Towards a deep and genuine Economic and Monetary Union

DIRECTORATE GENERAL FOR INTERNAL POLICIES POLICY DEPARTMENT A: ECONOMIC AND SCIENTIFIC POLICY Towards a deep and genuine Economic and Monetary Union NOTE Abstract The very recent Blueprint for a deep and genuine economic and monetary union published by the European Commission in November 2012 is a valuable exercise in order to give a clear road map for the future development. Nevertheless, its contents could be improved; its application could be shortened in time, avoiding waiting another ten years or more to achieve such an important and critical goal for the Europe Union. IP/A/ECON/NT/2012-06 December 2012 Part of the compilation PE 492.455 for the Monetary Dialogue EN

This document was requested by the European Parliament's Committee on Economic and Monetary Affairs. AUTHORS Guillermo DE LA DEHESA, Chairman, Centre for Economic Policy Research, CEPR RESPONSIBLE ADMINISTRATOR Rudolf MAIER Policy Department A: Economic and Scientific Policy European Parliament B-1047 Brussels E-mail: poldep-economy-science@europarl.europa.eu LINGUISTIC VERSIONS Original: EN ABOUT THE EDITOR To contact the Policy Department or to subscribe to its monthly newsletter please write to: poldep-economy-science@europarl.europa.eu Manuscript completed in December 2012. Brussels, European Union, 2012. This document is available on the internet at: http://www.europarl.europa.eu/studies DISCLAIMER The opinions expressed in this document are the sole responsibility of the authors and do not necessarily represent the official position of the European Parliament. Reproduction and translation for non-commercial purposes are authorised, provided the source is acknowledged and the publisher is given prior notice and sent a copy.

Towards a deep and genuine Economic and Monetary Union _ CONTENTS EXECUTIVE SUMMARY 4 1. INTRODUCTION 5 2. COMMUNICATION FROM THE COMMISSION 6 3. COMMENTS TO THE COMMISSION BLUEPRINT 8 3.1. Short-term measures 8 3.2. Medium term measures 9 3.3. Long-term measures 10 REFERENCES 12 PE 492.455 3

Policy Department A: Economic and Scientific Policy EXECUTIVE SUMMARY The recent Communication by the European Commission called A blueprint for a deep and genuine economic and monetary union published on 28 November 2012 is a very interesting start as part of an urgently needed European debate. It is a very positive report in the sense that it shows the urgent need to repair the large number of design failures, which have come into the open at the first serious crisis in the euro area and which were not acknowledged by the founders at the beginning of EMU. The proposed roadmap is a well thought exercise on how to achieve a true monetary union. However, it is too long, too cumbersome and difficult to implement and subject to too many requirements. It could be shortened without changing the spirit and values of the road map. In the short-term, it seems that the Single Supervision Mechanism (SSM) is not going to be so single and it is not clear that the ECB will be the sole supervisor. It seems that the single resolution mechanism (SRM) is not going to be used and it seems that the Deposit Guaranty Scheme (DGS) is not going to be single but national. In the medium term, the Redemption Fund is an old and excellent idea but issuing only bills and not bonds is a very bad idea, even more since, apparently, both financial instruments need a Treaty change. In the long-term, all the proposed steps need a Treaty change, so it would be better to group together the medium term and the long-term exercise in order to try all the necessary Treaty changes at once, instead of trying to modify the Treaty several times in a period of five years which does not make sense. 4 PE 492.455

