is the only person designated for contact outside the euro area. Responsibility for all other communications, however, including positions announced in global fora such as the G7, is shared. Prior consultations between the ECB and the political authorities are supposed to lead to a common policy line and public statements are supposed to be brief and infrequent.

It remains to be seen how this informal agreement will work when the chips are down. National politicians will have great difficulties resisting the temptation to state their views, including those on the exchange rate. It would be far better to appoint a 'Mr Euro', who would be the only person allowed to speak officially for the EU on the exchange rate of the euro.

Otherwise, the cacophony of the past will return at the next bout of instability in the dollar/euro exchange rate.

Emerging markets volatility

The recurrent financial and banking crises caused by the sharp swings in capital flows to emerging markets form another contribution to global financial instability. It is surprising that the EU has been completely invisible in international efforts to deal with this problem.

There is no direct EU competence involved so this issue has been left for member states to deal with according to their own perceived national interests.

Therefore no coherent EU position has ever been developed and defended, even in cases where Europe's strategic interests are clear, e.g. Turkey. In contrast, the US authorities usually have well defined interests and are so effective in influencing other institutions that at times it seemed as if the IMF was taking orders from the US Treasury.

The EU is also not using its financial muscle (or rather the financial means of its member states) in an efficient way.

The main EU instrument for channelling direct financial aid, Macro-Financial Assistance (MFA), is only available for a small group of countries (mainly in Europe).

For the favoured few, MFA represents only a fraction of the total support received from EU member states either directly (on a bilateral basis) or indirectly (via the international financial institutions). As a policy tool, MFA assistance is thus only of limited use.

Why has the EU so far been invisible in efforts to resolve emerging market crises? Much of the answer must be that the responsibility for fiscal policy and financial supervision remains largely in national hands. A collective EU approach to international financial crises would require a complex institutional set-up.

National financial assistance could in theory be strengthened through informal coordination, but in fact member states jealously guard their sovereignty in financial affairs. This is also the main reason why there is no EU institutional mechanism to coordinate positions within the international financial institutions. This deprives the EU of crucial leverage.

Any concerted effort to establish a 'European' position in a particular crisis (e.g. Turkey, Argentina) would require the cooperation of the European Central Bank, national ministries of finance, the Commission and probably the European Parliament. None of these institutions has a strong foreign policy background.

While the EU now has a foreign policy chief, he has no standing in the 'competent' bodies (mainly the Economic and Financial Committee).

The case of Turkey illustrates clearly the potential economic and political costs and benefits. The joint-banking and foreign exchange crisis that started in 2000-2001 seems to have subsided in early 2002, but the danger remains. The EU could have played a key role in easing the financial plight of the country, but this was never even considered. Member states and the EU institutions were happy to leave the management of this crisis to the IMF.

As there is no sign that this will change soon, one must conclude that for the time being the EU is simply not an actor on the global financial stage.

Major analysis feature in which author explains the EU's lack of contribution to market stability.