The Degeneration of EMU

Niall Ferguson and Laurence J. Kotlikoff

From Foreign Affairs, March/April 2000

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Summary:  To date, the successful launch of Europe's single currency has proven the euroskeptics wrong. But over time, the euro will be gravely threatened if the countries in the eurozone do not put their fiscal houses in order. Generational accounting, a careful analysis of long-term trends, paints a bleak picture: unsustainable spending will bury future generations under mountains of debt. Most governments using the euro must either endure deep budget cuts, swallow sharp tax hikes, or be forced out of the eurozone.

Niall Ferguson is Fellow and Tutor in Modern History at Jesus College, Oxford. He is the author of The Pity of War (1999) and has just published the second volume of The House of Rothschild (1999). Laurence J. Kotlikoff is Professor of Economics at Boston University and Research Associate at the National Bureau of Economic Research. He is the author of Generational Accounting (1993). Both were Houblon-Norman Fellows at the Bank of England in 1998-99.

HERE TODAY, GONE TOMORROW

From conception through gestation and birth, and now in its early infancy, the euro has consistently proved the skeptics wrong. Some Cassandras thought that Brussels-bashing nationalists would reject the single currency in referendums. Others doubted that Italy and other fiscally troubled applicants would fulfill the Maastricht Treaty's strict limits on budget deficits and national debt. Still others predicted that the fierce 1998 dispute over the presidency of the European Central Bank might abort the entire enterprise.

Yet economic and monetary union (EMU) has proceeded more or less according to plan. The French referendum's "petit oui" in 1992 may have required a little gentle massaging; the Maastricht fiscal criteria may have been honored partly in the breach; and of course the currency has, over the past year, depreciated markedly against the dollar. But the fixed exchange rates within the eurozone have held firm, despite warnings about speculative attacks during the transition. And with its depreciation spurring economic growth, the euro is likely to recover somewhat against the dollar this year.

Nevertheless, the skeptics may have the last laugh. For whether a euro equals a dollar tomorrow or the next day does not really matter. What matters is whether the entire monetary union will hold together in the years ahead. The euro's medium-term future will prove much shakier when Europe is hit by the fiscal crises looming for the majority of the eurozone's member countries.

THE NEW MATH

The notion that such fiscal problems exist is not new. Nor is the proposition that they could jeopardize monetary cohesion. But fresh evidence, drawn from a recent, comprehensive calculation of "generational accounts," shows the full extent of the fiscal crisis facing the eurozone.

Generational accounting provides answers to the following three questions: How large a fiscal burden does current policy impose on future generations? Is current fiscal policy sustainable without major additional sacrifices on the part of current or future generations? What policies are required to achieve generational balance -- i.e., to ensure that future generations will pay to the government the same share of their lifetime incomes in net taxes (taxes paid minus transfer payments received) as do today's generations?

This new method of accounting was developed not to augment the conventional measure of fiscal imbalance -- the official government debt -- but to replace it. For neither the size of the government debt nor its change over time (the budget deficit) are well-defined economic concepts. Rather, they reflect the arbitrary choice of fiscal vocabulary, specifically in labeling government receipts and payments.

Three things follow from this. First, the debt and deficit criteria laid out in the Maastricht Treaty bear no intrinsic relation to fiscal prudence. Second, one can satisfy the Maastricht criteria simply by using the appropriate accounting terminology -- something that observers of Italian entry into EMU may already have guessed. Third, the sustainability of EMU fiscal policies must be measured more objectively.

The bottom line is that generational imbalances across the eurozone gravely threaten the ...

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