Towards a deep and genuine Economic and Monetary Union 1. INTRODUCTION Originally, the Economic and Monetary Union (EMU) was designed to be achieved in three stages: First, the stage for convergence and liberalisation of capital movements, starting on 1 July 1990 and ending on November 1993, with the entering into force of the Maastricht Treaty. Second, the EMU stage from January 1994 to December 1998, where all EMU secondary legislation was implemented for those Member States which had achieved the requisites for joining EMU. Third, the Euro stage, from January 1999, that became the effective start of the Economic and Monetary Union and the introduction of the Euro, when ECU ceased to be a basket of currencies and became a currency in its own right renamed as the Euro. Since 1988 and during the first two stages until 1994, a large body of relevant economic research was produced by the Centre for Economic Policy Research (CEPR) outlining the best design of a monetary union for the European Union and pointing to the necessary conditions to be fulfilled in order to become a success as well as warning about possible design failures. An overview of the relevant literature can be found in de la Dehesa (2012). It is also important to mention the large body of economic research done in the field of Optimum Currency Areas (OCA), starting with the seminal work of Robert A. Mundell (1961). 1 Main short-comings and the resulting problems for the European Union engaging in a monetary union where mentioned in these economic research papers and books (de la Dehesa, 2012), inter alia i) lack of sufficient capital and labour mobility and lack of sufficient price and wage flexibility; ii) therefore a single monetary policy is not appropriate for all Member States; iii) asymmetric shocks might affect only single Member States; in order to reduce the effects some kind of single fiscal policy is needed (e.g. large common budget or treasury or at least large European Fund); iv) incentives for large fiscal deficits and/ or debt accumulation and free riding on other members (no exchange rate risk) makes also a fiscal authority necessary. Unfortunately, at the moment of deciding to build a monetary union, rational expectations theories and models containing perfect information and foresight and complete markets were in fashion and prominent. The reliance on these models, combined with a strong political will to go ahead, lead to a design of a European monetary union without taking into consideration the large empirical evidence about frictions, imbalances within monetary unions derived from large empirical evidence from previous and successful monetary unions, such as Canada and the US. Therefore, it was thought, that there was no need to monitor macroeconomic imbalances and disequilibria in the labour, product and financial markets or dealing with asymmetric shocks because the only source of instability were governments and their fiscal profligacy (Constancio, 2012) The present crisis has shown clearly all the weaknesses of such a minimalistic and eventually wrong design of a monetary union (de la Dehesa, 2012). Moreover, this design has unchained an extremely costly crisis for some Member States of the periphery and for the euro area as a whole, which has been faced by a too little to late crisis management response decisions by European leaders, bringing the euro area into large imbalances and a recession. The only institution which has been always ready to face and solve the monetary union problems has been the ECB, becoming the most trusted European monetary union institution by investors and analysts. 1 See for example: Ronald McKinnon (1963), Peter Kenen (1967), Paul Krugman (1993), Joerg Decressin and Antonio Fatas (1995), Ronald McKinnon (2001) and Charles Wyplosz (2005). PE 492.455 5

Policy Department A: Economic and Scientific Policy 2. COMMUNICATION FROM THE COMMISSION Fortunately, after suffering large asymmetric shocks and market self-fulfilling runs, which have ended producing very large imbalances in the euro area, the June 2012 European Council invited the President of the European Council, together with the Presidents of the Eurogroup, the ECB and the European Commission, to develop a road map for achieving a Genuine Economic and Monetary Union. The interim Report was published on 12 October 2012. The final report was published in December 2012. In addition, the Commission published on 28 November 2012 a Communication called A blueprint for a deep and genuine economic and monetary union - Launching an European Debate. In principle the Commission communication should be most welcomed, because it is sending a clear signal that, finally, institutional design failures of the monetary union, mentioned above, are going to be addressed in order to advance towards a deeper banking, fiscal and political union. Crises tend eventually to bring solutions as a reaction, even if some are being taken too late. Since the onset of the crisis, already many new institutions and new instruments have been created in order to remedy some of the above mentioned design failures. For instance: the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) as crisis resolution mechanism; the introduction of a Macroeconomic Imbalance Procedure (MIP) with an alert mechanism, a macroeconomic scoreboard, in-depth reviews and a Excessive Imbalance Procedure (EIP) in order to strengthen macroeconomic policy surveillance; the European System of Financial Supervision (ESFS) comprising of the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA), the European Securities and Market Authority (ESMA) and the European Systemic Risk Board (ESRB) improves financial regulation and supervision; CRDIV strengthens the banking system. The ECB has also introduced mechanisms to deal with the sovereign debt crisis and its impacts on banks, such as the Securities Markets Programme (SMP), the Longer-Terms Refinancing Operations (LTROs) and the Outright Monetary Transactions (OMTs). The Commission recognises this by stating, that 'EMU has been overhauled, but the work is not yet complete'. Today, there is still a large fragmentation and disintegration of financial markets and a redenomination risk, while monetary policy transmission mechanism does not work and it is pro-cyclical. Therefore, it is necessary to achieve a genuine banking union, fiscal union and, eventually, a political union, which legal basis is provided by article 136 of the Lisbon Treaty. According to the Commission, the main basic principles to follow in the way forward are i) combining substantial ambition with appropriate sequencing ; ii) combining more responsibility and economic discipline with more solidarity and financial support ; iii) deeper integration of financial regulation, fiscal and economic policy and corresponding instruments must be accompanied by a commensurate political integration, ensuring democratic legitimacy and accountability. The Commission proposes three steps going forward: 1. In the short-term (6 to 18 months), firstly the Six-Pack legislation with the European Semester should be fully implemented and the Two-Pack, which is still under negotiation, should be agreed on. In addition, it should be focused on measures, which can be implemented by secondary EU law. The proposed measures contain inter alia the following: The Single Supervisory Mechanism should be complemented by a Single Resolution Mechanism (SRM) for banks; an agreement on the Multi-annual Financial Framework (MFF); ex-ante coordination of major reforms and establishment of a 6 PE 492.455

