Governance, Institutional Quality and the Euro Area Crisis: What Lessons to East Asian Integration?*

1. IntroductionEver since the euro area crisis began in 2009, various reforms of economic governance system have been in progress.1 Almost all proposals for the reform of EMU governance have been aiming for strengthening fiscal and budgetary austerity and implementing the 'monetarist' view that emphasized a strong institutional framework. In addition, a new governance system such as banking and fiscal union has been proposed, but not activated.However, there are several issues to be further explored in the process of triggering structural reforms of EMU governance. The first issue is to what extent the euro states and other members of the EU should deal with conflicts between the pro-Europeans and euro-sceptics, both at national and European levels. The pressure to reconcile these conflicts in reshaping the governance architecture in the euro area is intense, fuelled by the euro area crisis. Studies that investigate this issue will inevitably have to deal with political decision making process: how politics affect the choices of governance measures to yield certain economic performance, which could differ from ones that come out from other political choices on governance measures.The second issue is that structural economic reforms typically taken in a currency union may not be sufficient to narrow growing imbalances and diverging trends in competitiveness, and converge economic cycles within the euro area. For example, the latest revision of fiscal policy governance is simply strengthening fiscal rules of the Stability and Growth Pact (SGP). The new rule demands that the annual structural budget deficit should not exceed 0.5% of nominal GDP, and contains an automatic correction mechanism that is triggered in case of deviation. However, the rule cannot solve the fundamental problems unless the origin of large budget deficits is identified and corrected. More generally, we should explore why economic performance is so different among member states.In this paper, we explore the data of institutional quality for the second issue. We find that institutional qualities of individual member nations were highly and significantly correlated with their economic performance in the euro area. We conclude that it is important to upgrade institutional quality of individual member nations as well as to narrow its heterogeneity among them.We also compare the governance system and quality of the euro area members with those of East Asian countries and draw policy implications for a regional integration in East Asia. We find that East Asia is far behind the Eurozone not only in institutional elements of the governance system at a regional level but also in institutional quality at the level of individual nations.The next section briefly reviews the literature on institutional quality and its relationship with economic performance, and discusses why institutional quality matters for maintaining a single currency area. Section 3 illustrates the data for institutional quality of the euro area member states and explores its close relationship with economic performance. Section 4 examines the data of institutional quality for East Asian countries and discusses policy implications for regional integration in East Asia. The final section concludes.2. Why Does Institutional Quality Matter for a Currency Union?2.1 Institutions and economic performanceNorth (1990) defines institutions as the rules of the game in a society or more formally as the humanly devised constraints that shape human interactions. In consequence they structure incentives in human exchange, whether political, social, or economic. The major role of institutions in a society is to reduce uncertainty by establishing a stable structure of human interactions. Institutions affect the performance of the economy by their effect on the costs of exchange and production. (pp. 3-6)2When property rights are not well secured, incentives and opportunities to invest and innovate will be reduced. …