Towards a Functioning Monetary Union – a Finnish Point of View
The euro crisis has revealed serious flaws in the construction of the euro zone. The euro has undoubtedly promoted integration – not least in the financial domain – and spurred growth. It has also kept the promise of monetary stability as measured by consumer price inflation. But as regards broader macroeconomic or financial stability, the way in which euro area institutions were set up has in fact very likely contributed to the severity of the crisis.
A series of reforms has been undertaken to correct shortcomings of the euro arrangement. Rules on economic policy making have been tightened through both community legislation and an intergovernmental agreement. A financial backstop – ESM – has been created to provide financial assistance to member states facing liquidity problems. Regulation and supervision of the financial system is being reformed profoundly. A process to create a “banking union” has started.
Many people argue that these steps – yet to be completed – will not suffice. According to them, a monetary union can function properly only if accompanied by a true fiscal union. The European Commission certainly shares this view. Last November, the Commission set out an ambitious agenda towards a federal Europe with common bonds and an EU ministry of finance. The four Presidents’ proposals to the December European Council were a watered-down version of the same ideas. And as we now know, only a fraction of the proposals was incorporated into the Council’s conclusions.
In Finland the federalist agenda is regarded with considerable scepticism. This stems from two sources. First, there is a fear that the joint and several responsibility of debt – a necessary part of a true fiscal union – poses an excessive and unfair risk to Finnish taxpayers, given that Finland’s own fiscal house is in a reasonable shape. This risk is potentially exacerbated by adverse incentives for the highly indebted member states to free-ride on the credit of others: in addition to redistributing risk, mutualisation of debt would increase its overall size. Second, the necessary centralization of decision making on fiscal policy is considered to imply too grave a loss of sovereignty for a small country like Finland, not compensated for by a corresponding gain of influence on the euro level policies. Furthermore, the performance of the neighbouring Sweden suggests that for a country with Nordic institutions and economic structures, it is not necessary to be a part of the euro to succeed economically.
Against this background it is next to impossible for a Finnish government of any colour to commit to reforms, which would involve further sharing of risks and loss of sovereignty to a significant extent. At the same time reasonable people recognise that the reforms decided upon may not render the currency union robust enough, and that a well-functioning euro zone is in Finland’s economic and political interests.
Therefore, the question of whether a functioning euro zone can be ensured without a full-blown federation is perhaps more burning in Finland than in any other euro area member state. Despite the very strong views of many renowned experts, I would not exclude the possibility that a monetary union could function properly even short of a complete fiscal union. What might be the key elements of such an alternative?
First, policy rules have to make occurrences of imprudent economic policies in individual member states infrequent and limited. The enhanced rules could be enough to achieve this; at least they deserve a chance to be tested.
Second, there should be a strong backstop to provide conditional assistance to solvent member states in liquidity problems. The current ESM alone is probably insufficient and the ECB’s OMT promise – important as it has been – may be too convoluted and problematic for an independent central bank with price stability as the primary objective. Increasing the size of the ESM combined with the access to ECB financing could be a solution.
Third, regulation and supervision of the financial institutions should be developed further to limit the risk of financial instability. Implementing the Liikanen group’s recommendations without watering them down and tightening capital requirements beyond what has been agreed upon are important measures in this regard. Risk capital is not as expensive as the banking lobby claims.
Fourth, a banking union with an effective resolution mechanism is a necessary part of a monetary union, to prevent failing institutions from taking down sovereigns. The resolution mechanism needs a financial backstop, and an enhanced ESM is a natural entity to perform this function.
Fifth, to provide the right incentives for creditors and to limit the fiscal burden of the backstop, creditor responsibility (private sector involvement) should be made the rule rather than an exception for both insolvent banks and insolvent sovereigns. Implementing the recovery and resolution directive is a first step. Ensuring the primacy of bailing-in in the resolution mechanism of the banking union is second. Third, and obviously the hardest part, is to establish a credible debt restructuring mechanism for sovereigns. The most natural way to get there would be to transform the ESM into what might be called a “European Monetary Fund”, with the principles of debt restructuring defined in the articles of the ESM agreement.
While no-one can guarantee that this approach would work, it has important advantages over a complete fiscal union. It would minimise the need for public financial assistance to banks and sovereigns and the associated political tensions. It would respect the subsidiarity principle and thus make the euro zone more attractive to those member states that put high value on national sovereignty. Finally, it would not (necessarily) require a hazardous process of Treaty change and is therefore a more realistic alternative in the medium term.