monetary policy

How to reform the euro zone

main 41860152 AP – Dutch Finance Minister Jeroen Dijsselbloem eurogroup finance ministers meeting Brussels EU euro zone Feb 20 2015
The euro zone: 19 nations, 20 opinions. Source: AP

Last week’s European Summit was supposed to culminate in a breakthrough for the euro zone. It followed a year in which the euro zone staged an impressive comeback as a driver of global economic growth. Now the zone’s leaders were meant to agree further steps toward integration. They did not. The political impasse in Germany and a general fading of enthusiasm for reform instead produced only the typical European weasel words. EU leaders “exchanged views”. They agreed that “the work of our finance ministers should concentrate on areas where the convergence of views is the greatest.” Read between the lines. Another opportunity has been wasted.

There are many ideas about strengthening the euro zone. Most have in common a desire to move from a purely monetary union in the direction of a political union. Tellingly, many of the proponents of this vision, which we could call the “federal model”, would prefer that European citizens don’t even notice the shift.

Their opponents used to try to undermine any reform efforts. Now, however, these anti-federalists have changed their strategy. They are taking a more constructive stance, by proposing their own vision for the euro zone. Their model is primarily a national one, but adds independent, technical institutions at the EU level.

A compromise between these two sides will be hard and would probably be sub-optimal. But compromise is the only way forward. What should the compromise, from an economist’s point of view, concentrate on? First, reform should reduce the risk that the euro zone could break up. Second, it should increase opportunities to reap the economic benefits of a monetary union.

The European treaties already state that there is an obligation for member states to treat their fiscal policies as a matter of common concern.

A credible way to reduce the risk of a break-up would be to depoliticize the European Stability Mechanism (ESM). It ought to have a firm legal basis to restructure the debts of member states, in coordination with an existing program (called OMT) by the European Central Bank (ECB), which would remain a credible lender of last resort.

At the same time, a more technocratic fiscal authority, such as a euro zone finance minister, should ensure the right balance between long-term sustainability and short-term stabilization of member states’ budgets. Since the creation of the euro, member states have been torn between national and supranational interests in determining their spending and taxes. The European treaties already state that there is an obligation for member states to treat their fiscal policies as a matter of common concern. This must now be enshrined in practice.

German officials, including Wolfgang Schäuble, have argued that the ESM should become a bailout-fund, a European Monetary Fund and a Fiscal Authority in one. Given its inter-governmental nature, however, the ESM would be overburdened by all of these roles. Also, the ESM would probably mingle national and euro zone interests and have a tightening bias in fiscal policy, due to the fact that its main focus is debt sustainability.

Further down the road, the EU could aim at harmonizing taxes and social security.

So a better approach would preserve some wiggle room in fiscal policies, in order to avoid a vicious cycle of austerity exacerbating recessions. Solidarity from the ESM should be conditional, in the form of “money for reforms”.

The euro zone should also complete two other paths toward financial integration: banking union and capital-markets union. These two steps would lead to a better allocation of capital – from bank loans to bonds and equity – across the euro zone. The resulting efficiency would unlock the monetary union’s growth potential.

Unfortunately, it currently looks as if a new crisis is needed to take these steps. But maybe an “optimal” outcome of complete integration is not even necessary. Even some additional tweaks could make the monetary union more sustainable. Here is my wish list: an ESM for bailouts, an ECB as lender of last resort, a banking union that cuts the link between sovereigns and banks, a fiscal authority to depoliticize the assessment of fiscal policies, and more cross-border investment. Further down the road, the EU could then aim at harmonizing taxes and social security.

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