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Why the eurozone needs stronger institutions



The institutional design of the eurozone has undergone a rapid change since the emergence of the European debt crisis. Notably, we are seeing stricter fiscal rules in the member states, while there has also been progress in macroeconomic and financial integration, the latter in the form of steps towards a European banking union. While transferring some degree of sovereignty to European institutions is admittedly necessary to ensure a stable currency union, experience has shown that this will run into major political resistance. The opposition is clearly evident given the incomplete design of the institutional framework established to date. A more solid framework is important both in terms of reducing the likelihood of future crises and in order to deal with the current crisis. This is because from a political perspective, no credible crisis mechanism will be established as long as the institutional framework of the eurozone is not strong enough to reduce the probability of future crises to an acceptable level. This study details the institutional measures implemented since the inception of the financial crisis in terms of fiscal, financial and economic integration and analyses to what extent they improve the stability of the currency union.

Political integration

Since the establishment of the European Coal and Steel Community in 1951, European integration has occurred in a number of areas, notably in the economic and monetary realm. This economic integration was accelerated when the internal market was created in 1993, and a milestone was achieved in monetary integration upon the establishment of the currency union in 1999. Although the economic and monetary integration were largely prompted by political motives – above all, preserving the peace in Europe – political integration has lagged behind these developments. Over the past sixty years, there have been frequent calls for greater political integration, but a number of developments have halted this process (ECB, 2013), including the failure of the European Defence Community after the French National Assembly voted it down in 1954, and the 2005 French and Dutch referendums that blocked the Treaty establishing a Constitution for Europe. European policy integration can be characterised by its reactive attitude instead of by any clear idea of the desired result. Both the economic and the monetary integration were instigated by the dissatisfaction with the status quo at the time. The signing of the Single European Act in 1986, which laid the foundation for the establishment of the internal market, was prompted in part by discontentment with the economic slump and the high unemployment in the preceding years, also known as ‘Eurosclerosis.’ The idea of a currency union found a fertile ground in the speculative currency attacks and resulting volatility of the exchange rates during the predecessor of the currency union, the European Monetary System (EC, 2008). Numerous institutional measures have been implemented in response to the financial crisis and the European debt crisis in terms of fiscal, financial and economic integration, as highlighted in this study.

In recent years, numerous economists have drawn attention to the institutional shortcomings of the eurozone. Many regard a political union as a key condition for the continued existence of a monetary union, and, based on historical currency unions, political factors also appear to be a critical success factor (Bordo & Jonung, 1999). However, the term ‘political union’ has sparked a great deal of confusion in the current debate. Hodson (2009) defines political integration (among other things) as the centralisation of economic decision-making with the objective of facilitating an efficient monetary union. De Grauwe (2006) interprets it as the transfer of sovereignty to coordinating organisations. It is important to note that transfer of sovereignty does not necessarily involve a centralisation of the decision-making process; in fact, the latter appears to be an advanced stage of political integration. The transfer of sovereignty has several gradations, making it difficult to determine when a political union has been created. In this article, we therefore refer to the process of political integration; that is, the transfer of control over national (economic) policy to European institutions. De Grauwe states that, although there has been a transfer of sovereignty in the eurozone in a number of areas, including agriculture and trade, this is not yet sufficient to ensure a stable currency union. He uses the theory of ‘Optimal Currency Area’ (OCA) to argue that far-reaching political integration is necessary in order to increase the chances of success of a currency union. In view of the political motives for European integration, optimality, while not a strict requirement from an economic perspective, is still a goal worth pursuing. The optimality of an OCA depends on various factors, including the level of symmetry of shocks between the member states. For example, it is undesirable if the impact of a substantial increase in oil prices affects member states in vastly different ways, since only a single monetary policy can be pursued for all member states and the limited mobility in the European labour market prevents a rapid adjustment process. Political integration makes it easier to absorb the effects of an asymmetric shock. De Grauwe uses the same argument as a plea for a larger centralised budget or long-term income transfers between countries, as with European unemployment insurance. Although this can theoretically increase the optimality of a currency union, this does not mean it is a prerequisite for the existence of such a union. Micossi (2013) states that, besides improving the optimality of a currency union, political integration may reduce the negative external effects of a member state’s economic policy. It is important to identify in what policy areas externalities occur and where political integration is therefore desirable in order to strengthen the institutional framework. The next chapter covers these issues in greater detail.

Integration in three areas

The European debt crisis has made it painfully clear that concerns about the public finances of a single member state can affect the stability of the currency union as a whole. Under major pressure from the market, the rescue funds EFSF (European Financial Stability Facility) and its permanent successor ESM (European Stability Mechanism) have been established in recent years. These funds are necessary in order to prevent sovereign default and the liquidation of systemic banks. Stability in the eurozone calls for a crisis mechanism of this kind, since the European Central Bank (ECB) does not regard it as its responsibility to support individual member states with large-scale monetary financing. However, sharing financial risks based on a crisis mechanism is unsustainable without a strong institutional framework due to the moral hazard risk created by this situation, including imprudent fiscal policies due to the presence of a safety net (ECB, 2013). For this reason, no credible crisis mechanism will be established as long as the institutional framework of the eurozone is not strong enough to reduce the likelihood of a future crisis to an acceptable level. Political integration is therefore both desirable in terms of reducing the probability of future crises and a condition to deal with the current crisis by establishing a credible crisis mechanism. The level of policy integration required to achieve this objective is ultimately a political consideration.

