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What we need is a holistic approach. Since the European Monetary Union is a highly interdependent system, any solution must not only remedy the problem at hand but also improve the working of the system as a whole. Unfortunately, many of the proposed solutions fall short of this requirement. Every policy not only addresses a problem, but changes the nature of the game as well. This has to be taken into account when evaluating the overall merit of any measure.
Eurobonds are a case in point. Granted, eurobonds would offer temporary relief to heavily indebted Member States of the euro area. But the introduction of eurobonds would distort the already lopsided balance between liability and control even further. While spending decisions would essentially remain a national prerogative, liability would become European. Incentives to incur further debt would thus be strengthened, not weakened. This would strain rather than smooth the working of the system.
Only if common liability were matched by common control would incentives be aligned sufficiently, as the IMF pointed out in a recent report. But even though the fiscal pact has stiffened the rules, genuine European control of fiscal affairs still requires a quantum leap in terms of ceding sovereignty to the supranational level.
As this seems to be out of reach at the moment, steps are needed that encourage each part of the system to behave responsibly, while at the same time making the system more robust against failures of its constituent parts.
Severing the overly close link between banks and sovereigns is a crucial example in that regard. The Banking Union goes a long way towards ensuring that taxpayers do not foot the bill in the event of a bank failure. And to further strengthen market discipline, the Single Resolution Mechanism (SRM) will have to ensure that banks without a viable business model can exit the market in an orderly fashion. Such a regime is crucial not only for financial stability, but for sustainable growth as well.
But the sovereign-bank-nexus goes both ways. We also need to make sure that worsening public finances do not infect the financial system. To strengthen the Banking Union, we need to end the preferential treatment for sovereign debt. Sovereign bonds have to be adequately risk-weighted, and exposure to individual sovereign debt should be capped, as is already the case for private debt.