Towards a deep and genuine Economic and Monetary Union 'Convergence and Competitiveness Instrument'. (contractual arrangements with financial support); and an external representation of the euro area. 2. In the medium term (18 months to 5 years) the proposals contain: an enhanced economic and budgetary policy coordination and integration; steps forward towards a proper fiscal capacity; a Redemption Fund, and Eurobills. Some of the proposed measures would necessitate Treaty changes. 3. In the long-term (beyond 5 years) a progressive pooling of sovereignty and solidarity to the European level, such as: an autonomous euro area budget large enough to absorb Member States asymmetric shocks; a common issuance of public debt (Eurobonds), which would enhance the functioning of the markets and the conduct of monetary policy, which all need Treaty changes. PE 492.455 7

Policy Department A: Economic and Scientific Policy 3. COMMENTS TO THE COMMISSION BLUEPRINT 3.1. Short-term measures Proposals They are mostly related to more budgetary and fiscal discipline to prepare for a fully fledge integrated budgetary framework and more structural reforms to avoid cross-member State externalities. It means more budgetary and economic surveillance by bringing the newly implemented economic governance tools to its full potential, e.g. the European Semester the reinforced Stability and Growth Pact (SGP) and the Macroeconomic Imbalances Procedure (MIP) and by a rabid adoption of the Two-Pack. By contrast, when mentioning the much needed Banking Union, the wording used is only progress versus or proposals for or even evolving over time towards a banking union, by: first, more regulation and supervision and second, a single rule book and a Single Supervisory Mechanism (SSM), which must ensure a full sharing of information, between national supervisors, about banks (that it means that there will not be a single supervisor?). This seems not to be the case, because later it mentions that the SSM is composed of the ECB and the national supervisors. Moreover, only when the SSM is in place, it will pave the way towards the use of the ESM as a public backstop, in order where appropriate, and once an agreement has been reached on this instrument, to offer mutualised support to directly recapitalise banks. Even more, there will need to be eventually a Single Resolution Mechanism (SRM). The European Council on 19 October 2012 stated that it notes the Commission intention to propose a SRM, once proposals for a Recovery and Resolution Directive and for a Deposit Guarantee Scheme (DGS) Directive have been adopted. Until then, that responsibility remains national. The SRM will be articulated around a separate European Resolution Authority (ERA), which will govern the resolution of banks and coordinate, in particular, the application of resolution tools. Even more, any potential intervention by the SRM will have to be based on the following principles : First, the need for resolution should be reduced to a minimum, given to strict common prudential rules and improved coordination of supervision. Second, where intervention of the SRM would be necessary, shareholders and creditors should bear the costs of the resolution, before any external funding is granted, and any additional resources should be provided by the banking sector, instead of by the tax payer money. Therefore, all these principles mean that the SRM will be never used. Finally, the Multi-annual Financial Framework (MFF) a decisive driver for investment, growth and employment in the euro area, will be dependent on the national reform programs and stability and convergence programs and it will be implemented via partnership contracts/agreements between Member States and the Commission and the application of rigorous macroeconomic conditionality which can be applied in two ways: reprogramming or suspension of the MFF in order to give support and incentives for structural reforms. Assessment In sum, there are still serious doubts about achieving a true SSM, the SRM may not be used, the MFF is delivered under strict conditionality and the Deposit Guarantee Scheme (DGS), which is not anymore single, as the SSM and the SRM, is not even mentioned. This latter absence is striking because the US Federal Deposit Insurance Corporation (FDIC), created after the Great Depression, is the Federal Agency that does all US bank 8 PE 492.455

