Challenges and Opportunities for Eurozone Governance 9781536134742

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ECONOMIC ISSUES, PROBLEMS AND PERSPECTIVES

CHALLENGES AND OPPORTUNITIES FOR EUROZONE GOVERNANCE

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ECONOMIC ISSUES, PROBLEMS AND PERSPECTIVES

CHALLENGES AND OPPORTUNITIES FOR EUROZONE GOVERNANCE

JOSÉ MANUEL CAETANO AND

MIGUEL ROCHA DE SOUSA EDITORS

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NOTICE TO THE READER The Publisher has taken reasonable care in the preparation of this book, but makes no expressed or implied warranty of any kind and assumes no responsibility for any errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of information contained in this book. The Publisher shall not be liable for any special, consequential, or exemplary damages resulting, in whole or in part, from the readers’ use of, or reliance upon, this material. Any parts of this book based on government reports are so indicated and copyright is claimed for those parts to the extent applicable to compilations of such works. Independent verification should be sought for any data, advice or recommendations contained in this book. In addition, no responsibility is assumed by the publisher for any injury and/or damage to persons or property arising from any methods, products, instructions, ideas or otherwise contained in this publication. This publication is designed to provide accurate and authoritative information with regard to the subject matter covered herein. It is sold with the clear understanding that the Publisher is not engaged in rendering legal or any other professional services. If legal or any other expert assistance is required, the services of a competent person should be sought. FROM A DECLARATION OF PARTICIPANTS JOINTLY ADOPTED BY A COMMITTEE OF THE AMERICAN BAR ASSOCIATION AND A COMMITTEE OF PUBLISHERS. Additional color graphics may be available in the e-book version of this book.

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Published by Nova Science Publishers, Inc. † New York

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“This book, written by most excellent scientists and edited by José Manuel Caetano and Miguel Rocha de Sousa stands out in the bulk of publications on the Eurozone because of its unique feature. Contrary to pure and simple economics this book grasps in a most splendid way the interdependency between the economic performance and political decision making in the aftermath of 2008. It is not only economics, stupid, but also politics which matters.” Michael Bolle, Director, Jean Monnet Center of Excellence for European Integration, Free University of Berlin, Germany. “This book edited by José Manuel Caetano and Miguel Rocha de Sousa, is written out of a concern of the different authors to improve the governance of the Eurozone. It contains important chapters identifying the weaknesses of the Eurozone and the reforms of its governance that will make it sustainable in the long run. This is a book I highly recommend for students, academics and policymakers in Europe. “ Paul De Grauwe, “John Paulson Chair” in European Political Economy, European Institute, London School of Economics and Political Science (LSE). “Much of the debate about the Eurozone crisis has been dominated by viewpoints from the Institutions and the larger countries. We have heard very little from the smaller countries that were at the center of the cyclone. It is fortunate that this book brings together contributions by (mostly) Portuguese scholars. They are economists and political scientists and they have much to tell. The readers will discover the extent of suffering that the crisis has brought to Portugal. Economic activity plummeted, unemployment soared, firms collapsed, of course, but these contributions also vividly depicts the frustrations from the 'solutions' that were imposed by the Troika.” Charles Wyplosz, Professor of Economics, The Graduate Institute of International and Development Studies, Geneva; Director, International Center for Monetary and Banking Studies, Geneva.