Weak fiscal discipline is the most common example of a direct externality, but it is certainly not the only cause of the debt crisis. Buti and Carnot (2012) highlight the role of financial and macroeconomic developments: recapitalisation of banks led to a sharp deterioration of public finances in many member states, while the adjustment of a macroeconomic imbalance caused many member states to plunge deeper into recession. The radical price adjustments in the Irish housing market – in the wake of excessive lending and the construction boom of the pre-crisis years – resulted both in a deep recession and caused public debt to skyrocket following the bank bailouts. In the years preceding the crisis, Ireland, fuelled by revenues from property taxes, saw several years of budget surpluses. Spain faced problems similar to those affecting Ireland, in addition to dealing with a highly procyclical labour market. Unemployment rose sharply due to the recession, which only exacerbated the problems in the financial sector and public finances. The above examples demonstrate that financial and macroeconomic policies in the member states can result in negative external effects for the currency union as a whole. Furthermore, it is clear that the developments described above can reinforce each other, causing the effectiveness of policy integration to remain limited as long as measures are not taken in all areas.

The direct and indirect externalities of weak public finances and insolvent banks clearly show that political integration in these areas is desirable. For macroeconomic policy, this only applies to policy areas that have a direct or indirect impact on other member states. A distinction between these policy areas is desirable from a political perspective, so as not to unnecessarily reduce national control over economic policy. In fact, Mijs (2012) states that national control is important in terms of gathering support for a variety of measures, including structural reforms. Here a distinction should be made between structural fiscal and economic reforms. The first category directly affects the sustainability of a member state’s public finances, e.g. policies relating to public sector expenditures such as healthcare and pensions. Structural economic reforms can boost potential economic growth. While this helps sustain the welfare state, it is not a strict condition for preventing negative effects on other member states. Italy, for example, can increase its potential economic growth by fighting corruption and improving its business climate. But if the country opts to reduce its level of public services in order to ensure that public finances remain sustainable, the lack of such reforms will not adversely affect other member states. However, the situation is different for some other economic reforms, including those relating to the labour market, the housing market and bank lending practices. Policy decisions in these areas can affect both potential growth and determine short-term growth. If countries have sharply divergent economic cycles, this both complicates an effective monetary policy and may have major unexpected effects on, for example, a member state’s public finances. In terms of policy that affects the competitiveness of member states, the situation is a little more complex, since a weakened competitiveness within a currency union cannot be compensated by exchange rate policy. This applies, for example, to the deregulation of the services industry in Portugal, which may result in lower prices through fiercer domestic competition. Theoretically, a proper functioning of the financial markets ensures that differences in competitiveness between individual member states do not result in an accumulation of unsustainable current-account deficits, but the pre-crisis years demonstrated that this is in fact possible in the eurozone.

Various European policymakers seem well aware of the need for political integration in the above areas. In late 2012, both the President of the European Council, Herman Van Rompuy, and the President of the European Commission, José Manuel Barroso, presented plans to strengthen the monetary union in the long term (Van Rompuy, 2012; EC, 2012a). In line with the economic theory outlined above, Van Rompuy proposes the policy framework to be reinforced in terms of public finances, the financial sector and economic policy. As a fourth component, he cites an increase in democratic legitimacy. We, too, believe that reducing the European democratic deficit is crucial to gathering wide support for the necessary institutional measures that must be taken in the eurozone. However, the scope of this study is limited to the three policy areas that are required, in a strictly economic sense, to strengthen the institutional framework. In the upcoming sections, 3, 4 and 5, we discuss the institutional measures that have been implemented in the above three policy areas since the start of the crisis. Section 6 describes how we expect the eurozone institutions to develop in the coming years. Section 7 concludes.

Fiscal integration

There were already many European laws relating to public finances in place prior to the debt crisis, and relatively many steps have been taken in this area since the crisis. The three main developments have been the reform of the Stability and Growth Pact (SGP) and the introductions of the Fiscal Compact and the Two-Pack. Below we describe these three steps and examine to what extent they can improve the stability of the eurozone.

Reform of SGP

The Stability and Growth Pact was introduced in 1997 with the objective of preserving the health of public finances of the member states. The Pact is based on two conditions: the budget deficit must not exceed 3% of Gross Domestic Product (GDP) and gross public debt must not exceed 60% of GDP. Compliance with the SGP rules, in particular, turned out to be a weak spot. Figure 1 shows that virtually all member states have exceeded both the budget deficit standard and the public debt standard on several occasions. This was due in part to the fact that the Council of the European Union (EU) – comprised of the finance ministers of the member states – was largely responsible for compliance. The fact that Germany and France blocked a strict implementation of the rules to their own advantage in 2003 is emblematic of the political influence on compliance with the rules (ECB, 2011). The fact that there was initially no possibility to take action against countries with public debt exceeding 60% of GDP was another weakness in the system’s design. In both 2005 and 2011, the rules of the Stability and Growth Pact were amended in order to improve both its design and compliance with the Pact.

