Stability to the economy from the development of the EMU

A group of experts has outlined two alternative visions for the development of the EU's Economic and Monetary Union (EMU). In the first vision, the Union strengthens the steering of Member States and increases joint responsibility. The second alternative is based on Member States' own responsibility for their economic policies.

The Expert group was tasked with assessing, from Finland’s perspective, various policy options for improving the stability of the EMU. This work provides input for formulating Finland’s position when the EU considers the further steps. EU leaders are due to discuss the matter in the October meeting of the European Council.

Fragile structures

The financial crisis showed that the EMU remains fragile. Its basic structures do not provide sufficient support for financial market stability and thus stable economic development.

There are different paths towards a more stable EMU. The two visions outlined by the group are both inherently consistent and provide a sound basis for democratic legitimacy. Each vision seeks to ensure the legitimacy of decision making by maintaining a close link between the exercise of power and the responsibility over the outcomes.

In practice, further steps in developing the EMU are unlikely to follow strictly either of these visions. However, it should be recognized that hybrid models typically entail contradictions which weaken the legitimacy of decision-making and the effectiveness of the system.

Centralised steering entails mutual responsibility

In the first vision, an EMU of centralised steering, the Union continues to strengthen its supervision and control over Member States’ fiscal and economic policies. In doing so, it also assumes increasing responsibility over Member States’ economic risks and stability.

The success of this vision depends crucially on whether the exercise of power at the Union level can be arranged in such a manner that it is approved by the citizens in various Member States.

If successful, centralised steering could yield beneficial results for all Member States, as it shares the risk and takes account of the overall interests of the euro area as a whole. However, the Union can only steer Member States' policies effectively if its exercise of power over the Member States is considered legitimate. Otherwise, centralised control will remain ineffective, which could lead to growing income transfers between Member States and deepening political divisions.

Market discipline requires Member States’ ownership of policies

The alternative vision, an EMU of market discipline, is based on each Member State’s full ownership of its own economic policies and their consequences. In this vision, the union will gradually cede the aim of controlling Member States’ economic policies.

When power and responsibility rest unequivocally with each Member States, questions of legitimacy are naturally resolved through national democratic mechanisms.

The Member States’ economic and fiscal policies are constrained by national fiscal policy rules and institutions and, ultimately, by market discipline. The role of fiscal policy in stabilising economic cycles remains modest.

An EMU of market discipline can still entail risk sharing mechanisms. However, instead of joint responsibility between Member States, risk sharing would be private and take place between the citizens and businesses within the EMU, and it would be implemented through common institutions. One example of this is the Single Resolution Mechanism in which the euro area's banks are paying into an insurance pool to cover the costs of crisis resolution in the euro area.

A crucial precondition for market discipline to work is the possibility of orderly debt restructuring for over-indebted Member States. At present, this remains a challenge. With many highly indebted Member States, a debt restructuring of one Member State could easily lead to widespread contagion and risk a systemic crisis in the euro area.

Therefore an EMU of market discipline requires a long transition period, during which the overall level of public debt is brought down and institutions for orderly debt restructuring are established.

Integration may be deepened in both visions

Neither vision would restrict possibilities for deepening European integration.

However, an EMU of centralised steering would be more likely to lead to closer integration than an EMU of market discipline. At the same time, the room for purely national sovereign decision making would shrink more than in an EMU based on market discipline.

No short-term alternative for rule-based coordination

The debate on the EMU has focused a great deal on strengthening of the coordination of the Member States' economic and fiscal policies. If the intention is to strengthen centralised coordination, the focus of future efforts should be on enhancing the implementation. On the other hand, if the objective is to strengthen market discipline, the direction should be more towards simplifying the rules framework and subsequently its gradual reduction.

However, in the near future, there is no realistic alternative for having the Union coordinate the Member States' fiscal policy on the basis of common rules.

Flexibility of structures supports stability

Structural reforms in the Member States are an important element in supporting the stability of the EMU. The more flexibly Member States’ labour and product markets adapt to economic shocks, the more robust the EMU will be.

Improvement of the functioning of the internal market would also support Europe's economic growth and competitiveness.

The banking union is compatible with both visions

The completion of the banking union is compatible with both visions. It is particularly important for the EMU of market discipline, as an orderly restructuring of Member State’s debt requires a strong banking union.

The establishment of an EU-wide deposit insurance scheme would support the aims of the banking union. However, to ensure a level playing field it is first necessary to put the different banking sectors on an equally sound footing and to harmonise the funding levels in national deposit insurance systems.

Also, the creation of the Capital Markets Union will increase stability in both visions. Reducing the bank-centricity of the European financial system and replacing the highly leveraged indirect financing by direct capital market financing reduces the financial system’s vulnerability to shocks.

In principle, the European Stability Mechanism (ESM) is compatible with either of the two visions for the EMU. In an EMU of market discipline, it is essential to ensure that ESM funding available to Member States is strictly limited to addressing liquidity problems. Insolvency problems should be addressed by debt restructuring where necessary.

The report was handed to the Minister

The Ministry of Finance set the working group on the 20th of August. The group handed its report to Minister of Finance Alexander Stubb on Thursday, the 1st of October.

Composition of the working group

Chairman:

• Antti Suvanto, Advisor to the Board, the Bank of Finland

Members:

• Kare Halonen, State Secretary, EU Affairs, Prime Minister's Office
• Tuomas Pöysti, Auditor General, the National Audit Office
• Tuomas Saarenheimo, Permanent Under-Secretary, the Ministry of Finance
• Suvi-Anne Siimes, Managing Director, the Finnish Pension Alliance TELA
• Teija Tiilikainen, Director, the Finnish Institute of International Affairs
•  Vesa Vihriälä, Managing Director, the Research Institute of the Finnish Economy ETLA
• Tuomas Välimäki, Head of Monetary Policy and Research, the Bank of Finland

Secretaries:

• Pauli Kariniemi, Senior Financial Adviser, the Ministry of Finance
• Päivi Leino-Sandberg, Academy of Finland Research Fellow, the University of Helsinki

The report will be published in English in October.

Further information:

Antti Suvanto, Chairman, Advisor to the Board, the Bank of Finland, [email protected], tel. +358 50 552 1511