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The eurozone – completing the monetary house



“… the task of completing Europe’s monetary house continued to resemble the home renovation project that never ends.” (Eichengreen, 2015)

  • While progress towards strengthening the currency union has been made in recent years, there are still several important steps that need to be taken to strengthen the currency union
  • Major adjustments are needed with respect to policy instruments: we put forward some recommendations in the field of economic and fiscal policy
  • Furthermore, the completion of the banking union and the conceptual development of the capital markets union should be given priority


Since the eruption of the crisis, several important reforms have been implemented in the eurozone, such as the (partial) introduction of a banking union. We take stock and look at what institutions are still needed in order to strengthen the European Monetary Union (EMU). The eurozone crisis was mainly due to (i) a lack of mechanisms and institutions that could prevent large macroeconomic and budgetary imbalances and (ii) a lack of institutions that could absorb shocks (see Wijffelaars and Loman, 2015a). We therefore look at the measures that have already been taken to address these two major problems and the measures that are still necessary and/or desirable.

Firstly, we focus on direct policy instruments in the form of economic, budgetary and monetary policy and conclude that major adjustments are still needed in the first two areas. We then deal with two fundamental reforms. The banking union needs to be completed in order to reduce the exposure of banks to weak government finances. A European deposit guarantee scheme also needs to be introduced over time, provided that certain conditions are being met. Capital markets union could strengthen the currency union, but for this to be achieved the concept of capital markets union has to be further developed.

Policy instruments

2.1 Economic policy

The Macroeconomic Imbalance Procedure
The Macroeconomic Imbalance Procedure (or MIP) was introduced in 2011. The procedure is designed to identify, prevent and correct macroeconomic imbalances that could threaten the functioning of the European Union. With a number of steps, the MIP identifies trends that could lead to booms and busts. After this, the MIP should help to formulate the correct policy responses to limit and manage these risks (for regulation, see Verduijn, 2013a and Wijffelaars, 2014a).

The idea behind the MIP is a good one. Especially in Ireland and Spain, macroeconomic imbalances were the primary cause of the crisis (Wijffelaars and Loman, 2015d, 2015g). In its current form however, the MIP fails to prevent excessive imbalances and the associated negative spill-over effects or to deal with excessive imbalances adequately once they have been identified (Wijffelaars and Stegeman, 2014). For this, the sanctions procedure of the MIP needs to be strengthened.

The sanctions procedure of the MIP needs to be brought more in line with that of the Stability and Growth Pact (Wijffelaars and Stegeman, 2014). Firstly, the European Commission must be able to impose sanctions to compel countries to take measures to prevent the accumulation of excessive imbalances and not only to make countries correct them after they have occurred. Secondly, the EC needs to act more quickly and/or more automatically in punishing member states when growing excessive imbalances are not being corrected. Briefly, the current situation is that the EC is free to refrain from this if the member states promise to do better.

Macroprudential policy
One important instrument in the prevention and correction of macroeconomic imbalances is macroprudential policy, meaning policy designed to protect the stability of the financial system as a whole. For example, this may involve the implementation of measures to combat excessive provision of credit for real estate projects, which played an important role in Ireland and Spain before the crisis. Macroprudential supervision hardly existed before the crisis, but it has been strengthened in recent years. In the context of Basel III, specifically to address macroprudential risks banks now have to maintain counter-cyclical buffers and system buffers (see Giesbergen, Loman and Weernink, 2015).

Macroprudential policy is of course not the only solution for the prevention or correction of macroeconomic imbalances. Macroeconomic imbalances indeed are not always the result of developments in the financial system. In addition, macroprudential instruments primarily focus on ensuring the stability of the financial system and not per definition on addressing the macroeconomic imbalances themselves.

Macroprudential supervision can contribute to the avoidance of new crises, but it is still a relatively new phenomenon. Further attention to this area of policy would thus seem to be justified.

The first and most important question concerns the instruments available. Although the buffers mentioned above can make the financial system more resilient, it is debatable as to whether they will be enough to prevent new bubbles forming. More radical macroprudential measures may be needed when new bubbles start to arise, such as limiting the amount that consumers can borrow as a percentage of their income (see for instance Turner, 2015). Such measures are however often politically difficult.

There is also the issue of coordination. The responsibility for macroprudential policy in the eurozone lies mainly at national level, although there is harmonisation via the European Systemic Risk Board and the ECB is authorised to top up system buffers and counter-cyclical buffers. One may question whether this represents adequate harmonisation at European level.