Figure 1. Stability and Growth Pact

Figure 1. Stability and Growth Pact

Source: Reuters EcoWin

In 2011, the preventive arm of the SGP – in which budget plans of member states are assessed that comply with the fiscal and debt standard – placed a greater focus on reducing public expenditure rather than increasing taxes. In the preventive arm, the EC assesses the member states’ annual budget plans and compares them with their medium-term budgetary objective (MTO). The MTO is determined in structural terms, i.e. adjusted for economic trends and non-recurring income and expenses. Since 2011, the MTO has also contained a strict guideline for expenditure: the increase in public expenditure must not exceed potential GDP growth and, in some cases, it must be lower. Two main adjustments were made to the corrective arm of the SGP. For one, the arm was extended to include a debt rule, which requires that member states with debts exceeding 60% of GDP reduce the portion above the norm by 1/20th per year (the 1/20th rule is used as an average over a 3-year period). Secondly, a number of measures were taken to enforce stricter compliance with the rules. For example, potential fines have been increased (maximum of 0.5% of GDP); sanctions are imposed more easily on member states in the eurozone if the rules are violated; and, since 2011, the Council of the European Union can block EC proposals only with a qualified majority. In the past, a qualified majority was required in order to adopt a recommendation.

While the 2011 reform of the SGP doubtless represents an improvement, we do note a number of weak areas. Within the corrective arm, the EC has no tools to control the balance between spending cuts and tax hikes. On account of the lower public resistance, politicians tend to opt too often for the latter, which further undermines economic growth. In addition, although political control over compliance with the rules has diminished, experience will have to show to what extent politicians will continue to use the remaining scope (Buti & Carnot, 2012). Finally, the SGP was designed to improve public finances in the medium term, but in recent years the debate between the EC and the member states has focused mainly on achieving the short-term budget target.

Fiscal Compact

In early 2012, an important step was taken with the implementation of the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (EMU), commonly known as the Fiscal Compact (Title III of the treaty). The treaty became effective on 1 January 2013, giving the 25 member states that signed it – the EU-27 at that moment excluding the United Kingdom and the Czech Republic – until 1 January 2014 to sign measures under the treaty into national law. Among other things, these member states have committed to a ‘golden rule’ which states that in the medium term, the structural budget deficit must not exceed 0.5% of GDP. This is based on the agreement that the structural budget target for the medium term must be enshrined in national law, preferably in the constitution and otherwise at a comparable level of legislation. The same applies to automatic mechanisms designed to ensure enforcement of the rule.

In theory, the Fiscal Compact provides a useful addition to the SGP, since the rules from the preventive arm of the SGP will have a greater impact due to their enshrinement in national laws (Buti & Carnot, 2012). However, there are a number of complications. The Fiscal Compact is based on the assumption of a cyclically-adjusted budget balance and therefore more accurately reflects the state of public finances than does the headline budget balance. Legierse & Smid (2012) state that focusing on a cyclically-adjusted budget balance theoretically will make fiscal policy less procyclical, with fiscal policy having a cushioning effect on economic fluctuations. However, they note that adjusting for economic trends presents complications, because it is difficult to determine the exact state of the economy at any given time. Since adopting a cyclically-adjusted budget balance is essential when it comes to setting the appropriate fiscal policy, this creates political scope to interpret the rules as desired with regard to the electorate. In terms of compliance, the next several years will show the effects of enshrinement in the national laws of the member states, but at this stage we can already question the sanction process. Specifically, member states will be authorised to bring each other before the Court of Justice of the EU if they believe that a fellow member state has failed to adequately integrate the rules or fails to comply with the recommendations made by the Court. Although the Court, in those situations, is authorised to impose a fine (equivalent to a maximum of 0.1% of GDP), the political barriers to disciplining one another in this way are likely to be high.


The Two-Pack, implemented on 30 May 2013, consists of two regulations – applicable only to the eurozone member states – that can potentially strengthen the preventive and coordinating effect of the current budget regulation. Through the first regulation, the EC has attempted to increase its control over the member states’ budgetary plans. For one, the eurozone member states will be required to submit a budget proposal for the coming year in mid-October. If this proposal fails to satisfy the conditions of the SGP, the EC may request that a new proposal be submitted. This regulation also requires that member states base their budget plans on independent macroeconomic estimates. The second regulation relates mainly to member states in the excessive deficit procedure and member states that receive or have received financial support. This will give the EC more options to assess the plans of these member states based on, for example, criteria stated in the SGP. Member states that have received financial aid will remain subject to tighter regulation by the EC until 75% of the funds received has been repaid. One advantage of the Two-Pack is that it provides the EC with more options for additional fiscal regulation if it deems this necessary, making it possible to improve the flexibility and preventive effect of existing legislation. This, in turn, makes it easier for the EC to monitor fiscal changes and intervene more quickly if necessary. However, the effectiveness of the Two-Pack depends largely on a proactive attitude on the part of the EC, with an additional disadvantage being that, under the Two-Pack, the EC can only make recommendations and does not have the possibility to enforce any rules.

