To the Point, No.1, Jannuary 30, 2012: The full monty: how to build a strong currency union while closing democracy gaps

1. To the Point
Discussion on the economy, by the Chief Economist January 30, 2012
The full monty: how to build a strong currency
union while closing democracy gaps
 The institutions for a strong currency union in Europe are still lacking. To be
effective, the EMU needs fiscal cooperation (or union), supranational bank
regulation, and a central bank as lender of last resort to banks and sovereigns.
 Euro zone politicians may opt for the less solid “transfer union” approach, using
rescue funds instead, but then these funds need to be larger and more flexible.
 The EMU is threatened by “democracy gaps”, which politicians need to address,
Cecilia Hermansson not least of which how to meet the challenges for young generations.
Group Chief Economist
Economic Research Department Fundamentals missing for a well-functioning currency union
+46-8-5859 7720
cecilia.hermansson@swedbank.se When Swedes evaluated whether or not to enter the EMU through the referendum in
2003, the focus was on economic effectiveness, stabilisation tools, and political
aspects of membership. Especially, a situation where Sweden experienced an
asymmetric shock was viewed as a risk, as it would be impossible to use sovereign
monetary policy to correct, e.g., an unfavourable cost structure. In addition, the
mobility of production factors, such as labour, within the union, was considered
insufficient. This was subject of much debate, as labour market mobility was part of
Professor Mundell’s optimum currency area (OCA) theories.
There were also those, e.g. Professor Assar Lindbeck, who argued that the EMU did
not have effective ways of transferring resources between countries. The focus of the
2003 referendum, however, was not on the deficiencies of the EMU, but on Sweden’s
prerequisites to become a member, not least since Sweden had just recovered from a
deep financial crisis at the beginning of the 1990s and was not yet confident it knew
how to pursue effective economic policy – which is certainly no longer the case!
There should have been more focus whether the fundamentals for a well-functioning
currency union would be in place. According to Professor Barry Eichengreen, the
prerequisites for a currency union are strong fiscal cooperation or a fiscal union, one
bank regulator/supervisor (not 17) and a central bank that is without doubt a lender of
last resort (with regard to both banks and countries).
The Brussels-based think tank, Bruegel, discusses the euro crisis and the “impossible
trilemma” of no shared responsibility for public debt, bank sovereign independence
and a strict prohibition of monetary financing. Its director, Professor Jean Pissay-
Ferry, argues that the euro zone faces this new trilemma (inspired by Mundell’s
famous trilemma of free capital flows, stable exchange rates and independent
monetary policy). He builds on Eichengreen’s argument, and finds that the EMU does
not have the fundamentals in place, in any of the three areas.
The Stability and Growth Pact (SGP) was not followed by the members, not even by
Germany. The no-bail-out clause (Article 125 of the EU Treaty) was at the forefront
of EMU policy, until the debt crises in periphery countries made it impossible to stick
to the Treaty. Without changing the Treaty, rescue funds, (the EFSF) have been set up
and, de facto, the EMU has turned into a transfer union despite the intention to avoid
this outcome. Monetary financing is not allowed by the Treaty (Article 123), but there
No. 1 have been ways to circumvent this rule, e.g., through ECB lending to banks at
2012 01 30 favourable terms to facilitate their purchases of sovereign debt bonds. Bank regulation
and supervision are still national. Pan-European stress tests have been given, but there
is no supranational bank regulator, which means that national interests take over, at
the expense of transparency and effective crisis management.

2. To the Point (continued)
January 30, 2012
Democratic shortages must be taken seriously
Chart 1: EMU:s trilemma
All three of these institutions must be in place to make the EMU work (the
“full monty”), but politicians have different views on which of the three they
would like to focus on. France, in particular, would like to start by giving more
responsibility to the ECB as lender of last resort, while Germany has a stronger
focus on using the fiscal compact to set fiscal discipline (even if a full-fledged
fiscal union is probably not preferred by anyone).
The problem with allowing more support through the ECB, without creating
sufficient fiscal discipline, is moral hazard and poorly working incentives. The
problem with focusing only on fiscal discipline is that the current crisis will
not be handled, and a systemic bank crisis evolves and confidence falls.
Instead, transfers are made through the rescue funds – types of support that
would probably not be needed if the three fundamentals were in place.
It seems as if politicians and voters alike are not ready for either a fiscal union,
Source: Bruegel or a “financial union” and thus the ECB:s role would continue to be limited, at
least in theory. Then, the solution with rescue funds would prevail, but, in
order to strengthen confidence so that the expectations of a break-up of the
EMU can recede, the size and flexibility of these funds must be increased.
Politicians are focusing on taxing financial transactions and creating a fiscal
Chart 2: Unemployment rates in euro zone compact. The first idea picks up on voters’ anger with banks and will not help
25,0
to solve the crisis; there is rather a risk that the financial sector will lose out in
22,5 Europe, and that would be negative for economic growth. The second idea is
20,0 necessary to create confidence for other support, e.g. from the ECB and IMF,
17,5
and would perhaps be a first step towards stronger fiscal coordination. Creating
Spain
Greece such a compact, however, is not sufficient for managing the current crisis, as it
Percent
15,0
would have to be coupled with sizable support through the rescue funds.
12,5
Euroland
10,0 Even if symmetric growth is not the most important for a currency union –
US
7,5 Germany
Wyoming and Texas do have different economic structures and growth
developments – it is not possible to build a well functioning EMU and EU
5,0
Japan without recognising that growth is needed. There is a risk that the crisis-struck
2,5
jan apr jul okt jan apr jul okt jan apr jul okt jan apr jul okt
countries in Southern Europe will pursue an anorectic economic policy, and
08 09 10 11
Source: Reuters EcoWin
that their populations will lose motivation for being part of the EMU and EU.
Source: National statistics, Ecowin
The increases in unemployment rates to 20% and above (closer to 50% for
young people) are the number-one concern. Unless these falls, it will be
difficult to hold societies together, and, when economies shrink, often the poor
are hurt the most, and income distribution worsens. Structural policies often
include the deregulation of markets to open up for competition, and positive
growth effects usually come, but with a lag and not for all groups. Democracy
gaps mean that people feel they cannot influence their future; neither the
development of the EU, the EMU nor their own situation.
What is needed to create a well-functioning currency union and – at the same
time – close the democracy gaps? We need to discuss which way to go
forward: Should the trilemma be solved, or is it better to continue with a
transfer union, using rescue funds? And how can fiscal discipline be combined
with growth policies? Especially, how can Europe place the young generations
at the forefront in policy making?
The institutions for a strong currency union are lacking, as are the democratic
institutions. The crisis has opened wide the window of opportunity to create
these institutions. This is the only way forward!
Cecilia Hermansson
Economic Research Department
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Cecilia Hermansson in To the Point.
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