Duly prodded by the accelerating financial-market rout across the euro area, political leaders have begun positioning themselves for what should—indeed must—be the final stage of the euro area political response to the sovereign debt crisis due to be launched at the upcoming EU Summit in December. Europe is getting close to having its "second TARP vote" now. While no one, being mindful of the political requirement to avoid the appearance of a diktat, should expect detailed discussions about changing the EU Treaty before all the political leaders who will have to shepherd it through their national political systems are in the room in early December, several things concerning the direction of where the European Union will be heading seems increasingly clear. The contemplated changes to the treaty will concentrate on strengthening the fiscal rules and surveillance for the euro area. The precise formulation will remain uncertain until early December at the earliest, but it seems evident that in this matter the largely overlapping ECB and German positions will win the day.1
The euro area will move significantly in the direction of a "stability union" based on automatically enforceable fiscal rules and national commitments, building on the October 26 Summit Conclusion's call for, for instance, mutual budget oversight, structural national balanced budget amendments by the end of 2012, and national budgets based on independent fiscal data and analyses. As such, the current crisis seems gradually to be achieving what the original Maastricht Convergence Criteria, the Stability and Growth pact (SGP), and the euro itself failed to achieve, namely to force euro area economic and fiscal policies much closer together. The crisis itself as it spreads to the euro area core has finally become "the locomotive" to move towards an economic union.2
Even in a euro area, which overwhelmingly nationally based public political self-identities and allegiances dictate must be run based on the "subsidiarity principle" (i.e., the principle that the center is responsible only for the tasks that cannot be effectively addressed at the national/local level closer to the citizen), the first currency union crisis since inception in 1999 has shown that there is such a thing as a "cyclically adjusted level of subsidiarity" and that due to the constant threat of future economic crises, the center requires more policy competences than it was granted under the initial "fair weather euro design."
Ideally, the increased political power of the euro area center would—as in regular democratic states—have to be anchored in the increased democratic legitimacy of the euro area and the European Union as a whole. Certainly, this is what cohorts of European parliamentarians, mindful of their own power and expense accounts, would argue is required, but the reality in Europe is that nationally based identities will dictate that the populations of Europe simply will not for the foreseeable future sanction the transfer of substantially more democratic decision-making power to Brussels. Compelled now to construct a stronger "euro area center," policymakers must therefore look in other directions to square the circle. This almost inevitably means an increased reliance first on pan–euro area policy rules, which democratically legitimate national governments can give consent to, and second on technocratic enforcement of these rules. The latter is clearly implied, for instance, in governments' commitments to rely on "independent fiscal bodies" and can more broadly be likened to a euro area fiscal policy version of the "independent central bank model," where (presumably at least) independent technocrats in central banks are tasked with implementing politically dictated monetary policy rules. While new fiscal rules for the euro area must by necessity be democratically sanctioned by member states in an "intergovernmental manner," it is not therefore a foregone conclusion that increased economic integration in the euro area will inevitably lead to more intergovernmentalism in the longer run. The new rules after all are at least partly a reaction to the SGP, which without binding rules and automaticity etc. turned out to be "excessively intergovernmental."
At the same time, it is evident that the envisioned increased euro area integration will lead to a more multi-speed Europe and that the EU Commission will therefore have to adopt its capabilities and the "Commission Method" to this new reality. The elevation of the post of commissioner competent for economic and monetary affairs to Commission vice president with responsibility for external representation of the euro area can only be a first step. Ultimately, the Commission will need to create a much larger institutional apparatus and likely an independent directorate general reflecting its new responsibilities for the euro area only.
In the run up to the EU Summit in December we should moreover expect to see an accelerating number of political quid pro quo's being floated by national politicians both inside and outside the euro area in return for signing up to the new tighter fiscal rules. David Cameron seems intent on securing an opt-out for the United Kingdom from the EU Working Time Directive, for instance, while the Irish government, which seems certain to have to hold a referendum (and hence has some political bargaining power), looks to secure cheaper funding from the European Financial Stability Facility (EFSF) to replace the very high-yielding National Asset Management Agency (NAMA) promissory notes issued to recapitalize Irish banks.