Current status: political control has diminished, but not eliminated

In summary, we can state that a relatively large number of policy measures have been implemented in recent years relating to public finances, which has provided the EC with significantly more tools to maintain fiscal discipline. As stated, it is difficult to determine exactly to what extent these measures improve the stability of the currency union, but the fact is that the described transfer of control, coupled with high market pressure, was sufficient from a political perspective to establish the permanent rescue fund ESM, even though we believe its effective lending capacity of €500 billion is too small to have sufficient credibility. When we review the measures that have been taken in relation to the SGP, the Fiscal Compact and the Two-Pack, we note that these measures are mainly of a coordinating and regulatory nature, which is notably different from the option of centralising policies. For instance, while regulation of budgetary rules has been tightened, there is no substantial federal European budget in place. It is important to note that centralisation is not necessary as long as the ultimate control over policy has been transferred to coordinating organisations. In terms of content, we believe the focus of the implementation of the SGP is too much on improving public finances in the short term, when in fact both the SGP and the Fiscal Compact are designed to improve public finances in the medium term. Besides the limitations of the actual design of the framework outlined above, compliance and the political implementation of all three regulatory mechanisms, in particular, remain crucial. Although options to enforce policy by imposing fines and enshrining these regulations in national laws have increased, this has certainly not eliminated political scope. Experience will need to show to what extent the EC will allow this scope to be utilised.

Financial integration

The process of European financial integration – which at this stage focuses on establishing a European banking union – is currently underway, but it will not be completed for some time. Bank regulation and resolution in Europe has always been the responsibility of national institutions. The European Commission and the IMF can exercise control over the design of the Spanish banking sector only as part of the financial rescue package for Spanish banks introduced in late 2012. The above-mentioned Van Rompuy plan identifies four building blocks for a full banking union: uniform supervision, a uniform resolution mechanism (and a European resolution authority), a common resolution fund and a uniform Deposit Guarantee System (DGS). We likewise believe that these are necessary measures to reduce the negative externalities of national policies and thereby improve the stability of the currency union. An additional effect will be that taxpayers will be spared the cost of future banking crises as much as possible. Below we describe that integration of the four aspects listed above provides clear advantages over institutional design at the national level.

Uniform supervision is important because national regulators may act primarily in the interest of their own countries rather than in the interest of a currency union as a whole (Gros, 2012). Goodhart (2012) states that national regulators tend to be soft on their own ‘champion’ banks, which may cause any problems that might arise to be addressed too late. For example, the delay of the necessary measures in the Spanish banking sector was due in part to the substantial political impact on the regional savings banks (cajas) (Garicano, 2012). Besides creating a level playing field, uniform supervision can also help enforce structural banking sector reforms. Despite the benefits listed above, it should be emphasised that uniform supervision can only help prevent financial crises to a limited extent; these crises are of all times and are generally difficult to forecast, both for national and for European regulators.

single resolution mechanism and a European resolution authority can help establish a level playing field by creating clear guidelines for resolving and restructuring troubled banks, as well as creating a framework for coordinated action if the bank in question has branches in multiple European countries. Ambiguity regarding the level of bail-in – the write-down or conversion into equity of unsecured claims when a bank is heading for bankruptcy – as in the negotiation of the Cypriot aid package, can be avoided. This could improve financial stability, even though stability in this case depends on the extent to which bail-in is used. Although a major focus on bail-in helps to prevent a large burden placed on stronger banks through the resolution fund, it can actually undermine financial stability through contagion channels. This makes it clear why a common resolution fund is essential. Establishing guidelines for future crises may also affect the current crisis. Financial markets add the potential loss from claims in a bail-in to banks’ financing costs. This affects a number of banks – particularly in Southern Europe – due to their relatively weak current position.

By establishing a common resolution fund, the banking union to some extent breaks the link between banking problems and governments of individual countries, because banks’ rescue operations are no longer financed using funds of the member state itself. National funds (ex ante financed by banks based in the same country) tend to fall short when rescuing large banks. It is important to note that a part of the negative link between governments and banks will remain in place both with national and common funds, since banks generally hold large quantities of government bonds issued by their own governments. Although a common fund can break through the negative feedback loop, concerns about a country’s public finances can continue to cause unrest about the banks in question. The introduction of eurobonds can prevent this problem in the form of a single, stable bond market (Boonstra, 2011).

uniform DGS strengthens the trust of deposit holders and can therefore help prevent a deposit flight. The European debt crisis has demonstrated that deposit flight can exacerbate a country’s economic problems, for example because it furthers pressures bank lending. A DGS at the member state level can also prevent a deposit flight, but uniform rules help create a level playing field and prevent a situation where savers park their funds in countries that have the best systems. Unlike national funds, common DGS funds operate similarly to an insurance policy against high costs at the individual member state level. This is desirable because banks and their deposits can be sizeable compared to the banking sector in their own country, but not compared with the European banking sector as a whole.

The four building blocks of a full banking union, as described above, offer clear advantages over design at the national level. If the steps outlined above do indeed create a level playing field, international competition and cross-border activities from banks within the eurozone will increase, which will theoretically improve the allocation of funding within the eurozone. There are a number of key discussion points regarding the institutional design at the European level, in which economic, political and legal factors all play a role. We have described two key aspects below.