National competitiveness boards
National competitiveness boards, which are still to be formed, could also contribute to preventing the accumulation of or combating macroeconomic imbalances. For example, before the crisis unit labour costs rose sharply in many of the crisis-hit countries in comparison to the core countries, and most notably in comparison to Germany. These boards have to be in place by the end of 2017. A competitiveness board is a board of experts that among other things has the duty of advising its own government with respect to policy that can enhance the country’s international competitiveness (European Commission, 2015a)[1]. As part of this process, the boards have to consider the country-specific recommendations that the European Commission (EC) makes to member states each year in the context of the European Semester[2]. Policy designed to improve competitiveness can lead to a reduction of imbalances in the current account of the balance of payments (Wijffelaars and Loman, 2015b).

According to the current proposals, the boards can only advise their own national government, and a government may ignore the advice given. To increase the effectiveness of the boards, their advice should be binding or only ignored if the government takes measures with a similar impact.

2.2 Budgetary policy

Especially in Greece, but also in Italy and Portugal, an important cause of the crisis lay in the fiscal policy conducted before the crisis (Wijffelaars and Loman, 2015c, 2015e, 2015f). Since the introduction of the currency union, budgetary rules have been in place. For instance, the government deficit and government debt may not exceed 3% and 60% of GDP respectively. These rules are enshrined in the Stability and Growth Pact (SGP). Problems arose because rules were often not complied with, because they were not sufficiently enforceable. In addition, the rules were wrongly formulated, with too much focus on the actual budget deficit instead of government debt and the soundness of the government finances in the medium to longer term.

Changes to the budgetary rules
The fiscal rules were amended on several occasions between 2011 and 2013 in order to improve their formulation and observance (see Verduijn, 2013a)[3]. In early 2015, the EC also established how more account could be taken within the existing regulation of (i) the state of the economy (this only applies in the preventive arm[4]) and (ii) the commitment to reform by member states. This was because it became apparent in the crisis years that severe austerity during an economic downturn is not necessarily a solution to a (debt) crisis, while the right reforms and investments could over time lead to more sustainable government finances as a result of higher economic growth (Kalf and Wijffelaars, 2016; Wijffelaars and Loman, 2015; Stegeman et al., 2014).

We take the view that the fiscal rules have improved in recent years. The eurozone is now in a better state to avoid the accumulation of weak government finances than it was before the recent crisis. There is however still room for improvement in several respects:

(i) Integrate the Stability and Growth Pact and the Macroeconomic Imbalance Procedure

The European Commission would actually have to be able to compel a member state to institute structural reforms to enhance growth in exchange for more budgetary flexibility. Since the EC does not currently have the power to enforce reforms in member states in the context of the SGP, there is the risk that government finances will deteriorate further if the EC makes use of the flexibility within the rules emphasised in 2015.

To prevent such a deterioration, the SGP and the Macroeconomic Imbalance Procedure should be combined into a single pact or procedure (Wijffelaars and Stegeman, 2014). In order for this new single pact to be optimal, enforcement of the MIP has to become more powerful, though.

(ii) Monitoring of compliance with the fiscal rules has to be more strict

Member states have still been able to escape sanctions on numerous occasions in recent years. This reduces the credibility of the rules, with the risk that other member states will also no longer comply with them[5].

(iii) Design an income rule that is the same as the existing expenditure rule

Just as a maximum is set for the discretionary growth of government spending, a maximum also has to be set for the discretionary contraction of government income in order to ensure the soundness of government finances in the medium to longer term. This will reduce the loopholes in the current regulation that makes it possible for countries to escape sanctions even if they actually break the rules (Giesbergen and Wijffelaars, 2016).

Absorbing shocks
The above recommendations relate to preventing weakness in government finances. In the field of budgetary policy, a strong currency union however also requires mechanisms that will help to absorb shocks. The support programmes from collective EU/euro member states and the IMF have given member states time to absorb shocks. But, since this support is in the form of loans and only available after political interference (or negotiation), the shock-absorbing effect is limited[6]. There is hardly any automatic shock-absorption mechanism available in the eurozone, apart from the balance sheet of the ECB (see 3.1). The budget of the European Union is only 1% of the EU’s GDP.

The absence of an automatic shock-absorption mechanism in the budgetary field means first of all that there is an important coordination issue when a shock occurs. The adjustment process for crisis-hit countries was for instance made more difficult during the eurozone crisis because countries not affected by the crisis also introduced austerity measures. A more accommodative fiscal policy in countries not affected by the crisis with sounder government finances could possibly have eased the pain in the crisis countries. More coordination between member states with respect to fiscal policy is therefore needed.

