Galbraith and Varoufakis provide a valuable service in charting the evolution and interrelationships between various plans to ‘save’ the Eurozone. It is clear where their sympathies lie: for reforms that can be implemented now, rather than schemes for yet further (fiscal and political) integration. As that is also where my sympathies lie, there seems little point in my trying to find detailed issues on which we might disagree. Instead I want to provide a complimentary, and I hope non-technical, account of why further integration is not the only way to fix the Eurozone. I think it is interesting that I come to the same conclusions as they do, although perhaps by a different route.

We need to begin with the financial markets after the Eurozone was formed. Those markets made two mistakes. The first was to assume that no Eurozone government would be allowed to default, so interest rates on periphery government debt became virtually identical to rates on German government debt. Lower interest rates encouraged agents in the periphery to borrow, and the second mistake that markets made was to supply too much credit to these agents.

The architects of the Eurozone anticipated and then obsessed about the first mistake, because they thought the resulting lack of market discipline (national interest rates would not increase if individual governments borrowed more) would encourage some governments to become profligate. So the Stability and Growth Pact (SGP) was all about trying to restrict government borrowing. They ignored the second problem, despite the warnings of economists before and after the Euro was created. As a result, countries like Ireland and Spain experienced a boom which drove up inflation, but it also meant that their government’s fiscal position passed the SGP criteria.

The markets realised their second mistake following the Great Recession in 2009, which ended the periphery boom, and banks in periphery countries got into trouble. They realised their first mistake a year later, and interest rates on periphery government debt rose rapidly.

For those advocating further integration, this history implies that a monetary union without a fiscal union is doomed. But it is important to see how the crisis that began in 2010 came to an end. It did not come to an end because austerity convinced the markets that their fears about Irish or Spanish default were unfounded. It ended because the ECB introduced OMT, where it promised (with caveats) to support any government it judged as solvent. It promised to be a sovereign lender of last resort.

With that information, could we rerun history so that the crisis of 2010 did not become an existential threat for the Eurozone? How about this. Instead of the SGP, we had a fiscal regime which encouraged aggressive national countercyclical fiscal policy. So as inflation rose in the periphery, we would have seen much tighter fiscal policies in these countries than actually occurred. But let’s also assume that in Greece this did not happen, and the true extent of Greek indebtedness was revealed at exactly the same time as it was in reality. However at that point, in my counterfactual history, Eurozone governments did two things differently. First they immediately agreed that Greece had to default - not partially but totally. They were prepared to lend money to give Greece some time to put its house in order, as the IMF typically does, but not in an effort to avoid default. At the same time the ECB invokes OMT, and applies it to all other periphery governments, declaring that unlike Greece these governments are solvent.

This combination of countercyclical fiscal policy before the Great Recession and OMT or default after it could have prevented the drawn out 2010-12 crises. Of course Greek default would have been difficult for Greece and embarrassing for the Eurozone as a whole, but it would not have been an existential threat. However, although countercyclical fiscal policy would have reduced the extent of competitiveness loss experienced in the non-Greek periphery, it is unlikely to have prevented it completely. A recession, and austerity to a milder degree, in these countries was therefore inevitable. But in my counterfactual this need not have created a second Eurozone recession for two reasons. First, the ECB could have behaved like its counterparts in the US and UK, and aggressively eased monetary policy (rather than raising rates in 2011). Second, to the extent that this policy was partially unsuccessful because nominal interest rates cannot be negative, the non-periphery Eurozone governments would have agreed a temporary coordinated fiscal expansion.

It is only with this last element that we see a clear case for the need for greater fiscal union. The argument is that without this union, Germany would never agree to fiscal expansion by its government, when demand in Germany was strong because it is enjoying a competitive advantage. Maybe this is true, but the Eurozone roughly consists of three parts: Germany, the periphery plus Italy, and a third that includes France and the Netherlands. While Germany may have felt comfortable with a more modest second Eurozone recession, this third group would not. France is expected by the OECD to have an output gap of over 3 percent next year, and this number for the Netherlands is even higher at about 4.5 percent. With OMT in place, and without the current enhanced and draconian SGP, these countries should have been willing and able to undertake fiscal stimulus to offset any austerity in the periphery. That, together with easier monetary policy by the ECB, would have made competitiveness adjustment in the periphery much easier.

If you contrast my alternative history with what actually happened, what would emerge as the clearest problem with existing arrangements? I do not think it would be the lack of a fiscal union. Instead it is the obsession with public deficits and the need for austerity. Here I arrive at the same point as Galbraith and Varoufakis. Ironically it was the focus on deficits that allowed Spain and Ireland to avoid countercyclical fiscal policy. If instead fiscal policy had focused on relative inflation rates, fiscal policy could have been tighter. It was the belief that austerity could be painless that led governments to pretend they could avoid Greek default, and the ECB to delay OMT for two years. Austerity led to the second Eurozone recession. It is this obsession with austerity that needs to change. As Galbraith and Varoufakis point out, many of the reform proposals that suggest fiscal and political union also see this as a means of applying yet more austerity.

My counterfactual actually involves less central control of fiscal policy decisions. The premise behind the SGP was that the union would diminish market discipline on fiscal actions in member countries. For a time it did, until the markets realised that government default was still possible. Once that happened, market discipline became too intense, which is why the debt crises following the Great Recession were largely confined to the Eurozone, and why OMT was necessary. As long as the option of default, and therefore not implementing OMT, remains credible, the rationale for central control of fiscal policy disappears.

With this in mind, I would make two additions to the “modest proposals” of Galbraith and Varoufakis. The first is to formalise the procedure the Union would adopt if a country applied for OMT. This would put less emphasis on required austerity commitments, and more on the criteria that member states would use to assess fiscal sustainability (I discuss these issues further in this blog post.) In doing this member states would be wise to utilise the expertise of the network of national fiscal councils that is in the process of being completed across the Eurozone.

The second addition is to make the ECB more accountable. While the austerity drive across the Eurozone was a key factor behind the second Eurozone recession, another was the failure of the ECB to act decisively to prevent it. Interest rates were raised in 2011, and there is still no equivalent to the Quantitative Easing programmes of the US, Japan or UK. The ECB has more autonomy than the independent central banks of the US and UK, and its performance has been worse.

Despite these modest suggestions, many will still believe that a complete fiscal and political union could work better than an improved monetary union. However economists typically examine macroeconomic regimes run by benevolent policymakers, with no problems of democratic accountability. The events of the last few years have clearly shown the Eurozone is far from this ideal. Giving much more economic power and responsibility to a system with such a clear democratic deficit seems foolhardy.