Integrated approach

First of all, many economists highlight the importance of an integrated approach of a banking union (Beck, 2012; Goodhart, 2012). If the integration is only partial and some of the powers remain with the individual member states, a banking union will not be effective and may even function less effectively than the current national design (Beck, 2012). Schoenmaker (2012) describes a scenario in which supervision is the responsibility of the ECB but only the national authorities have the power of resolution. In this scenario, it is conceivable that the ECB doubts the solvability of a specific bank but that the national authorities are in favour of minimising their costs and therefore allow the bank to use the ECB's liquidity as long as possible. Since the combination of European supervision and a national strategy for resolution may cause the necessary measures to be delayed, it is crucial for both aspects to be designed at the same institutional level.

From an economic perspective, the arguments above argue for a simultaneous (to the extent possible) integration at the European level of the various policy aspects. From a political perspective, uniform regulation must be implemented at least simultaneously with, and preferably before, the transfer of powers to bank resolution and DGS (Ioannidou, 2012). This is because, from a political perspective, it is difficult to sell the idea of supporting foreign banks financially without the country having had any say during the period when the problems first arose.

Short term versus long term

While several policy measures have already been implemented, the establishment of a banking union – particularly a single resolution mechanism and a common fund – has proved to be a long, drawn-out process. Buch and Weigert (2012) argue that this process is being delayed by the existence of legacy problems; the different financial positions of the banking sectors in the member states and, in particular, the major (future) losses in, for example, the Spanish and Irish banking sectors which could result in substantial recapitalisations in the future. They compare the introduction of a single DGS to purchasing insurance for damage that has already been done. The ECB has therefore announced an Asset Quality Review (AQR): an admission test for the Single Supervisory Mechanism (SSM), which must ensure that a common fund can only be used for institutions that were healthy at the time of admission. However, we should emphasise that such an admission test will have no credibility as long as no resolution fund has been established. Without a fund, the government concerned and, if necessary, the ESM will need to provide undercapitalised banks with additional capital, which raises the question as to whether the AQR will dare to expose a substantial capital shortfall. Besides, it simply takes too much time to let new institutions become operational, in terms of infrastructure and highly trained staff (Ioannidou, 2012). There is also an ongoing legal debate of whether European treaties should be amended in order to make the decision for resolution the responsibility of European institutions. For the reasons listed above, Beck (2012) states that it would be unwise to regard the institutional establishment of a banking union as a solution to the current problems facing the banking sectors of countries such as Spain and Ireland. This is because, as with fiscal integration, a common resolution fund will only be established if the likelihood that the fund will be used is acceptably small or limited in size. The different starting positions of the member states could also form a barrier, since this means the probability of the expected use of the fund by the member states is not equal. It is problematic that the banking sectors in the various countries are in need for a short-term solution; if such a solution is not forthcoming, the socioeconomic costs of the delay of necessary measures will continue to increase.

European policy measures

In September 2012, the European Commission submitted a proposal for central banking supervision (EC, 2012b). A Single Supervisory Mechanism will be established, in which the European Central Bank (ECB) will be responsible for the regulation of all 6,000 banks in the eurozone and of the banks based in non-euro countries that voluntarily participate in the SSM. The ECB will supervise banks that 1) have assets in excess of €30 billion or 2) assets exceeding 20% of the GDP of their country or 3) have received or applied for financial support from the EFSF or ESM rescue funds. The other institutions will remain under national supervision, with the ECB being authorised to decide to take over at any time. The ECB intends to begin its regulatory activities in the second half of 2014.

In July 2013, the EC also submitted a proposal for a single resolution mechanism (EC, 2013a). Under the proposal, a Single Resolution Board, comprised of representatives of the EC, the ECB and national regulators, can draft a recommendation for resolution. However, under the proposal the EC will make the final decision regarding resolution. The Single Resolution Board – in which national regulators can theoretically also assess national interests against each other – will have an advisory role and will be authorised to execute the resolution, but will have no decision-making powers. The EC proposal came in the wake of the political agreement regarding a ‘bail-in framework’, which the Council of the EU, comprised of the finance ministers of the member states, had signed several weeks earlier. Although this framework sets out uniform rules for resolution, national regulators will retain a certain degree of flexibility in applying these rules. Specifically, within certain limits they have the scope to protect groups of creditors against losses in order to maintain critical banking functions or prevent contagion. Clearly, the EC has presented a significantly more ambitious proposal regarding the transfer of powers to itself and regarding the establishment of a common resolution fund than some of the member states – and, by extension, the Council – currently consider desirable.

