What is the logic of functionalism? The logic of functionalism posits that economic integration in one area leads to greater integration in other areas. Further integration allows states to more fully capture the benefits of the enhanced interaction in those areas where integration has already taken place. This is the concept of positive spill-over effects, whereby integration breeds further integration.
A stylized account of European economic integration from the creation of the European Coal and Steel Community in 1952 to the present would look something like this: in order to capture the benefits of closer trade relations and trade liberalization more fully, European economies partly liberalized their capital accounts to facilitate cross-border settlements and sought to stabilize intra-European multilateral exchange rates following the breakdown of the Bretton Woods system.
Excessively volatile exchange rate rates, in part underpinned by a more open capital account, make it harder to exploit the benefits of trade fully. It may even undermine trade in the case of so-called ‘beggar-thy-neighbour’ policies. It makes good sense for countries to seek to maintain a multilateral exchange rate system aimed at limiting exchange rate variability. This is what happened in the form of the various fixed, but adjustable exchange rate systems. They, however, are fragile, especially under conditions of free cross-border capital flows. The emergence of balance-of-trade imbalances combined with large-scale cross-border capital flows led to repeated devaluations and crises until the major European countries in the early 1990s agreed on the creation of a full-fledged monetary union and this the complete elimination of exchange rate risk and a further reduction in transaction costs. In order to safeguard the free trade of goods and capitals thus initially led to the creation of ultimately unstable exchange rate regime and was finally replaced by a supra-national monetary regime with monetary policy vested in a supra-national central bank.
Monetary union, in turn, potentially proves unstable, absent significant safeguards regarding national fiscal policy and banking sector stability given the high level of interconnectedness that emerges between sovereign and banking sector risk and between member-countries in the context of a monetary union. This is all the more so since the Euro Area not an optimal currency area. An exogenous shock can prove destabilizing, economically and financially. High levels of cross-border asset holdings mean that financial instability and in extremis a sovereign default in one Euro Area member-state quickly causes instability in other and potentially all member-states. Absent closer financial co-operation and perhaps ultimately integration, the monetary union is at risk of experiencing widespread financial dislocation and economic destabilisation, potentially even a break-up, in the wake of shocks.
In order to prevent such instability, which could potentially threaten monetary union and the common market, closer co-operation and integration in the form of credible, binding and enforceable fiscal rules and the availability of financial resources to support fiscally-challenged sovereigns and vulnerable banking systems are required. This can take the form of closer inter-governmental co-operation (e.g. fiscal compact) or supra-nationalisation (e.g. Eurobonds, transfer union), or a combination of the above. Similar to the move from fixed, but adjustable exchange rate to full-fledged monetary union, functionalist logic militates in favour closer co-ordination and integration of fiscal policies, containing at a minimum strict, enforceable fiscal and debt targets and temporary or permanent financial support mechanisms (e.g. various rescue funds, fiscal compact).
Last but not least, the complete supra-nationalisation of fiscal policy, especially if it implies significant and permanent financial transfers of fiscal resources from one country to another country, would likely necessitate the creation of a true political union. After all, the power to control public finances has historically been the raison d’être of democratically elected legislatures (e.g. England). In order to legitimise large permanent fiscal transfers, political legitimacy would likely have to be achieved by creating a full-fledged European government.
Functionalism does not posit that complete integration is the inevitable outcome of greater economic co-operation. The functionalist logic is only imperfectly compelling. As the history of European integration shows, the process of integration has often been choppy. Frequently, countries for a variety of reasons ‘opt out’ of further integration. Functionalism does cast light on the logic underpinning and driving integration in the economic sphere.
The functional logic of intensifying interactions requires closer co-operation and ultimately supra-nationalisation of adjacent policy areas. Often not proceeding further with integration creates the risk of reversing integration with all that this implies in terms of reduced (aggregate) economic benefits. A break-up of the Euro Area, for instance, would prove extremely disruptive of trade and financial flows and the short-term and long-term economic and financial costs would prove enormous. Indeed, crises have historically been a major driver of ever closer economic integration.
