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Despite the political stalemate in Germany, the recent publication of the European Commission's new roadmap for completing the Economic and Monetary Union (EMU) signals that progress toward economic reform in Europe is on track for 2018.
The Commission's new proposals follow the 2015 Five Presidents' Report with short-term steps in the next 18 months and medium-term steps for 2019–25. Ultimately, the political power to reform European institutions lies with member states, but the Commission would not be making these suggestions if there were not a reasonable chance of agreement on them. But the coming 18 months will test the EU's capacity for reform in the absence of a crisis. Like previous structural reforms, the next important steps on banking and fiscal union are likely to come with a lengthy implementation period (e.g., the euro was introduced seven years after the Maastricht Treaty was signed in 1992). In the coming months, therefore, leaders should aim to produce a medium-term timetable for important reforms to come to ensure they are implemented.
Ironically, the Brexit disruption is likely to increase unity between euro and noneuro members, as the euro area becomes even more dominant, representing 85 percent of the EU-27 economy. Noneuro members (particularly Denmark and Sweden) may reconsider their nonmember status as banking union is implemented amid improved economic performance of the euro area in general, eventually making the euro an EU-wide currency. To overcome traditional turf wars, the Commission's proposals seek to make decision making among the EU's complex institutional framework more efficient. Finally, increased democratic accountability at the European level requires long-term treaty reform of the role and powers of the European Parliament, a lengthy process that will leave national parliaments in the dominant role for the foreseeable future.
Following is an analysis of four main proposals of the European Commission. (A fifth, creating a European Minister of Economy and Finance, has already been dismissed by member states.)
A New European Monetary Fund (EMF)
This proposal would convert the existing European Stability Mechanism (ESM), an emergency lending agency, into a new organization. As my colleague Nicolas Véron has noted, its name is inapt, in that it has nothing to do with monetary policy. Rather the proposal represents a return to an earlier proposal by former German finance minister Wolfgang Schäuble of adding responsibilities to the ESM framework. The EMF would become the common fiscal backstop for the European banking union's Single Resolution Fund, for example, enabling it to join the management of future assistance programs and develop financial instruments to support European policy priorities. Logically, an EMF would also eventually become the fiscal backstop for a common European deposit insurance scheme to help manage future bailouts.
In terms of governance, however, the Commission's EMF proposals seem timid. By retaining the shareholding structure and voting rights of the ESM, the EMF would let France and Germany continue to exercise vetoes over issues not governed by simple majority. (Italy would have a national veto over issues requiring reinforced qualified majorities). This arrangement is not suitable given the new fund's broader responsibilities. The proposal also does not mention additional financial resources, despite the obvious need if it is to live up to its new expanded mandate.
Integrating the Intergovernmental Treaty on Stability, Coordination, and Governance into the Regular EU Treaty
This proposal amounts to sensible legal housekeeping for which there is no pressing political or economic justification at the moment, but it may be opposed by several euro area member states regularly at risk of infringing European fiscal rules.
New Budgetary Instruments
The aim is to promote economic convergence of non-euro-area members, help EU members design and implement structural reforms, and create a "stabilization function" in the EU budget to help preserve public investment during large asymmetric shocks. The first two objectives echo a previous German proposal to reward member states for undertaking reforms, but with new financial incentives, a worthwhile step though one with little economic impact across the EU.
A New Stabilization Function
The proposed new stabilization function for the euro area aims to address economic shocks among member states. The euro area institutional architecture has long lacked a central shock absorber beyond ex post facto mechanisms like the ESM and the European Central Bank's Outright Monetary Transactions capability. The euro area needs a centralized capacity to quickly assist member states before they lose market access and have to be rescued outright.
The common currency area has in recent years been minimizing the risk of large asymmetric shocks through other means. The banking union is designed to help national governments cope with the costs of a crisis among resident banks, but it does not protect against government revenue loss from an economic slowdown caused by a financial crisis; the EU's cash border deals with Turkey and various Libyan factions help insulate individual members from sudden refugee inflows; and French president Emmanuel Macron's broad idea of a European "Civil Protection Force" is envisioned to protect residents and governments of member states against sudden natural (and/or man-made) disasters. But a new euro area stabilization function is needed to protect against future crises.
Such a function does not need any permanent budgetary structures. Rather it needs a centralized euro area entity able to borrow and make financing available to member states that have lost market access.
Quick low-cost loans imply at least some fiscal transfer to troubled or errant states. If the International Monetary Fund's (IMF) historical experience with its different lending facilities, including the Flexible Credit Line (FCL) and Precautionary and Liquidity Line (PLL), are any guide, however, such financial savings tend not to be sufficient to convince a government to actually use outside funds, even when available on favorable terms.
To date, only three IMF members, Colombia, Mexico, and Poland, have ever used the IMF FCL facility and none of them has ever drawn on it, while only Macedonia and Morocco have ever used the PLL facility. Severe political stigma remains attached to countries' participation in such "hypothetical rescue programs," and concerns about moral hazard causing "objectively unneedy countries" to join such programs are vastly overblown. Indeed, the real risk is that no member state would use a new euro area stabilization function, even though peer pressure in the Eurogroup is higher than among IMF members.
Because of the history of states' reluctance to turn to the IMF, the European stabilization function must be designed to ensure that euro area members in need actually use it. The ESM/EMF has one important advantage in this regard: Due to very long lending horizons it can provide concessional loans at low interest rates, which greatly reduces the net present value of its loans. This has been done repeatedly with ESM loans to Greece.
Such stealth transfers through the ESM/EMF could make a new euro area stabilization function far more appealing to member states, especially if those transfers were also supplemented with grant-like transfers from the regular EU budget, which has that capability. Hence it would seem most sensible for the ESM/EMF to play the leading role in providing any stabilization financial assistance to member states, with the regular EU budget playing a potential supplementing role.
A crucial issue for quick access to any stabilization mechanism is the conditionality imposed. To encourage countries to take advantage of such aid, several terms for conditionality could apply.
The new EMF could start doing its own fiscal surveillance of member states, independent of the European Commission, granting automatic access to the stabilization mechanism if the EMF approves a member state's economic fundamentals. Automatic access as part of a more targeted EMF fiscal surveillance would also eliminate any political stigma of having to apply for the stabilization function. Qualifying fiscal surveillance of member states could also be part of the Commission's regular European Semester process, though given that EMF resources would remain intergovernmental, it seems unlikely that member states would want such surveillance carried out solely by the Commission.
Lending could also be limited to well-known high fiscal multiplier issues, such as a member state's public infrastructure investments, unemployment/pension benefits, educational expenditures, and other areas needing preservation in crises.
In the end, the European Commission's caution is understandable. The euro area does not need a huge new central budget. But it does require a new central budget function for quick financial support to member states. The Commission's roadmap can help get Europe's political leaders to such an institutional improvement.
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