This article reflects upon the importance of the three eurozone policy "deficits" identified by Nicolas Veron of Bruegel. He refers to them as the analytical deficit, the executive deficit, and the democratic deficit. Implicitly, he raises again three long-standing sets of questions pertaining to the pursuit of good public policies. What should be done (the analytical deficit); what could be done (the executive deficit); and what will be done (the democratic deficit)? Broadly put, the answer to the first question is in the realm of economics, the second in the realm of law and regulation, and the third in the realm of politics. Failure at any individual level could threaten the future of the eurozone as a whole.
A first consideration is whether is whether these deficits have contributed materially to the current economic problems in Europe. It is argued here that they have. A second consideration is whether these deficits can be filled adequately enough and quickly enough to ensure continued progress towards the initial vision and an intact eurozone. This is a much more difficult question, not least because the judgement of "adequacy" will be made by fickle financial markets. It is argued here that member governments need to take significantly stronger measures than they have. Relying heavily on the European Central Bank to preserve the integrity of the eurozone could prove a fatal error.
THE "SHOULD" PROBLEM
At the level of economic theory, what "should" eurozone policymakers do to best support the integrity of the eurozone? An unfortunate starting point is that many policymakers in the eurozone, particularly in the core countries, seem to have false beliefs about how the eurozone economy actually works. These false beliefs have contributed materially to the eurozone's continuing problems.
To begin with, false beliefs contributed to the onset of the crisis. That is to say, measures expected to ensure crisis prevention failed totally. Moreover, false beliefs also contributed to bad crisis management, not least through giving undue emphasis to the problem of "moral hazard." Similarly, excessive fears about contagion and financial instability have contributed materially to the failure to bring about crisis resolution. That is, neither the overleveraging of lenders in core eurozone countries nor the over-indebtedness of borrowers in peripheral countries has been adequately dealt with. Thus, the eurozone remains highly vulnerable to further shocks, whether internal or external.
Perhaps the most important false belief in the eurozone was one shared with many other policymakers outside Europe; namely, that the achievement of price (CPI) stability effectively ruled out the possibility of other macroeconomic problems. The starting presumption was that "really bad things" could not happen, which we now know is not true.
Against this comforting analytical backdrop, it was also all too easy to believe that growing current account imbalances within the eurozone were of no great importance. Unfortunately, while it was true that exchange rate risk had disappeared, at least as long as the eurozone hung together, counterparty risk had not disappeared. The materialization of this risk, a "sudden stop" of the capital flows required to finance debtor countries, then led to the crisis and even a heightened possibility of the collapse of the exchange rate regime itself.
Moreover, since the crisis began, the ancillary factors that encouraged capital outflows from deficit countries have actually become stronger. The problem of the banksovereign nexus, the concern of creditor banks about their own solvency, the concern of regulators about the same issue, and the concern of depositors in peripheral country banks about the safety of their assets (in euros) have all worsened since the crisis broke. Arguably, official policies in the post-crisis period have contributed materially to these concerns in a variety of ways.
The failure to recognize that the eurozone had to deal with a balance of payments crisis meant that another explanation had to be found. The narrative chosen was that the peripheral countries had unsound fiscal positions, although this was evidently not true in the case of Spain and Ireland and not obvious in the case of Italy. Given the false diagnosis, it was not surprising that the false solution of fiscal austerity was prescribed everywhere. Indeed, far from recommending symmetrical easing in creditor countries, as would have seemed obvious given...