An EMF could solve euro’s principal conundrum

March 9, 2010

There are tough political obstacles to the creation of a European Monetary Fund. But if the relevant treaties can be amended or skirted, such an organisation could effectively address the euro zone’s central problem: the lack of fiscal policy coordination.

When the euro was founded, commentators pointed out that the Maastricht criteria for fiscal policy were too weak to ensure proper coordination, leaving profligate countries free to endanger the system. Euro-sceptics predicted either doom or an unacceptable surrender of sovereignty to a central fiscal authority.

A decade on, the fears look partially justified. The common monetary policy exerts the least discipline on profligate governments that need discipline most while language and other barriers keep workers from migrating and pulling down wages in countries where they have risen excessively.

A properly constructed EMF can’t make Germans move to Greece, but it could help resolve the fiscal problems. Like the International Monetary Fund, it would provide a healthy discipline on euro zone countries that had got into trouble. The key would be loan conditionality: money only comes to countries that deliver draconian public sector cuts, pension and healthcare restrictions and overall wage cuts.

Politicians in receiving countries know that such bitter cures are required, but face tremendous flak from voters. They are tempted to lobby their peers for softer treatment. But an EMF run by stern central bankers could afford to be hated. Potential client countries would do everything possible to avoid it, which would be good for everyone.

While the UK is unlikely to be a founding member of the EMF, the fund should take a British model — the Bank of England under Montagu Norman. In 1931, he forced the formation of the fiscally responsible National Government before leaving the gold standard.

Norman was reviled, but Britain avoided the worst of the Great Depression and enjoyed rapid economic growth thereafter. The closest present-day equivalent to Norman might be Otmar Issing, the former chief economist of the European Central Bank who is currently advising Chancellor Merkel against a weak-willed Greek bailout.

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