Current status: incomplete design

In summary, we regard the proposals above as a step in the right direction of a full banking union, but the institutional design is clearly not yet completed. A banking union can only be effective if supervision, resolution and emergency funds are established at the same institutional level. Although a strong emphasis on ‘bail-in’ can reduce costs for stronger banks and taxpayers, a common resolution fund will ultimately remain essential in order to improve the stability of the currency union, and it is precisely on this crucial issue that the member states continue to disagree. Common supervision and a single European resolution mechanism are a political condition for having a resolution fund, but we believe the Council’s agreement regarding future resolution is not far-reaching enough. Since the proposals of the Council and the EC are very different in terms of the level of flexibility and control of national institutions, it is unclear at this point whether the finalised European directive will be ambitious enough. A strict admission test conducted by the ECB is important for the various member states in order to protect the fund from banking issues that have arisen in the past. Paradoxically enough, this test requires that a credible fund finances the necessary bank recapitalisations that might be revealed in the test. As long as policymakers fail to find a credible solution to the current problems in the various banking sectors, we will not see the establishment of a full banking union. As a result, the policy for both the current crisis and the policy to prevent future crises are clearly tied up together, with the unwillingness of politicians to take the inevitable losses of the current banking problems being reflected in the inadequate design of the current proposals.

Economic integration

The European integration of economic policy was highly limited prior to the debt crisis, and even though a number of measures have been taken since the crisis, the European influence in this area remains dependent on the goodwill of the member states and on a proactive role on the part of the EC. Under the 2007 Lisbon Treaty, the member states agreed that they ‘would design their economic policy with the objective of contributing to achieving the goals of the European Union’. However, this vague guideline was not accompanied by any kind of enforceable mechanism (CEPR, 2013). The financial emergency aid to various member states during the crisis allowed the EC to exercise control over economic policy through a reform programme, but this mechanism works on an ex-post basis, i.e. when the stability of the currency union has already been jeopardised. Section 2 of this publication describes why integration in various macroeconomic subareas is important for a stable currency union, both directly and indirectly, through the effect on public finances. The Van Rompuy document and recent policy proposals demonstrate that various European policymakers are all too aware of this but that the political opposition in a number of member states remains strong. Below we discuss the policy measures implemented so far, along with a recent proposal.

European Semester

The European Semester was established in 2010 in order to improve European coordination of economic policy and be able to exercise control on the member states’ policies in a timely manner. The Semester is an annual cycle in which the EC assesses both fiscal and economic policy plans of member states and makes policy recommendations on this basis. Besides streamlining the SGP and the Macroeconomic Imbalance Procedure (MIP; see the next paragraph), the EC makes country-specific recommendations based on the national reform programmes submitted. A key aspect of this process is that the recommendations are not enforceable; the Semester’s success therefore depends on its implementation by the member states themselves (Mijs, 2012). A study by Bruegel (2011a) shows that there are differences in the level in which member states comply with these recommendations. The number of years the country has been an EU member, the size of the economy and the number of economic ties outside the EU are all factors that could potentially influence this. The Bruegel study also criticises the lack of transparency in the design of the Semester. The current recommendations do not specify clearly enough what policy measures in which member states have the highest priority. The Council of the EU also has the option to (slightly) amend the recommendations in a rather opaque way, since it ultimately ratifies the EC’s recommendations. The lack of transparency was also highlighted during the period that several member states were allowed by the EC in May 2013 to bring their fiscal targets in line with European rules. France was granted a two-year extension to meet the deficit target, although the EC also demanded a stronger focus on structural reforms, including an overhaul of the French pension system. A trade-off between fiscal measures and structural reforms is desirable in theory, since the correlation between the two policy options is important in order to be able to reinforce the long-term sustainability of public finances without allowing short-term costs to run too high (Piljic & Stegeman, 2012). Although the current implementation of this policy – through political negotiations within the parameters of the SGP – is an effective way for the EC to increase its control over the member states in the short term, there are a number of disadvantages. Since the SGP basically does not allow for an exchange of this kind, the reforms are not enforceable and also do not improve the transparency of European control over national policy.

Table 1. Macroeconomic Imbalance Procedure (2008)
Table 1. Macroeconomic Imbalance Procedure (2008)Source: European Commission, Rabobank

Macroeconomic Imbalance Procedure

Like the reform of the SGP, the Macroeconomic Imbalance Procedure (MIP) is part of the Six-Pack introduced at the end of 2011. The MIP is attempting to prevent macroeconomic imbalances from being created in member states, and to correct it when it does arise. The MIP involves an annual cycle that starts with a scoreboard (currently including 11 indicators) based on which an initial assessment is made of the existence of imbalances. In addition, the MIP also includes a 'preventive’ and a ‘corrective' arm, in which the EC and the Council of the European Union can make recommendations to the member state. If eurozone member states fail to fully comply with these recommendations, they risk incurring a fine equivalent to a maximum of 0.1% of GDP.