Towards a deep and genuine Economic and Monetary Union resolutions in a very efficiently way. Only in the last financial crisis several hundred banks have been resolved by the FDIC. My understanding, after reading the chapter on short-term measures, which, in principle do not need Treaty changes, is the following: first, the stick will continue to be applied rigorously and, only after, some subliminal promises of a carrot are expected. 3.2. Medium term measures Proposals The medium term proposals include measures which will need Treaty changes. 'More mutualisation of financial risk' requires in general a deepened coordination of budgetary policy by collective control over national budgetary policy in defined situations. First, the measures already proposed in the Two-pack (e.g. opinion on draft budgetary plan, request a new draft budgetary plan) would be completed by further measures, inter alia by a EU level competence for harmonisation of national budget laws (along the lines of the TSCG) and in case of deviations from European obligations, i) a requirement of revision of national budgets; and ii) requirement of revision of individual budget execution decisions. Additionally, an enhanced coordination in the fields of tax policy as well as of employment and social policies is envisaged. Second, the euro area should be endowed with an autonomous (revenues relying on own resources and possibility to borrow) and effective 'fiscal capacity', supporting structural reforms in large distressed euro area Member States. An initial development under secondary law seems possible, but the borrowing might necessitate Treaty changes. Third, a European Redemption Fund (ERF) with the following features was proposed: i) strict conditionality; ii) penalty payments in case of non-compliance; iii) strict monitoring by the EU Court of Justice; iv) stop of debt transfers to the fund during the roll-in phase in case of non compliance; v) pledging of Member States international reserves, as security and or tax revenues to cover the debt service. The ERF would take all the euro area Member States debt above 60% of GDP, bringing the level of their government debt back to the maximum allowed by the Maastricht Treaty. This step would reduce the overall funding costs of over indebted Member States and facilitate more investment in growth supporting measures. It would need a change in the Treaties and would require great legal precision. Once the new Treaty would establish the legal base to set it up, the ERF would be approved through a decision by the EU Council, adopted by unanimity of euro area Member States, with the consent of the European Parliament, and subject to the ratification by Member States according to their Constitutions. A European debt management agency, within the Commission, accountable to the European Parliament, would manage the ERF. Fourth, the issuance of Eurobills up to two years by the euro area would complement the ERF with the short-term side of the fiscal euro area financing needs avoiding the large present segmentation and fragmentation of the financial markets among the different euro area Member States and restore the transmission mechanism of the ECB monetary policy. Given that Eurobills need a joint a several guarantee of all Member States of the euro area a change in the Treaties is also necessary because it will also need to establish a euro area Treasury. Assessment First, the idea of the Redemption Fund is not new, Alexander Hamilton, US Treasury Secretary, proposed it, in 1790, after the Revolutionary War of Independence, to all the PE 492.455 9

Policy Department A: Economic and Scientific Policy bankrupt US States under the name of Sinking Fund, which would refinance all their debt in the medium to long-term. In exchange of taking their debt to the sinking fund, he prohibited the US states to have deficits, unless they were fully invested and for a maximum of 2 years and also to issue debt. Only the US Federal Government could issue debt and, therefore, he started the US Treasury bond and bill market. All these decisions were taken by the US 222 years ago, and today, in the euro area we are still trying to reinvent the wheel. Second if both the European Redemption Fund and Eurobills need Treaty changes, why do not add Eurobonds as well? They would allow the euro area to compete with the US Treasury Bonds and Bills market, the largest, deepest and most liquid financial sovereign market in the world. By replicating the US Treasury market, the euro area would get, as a whole, much cheaper financing, given that it would be able to compete favourably with the US to attract large amounts of Central Banks, Sovereign Wealth Funds and large private banks, funds and investors, which want to be positioned in the two largest currencies investing in very low risky assets, in a market which is as safe, liquid and deep as the US Treasury market. Another reason for the high demand and the success of the Euro Bill and Bond market is that most investors tend to be positioned in both world major currencies is that they can get a perfect hedge to currency risk, given that the inverse correlation between both currencies is very high, reaching 0.8 or 0.9, when one goes up the other goes down in quite the same proportion. 3.3. Long-term measures Proposals The Commission does not propose measures over the longer term of 5 to 10 years, but what it calls only a long-term vision. Its vision is that the EU should move towards a full banking union, a full fiscal union and a full economic union, which will, in turn, require a political union as the fourth element for achieving appropriate democratic legitimacy and accountability in decision making, so that a major Treaty change would be needed. In this vision, the elements of a full banking union consists of a single ( direct in the Commission version) supervisor, the ECB, applying a single rule book and the standards set by the European Banking Authority. Euro area macroeconomic policy tools; a common system of banking resolution; and effective and solid deposit guarantee scheme, in all Member States are supplementing this set up. A full fiscal and economic union would be the final stage of EMU and by achieving a central budget with its own fiscal capacity and means would need a de facto political union. It is then when the Commission envisages a common bond issuance. Only at this stage the central budget should ( probably according to the Commission) be given the capacity of borrowing and issuing bonds. Moreover, monetary policy would still remain the primary instrument to address common shocks and these schemes should operate in such a way to avoid permanent transfers across Member States. They should be designed in such a way that, over a too long a period of time any Member State should be a net loser or winner from the scheme. Assessment First, keeping the deposit insurance schemes national does not make any sense and hinders the completion of the Banking Union. 10 PE 492.455