Functionalism explains why ever closer integration is necessary if the full benefits of economic interaction are to be captured fully or, negatively, the risk of a reversal minimized. Further integration provides a, often temporary, solution to a problem. The logic most powerfully asserts itself in a situation where the risks and costs of reversing integration are deemed politically and economically as unacceptably high. Even then, however, different solutions are on offer. Functionalism has not much to say about the nature and shape the supra-national regime that eventually emerges other than it has to help to capture the benefits of co-operation more fully and/ or prevent a costly reversal of the integration hitherto achieved. To account for the specific characteristics of the institutions, it is necessary to move to a state-centric approach.
What is the logic of state power? While functionalism explains why integration feeds further integration, it has not much to say about the specific features of the resulting more integrated regimes. This is where a state power perspective offers important insights. The more powerful a state, the more its interests and preferences will be reflected in the new regime.
Naturally, state power is not simply a function of economic and financial power, but economic and financial power matters. Economic integration occurs in a wider political context. West Germany’s position was weak in the 1950s. Germany’s position in 2010 is incomparably stronger. The European Coal and Steel Community was a successful attempt to pool sovereignty and prevent the resurgence of a revanchist Germany after WWII. West Germany depended on Western European economic co-operation and on US protection for its very survival. (Naturally, both Western Europe and the US depended, though somewhat less, on West Germany’s industrial and military potential to prevent a Soviet takeover of Western Europe.) With the disappearance of the security threat after the Cold War, economic and financial power counts for much more than before. As a result, Germany’s ability to shape newly-emerging regimes such as EMU and whatever regime will eventually emerge from the present Euro Area rescue efforts has grown enormously. Nonetheless, Germany’s economic-financial power had been growing, in leaps and bounds, over long time.
The collapse of the Bretton Woods system in the early 1970s and the emergence of flexible exchange rate enhanced Germany’s economic and financial power in Europe. Germany was, and still is, the largest economy in Europe, albeit not by a large margin. Conservative fiscal policies, a strong commitment to low inflation and a highly industrialised and competitive export sector contributed to long-standing trade surpluses. As a result, the deutschmark emerged over time as the de facto anchor currency of various European exchange rate regimes. Many of the smaller, open economies characterised by a significant trade dependence vis-à-vis Germany basically pegged their exchange rates to the currency of their major trading partner (e.g. Austria, Netherlands, Benelux and, over time, others). The various multilateral exchange rate regimes that emerged after the collapse of the Bretton Woods system thus turned out to be, for all intents and purposes, deutschmark zones. Countries with weaker balance-of-payments and/ or less disciplined, price-stability-oriented policies were repeatedly forced to devalue their nominal exchange rate throughout the 1970s, 80s and 90s.
This provided Germany with so-called structural power, that is, power of a state to indirectly influence others by controlling the structures within which they must operate – in this instance, the international monetary system. Under conditions of significant, if incomplete, capital account convertibility, the German central bank effectively set interest rates for all those countries that were pegging their currencies to the deutschmark (‘unholy trinity’). In the monetary realm, this meant that when the German central bank raised interest rates, other countries generally faced market pressure to follow suit if they wanted to maintain the peg with the deutschmark. This type of power, however, is not relational in the sense that it intends to change others’ behaviour. A change in behaviour is rather a side-effect of Germany’s dominant position in the European economic, financial and monetary realm.
This power reflected different German policy preferences and a different set of economic institutions underpinning German policy. A hawkish central bank made Keynesian demand-management policies a largely a non-starter. Wage policy was dominated by unions in export sectors who understood the detrimental effects of higher wages for activity and employment for their sector. By contrast, France did not have an independent central bank, allowing it to pursue more active stimulus policies as well as accept higher inflation, and had a less export-oriented, less industrialized economy than Germany and a less competitiveness-conscious wage bargaining regime.
Germany as the surplus country may have suffered repeated revaluations but was rarely forced to fundamentally change its economic policies. By contrast, deficit countries were forced to adjust their policies more dramatically, up to being forced to abandon their policy preferences altogether. In the early 1980s, France made its last experiment with Keynesian-type fiscal policies before it switched to a so-called ‘franc fort’ policy. German structural power had forced France to reverse its policy priorities and essentially adapt the German model. France reasoned that the creation of common currency would put an end to repeated currency crises and get Germany to share the benefits of economic stability in terms of low interest rates and forcing the French economy to become more competitive rather than relying on repeated (and politically unpopular) devaluations. Britain, by contrast, opted for greater flexibility, exiting the ERM altogether in the early 1992.
