The two most important questions for the future of Europe are, first, what the euro area must do to rescue itself and, second, whether it has a strategy. The first question arises because the euro crisis has exposed grave design flaws. It is these flaws, compounded by repeated tactical mistakes in responding to market alarms, that explain at least as much as failures to enforce rules why Europe has reached the point at which the very existence of its currency is at stake.
Monetary union in its first 12 years relied on a series of assumptions that were ultimately proved wrong. To start with, it was assumed that, beyond the European single market, a common currency required only the delegation of monetary authority to a common central bank and ensuring that governments abide by fiscal discipline rules. According to this view – in effect, a variant of the Lawson doctrine – there was no need to monitor privately determined external imbalances and credit booms and there was no need for a euro-area financial policy.
Even in the late 1980s, this was disputable. The absence of a financial component to the euro was raised by the Bank of England in the negotiation of the Maastricht Treaty but the seriousness of this omission became clear only with the debacle of Ireland and Spain, whose fiscal records were apparently impeccable, and the sudden arrest of north-south capital flows within the euro area. Another related, erroneous assumption was that, apart from monetary policy, governance had only to rest on rules. This amounted to pretending that effective arms control makes an army redundant.
Finally, there was an assumption that as all EU countries would join at some point – at least all those without a waiver – the complexities inherent in the coexistence of countries inside and outside the currency area would disappear. The functioning of the euro could therefore be based on a relatively narrow set of specific provisions and arrangements. This assumption, however, is no longer credible, if it ever was. If the euro survives its crisis (which is still likely), it will be seen as a coalition of the willing, not the currency of the EU. In such conditions, there must be a much clearer distinction between what belongs to the 27 and what belongs to the 17.
Reform has started. For two years, the euro area has painfully built financial and operational crisis-management capabilities. In the process, it is creating a sort of government that is able to take decisions based on judgement and has the ability to act upon them – at this stage admittedly still a rather awkward one. A messy but undisputable process of rebuilding has begun with the adoption of eurozone-specific legislation and a new fiscal treaty. There are plans to monitor internal imbalances and credit developments. At the euro summit in June, there was a recognition that in order to be financially resilient, the euro area must equip itself with a banking union.
The euro-area countries have thus embarked on a journey into new territory. Even something as apparently technical as a banking union has far-reaching implications. It involves cutting incestuous ties between banks and governments at the national or regional level. It implies giving a European authority the power to close down banks and distribute losses between shareholders, creditors, depositors and taxpayers – an inherently political choice. It makes it indispensable to secure access to tax revenues, so that the ability to act in a crisis is not hampered by a lack of resources. It entails the risk of large-scale, cross-border transfers in the event of a banking crisis affecting part of the area only. It requires representation of taxpayers and the accountability of supervisors.
In effect, a banking union is a sort of off-balance-sheet fiscal union. Its off-balance-sheet character is a source of complexity but it magnifies rather than diminishes its fiscal character. One should never forget that the median fiscal cost of a banking crisis is 5 per cent of GDP in advanced economies and that for Ireland it has reached 40 per cent.
Yet the process lacks credibility. Markets are being told there is agreement on strengthening governance but what has emerged from the recent ministerial meeting is another unconvincing compromise; they are being told a banking union is in the making but neither the agenda nor the timetable for building it; they are being told that the European Stability Mechanism could buy Italian debt but neither how much nor when; they are being told that leaders will do whatever it takes to maintain the integrity of the euro area but preparations are being made for a Greek exit. The markets cannot be blamed for emulating Saint Thomas and believing only what they can touch. They cannot be blamed for asking if words will be followed by deeds.
Part of the process
Lack of credibility is lethal because it makes the solution to any problem much more demanding than it should be. Italy is a case in point: last year, it had a structural primary surplus of 2 per cent of GDP on its budget, more than any other euro-area country. But self-fulfilling market doubts are putting its solvency at risk.
In this context, the first thing needed is a precise agenda for negotiation on banking union and other systemic reforms, such as debt mutualisation. Leaders should not pretend to concur on issues they have not even discussed but should rather initiate a thorough, time-bound and credible process of discussion among ministers. Markets can be patient if they are assured that such a process has started in earnest and will deliver results within a certain time frame.
The other and no less urgent thing leaders should do is to adopt a coherent stance on problem countries. One strategy is to keep the euro area together and make sure all participating countries are given the chance to recover within it. This implies doing more for Greece, setting a framework for giving assistance to Spain and protecting Italy. Another, more adventurous strategy is to kick out Greece and ring-fence the countries that are to remain part of the euro. Either is conceivable. But a choice must be made, policies must be coherent with it and it must be supported by appropriate means. To enter the battle with limited resources and, worse, lack of resolve to use them is a recipe for defeat.
Jean Pisani-Ferry is the director of Breugel, a think tank based in Brussels