Even when there is better coordination, the absorption of shocks through fiscal policy will be relatively limited. Over the somewhat longer term, the introduction of limited transfer mechanisms could strengthen the currency union, but only if there is also a partially common control and the issue of moral hazard is addressed.

(iv) Make the advice of the European Fiscal Board to the European Commission binding

The European Commission made a start on this with the formation of an independent ‘fiscal board’ that has to be installed by 2017. The fiscal board will have to inform and advise the EC as to how accommodative or tight fiscal policy should be in the eurozone as a whole, within the regulatory frameworks (European Commission, 2015b. The European Commission can then take account of this desired overall fiscal stance when it gives country-specific recommendations with respect to fiscal policy to the member states. The installation of a fiscal board can help the eurozone to absorb shocks more effectively if it ensures that member states with sound government finances ease, and are allowed to ease, at times when member states with weak finances have to tighten their belts. Under the current plans, the board will however only have an advisory role, meaning that its effectiveness may be limited.

(v) Give the European Commission more tools so that it can coordinate fiscal policy across the eurozone more effectively

In order to ensure that fiscal policy in the various countries is harmonised and the fiscal policy in the eurozone as a whole is accommodative or restrictive enough, it would be good over time to centralise responsibility for this (to some extent) in Brussels (Wijffelaars, 2014b). Another solution would be to give the EC the possibility of forcing member states to spend on penalty of a fine if this is in the interests of the union as a whole. From a political point of view this is not a realistic idea at this time, but times can change.

(vi) Investigate how shocks can be absorbed through fiscal policy over the longer term

Shocks in the eurozone could be absorbed far better if there was a higher level of fiscal transfers between countries. This is still difficult, certainly while countries can largely pursue their own economic policies. A European unemployment fund could for example absorb shocks, but this can only work if the contributing member states feel assured that an effective labour market policy is being pursued in the other member states. A eurozone in which national governments retain authority over many policy areas is difficult to reconcile with the level of fiscal transfers that exists for instance in the USA. To avoid moral hazard, limited transfer mechanisms could also only be introduced if the fiscal rules and the Macroeconomic Imbalance Procedure turn out to work well in practice. In this respect, there is still a long way to go.

2.3 Monetary policy

The ECB played a crucial role in absorbing shocks, especially during the acute phase of the European debt crisis. The ECB replaced private capital flows, mostly in the form of the long-term refinancing operations (LTRO) programme, whereby the collapse of banking systems in the crisis countries and thus of the EMU itself was avoided (Kamalodin and Bruinshoofd, 2013). With its commitment to do whatever it takes to maintain the euro and its subsequent launch of the Outright Monetary Transactions (OMT) programme, the ECB ensured that the crisis countries regained access to (affordable) market funding. With Draghi’s commitment and the launch of the OMT, the ECB became de facto not only the lender of last resort for banks, but for national governments as well.

The ECB has nearly exhausted its arsenal of monetary policy instruments. The ECB anyway cannot absorb all shocks, and other mechanisms in the eurozone are therefore needed, in particular better coordination of budgetary policy. For this reason it would be a good idea to have a plan B ready for when the eurozone is hit again by new serious shocks.


3.1 Banking union

The banking union is probably the most important reform introduced in the eurozone, but the union is not yet complete. The crisis showed that nationally organised supervision often is inadequate and therefore cannot prevent imbalances. During the crisis, the interaction between weak banks and governments with weak budgetary positions exacerbated the problems in the crisis countries. The banking union should remove this interaction. Lastly, the banking union could also contribute to absorbing shocks. A banking union could facilitate cross-border mergers and acquisitions between banks and the resulting more integrated banking system could help to absorb asymmetric shocks. On the other hand, mergers could increase the size of banks and therefore increase ‘too big to fail’ problems.

The first two pillars of the banking union are now in place. The third pillar, a European Deposit Guarantee System (EDIS), is still missing.

Thanks to the first pillar, the Single Supervisory Mechanism, or SSM, the biggest banks in the eurozone are now directly supervised by the ECB. Supervision has thus been distanced from national authorities and supervisors have better insight into cross-border banking activities. The second pillar, the Single Resolution Mechanism, or SRM, came into full effect on 1 January 2016. This arose from the Bank Recovery and Resolution Directive, or BRRD, which took effect on 1 January 2015. By making resolution for banks possible and creating a (by 2024 fully) common resolution fund the costs for governments ensuing from problems at the banks will be greatly reduced. The fund with a size of 1% of the eurozone’s covered bank deposits (that is about EUR 55bn) will be build-up gradually by bank contributions and has the be fully funded by 2024.