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CONTENTS

List of Figures

ix

List of Tables

xi

Foreword

xiii António Mendonça

Introduction

xxi José Manuel Caetano and Miguel Rocha de Sousa

Acknowledgments Chapter 1

Chapter 2

Chapter 3

Chapter 4

The Euro Monetary Union with a Flawed Conceptual Framework Vítor Bento The Endogeneity of OCA Conditions and Macroeconomic Imbalances in EMU Carlos Vieira and Isabel Vieira Trends in Business Cycles Synchronization in the EMU José Manuel Caetano, Elsa Vaz and António Caleiro The Risk of Incomplete Financial Integration in the European Union Paulo Ferreira, José Manuel Caetano and Andreia Dionísio

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xxxv 1

19

35

61

viii Chapter 5

Chapter 6

Chapter 7

Chapter 8

Contents Towards a Full Banking Union in Europe: Waiting for the Next Crisis? Luís Brites Pereira and Miguel Rocha de Sousa

81

Eurozone Governance in the Aftermath of the Crisis: A Proxy for a New Institutional Balance? Paulo Vila Maior and Isabel Camisão

97

Completing the Economic and Monetary Union: What Economic and Fiscal Governance? Ana Fontoura Gouveia

121

What Can and Should We Expect from the EU Budgetary Policy? Manuel Porto

145

Chapter 9

Completing EMU, Deepening the EU Annette Bongardt and Francisco Torres

Chapter 10

Does the European Economic and Monetary Union Require a Social Dimension? José Manuel Caetano and Nuno Rico

183

The Political Union and Its Eurozone Future: Conflictual and Collaborative Commons Governance António Covas

203

Chapter 11

Chapter 12

On the Scenarios for the Future of the Eurozone António Caleiro and José Manuel Caetano

165

225

About the Editors

243

About the Contributors

245

Index

249

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LIST OF FIGURES CHAPTER 1 Figure 1. Figure 2. Figure 3. Figure 4. Figure 5. Figure 6. Figure 7. Figure 8. Figure 9. Figure 10.

Income Per Capita (% Growth, 1998-2016). Unemployment Rate, Average 1999-2016. Current Account Balances (% GDP) – Countries with External Support. Government Debt (% GDP) – Countries with External Support. GDP per Capita (2010 Prices), % ∆ (2007-14). Government Debt (% GDP). Domestic Demand and GDP (2010 Prices) - ∆% (2007-14). Changes in External C/Account & Unemployment Rate, 2007-14. World Savings (%GDP, PPS). Long Term Interest Rates (Synthetic Indicator).

2 3 4 4 13 14 15 15 16 16

CHAPTER 2 Figure 1. The evolution of the OCA index by European country Figure 2. The change in the OCA index, 1988-1998 Figure 3. The change in the OCA index, 1998-2016 Figure 4. The 1998 OCA index and average government budget balances Figure 5. The 1998 OCA index and average current account balances Figure 6. The 1998 OCA index and the 2016 net international investment position Figure 7. The 1998 OCA index and the average unemployment rates (1999-2016)

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24 26 27 28 29 30 31

x

List of Figures

CHAPTER 3 Figure 1. Figure 2. Figure 3. Figure 4.

Correlations (with 7 clusters) for 1990-2016. Correlations (with 7 clusters) for 1990-1998. Correlations (with 7 clusters) for 1999-2007. Correlations (with 7 clusters) for 2008-2016.

41 43 45 46

CHAPTER 6 Figure 1. Figure 2.

Policy rates: The US FED and the European Central Bank. a), b) and c). Long-term interest rate (%) for convergence purposes, 10 years’ maturity denominated in Euro, respectively for Greece, Ireland, and Portugal.

104

107

CHAPTER 12 Figure 1. Figure 2.

The four quadrants of possible scenarios. Four scenarios for the future of the Eurozone and of the European Union.

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228 233

LIST OF TABLES CHAPTER 2 Table 1. European countries ranked by OCA index

23

CHAPTER 3 Table 1. Some results on synchronization [1990-2016] Table 2. Some results on synchronization [1990-1998] Table 3. Some results on synchronization [1999-2007] Table 4. Some results on synchronization [2008-2016]

42 44 46 48

CHAPTER 8 Table 1. Own resources/GDP per capita Table 2. Estimated evolution of the structure of EU financing (2012-2020)

155 156

CHAPTER 11 Table 1. The hybridism of the European political system Table 2. European economic policy: Squaring the circle Table 3. European commons and cooperative federalism