In theory, the design of the MIP provides enough instruments to counter macroeconomic imbalances, to the extent possible, but experience has shown that it is difficult to detect such an imbalance in a timely manner (Bruegel, 2011b). The MIP scoreboard showing the 2008 indicators shows four crisis signals for both Greece and Denmark, but the situation in these countries, and certainly also the extent to which this affects other member states, varies significantly (see table 1). This highlights that a strictly quantitative approach does not sufficiently cover the different situations in the member states (Altomonte & Marzinotto, 2010). For this reason, the scoreboard always includes an in-depth review. However, this necessary qualitative addition does create some political scope. The Bruegel study states that there are limits to the effectiveness of discretionary powers in this area, since there is generally a great deal of resistance to policy measures designed to prevent an imbalance. Experience will therefore need to show to what extent the EC is able to let the MIP operate. It is too soon at this stage to give a definitive conclusion, but a recent example shows that there are certain questions to be raised. In April 2013, the EC called the macroeconomic imbalances in Spain and Slovenia 'excessive’. Based on this assessment, the Council of the EU can launch a procedure in which these member states are forced to change their policies. However, the Council, at its meeting on 14 May 2013, stated that the EC would first review the national reform programmes of these countries, and on this basis it would be assessed whether additional policy measures were necessary. It is important to note that these measures will not be enforceable as long as no procedure is launched. Besides the fact that the influence of the Council adds a political dimension to the MIP, it is a weakness that measures can only be enforced (i.e. by imposing a fine) at a late stage, namely after the imbalance has been ruled as ‘excessive’. As with the SGP and the Fiscal Compact, the EC can therefore make recommendations on economic policy at an early stage, but the use of an enforceable mechanism is possible only at a later stage of the process and is not immune to political influence.

Proposal: binding contracts

Van Rompuy (2012) describes the option of using another instrument to increase control over the economic policies of the member states, proposing that member states and the EC  draft binding contracts to implement structural reforms. These contracts could be combined with financial support, both as a financial incentive and in order to reduce the negative short-term impact of structural reforms. The EC (2013b) has launched a similar proposal under the name ‘Convergence and Competitiveness Instrument’. In October 2012, the European Council – comprising the government leaders of the EU member states – stated its intention to explore similar ideas, but no specific measures have been taken to date. It is important, first of all, to indicate that these types of contracts are not necessary for all policy areas. In Section 2, we state that, while various reforms can increase a country’s potential growth, European control is advisable particularly in the policy areas that affect the other member states. This applies, in any event, to structural fiscal reforms and to policies that determine the  economic cycle. In theory, since such policies are already influenced by the SGP and the MIP, the added value of binding contracts would appear to be limited. However the introduction of such contracts can provide an extra incentive at an early stage of undesirable policy as, at that stage, the SGP and the MIP can only give recommendations.

Current status: practical implementation remains uncertain

In summary, we can state that, although the EC can make recommendations at an early stage regarding macroeconomic policy, the implementation of an enforceable mechanism is possible only at a later stage and does inevitably involve political influence. As with fiscal regulation, the transfer of control is mainly coordinating and regulating in nature. The MIP provides the appropriate structure to prevent and correct macroeconomic imbalances but the effectiveness of the current design has not yet been demonstrated in practice in any way. Particularly compared with, for example, fiscal regulation in the form of the SGP, which has been in place for more than sixteen years, the transfer of control over economic policy is still at an early stage and will likely be further developed in the coming years. While the conclusions on the Semester and the MIP are premature at this stage, there is a reason to doubt their effectiveness. The lack of transparency with which the EC has been attempting to enforce a pension reform in France indicates that other institutional options for the EC are limited. Furthermore, the fact that European policymakers are pressing ahead with their plans for binding contracts shows that the MIP currently does not yet function as an effective instrument in fighting imbalances. 

Future outlook

The sections above demonstrate that the institutional design of the eurozone has been accelerated since the emergence of the debt crisis. Besides the transfer of sovereignty in the fiscal, financial and economic areas, the EFSF and ESM rescue funds were established. One problem is that the financial support provided to the peripheral member states has in recent years met with significant political opposition in the Northern member states, including Germany, the Netherlands and Finland. Besides that, for some Northern member states it seems difficult to accept that giving up control over national policy is necessary for all member states, not only for the peripheral countries. Both are a barrier to the creation of a credible crisis mechanism. As stated in Section 2, no credible crisis mechanism will be established as long as the institutional framework of the eurozone is not strong enough to reduce the probability of a future crisis to an acceptable level, given that the Northern member states do not want to foot the bill once again for events over which they have only been able to exercise limited control.

It is difficult to indicate what level of political integration is a necessary condition for a credible crisis mechanism that can address both the current crisis and future crises. It is clear, however, that it is necessary to transfer control in policy areas that could negatively affect other countries and the currency union as a whole. However, political integration is a process that can be designed in various ways and has different levels. In retrospect, we note that the policy changes implemented in recent years are mainly of coordinating and regulating nature, making it vastly different from the option of policy centralisation. Given the extremely slow-moving negotiations on the multiannual EU budget, a substantial federal European budget for the coming years, for example, does not seem realistic. As is the case with the transfer of sovereignty, there are also various levels in the design of a crisis mechanism and structural income transfers between member states. The current EU subsidies belong to the second category, but there has been no extension of this through, for example, a centrally funded social security system. Although a European unemployment insurance can theoretically absorb asymmetric shocks, there are currently no such proposals in place. From a political perspective, this type of insurance likely requires far-reaching control over the national labour market policy, since the difference in structural unemployment between countries with these types of systems in place will result in permanent income transfers. Crisis mechanisms can also be designed in a variety of ways, for example through a reinforced and increased ESM or through the introduction of eurobonds. The latter offers the advantage of a large, stable bond market, thereby protecting individual member states from market volatility. It is clear that the design of a crisis mechanism requires a corresponding level of transfer of control and that the political opposition to this transfer forms the limit for what will be feasible in the coming years. It cannot be ruled out that, although a crisis mechanism may be adequate in fighting the current crisis, future crises will necessitate further financial guarantees and therefore further political integration.