As always, numerous trial balloons will ahead of the summit be floated strategically in the media by policymakers in order to for their own advantage increase or decrease the financial market panic.3 The really big political question however is, given how the Treaty change agenda has been set largely accordingly ECB and German demands, what strategic quid pro quo the rest of the euro area should demand from Frankfurt and Berlin? Financial markets have long in a fashion increasingly reminiscent of Jim Cramer's infamous August 2007 CNBC call for Ben Bernanke to "call someone, because he has no idea what it is like out there" made it clear that only joint liability euro bonds and large scale ECB interventions now can possibly rescue the euro from collapse. Whether this comes true or not, though, looks likely to be tested in the coming months, as there will not be a move to immediately introduce euro bonds at the December EU Summit. But what can Nicolas Sarkozy, Mario Monti, and the other EU leaders instead demand?
A fairly straightforward quid pro quo for signing up to much tighter fiscal rules would be for collective action clauses (CACs) on national government bonds to be removed from the European Stability Mechanism (ESM) Treaty. This would not only please the ECB (which hates them) but also probably help restore the risk-free status of euro area sovereign bonds impaired after the Greek PSI has been implemented. With binding fiscal rules in place, the disciplining requirement for CACs should moreover be reduced and the focus can shift to "making clear that Greece is a special case."
A longer-term timetable for jointly guaranteed debt issuance should also be a quid pro quo, which could, similar to the Maastricht Treaty itself in 1992, lay out the likely multi-year chronology and fiscal and economic deliverables for eurobonds to potentially become a reality "at the end of a process," as expressed several times by Wolfgang Schauble and other senior German policymakers. Getting a conservative German government to commit to eurobonds in the longer run will in itself be valuable but obviously ultimately reflects the political reality that getting Germany (and others) to agree to eurobonds ahead of, or even simultaneously with, binding fiscal rules is simply not going to happen.
Frankly, neither quid pro quo amounts to much "in return" in political and institutional terms, so hopefully policymakers around Europe have more imagination than myself when it comes to making constructive demands of especially Angela Merkel in December. It is crucial for the longer-term stability in Europe that Germany is compelled by other leaders to be magnanimous at this peak time of its influence in Europe.
Meanwhile, however, it is clear that the lack of "eurobonds now" will put even more onus on the ECB to act more decisively in the short run to address accelerating concerns in the financial markets. One implicit "German concession" in December will therefore almost inevitably have to be for "Berlin to stand aside," while the ECB does a lot more to secure the financial stability of the euro area. For Angela Merkel, who as German nuclear power plant operators can surely attest can be a highly pragmatic leader when circumstances demand, who just a few weeks ago secured her CDU party's blessing for "ECB interventions as a last resort," and who faces just one (in Schleswig-Holstein in June) regional election in 2012, this will probably not be a terribly difficult decision to make, once countries have signed up for much tougher fiscal rules.
Yet, what about the ECB itself, as Mario Draghi prepares to attend his first EU Summit in December as ECB president? As asserted multiple times on this blog, the ECB's response function so far in this crisis can rationally be seen to have been below what the financial markets want (and have come to expect from the US Federal Reserve), as Frankfurt has been "passively aggressive" by refusing to act as a bazooka and relying on market pressure to deliver its political reform goals for the euro area periphery and institutions. So what should be next, as the ECB, with the likely implementation of some form of binding fiscal rules in the euro area, can reasonably be said to have accomplished previously—e.g., before the crisis—unthinkable progress on all its demands?
The ECB, which is after all a central bank that claims to derive its inflation fighting legitimacy directly from the European populace, will surely know that even the bond markets cannot deliver the profound shifts in public loyalties required to legitimately base the required further EU integration on a direct foundation of euro area/EU democracy. In short—after agreeing to an unprecedented handover of fiscal sovereignty by states—of the kind historically since the Peace of Westphalia in 1648 associated only with war reparations—there isn't (considering that simply beefing up the EFSF to €2 trillion is hardly credible in the current fiscal situation) much more euro area politicians can do at this stage. Getting massive financial support from the other G-20 nations, which would be hugely beneficial and cannot be ruled out in the medium term, is ultimately out of the hands of euro area leaders and invariably and appropriately rests on the self-interested political and financial goodwill of policymakers there. Irrespective of its independence from European politicians, it cannot be the function of ECB policies to push the financial destiny of the euro area into the hands of non–euro area leaders. It would indeed be a cruel irony and a gross violation of the ECB's commitment to Europe's own populations, if its actions were to deprive them of the opportunity to elect the leaders responsible for their own financial future.