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209 214 217

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FOREWORD António Mendonça School of Economics and Management University of Lisboa, Portugal President of CEsA – Centre for African, Asian and Latin American Studies

A few notes on the economic and financial crisis in the Eurozone and the role of the European Central Bank The latest economic projections presented by respectable international institutions, such as the European Central Bank or the International Monetary Fund, consider that the world economy, and the European economy in particular, is finally on the path towards a minimally sustained recovery, after almost a decade of persistent difficulties and uncertainties. Indeed, looking at the latest figures to be published (at the end of 2017), output and employment reveal a long overdue positive growth, investment seems ready to recover from the lethargy into which it had sunk, and international trade shows signs of embarking on a new cycle of economic globalisation. There still remains only one unanswered question, which does not seem to overly concern economic decision-makers: inflation remains at very low levels, particularly in Europe, where the sacrosanct 2% target still seems a long way from being reached. Moreover, it continues at this level even when faced with the threat of its upward trend being reversed by a return to the earlier deflationary dynamics that lay behind the quantitative easing practised by the main central banks. Until now, the adoption of such measures has proved controversial, meeting with opposition among those responsible for conducting economic policy both in Europe and in the US.

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António Mendonça

Despite this conjuncture of positive indicators about the state of the world economy, and the European economy in particular, there is a question that must be asked: why has the recovery of the world economy, if real, taken so long to manifest itself? It is not easy to reach a consensus about this issue, for the very same reasons why it has not been possible to reach an agreement about the causes that led the world economy to sink into one of the deepest recessions in living memory. In terms of its length and depth, this recession is only comparable with the economic, political and social problems triggered by the great depression of the 1930s, which pushed the World into the catastrophic Second World War. Even at this level we can find similarities in the escalation of international conflicts that are experienced today. First and foremost, there are ideological and political reasons for this lack of consensus about the factors explaining both the origin and spread of the crisis, beginning with the implosion of the American subprime mortgage market and leading to the so-called sovereign debt crisis in Europe. However, there are also factors relating to the economic culture and theory of key players and of those managing the institutions responsible for the design and implementation of economic policy measures to combat the deepening of the crisis. It is perhaps most interesting to note that such contradictions and the lack of consensus were probably most strongly felt in Europe, precisely in a region where a shared purpose and solidarity were presumably the very raison d'être of the project for greater integration. On the contrary, in the US, perhaps because it all started there, a broad consensus was reached about what to do, which led to a more rapid and more sustainable recovery. In fact, looking back, it is astonishing to note the attitude displayed, in July 2008, by the ECB, which was chaired at the time by Jean-Claude Trichet, in raising interest rates from 4% to 4.25% in the midst of the European economic crisis, invoking the possible danger of accelerating inflation in the Euro zone. This measure was implemented at precisely the same time that their American, British and Japanese counterparts were doing exactly the opposite, concerned as they were with the deepening of the crisis and its effects on output and employment. Of course, the harsh reality of this state of affairs gradually penetrated into the minds of the most stubborn policymakers, and, shortly after this, the ECB reversed its policy and aligned with its partners in reducing interest rates. However, precisely when the crisis was deepening even further, the ECB repeated the process and, in April and July 2011 (still under the presidency of Trichet), it raised interest rates to 1.5%. Once again, it was forced to retract and, in November of that same year (now with Mario Draghi as president), the ECB began the process that would create a break from the more orthodox position of its former leaders. This led to the adoption of the so-called unconventional monetary policy measures, which brought interest rates to the zero lower bound at which they still find themselves to this day.