Most dramatically, German preponderance was demonstrated in the early 1990s. The end of the Cold War and German re-unification led Germany to pursue an economic policy consistent with its interests. Fiscal expansion necessitated by reunification forced the central bank to raise interest rates. Other countries were at a different stage of the economic cycle saw their currencies come under attack by markets who rightly believed (in some cases) that following German policy would be politically difficult to sustain. This eventually did lead to the ejection of several countries from the ERM in the early 1990s.
By the 1980s and 1990s, Germany had emerged as the economically dominant power in Europe. Agreeing to EMU may or may not have been a German concession, but the final shape of monetary union reflected almost entirely German preferences. During the 1990s, Germany was regarded as the ‘sick man of Europe’. Germany was burdened with the financial costs of re-unification and it had entered EMU at at an overvalued exchange rate, resulting in interest rates that proved too high. However, Germany used to operating under such conditions restructured its economy and reformed its labour markets. Through a combination of structural reform, wage restraint and ‘competitive disinflation’, it was able to gain intra-EMU export shares. The previously financially weaker, high-yielding non-core EMU members faced the opposite situation. Low interest rates led to a credit-fuelled economic boom, rising labour costs, an appreciating real exchange rate and widening external imbalances. Germany also took full advantage of its long-standing specialisation in less price-sensitive capital goods and the rapidly rising demand in emerging markets to re-generate economic growth. Germany’s current account surplus surged, while continued fiscal discipline helped solidify public finances.
What are the sources of German preferences and power? Once the Euro Area crisis started, Germany is economically and financially the most powerful state in Europe. It has the largest economy and the most favourable fiscal position and lowest interest rate costs (among the larger European economies) and hence the greatest borrowing and lending capacity. Very large external surpluses and a commitment to low inflation make Germany the “safe haven’ of the Euro Area. Moreover, Germany’s commitment to fiscal rectitude has been institutionalised in constitutional law (so-called ‘debt brake’). Last but not least, it has Europe’s largest and most competitive export sector, allowing it more than other Euro Area members to tap external sources of demand (e.g. China, Russia).
In the 70s, 80s and 90s, German power was largely structural in nature. Today Germany’s economic strength allows it to exercise relational power and, ultimately, have its economic policy preferences prevail. It goes further. Not only is it able to maintain its economic policy preferences (monetary stability, fiscal discipline) and thereby, for better or worse, push the ‘transitory costs of adjustment’ onto the financially weaker countries. It seems also poised to export the German approach to macroeconomic policy to the rest of Europe by way of conditional financial support and by leading by example. This position of preponderance allows it to stick to its economic policy preferences, while getting others to adjust economically and financially. Naturally, German benefits from the support of other financial sound European countries. But Germany, by virtue of its size and borrowing capacity, plays the leading role. Without its financial support, a Euro Area would be impossible.
Naturally, this does not mean that Germany is omnipotent in terms of having complete control over other countries’ policy choices. First of all, its borrowing capacity may be the largest among European countries, but it is not nearly enough to provide a bail-out package large enough to save the larger EZ members, should they run into re-financing difficulties. Being the financially strongest country, Germany has by far the largest say over rescue policies and retains an effective veto over rescue efforts and concomitant reform. Second, a sovereign default or a Euro Area exit would hurt Germany economically and financially. The German public and/ or private sector would incur significant financial losses as a result of a default and/ or currency re-denomination. It would also be faced with an appreciating currency, undermining its export competitiveness and potentially severely hurting economic activity. Nonetheless, it is clear that the costs to the defaulting (exiting) country would be far higher than to Germany in both the short- and long-term. Mutual dependencies are rarely symmetrical, but rarely are they completely asymmetrical either. It is this asymmetry in terms of vulnerability and the provision of conditional financial support that provides Germany with significant influence over on-going rescue efforts.