(i) A European deposit guarantee system is essential in the slightly longer term

All that has happened so far with respect to deposit guarantee systems is some harmonisation of existing systems. National governments will still be forced, however, to contribute when the deposit guarantee funds accumulated with contributions from the banks are exhausted (in principle this contribution is temporary, since when deficits arise the banks will have to make ex-post contributions). National governments are thus still exposed to problems and the banks also continue to be especially vulnerable if the national government gets into difficulties. At the end of 2015, the Commission presented a proposal for an EDIS (European Deposit Insurance Scheme) that provides for a phased introduction of a completely common system that would have to be fully effective by 2024. So far, the proposal has received extensive criticism from the North European countries. It is understandable that requirements have to be set with respect to risk sharing in an EDIS (see for instance our recommendation below) and the other pillars of the Banking Union should work well before greater risk sharing can be introduced, but in the longer term a common deposit guarantee system would seem to be essential for a strong eurozone.

(ii) Reduce the amount of sovereign debt issued by their own government on bank balance sheets

Another important fact is that banks often hold large amounts of government bonds issued by their own governments on their balance sheets (Verduijn, 2013b). Concerns regarding government finances in a country can thus cause problems for individual banks even after the introduction of an EDIS. This problem could be addressed by the introduction of eurobonds (Boonstra, 2012) or by setting a maximum for the amount of government debt issued by a bank’s own government it can hold on its balance sheet.

3.2 Capital markets union

At the end of September 2015, the European Commission published an action plan for a European capital markets union that should come into effect in 2019. Capital markets union is a general term that encompasses several different initiatives, such as a prospectus directive and the drafting of a securitisation directive, but in principle it concerns two dimensions: increasing the role of capital markets in the EU and the integration of capital markets within the EU. A more integrated capital market could contribute to shock absorption, since these shocks are then absorbed to a greater extent by foreign investors and/or credit providers, meaning that the impact on the domestic economy is lessened. Moreover, a shift of activities from the banking sector to the capital market could mean that problems in the banking sector would have less effect on the economy and thus strengthen the banking union.

The way in which the capital markets union can contribute to strengthening the currency union needs to be further worked out by the European Commission. However first of all it is highly questionable to what extent and over what time period the proposals, which still need to be worked out in numerous respects, will actually lead to more integrated capital markets. For example, the removal of significant obstacles in the form of differences between bankruptcy and tax legislation will most likely raise objections from the member states.

In addition, it is not clear how supervision will be organised at this time. While the so-called ‘Five Presidents’ Report’ (European Commission, 2015c) of June 2015 states that the capital markets union ultimately must lead to a European supervisor for the capital market, the capital markets union plan presented in September 2015 says that no institutional reforms are necessary. The existing institutional structure could thus actually work against integration (Veron, 2015). A further complication is that the capital markets union is intended for all EU member states, so not for the eurozone member states in particular. The EC is right to say that a capital markets union has to strengthen financial stability, but there is also a risk that a more integrated capital market could lead to larger bubbles or that capital market integration would fragment in times of crisis.


[1] The introduction of national competitiveness councils is one element of the so-called ‘Five Presidents’ Report’ (European Commission, 2015c). These councils already exist in some countries, or similar tasks are already carried out as part of a different assignment by other institutions.

[2] The European Semester is an annual cycle in which the European Commission assesses whether the budgetary and economic policy plans of member states are in line with the Stability and Growth Pact and the Macroeconomic Imbalance Procedure. If this is not the case, countries have to take measures.

[3] See the infographic for a brief overview of the total current regulation under the Stability and Growth Pact.

[4] Under the preventive arm of the Stability and Growth Pact the European Commission monitors the structural budget deficit and growth in government expenditure. The structural budget balance is the actual government budget balance adjusted for the business cycle and one-off revenues and expenditures. In fact it is the expected average government budget balance over the longer term based on current fiscal policy. During an economic upturn the structural budget balance is typically worse than the actual government budget balance and vice versa.

[5] We are not concerned here with the question of whether the current maximum values for variables such as the budget deficit or government debt are correct. We are only concerned with the point that compliance with the rules is needed for the rules to have the desired effect, i.e. preventing the accumulation of imbalances.

[6] The extension of terms and the reduction of interest rates on loans provided to Greece in particular (which measured in net present value terms means that the loans have partially been converted into gifts) have stretched this boundary.


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