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Foreword

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In fact, the effects of the international financial and economic crisis in the Euro zone revealed another specific problem in this region, which had been latent for several years and took the form of a broader identity crisis linked to the European integration project itself, which was further exacerbated by the rapid process of its enlargement to the east. This wider structural crisis was to take on a more concrete and specific dimension, expressed in the crisis of the Euro system itself when it proved incapable of responding to the problems of the internal adjustment of the zone, revealing all the inadequacies of its initial architecture and the theoretical illusion of the underlying hypothesis of the endogeneity of the monetary zone. When it was to be expected that the Euro zone, as a whole, would find suitable solutions for its systemic crisis, in reality, the opposite was true. The weakest countries were made responsible for the problems of the region – precisely those where the Euro system was supposed to enable them to converge with the strongest ones – as a crisis in the Eurozone’s adjustment mechanism was turned into a set of separate sovereign debts, with contractionary pro-cyclical economic policies being chosen to the detriment of the integrated macroeconomic policies for economic recovery that the situation called for. Here, it is important to emphasise the change that took place in the ECB’s attitude, promoted by the new leadership of Mario Draghi and well theorised by the Portuguese Vice-President Vítor Constâncio, among others. The worsening economic conditions of the Euro zone, in 2012 and 2013, paved the way for the ECB to launch a broader plan of direct intervention, replacing those in charge on the Ecofin who were responsible for conducting the zone’s economic policy and even in a conceptual contradiction with the dominant positions at this level, particularly with Germany. An intervention that has been continued until today with the implementation of the unconventional monetary policy measures, which, in practice, meant a direct injection of liquidity into the economy, avoiding the self-feeding of the contractionary dynamics and, at the same time, ensuring the functioning of the channels for providing finance to the companies and to the State itself, through complex mechanisms based on the purchase of public debt. In practice, this new attitude adopted by the ECB demonstrated its lack of confidence in the ability of the financial sector to play its traditional role, opting, instead, to create direct channels for monetary transmission to the economy, converging towards a programme of quantitative easing, followed by the Fed and other central banks, and in line with the role of the central bank as the lender of last resort. Such an orientation had previously been rejected or, at least, had never been directly assumed until then. However, while the ECB was following a path that was hardly suited to the role initially assigned to it under the management of the Euro system and established by its own statutes, but nonetheless one that was forced upon it by dint of circumstances, a new phase was beginning in the development of the Euro zone crisis and its respective management. This phase can be defined as "schizophrenic", taking into account the way in which the

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relationship between monetary policy and other economic policies, particularly fiscal policy, is regarded. First and foremost, we must draw attention to the ongoing discussion about the effectiveness of the unconventional monetary policy. According to the most orthodox positions, the idea of supplying unlimited liquidity (defended by Draghi as a way of preventing the deep recession experienced at that time from turning into a great depression similar to that of the 1930s) is wrong and it will have long-term consequences by creating conditions for the emergence of new speculative bubbles and new inflationary dynamics. So, it should be quickly reversed, particularly in the current context of economic recovery. According to this view, facilitating conditions for the provision of finance, particularly in the case of States that have not taken proper care of their public accounts, prevents or delays the process of structural reforms, which guarantees the recovery of the potential product and builds the basis for sustainable growth. Seen from this perspective, priority should continue to be given to the correction of internal and external imbalances, and to the recovery of the necessary conditions for competitiveness, especially by reducing the unit labour costs. This means a return to austerity policies. Rejecting these positions does not, however, mean that questions about the path followed by the ECB cannot be challenged, namely regarding the limits of using monetary policy in the current context and particularly the effectiveness of unconventional instruments. When reviewing the ECB’s interventions in response to the Euro zone crisis, two time periods are clearly identified: the period before Mario Draghi’s presidency and the period afterwards. In the first period, despite the adoption of measures that anticipated the quantitative easing approach, central bank officials were clearly uncomfortable, which resulted in continuous hesitations. This was indeed shown in the raising of interest rates, as already mentioned, which turned out to be inappropriate and was not exempt from responsibility for the worsening of the economic situation and for prolonging the recession in the Euro zone. In the second period, there was an effective rupture. Not only in practice, since measures were taken to meet the operational needs of the Euro zone economies. There was also a theoretical and political rupture, expressed, among other things, by the attempt to construct a rationale that went beyond the simple analysis of economic dynamics and monetary trends, and sought to arrive at the fundamentals behind the functioning of the economic system and the role of monetary policy. The starting point for the construction of this new rationale was the hypothesis that the transmission mechanism of the Eurozone monetary policy had stopped working properly as a result of the crisis. This would have forced the ECB to find direct channels for monetary transmission in a context where the banking and financial system had shown

