17 December 2012

Stefan Collignon for ECON Monetary Dialogue: Towards a Genuine Economic and Monetary Union

This paper reviews the arguments which show EMU as an indispensable complement to market integration, and then assesses ideas for reforming the euro area's governance - with respect to Banking Union, Economic Union and the crucial question of democratic legitimacy.

Executive Summary

• Europe stands at a crossroads. While the European Central Bank has managed to calm markets, the persistent political cacophony and the institutional inability to conduct coherent macro-economic policies at the euro level have undermined trust in the viability of the euro. The contradiction between the economic and the political dimensions of European integration is the fundamental cause behind the euro crisis.
• The Monetary Union is an indispensable element of European integration, for without monetary stability a fully integrated internal market is unsustainable. The rational for monetary integration is derived from three main arguments: (i) the theory of inconsistent quartet first derived by Padoa-Schioppa (1987) from the Mundell-Fleming model of open economics, (ii) the private sector arguments of reducing transaction costs in the single market, and (iii) the optimum currency area theory.
• A currency area is not a fixed exchange rate system. It is a payment union. The euro area functions exactly as any other currency area. Like all institutions, money can only exist because there is a critical mass of trust and mutual reliability in society. Maintaining trust in the euro and confidence in the reliability and enforceability of financial contracts, must be the highest priority for ensuring the sustainability of the monetary union.
• A genuine monetary union is more than a policy rule for issuing money. Money is supplied by banks and an efficient banking union is crucial for the proper functioning of EMU. Lack of harmonisation has maintained the idiosyncrasies of national banking systems and prevented the genuine integration of financial markets. A unified banking supervision must overcome these shortcomings.
• Micro-prudential supervision is a partial-equilibrium conception of financial regulation; it does not cover the external effects on the economy’s general equilibrium that macro-prudential supervision seeks to avoid. The two most important externalities are the danger of bank-runs and credit crunches causing output losses and unemployment in the real economy.
• The traditional micro-approach of setting minimum capital requirements is insufficient to preserve the stability of the system, because it does not take into consideration whether banks adjust by raising new capital or by shrinking assets. The simultaneous attempt by banks to deleverage is a major cause for recessions and slow growth after financial crises.
• In open competitive market-driven systems, banking supervision benefits if the central bank is in charge. Putting the ECB in charge, reflects the realities of European Monetary Union.
• Macro-prudential supervision is one side of avoiding systemic risks; reducing the likelihood of regional booms and busts in the real economy is the other side. Avoiding macroeconomic imbalances can reduce these dangers ex ante, while fiscal policy may be needed to stabilise the economy ex post.
• One argument against EMU is the ‘one size does not fit all’ slogan, which was supported by the Walter’s critique according to which inflation differentials cause booms and busts through their effect on real interest rates. However, rising prices also undermine competitiveness. Our empirical tests do not find any confirmation of the Walter’s critique, but support the hypothesis of excessive imbalances being self-correcting through competitiveness pressures.
• Nevertheless, relative costs and wage setting create incentives for investment and growth. We calculate an index for competitiveness based on a novel concept of equilibrium unit labour costs that shows northern Member States are generally below equilibrium and the south above. While the standard adjustment mechanism takes a long time, coordinated wage bargaining could help to restore macroeconomic equilibrium and reassure trust in the euro area.
• The second major policy tool to reduce growth imbalances is fiscal policy. However, in the euro area fiscal policy is not used as a policy tool, because Member States’ policies are discussed as a partial equilibrium without taking into consideration the aggregate dimension of fiscal policy for the euro area as a whole. As a consequence, aggregate demand is not sufficient to stimulate investment and return GDP to pre-crisis levels.
• Fiscal policy in the euro area has to meet two challenges: efficiency and legitimacy. Efficiency requires the determination of an aggregate fiscal policy stance. An improved fiscal capacity for the euro area could be a step in this direction, especially when related to stabilisation policies and unemployment insurance, but this is only a partial solution.
• Ultimately, the biggest obstacle to a genuine European monetary union is the lack of democracy at the European level, because without democratic consent efficient policies cannot be implemented. The segmentation of national polities in the euro area prevents the emergence of border-transcending consensus.
• The euro crisis has revealed one certainty: Europe’s model of governing its single currency is not sustainable in its present form. The alternative to dismantling the European Union is setting up a government that will administer European public goods with full democratic legitimacy by the elected representatives of all European citizens.

Full article

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