The Crisis of the European Common Market

6 MINS READApr 11, 2013 | 05:09 GMT
The European common market allowing for the free movement of people and goods also enables capital flight, which has increased strains on weak banking sectors

The European Union was founded on the free movement of people, goods, services and capital. All of these basic freedoms are inextricably intertwined with the European crisis. The free movement of people is being questioned in numerous countries, while the free movement of goods and services is in part responsible for the current crisis. The free movement of capital has forced EU leaders to face the consequences of different national banking regulations that allow capital flight and tax evasion. While better oversight and collaboration make tax collection across borders easier, they do little to stem capital flight, which weakens banking sectors in already struggling economies.

The creation of a common market where people, goods, services and capital could move freely was one of the main goals of the Treaty of Rome — the agreement between France, West Germany, Italy, the Netherlands, Belgium and Luxembourg that created the European Economic Community in 1957. It took the four decades between the Treaty of Rome and the 1992 Treaty of Maastricht for the members of the European Union to develop the principles of the common market, and some gaps remain.

The free movement of people is the principle that allows EU citizens to travel to or live and work in any member country. It has come under threat from several governments and political parties in Europe. In the United Kingdom, the conservative government of Prime Minister David Cameron is analyzing ways to prevent the arrival of Romanian and Bulgarian workers, who will be allowed to work legally in the United Kingdom starting next year. According to the British government, those workers would collapse the British healthcare system. In countries such as France, Sweden, Finland and Denmark, parties that reject immigration are gaining ground.

The free movement of goods and services is fundamental to the customs union and a key component of the crisis of the eurozone. The creation of the eurozone put 17 countries with varying levels of economic development and competitiveness in a currency union. This has created significant trade imbalances between the less developed economies in the eurozone periphery and Germany, Europe's main exporter. Before the introduction of the euro, countries in the periphery could apply monetary policy to deal with growing current account deficits, but now the common currency has deprived them of that tool.

As the crisis deepens, the European Union has begun to pay more attention to the links between the crisis and the last founding principle — the free movement of capital. The bailouts for Ireland, Greece and Spain highlighted the fragility of the banking sectors in the eurozone periphery and created fears of financial instability spreading to the rest of the members of the common currency. The bailout for Cyprus incorporated an additional element, due to the island's opaque banking sector, that forced depositors to take a hit. This decision brought uncertainty about the future format of EU bailouts. Even though the leaders of Portugal, Slovenia and Luxembourg said that Cyprus was an isolated issue, there is no way to be certain that this will not be the new norm for bailouts in the eurozone. 

The European Union is trying to address the problems of its banking sector through the creation of a banking union — a mechanism that would put all the eurozone banks under the supervision of a single entity, provide joint funds to rescue banks in distress and provide all banks with the common deposit guarantee. This idea has been controversial since the beginning. First, there was a debate regarding which banks should be supervised. In December 2012, the European Union agreed that only the largest banks in the eurozone would be put under supervision. Second, the idea of a joint insurance mechanism and bank resolution fund was highly controversial because countries with strong banking sectors refuse to take responsibility for failing banks. As a result, EU leaders decided to postpone the insurance mechanism's implementation.

With the first stage of the banking union projected to become operational in early 2014, EU leaders are dealing with another one of the eurozone's problems: the fight against tax evasion. Often, residents of EU countries are able to avoid taxation in their country of residence by having bank accounts in another member state. In 2003, the European Union tried to solve this problem by getting EU members to agree to implement an automatic exchange of information between states concerning interest payments.

But Belgium, Austria and Luxembourg objected to the disclosure of account holders' names, arguing that they would not be able to compete with non-EU countries with strong banking sectors such as Switzerland and Liechtenstein. As a result, they were granted exceptions to the system of information exchanging. In 2010, as the crisis on the Continent intensified, Belgium decided to comply with the exchange of information system, and now Brussels is pressuring Austria and Luxembourg to do the same. The issue has recently become particularly heated. Countries such as France and Spain have seen numerous corruption scandals in which public officials had secret bank accounts in other countries.

Under pressure from the European Union, the government of Luxembourg announced April 10 that it will implement rules on the automatic exchange of bank account information with the rest of the European Union beginning in 2015. The decision took place one day after the finance ministers of Germany, France, the United Kingdom, Italy and Spain sent a letter to the EU Commission proposing the creation of an information exchange system to fight tax evasion. In addition, Austrian Chancellor Werner Faymann said April 9 that his country is ready to discuss a more intensive exchange of information about its banking sector.

While efforts to share banking information are moving forward, two problems remain. The first is enforcement. In their April 9 letter to the EU Commission, Europe's five largest economies (Germany, France, the United Kingdom, Italy and Spain) proposed to improve the current mechanisms of information exchange among banks in the European Union, admitting that the mechanisms in place are not enough to prevent evasion. Second, these information-sharing measures are not designed to prevent capital flight from countries in the periphery to countries in the core — another significant problem based on the free movement of capital. In October, the International Monetary Fund warned that uncertainty is encouraging flights of money from the periphery to Northern Europe and to countries outside the currency union.

Leading up to the crisis, free capital mobility facilitated a credit boom in the eurozone periphery. With the crisis, this mobility has weakened the banking sectors of countries in the periphery because depositors face no hurdles in fleeing to more stable banking sectors in the north. Bank loans are the most important credit channel for companies in Europe, so the continued weakening of banking sectors in the periphery adds more problems to these already struggling economies, thus exacerbating the differences between the core and the periphery of the eurozone.

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