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Foreword

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itself to be incapable of performing its traditional function of financing the economy. At the same time, a Keynesian analysis of the liquidity trap was introduced, which proved to be crucial not only in justifying the adoption of measures to ease the liquidity supply, but also in demonstrating the limits of the effectiveness of monetary policy in zero lower bound contexts and the need to use other types of policies of an expansionist and noncontractionary nature, such as fiscal policy. The liquidity trap analysis was complemented by the hypothesis of money creation endogeneity, meaning that the causal relationship goes from money demand to the monetary base and not from the monetary base to money demand and strengthening the idea that monetary policy can help to create the conditions for economic recovery, but it cannot be a substitute for other policies that help to recover aggregate demand, particularly in a context where this demand is deeply depressed. Lastly, to silence the most vociferous critics, the separation principle was introduced. This lends a complementary nature to unconventional measures, rather than becoming a replacement for conventional measures. Such measures should only be applied during the time period when the monetary policy transmission mechanism is malfunctioning, and should be removed as soon as the problem ceases to exist. The rationale constructed by the ECB for its unconventional monetary policy was undoubtedly a strong one. However, more important than this was the evidence that the intervention framed within those references proved to be suitably adapted to the operating needs of the Euro zone economy, particularly from July/September 2014 onwards, when the intervention programmes were launched in the financing markets of the non-financial private sector, namely the Asset-Backed Securities Purchase Programme (ABSPP), the Covered Bond Purchase Programme (CBPP3) and the Targeted Long-term Refinancing Operations (TLTROs). This crucially helped to compensate for the absence of another kind of measures that were geared more towards recovering the economy and to mitigate the negative effects of more restrictive measures, which mainly undermined the most vulnerable countries, such as Portugal. Nevertheless, despite the good basic intentions of the unconventional measures and the positive results obtained, the recognised restrictions of monetary policy itself were also revealed in the attempts made to deal with a persistent recessive situation. This led to a progressive exhaustion of the effectiveness of all these measures, as was clearly demonstrated by the decision taken on 10 March 2016, by the Governing Council of the ECB, which set the interest rate of the main refinancing operations at zero per cent, and, above all, opened up the possibility for financing the economy at rates that were as low as the rate applied to the deposit facility at the beginning of the operation, i.e., at negative rates (TLTRO II). Seen from this perspective, as far as the Eurozone economy is concerned, unconventional monetary policy seems to have performed the same role as medicines do for an addicted patient who needs ever greater doses in order to control the symptoms of his disease as his body becomes increasingly used to the substance he is taking.

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António Mendonça

Here, we return to the initial issue, questioning the reasons why the economic recession in the Euro zone lasted longer than expected in a context where it was thought that there already existed appropriate instruments for dealing with the problems manifested. In these brief notes, we have argued that one of the fundamental reasons for the inability to combat the recession was the lack of real integrated economic policies for economic recovery in the Euro zone as a whole. The exception was the monetary policy of the ECB, which, after a certain point in time, was extended to include unconventional instruments precisely in order to compensate for the absence of such policies. We have also argued that the monetary policy itself, even in its newly extended version, ended up revealing its own weaknesses and limitations, leading to a progressive process of exhaustion and pushing the economy to a situation that was very close to the so-called liquidity trap. This situation led the ECB officials themselves to make successive interventions in order to justify the need for fiscal policies and others, less constrained by austerity objectives and geared more towards the recovery of investment, particularly public investment. Indeed, as far as the global economy is concerned, this idea was shared by the highest IMF officials, such as Christine Lagarde and Oliver Blanchard, among others, and by the OECD itself. Recognising the weak global economic growth, it emphasised that “A strong collective policy response is urgent. Global macroeconomic policy, comprising monetary, fiscal and structural actions, must become more supportive of demand and resource allocation. Experience to date suggests that reliance on monetary policy alone has been insufficient to deliver satisfactory growth, so that greater use of fiscal and structural levers is required”, (OECD, Interim Economic Outlook, 16 February 2016).