One solution is to force the entire burden of adjustment on the weaker countries, albeit flanked by conditional financial support. There may be political and economic limits to such a one-sided approach. Not only may deflation undermine the very fiscal adjustment that is required to make debt sustainable. Austerity and structural economic reform may lead to domestic political break-down in some of the weaker countries against the backdrop of high unemployment, low growth and declining living standards (e.g. Argentina 2001). Another solution is for the fiscally sound countries to pump-prime and reflate their economies in order to generate growth and import demand, thus easing the adjustment burden for the weaker countries. Naturally the two solutions can be combined. In practice, it is unlikely that Germany will allow itself to be forced into a fiscal expansion and internal revaluation. It almost certainly will not accept any arrangements that would lead to more symmetric burden sharing, other than providing conditional, temporary financial support (e.g. John Maynard Keynes versus Harry Dexter White at Bretton Woods).
Germany naturally prefers to push the burden of adjustment on the deficit countries by forcing them to implement fiscal austerity to re-establish government debt sustainability, to introduce structural reform to raise (medium-term) economic growth and to deflate the economy to make it more competitive. Germany is willing to support this by way of conditional financial support. But Germany is unwilling to reflate its economy by pursuing an expansionary fiscal policy, which would facilitate the adjustment of the debt-constrained Euro Area economies. Being in an economically and financially stronger position, Germany is not willing to compromise its economic policy preferences, notably low inflation, fiscal discipline and export-led economic growth.
Germany’s stance is, however, not solely determined by an ideological commitment to or a preference for a certain type of economic policy. Reflating its own economy or going for the so-called ‘bazooka’ solution – whether in the form of offering unlimited financial resources or encouraging the ECB to intervene more aggressively – would create moral hazard and it could undermine Germany’s financial position. Eurobonds, permanent fiscal transfer or an ECB-led bail-out, to the extent to which these are options at all given the domestic and supra-national legal constraints, carries the risk of undermining the Euro Area´s commitment to price stability and, more seriously, could lead to a permanent weakening of the regime.
It is true that the gradual approach to solving the crisis and the ‘too little too late’ approach played a role in exacerbating the crisis. It is also true that imposing fiscal austerity on a country unable to gain competitiveness via currency devaluation makes achieving sustainability more difficult, perhaps impossible. These arguments carry a lot of weight if what Europe is dealing with is a liquidity crisis rather than a solvency crisis. If it is not, it is difficult to see how the provision of bazooka-like, even unlimited financial support will help solve the crisis. It would only end up undermining the entire regime. Thus the German approach does make political sense.
By providing conditional financing, albeit at subsidized rates, is the most cost-effective way to try to solve the crisis. It is also the more cautious approach. It limits the risk of a potential German financial over-commitment (or a weakening of ECM commitment to low inflation) by limiting the risks to its own balance sheet, which provides the backbone of any credible Euro Area rescue effort. While it is cumbersome and has worsened the crisis, it allows Germany to deal with moral hazard and to retain room for manoeuvre in case the current crisis is more than a liquidity crisis. Last but not least, by choosing a gradual approach and maintaining conditionality, it allows Germany to determine the characteristics of the newly emerging, more integrated fiscal regime.
Germany as the economically most powerful country has been able, by and large, to have its preferences prevail during the economic integration efforts over the past couple of decades (EMU, fiscal compact). Pre-EMU, it sought to prevent currency devaluation in its major European trading partners through FX intervention. Today, it is seeking to rescue the Euro Area by offering limited and conditional fiscal support. In both cases, the support was limited and pushed the adjustment burden on the financially weaker country. By institutional (constitutional) design, habit and, perhaps, cultural inclination, it will stick with a policy of –as some (critics) call it – competitive disinflation. Germany is visibly willing to act as a “financial stabiliser”, for good, self-interested reasons, ranging from the financial exposure of its banking sector over a potential EMU sovereign default to preserving EMU for both economic and political reasons. Germany’s policy DNA, a mix of institutions and beliefs, does not seem to allow it to act as a significant (discretionary) “economic stabiliser” in terms of generating intra-EU demand, but it is willing to act as a temporary “financial stabiliser” and as an economic moderniser by compelling other countries to implement structural reforms. This prudent, cautious and gradual approach has no doubt exacerbated the Euro Area crisis. Then again, leaving the domestic institutional and ideological commitment aside, would any government in the world run the risk of providing large-scale financial support without policy reform commitment.