As a result, the ECB's highly successful strategy so far during this crisis, in political terms, must come to an end in December. While it should remain true, as stated by ECB Executive Board Member Jose Manuel Gonzalez-Paramo last week "that the nature of the SMP [Securities Markets Programme] as a measure that supports the central bank in the pursuit of its goal of maintaining price stability does not distort the incentive structure among different policy actors that lie at the heart of EMU,"all wars should be fought with the intent to secure a better peace, and with the contours of the euro area's institutional future now clearer, the ECB must act accordingly. Once EU political leaders show their hand and commit to establishing—again in the words of Gonzales-Paramo—"incentives for sound fiscal and macroeconomic policies in a monetary union"(and a host of other EU institutional and structural reforms), the ECB should equally credibly commit to supporting the proper functioning of the stability-oriented monetary union that it wants and that these countries intend to establish. Paraphrasing my colleague Angel Ubide, the creation of European economic union must not ultimately come at the expense of the proper functioning of the European monetary union.
In the short term this should imply much more aggressive ECB support for euro area banks struggling under the impact of the general euro area confidence crisis, as well as if required much more aggressive SMP interventions in euro area sovereign bond markets. The recent weekly averages of €6 billion to €7 billion may not be compatible with financial stability, even if the euro area experiences only a short and shallow downturn in the coming quarters.
Of course such an approach invariably raises the question of political moral hazard and implementation risk in the European Union, because how can the ECB be certain that euro area leaders actually deliver on promised changes to the EU Treaty and other structural reforms? Basically, there is no way that the ECB Governing Council can be absolutely certain, but given the governments now in place across the euro area the political commitment in December will in all probability be "beyond reasonable doubt" and like in a court room ought to be good enough for new ECB policy decisions to be taken.
It might though still be that the timetable for any concrete proposals for complex process of EU Treaty changes to be announced are too far into the future to instill both more confidence in the financial markets and the ECB about euro area leaders' "willingness to do whatever it takes." In that scenario, and also as a way for Germany and France to implicitly put other recalcitrant euro area members under political pressure to agree fast to "remain in the club," we might see proposals for a "Schengen Area–like coalition of the willing" to take more expedited political action through a plurilateral agreement that could subsequently be expanded to cover the entire euro area.
Continuing its quid pro quo political leverage strategy, the ECB might then proceed implicitly through additional interventions in the bond markets to support only those euro area members that agreed to join the new accelerated fiscal measures. Given, however, that the success of such a strategy would imply the breakup of the euro—i.e., warfare resulting in a much worse peace than ex ante—such proposals should most likely be seen mostly as part of the negotiating process of securing the largest possible commitment to more euro area fiscal integration by the largest possible number of euro area members. In negotiating terms, the parallels with the "you are either in or out" ultimatum issued to Greek Prime Minister Papandreou at the G-20 Summit by Merkel and Sarkozy are obvious. Yet, while potentially beneficial to speed up the process (changing the EU Treaty may take at least a year), it is hard to imagine any plurilateral Schengen-like agreement will not ultimately include all the 17 current members of the euro area.
1. It would however be a mistake from this overlap between the ECB and German policy positions to infer that Frankfurt and Berlin form a close alliance, as they have clashed violently on other important issues, like private sector involvement (PSI) during this crisis.
2. It is similarly clear that the crisis has simultaneously fostered a significant convergence in other aspects of policymaking across the euro area, where for instance flexibility-inducing firm-level wage bargaining practices are now being implemented in the Southern periphery, too.
3. Typically, German policymakers will try to lower expectations for EU Summit deliverables in order to surprise on the upside and minimize their need to "write a check," while other EU leaders will try to maximize financial-market expectations ahead of a summit in order to threaten German representatives with "huge market disappointment" unless something big (and expensive) is agreed to.