When it comes to finding a future balance between a crisis mechanism and the transfer of control, there are various factors that will continue to dominate the European political playing field in the coming years. First of all, the euro crisis is not just a debt crisis and a banking crisis, but also a governance crisis. Underhill (2012) explains, for example, that decisions regarding the institutional design of the banking union and other institutions are so problematic because member states are all attempting to pursue their own, often conflicting, interests. Even though the member states have a combined interest in a well-functioning and stable currency union, this need not necessarily result in a solution that is best for the eurozone as a whole. It has also been demonstrated in recent years that substantial pressure from the financial markets may incite the national government leaders to change their policies. If the financial markets calm down, such as through the announcement of the 'Outright Monetary Transactions’ programme by the ECB, this unfortunately also reduces pressure among politicians. The reactive attitude of politicians to European integration – as described in Section 1 – explains why the institutional design is taking such a long time to take shape. It might also explain why politicians, time and again, opt for the minimum policies required to ease the unrest at that time, and rarely agree to more than is strictly necessary. A broad acceptance of the benefits of Europe can change this reactive stance. Finally, national election cycles play a role in the European political process. Assuming that the national interest is given greater priority during the period just before national elections, these can, particularly in the large, influential member states, have an impact on European politics. The German parliamentary elections scheduled for September 2013 are therefore of major importance to Europe. Although the election programme of the current coalition party, CDU, is optimistic about European political integration, far-reaching measures, such as the introduction of eurobonds, are firmly rejected.

In sum, it is clear that there are several factors that are slowing down the institutional completion of the eurozone. Since the influences described above will remain in place for the next several years, future integration is also likely to be established very gradually, resulting in a long, drawn-out process. One positive aspect is that European politicians have consistently shown in recent years that, when the pressure is on, they take the measures necessary to keep the eurozone together. We expect that they will continue to do this in the coming years. Given the current incomplete design of the eurozone, it cannot be ruled out that a future crisis will be necessary in order for these follow-up measures to be implemented.


Compared with the decades preceding the debt crisis, European political integration has accelerated since the crisis. Although numerous institutional measures have been taken, particularly in terms of the regulation of public finances, there are still reasons to doubt both the design of and compliance with the SGP and the Fiscal Compact. While the first steps towards a banking union have now been taken, the institutional design has clearly not yet been completed. A banking union can only be effective if regulation, resolution and emergency funds are established at the same institutional level, where it should be noted that, if the pace of harmonisation of these steps differs, they can actually undermine financial stability. The political unwillingness to accept the inevitable losses of the current banking problems in various peripheral member states is a barrier to the creation of a fully-fledged banking union. In theory, the Macroeconomic Imbalance Procedure provides the appropriate structure to prevent and correct macroeconomic imbalances, to the extent possible, but the effectiveness of the current design has not yet been demonstrated in practice at all. As with the fiscal regulation under the SGP and the Fiscal Compact, the EC can make recommendations on economic policy at an early stage, but the use of an enforceable mechanism is possible only later in the process and is not immune to political influence.

Despite the steps already taken, financial and economic integration are therefore still at the development stage, while the crisis has made it painfully clear that policy in these areas can lead to negative external effects for the currency union as a whole. In addition, it has also become clear that fiscal, financial and macroeconomic trends can reinforce each other, as a result of which the effectiveness of policy integration remains limited as long as measures are not taken in all areas. It is not possible to determine exactly what level of political integration is required in order to weather the current crisis. Since investor confidence in the public finances and banks of peripheral member states has yet to recover, we can conclude that the capacity of the current rescue fund is insufficient. From a political perspective, there will be no credible crisis mechanism as long as the institutional framework of the eurozone is not strong enough to substantially reduce the likelihood of a future crisis. From this perspective, the transfer of control and the design of a crisis mechanism will therefore need to coincide with each other. We expect that both aspects will gradually be further developed, whereby the reactive attitude of European politicians requires a certain degree of market pressure and, possibly, will even require a future crisis in order to continue developing new policies. We are therefore not likely to see an institutional framework for a stable eurozone in the immediate future. A realistic outlook shows a political process with many hurdles that will take many years to be resolved.


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This Special is a publication by the Economic Research Department (ERD) of Rabobank Neder-land. The view presented in this publication has been based on data from sources we consider to be reliable. Among others, these include Reuters EcoWin, European Commission, International Monetary Fund.

This data has been carefully incorporated into our analyses. Rabobank Nederland accepts, however, no liability whatsoever should the data or prognoses presented in this publication contain any errors. The information concerned is of a general nature and is subject to change.

Used abbreviations sources: EC: European Commission, ECB: European Central Bank, IMF: International Monetary Fund.

Used abbreviations countries: AT: Austria, BE: Belgium, DE: Germany, ES: Spain, FI: Finland, FR: France, GR: Greece, IE: Ireland, IT: Italy, NL: Netherlands, PT: Portugal.

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Author: Michiel Verduijn, Economic Research Department, Rabobank Nederland

Editors: Allard BruinshoofdTim LegierseShahin Kamalodin

Production coordinator: Christel Frentz

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