Where are we likely to go from here? Both the neo-functionalist and the state-power perspective point in the same direction. Further co-ordination and integration in terms of setting enforceable fiscal policy and public debt target as well as establishing a permanent financial support mechanism is compelling in order to deal with the current crisis and limit the risk of future instability. (This is, of course, exactly what is happening.) Functionalist logic points towards greater supra-national integration, including, ultimately, legally enforceable restrictions on national fiscal policies and potentially significant automatic, if conditional, fiscal transfer and/ or guarantees.
The logic of the state power approach points toward continued inter-governmental arrangements, continued financial conditionality and limited, if any, automatic financial transfers and/ or guarantees. A financially strong state would rather limit its potential financial commitments in the course of extending its policy preferences to other states. But this would potentially leave the EMU is a half-way house at risk of being brought down by the next storm. For instance, if a Euro Area government is not able to meet the fiscal targets and financial support remains conditional, as it likely would, market pressure could nonetheless translate into rising financial instability, absent the ability of the other states to force this country to undergo adjustment. Functionalist logic would then point towards complete supra-nationalisation of fiscal policy combined with more extensive fiscal support (e.g. US model). A state power perspective, by contrast, would expect the most powerful state to limit its financial commitment and deal with potential financial stability by, for instance, ring-fencing the crisis and strengthening national banking systems before making significant and potentially open-ended financial commitments. The ability to tax and spend is, after all, the basis for state power.
Interestingly, Germany has been the strongest advocate of the supra-nationalisation of fiscal policy, seeking to enshrine fiscal rules in a new EU treaty and enforced by European Union institutions. But this specific proposal to supra-nationalise policies was meant to supra-nationalise fiscal policy only, not create automatic fiscal transfers. The state power perspective predicts that Germany would be extremely reluctant to agree to significant fiscal transfers and/ or guarantees. Financial support is a means to a short-term end, not a permanent mechanism for redistributing wealth.
Should this prove insufficient, the complete supra-nationalisation, that is, a full-fledged regime of legal control and coercion might become necessary. This, however, could require Germany to give up significant control over its balance sheet. At a minimum, the financial and fiscal risks would have to remain very limited for such a proposal to fly from a state power perspective. Some observers call for a European Marshall plan in order to mould the Euro Area more into a less imperfect OCA.
Although a lot depends on the fine print, here then is where the logic of functionalism and the state power perspective seem to part ways. Functionalist logic pushes for a hard-and-fast fiscal rules enforced by supra-national institutions, potentially significant fiscal transfers and or financial guarantees (‘conditional’ on the national governments meeting the fiscal targets laid down in the supra-national legislation). By contrast, it is difficult to see how a financially strong state would agree to extend its balance sheet in an automatic rather than discretionary way. While such a state may well support the supra-nationalisation of fiscal rules, it will oppose significant, open-ended and automatic financial commitment that a functional logic would foresee. Such a situation would be equivalent to the fiscally stronger states subsidising the weaker states. States may be willing to provide such a subsidy, but only if it is strictly limited. This, however, may not be enough to stabilise the Euro Area for good.
What seems certain is that the Euro Area will be looking more and more like Germany. The creation of the common currency enshrined German preferences for low inflation. The fiscal compact (and whatever it may be eventually be replaced by) enshrines strict fiscal and public debt targets, thus enshrining German fiscal discipline. Whether this will be politically and economically sustainable run remains to be seen. It is clear, however, that (largely) removing monetary, fiscal and exchange rate policies from economies tool kits will force them to make their economic more flexible and more competitive. To what extent fiscal policy is not available will depend on the specific design of fiscal rules. It is to be hoped that these rules allow for a degree of countercyclical policy.
As the state that would have to foot the largest bill, Germany has an interest in limiting its financial commitment. It has also a strong preference for ‘competitive disinflation’ rather than Keynesian-type stimulus policies. (Whether the Euro Area would be better off 'net-net' if the fiscally stronger countries pump-primed their economies requires a separate economic analysis. There are, believe it or not, good arguments on both sides.) Germany also has a preference for limiting its financial commitments, however strong its interest in saving the Euro Area. It remains to be seen whether this will be enough to stabilise the Euro Area. My prediction is ‘yes’. The Euro Area will survive, even if Greece were to leave and Portugal to enter into a debt swap.
