Fiscal reform within EMU: a topic that will run and run

February 12, 2010

cr_mega_764_JaneFoley.JPG- Jane Foley is research director at Forex.com. The opinions expressed are her own.-

There was never any secret that a deep recession would uncover the budgetary cracks in some EMU countries.

The Bundesbank frequently reiterated the need for structural reform, but since there is no fiscal union within EMU once governments had passed the entry criteria there was no strict way to enforce that governments embarked and maintained additional programs of reform.

Under current rules the European Commission can ultimately impose financial sanctions on a country that fails to bring its budget deficit back in line.  The rules are inadequate.   Clearly the imposition of financial sanctions would not help Greece’s budget position and could turn public support within Greece against EMU.   On the other hand the downsides to a bail-out are clear.

A monetary handout would lessen the incentive of the Greek electorate to tolerate budget reform or enforce tax collection.  Also, suggesting to the German tax payer that he increases already generous subsidises to a nation where taxes are habitually not paid would also not be a prudent step for a German politician to take.  That said there is a lot of political will invested within EMU and not to support Greece would have been to risk further contagion which would pressure the banking sector, potentially undermine the cohesion of EMU, and maybe even trigger a collapse.

By now the market is very familiar with the concept that many countries both within and outside of EMU must take measures to rein in their budget deficits.  It is a process that it easier said than done.
Budgetary reform may force some workers to take pay cuts and put others out of work entirely.  Simultaneously, pension and welfare benefits may become less generous, while resources could be directed away from education and health care.

The public sector strikes that have recently paralysed Greece are evidence of how unpopular reform can be.  But a well structured budget is crucial for a country’s competitiveness.  Earlier this month the European Commission’s Almunia stated that Greece, Spain and Portugal had all seen a permanent loss of competitiveness since joining EMU.   He pointed to their relatively high labour costs compared with others in EMU.

In most sovereign states a loss of competitiveness would be associated with a decline in the value of the currency which would provide support through an increase in exports.   Neither Greece, Spain nor Portugal have this option.

They are faced with the prospect of rebuilding their competitiveness through a relative downward adjustment in wages while simultaneously tackling areas such as healthcare, education, welfare and pension.  Eurozone officials have been promoting the view that these counties will not only be able to manage this gigantic task, but that most of the work will be done in the next 2 or 3 years.

In short the European Commission current deadlines for correction in the deficits of Greece, Spain and Portugal appear to be widely optimistic.

In view of the difficulties in implementing budget reform and given the risk of contagion if this situation is not controlled, it is unsurprising that EMU officials admitted the need for a carrot/stick support plan for Greece.

Crucially, any ‘solution’ that EU ministers may find for Greece should not be considered as an end to the issue but rather as a start to a prolonged series of discussions as to how fiscal controls within EMU can be strengthened.

While ministers may be able to push the present crisis under the carpet, the issue about fiscal controls could persist for years.  As a consequence EUR/USD is likely to continue its downward adjustment.

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