by Professor Philip R Lane, Whately Professor of Political Economy
The ongoing Greek crisis (and the more general crisis that has dominated the European economic debate) has underlined the importance of institutional reform of the euro zone to avoid similar tragedies in the future. The recent Five Presidents’ Report Completing Europe’s Economic and Monetary Union provides a possible roadmap.
One important principle in this report is to address the governance of the euro zone as a collective entity, rather than just laying out a common rule book that imposes conditions on individual member countries. The report explicitly recognises that cross-border imbalances requires adjustments by surplus countries as well as deficit countries and that risk surveillance should take an integrated view of imbalances rather than just focusing on deficit countries.
In terms of the reform agenda, the report highlights that a deeper banking union is critically important. Further progress on developing a common resolution regime and a common system of euro-zone-wide deposit insurance is essential.
In addition, an integrated financial system also requires that barriers to the development of cross-border bond and equities markets and direct investment channels should be lifted (without sacrificing financial stability). An enhanced role for equity over debt financing would improve risk sharing and reduce the scope for leverage cycles.
In terms of risk mitigation, the report calls for an enhanced role for macroprudential institutions. In Ireland, the new limits on loan-to-value and debt-to-income ratios in mortgage lending provide a vivid illustration of the scope for macroprudential regulation. However, a wider set of interventions could be deployed, both in relation to banks and non-bank financial intermediation.
The report also supports the principle banks should not have excessive holdings of domestic sovereign bonds (even if this is most easily accomplished in the context of a global shift in the regulatory treatment of sovereign bonds). A multi-country diversification requirement in the sovereign bond portfolios held by banks would weaken the diabolic risk loop between sovereigns and banks.
As advocated by the euro-nomics group (of which I am a member), a further enhancement would be to divide a pooled bundle of sovereign bonds into senior and junior tranches, with the senior tranche constituting a euro-zone-wide safe asset (European Safe Bonds or ESBies). ESBies could become the main instrument for eurosystem liquidity operations and quantitative easing.
A recurrent theme in the report is that a greater degree of economic union is required if monetary/financial union is to be sustainable. The report advocates a more vigorous policy orientation towards pro-growth reforms, with a leading role to be taken by a system of national competitiveness authorities. (In Ireland, this would build on the significant work of the National Competitiveness Council.)
While the exact pro-growth policy configuration would naturally vary by country, a common analysis and shared policy evaluation framework could be helpful in developing a euro-zone-wide understanding of the underlying growth potential for each economy.
In the longer term, a greater degree of economic union and shared trust in the quality of national policymaking could allow the development of a limited fiscal union.
An important theme in the literature on optimal currency areas is the value of a federal fiscal system in absorbing asymmetric shocks. However, the asymmetric cyclical outcomes during the boom/bust cycle in Europe may have more to do with asymmetric policy errors and the lack of a banking union. With the construction of a deep financial union and implementation of counter-cyclical macroprudential and fiscal policies, the scope for large-scale asymmetric cyclical outcomes may be more limited. Still, a limited fiscal union that augments national counter-cyclical stabilisation policies could be a valuable additional instrument in relation to exceptionally large macroeconomic shocks.
Of course, as the report makes clear, a greater degree of fiscal union will require significant democratic oversight, including enhanced powers for the European Parliament and national parliaments.
Finally, the process of setting national fiscal policies should be revised to ensure the aggregate fiscal policy at the euro-zone-wide level is appropriate in terms of macroeconomic stabilisation. To this end, the appointment of an independent European Fiscal Board is desirable in determining the appropriate stance for the fiscal position. A European Fiscal Board would also play a complementary role to the new system of national fiscal councils in monitoring national compliance with fiscal rules.
In summary, the report provides an important reference point in developing a coherent vision for the governance of the euro area. An open question is whether substantial governance reform can gain political traction while the aftermath of the crisis still dominates policymaking in many countries.
For this reason, the aspirational vision in the report needs to be married with a resolute determination across the euro zone to ensure legacy debt does not unnecessarily constrain the evolution of the euro zone.