11 Jan 2016

A more perfect, but also smaller union?

Daniel Gros


by Daniel Gros

2015 brought once again fundamental challenges for the European construction. Two key elements of integration came under strain: the euro and passport-free travel within the so-called Schengen zone. Neither challenge has been fully met. Europe is muddling through on both fronts; but something fundamental has also changed: for the first time ever, the threat of exclusion has been deployed.

This is most apparent in the case of the euro.

The Great Financial Crisis showed that Europe’s monetary union was very imperfect. It took the ‘near-death’ experience of the euro crisis of 2010-12 to force Europe’s leaders to act. The response was then to create a large fund to help states in difficulty (the €700 billion European Stability Mechanism, or ESM) and the (imperfect) banking union, with its common supervision by the ECB and a nascent common fund (of up to €55 billion, the Single Resolution Fund or SRF) to restructure failing banks – but no common system for deposit insurance.

This construction helped to keep financial markets calm in the first half of 2015, when the new Greek government challenged the basic tenet of the European approach to dealing with a national financial crisis: financial support is provided against pledges of belt tightening. In July the Greek electorate voted in a referendum to reject the conditions offered to them, and the German finance minister suggested that Greece should be offered a ‘holiday’ from the euro – a thinly disguised threat of excluding the country from the eurozone. It worked. A few weeks later the same Greek Prime Minister, who had campaigned to reject austerity, did in fact accept a new bail-out programme, which in some ways was even tougher than the one that had been rejected earlier. He was supported in this move by an overwhelming majority in Parliament and public opinion.

One interpretation of this episode is that the euro area has de facto become a fixed exchange rate system, since any country in difficulty might find it preferable to leave if it wanted to, or it might even be excluded. Some have concluded that this means the euro area will not survive long since no fixed exchange rate system has lasted forever.

Another interpretation of this episode could be just the opposite: that the system has a remarkable resilience and cohesive core. The attractiveness of the common currency must have been really strong if the government (and the people) of Greece rejected the idea of going back to a national currency even after a fall in GDP larger than that experienced during the Great Depression of the 1930s and even though they had been offered a cut in their debt if they left.

This monetary union, however imperfect it still may be, has thus become more cohesive. The common rules can be enforced much more stringently if countries, which do not want to abide by them, can be excluded. The euro area is thus becoming a club membership of which is highly prized, but cannot be taken for granted forever.

The problems within the Schengen area illustrate a similar evolution. Schengen is also incomplete because the abolition of internal border controls was not accompanied by the creation of a common mechanism to police the external border. For a long time this omission was not considered vital because the pressure on the external borders was rather low as dictatorial regimes on most of the Mediterranean shores cooperated in controlling the migratory pressure from the wars in the Middle East and the failing economies across most of Africa.

But the external migratory pressure has mounted over the last few years with the worsening of the civil war in Syria and domestic upheavals elsewhere. It was only a question of time before the weakest link in the external border would buckle under the pressure. By the summer of 2015 the authorities along the Balkan route (first Greece, but then later Hungary, Slovenia, etc.) could no longer cope with the hundreds of thousands of refugees desperately trying to flee a war-torn Middle East.

The first reaction has been confusion with different member states taking radically different approaches. But a common line has emerged in a few months: to keep internal borders open while strengthening the common external borders.

The mechanism to defend the external borders is still weak. But it has already been made clear to one country (Greece, again) that membership of the Schengen area can also be taken away if the country is seen to be unable to control the external border.

At present it looks as if Schengen is in tatters. But in reality border controls are still the exception, rather than the rule. The reason for this is practical: reinstating full controls across all internal borders would create huge costs, and would be impossible without diverting a large part of the police forces away from their primary job of fighting crime and terrorism. These present border controls are a temporary second-best measure, just like capital controls in Greece (and until recently in Cyprus). The goal remains to return to the ‘normal’ state of free internal borders.

Both monetary union and Schengen thus have a tendency to survive the test of real life because they bring tangible benefits. Economists call this ‘revealed preference’. One should not listen to declarations of principles of sovereignty, but rather should look at what governments do, when faced with concrete problems.

The year 2016 can thus be expected to bring more piecemeal progress towards a real passport union with a common protection for the external borders. But progress can now be much more decisive because it has now been established that member states that who do not want, or are not able to, abide by the rules will simply be left out. The real value added from European integration thus no longer derives simply from ‘naked’ membership in the EU, but rather from participation in its different sub-groups like the eurozone or Schengen.

Daniel Gros is Director of CEPS. An earlier version of this editorial was published by Project Syndicate, 8 January 2016, and syndicated to newspapers and journals worldwide (http://www.project-syndicate.org/commentary/eurozone-threat-of-expulsion…). It is republished here with the kind permission of Project Syndicate.