Towards a deep and genuine Economic and Monetary Union Second, it is incomprehensible why euro bonds cannot be issued until the final stage and only probably when they should be issued in the medium term stage together with euro bills. Third, the Commission sees itself as the euro area de facto government, accumulating a large power over the Member States at least until a proper euro area government coming out of the last stage is designed by the party or parties achieving a majority after a pan euro direct elections to the candidates to the European Parliament. As a matter of fact, the Commission suggests that a genuine EMU would need over the medium term an EMU Treasury and that the Commission should also take that role and even saying that the Vice President of the Commission for Economic and Monetary Affairs should be responsible for running the euro area Treasury, together with the Budget Commissioner. Finally, as a Treaty change is so complex and long, it would be much better to do all Treaty changes, both the required over the medium term as well as the long-term at once, in the medium term. The Lisbon Treaty took 12 years to be in force and a full Fiscal and Monetary Union cannot wait so long. PE 492.455 11

Policy Department A: Economic and Scientific Policy REFERENCES CEPR, Centre for Economic Policy Research Monitoring European Integration Annual Reports 1990-2003, London Constancies, Victor (2012) Completing and Repairing EMU, ECB, Frankfurt Decreasing, Jorge and Fatas, Antonio (1995) Regional labour dynamics in Europe, European Economic Review Vol. 49, No. 9 De Grauwe, Paul (1992) The economics of monetary integration, Oxford and New York, Oxford University Press De la Dehesa, Guillermo and Krugman, Paul (1992) EMU and the Regions Washington DC, The Group of Thirty Occasional Paper 39 De la Dehesa, Guillermo, Giovanni, Alberto and Ports, Richard (1993) The monetary Future of Europe, London, Centre for Economic Policy Research, March De la Dehesa, Guillermo (2012) A self-inflicted crisis?, Design and management failures leading to the Eurozone crisis. Washington DC, The Group of Thirty G30 Occasional paper 86; De Cecco, Marcello and Giovanini, Alberto (1998) A European Central Bank? London, Centre for Economic Policy Research, CEPR Eichengreen, Barry and Von Hagen, Jurgen (1995) Fiscal Policy and Monetary Union: Federalism, Fiscal Restrictions and the non-bail-out clause, CEPR Discussion Paper 1247 European Commission (2012), A Blueprint for a deep and Genuine EMU: Launching an European Debate, COM(2012)777 final/2; http://ec.europa.eu/commission_2010-2014/president/news/archives/2012/11/pdf/blueprint_en.pdf European Council, The President (2012), Towards a Genuine Economic and Monetary Union, Interim Report, 12 October 2012; http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/132809.pdf. Fratiani, Michele and Jurgen von Hagen (1992) The European Monetary System and European Monetary Union, Oxford, Westview Press Giavazzi, Francesco; Micossi, Stefano and Miller, Marcus (1988) The European Monetary System London and Cambridge, CEPR and Cambridge University Press Gros, Daniel and Thygesen, Niels (1992) European Monetary Integration, London, Longman Kenen, Peter (1967) The theory of optimum currency areas: an eclectic view, In Monetary problems in the international economy Ed. R. Mundell and A Svoboda, Chicago, Cambridge University Press Krugman, Paul and Venables, Anthony (1993) Integration, specialization and adjustment, London, CEPR Discussion paper 886 McKinnon, Ronald (1963) A theory of optimum currency areas, American Economic Review, Vol. 53, No. 4 Mundell, Robert A. (1961) A theory of optimum currency areas American Economic Review Vol. 5, Wyplosz, Charles (2006) European Monetary Union: the dark side of a major success, Economic Policy 21 (46) 12 PE 492.455