In the colonies it used to be said of England that Britannia did not so much rule the waves as it waived the rules. One hopes that the same might soon be said of European policymakers. If they fail to waive a number of basic European rules, they should brace themselves for further political backlashes that could in the end result in an unraveling of the whole European project.
In an effort to secure greater economic and policy integration, European policymakers have formulated a number of fundamental rules for EU membership. As an example, access to Europe’s single market requires that members subscribe to the free movement of goods, capital, services, and most importantly the unfettered movement of people between the 28 European Union member states.
Similarly, as a precondition for a move towards a European fiscal union, Eurozone membership requires that countries abide by strict fiscal rules aimed at keeping budget deficits below 3 percent of GDP. Meanwhile, as a precondition to an eventual European banking union, Eurozone membership now requires that countries do not engage in bank bailouts without first requiring that bank bondholders also take a loss on their holdings (known as a “bail-in”) with a view to saving the taxpayer money.
The trouble with each of the abovementioned rules is that, well intentioned as they might be, they are producing a political backlash across Europe that is raising the serious risk of an eventual disintegration of the Union. This backlash was all too evident in the recent Brexit referendum where 52 percent of the UK electorate voted in favor of the country withdrawing from Europe. It did so primarily in the hope that the country would gain greater control over its border. In deciding how to vote, the UK electorate allowed immigration to trump fears over any likely economic cost to the country of a Brexit.
The UK’s political backlash against immigration is being replicated in other important European countries such as France and the Netherlands. To defuse this backlash, European policymakers would do well to revisit the rule that access to the single market requires the acceptance of unfettered movement of people within the European Union. Flexibility on the immigration issue would also be helpful in allowing a compromise to be struck in forthcoming Brexit negotiations with the UK that might allow a post-Brexit solution that was in the mutual interest of the UK and the European Union.
Flexibility would also be politically desirable in applying the Eurozone’s fiscal rules that currently require member countries to seek budget balance relatively soon. Over the past few years, the blind commitment to budget austerity in a Eurozone straitjacket has contributed importantly to Europe’s dismal economic performance and its continued high rate of unemployment. That poor performance has in turn given fuel to anti-European sentiment, particularly in southern European countries such as Greece, Italy, Portugal, and Spain, where there has been a disturbing degree of political fragmentation. The need for greater fiscal flexibility would seem to be all the more pressing today at a time when the European economy could be hit hard by the economic fallout from the Brexit vote.
Perhaps the most immediate need for flexibility in the application of Europe’s rules is in relation to bank bailouts. Insistence that such bailouts be accompanied by bail-ins of bank bondholders could very much cloud the Italian economic and political outlook ahead of an all-important Italian constitutional referendum scheduled for this October.
Italy is at present in the grip of a banking crisis that needs early resolution. Italian bank shares have now declined by around 70 percent over the past year while non-performing bank loans have risen to 360 billion Euros, or around 18 percent of the Italian banks’ balance sheets. Should the European Commission now insist on a bondholder bail-in as part of any Italian bank bailout package, this could be politically very costly for Prime Minister Matteo Renzi since many Italian households own those bonds. It could thereby pave the way to power of the populist and anti-Euro Five Star Party which could in turn pose an existential threat to the Euro itself.
European policymakers would now seem to have a clear choice to make. They can continue to rigidly insist on the EU’s rules but thereby risk a further political backlash against the European project itself. Alternatively, they can be more flexible in applying those rules. That would give the Union a better chance of surviving albeit in not quite as pure a form as European policymakers might have wished. Let us hope that European policymakers make the right choice.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
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