And also, more recently, Mario Draghi, even though he recognised the dynamics of the global economic recovery, still mentioned the need for restrictions in terms of monetary policy: “For many years after the financial crisis, economic performance was lacklustre across advanced economies. Now, the global recovery is firming and broadening. A key issue facing policymakers is ensuring that this nascent growth becomes sustainable. Dynamic investment that drives stronger productivity growth is crucial for that – and in turn for the eventual normalisation of monetary policy. Investment and productivity growth together can unleash a virtuous circle, so that strong growth becomes durable and self-sustaining and, ultimately, is no longer dependent on a sizeable monetary policy stimulus”, (Mario Draghi, ECB Forum on Central Banking, Sintra, 27 June 2017).

I will finish these brief notes, which are already quite lengthy, by praising the work now being published under the editorial responsibility of José Manuel Caetano and Miguel

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Foreword

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Rocha de Sousa, Challenges and Opportunities for Eurozone Governance. The aims that are proposed, the authors of the papers and the topics addressed, all display a clear multidisciplinary concern and are highly pertinent to what is currently driving academic research and to the challenges facing the pursuit of the European integration project, which is far from overcoming its crisis in terms of identity and purpose, as has already been mentioned here. At a certain moment in time, the expectation was that the depth and extent of the problems would lead policymakers to display greater responsibility and a clear vision of the future in deciding what needed to be done in order to place the project of economic and monetary integration back on track, after it had been derailed, to a large extent, by the structural flaws in the conception and construction of the Euro system. Today, however, our expectation is no longer the same, both due to the way in which the crisis has evolved and the changes that have taken place in the political and economic correlation of forces in Europe, and due to the widespread acceptance of a new "state of affairs", which barely resembles the initial principles and guidelines of the European project. Nevertheless, this should not allow us to become demoralised or to lose interest in studying the themes related to the question of European integration. We should remain particularly focused on the need for research into the conditions that can make the functioning of the single currency system more efficient, in a context where asymmetries and diversities between the countries are increasing and political union is non-existent. The work that has been included in this book follows exactly that path and those concerns. It will undoubtedly become a major academic benchmark and compulsory reading for policymakers and for all those who wish to understand the challenges facing our common European life.

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INTRODUCTION José Manuel Caetano1 and Miguel Rocha de Sousa2 1

Department of Economics, University of Évora, Évora, Portugal 2 CEFAGE & CICP and University of Évora (Department of Economics), Évora, Portugal

The recent global financial crisis and its impacts on the Eurozone (EZ) has been object of many studies, with these analysis being dominated by the economic dimension. Nevertheless, the different patterns of responses to the crisis by countries or by institutions reflect very disparate political stands. Henceforth, in order to understand the crisis complexity, it is required a multidisciplinary approach, involving both aspects of economics and political science. We do believe that in order to have an integrated vision of the Eurozone crisis and its subsequent limitations presented by its economic governance model, one should make use of economic foundations and economic grid analysis about the causalities and interactions among macroeconomic variables. Whilst, one should also take into account aspects related to decision making processes and resource allocation in a multilevel governance framework, that this crisis has come to put on the agenda and to stress it in an impressive way. Taking into account the more economic-oriented component of this publication, the focus of the book is centred on the Mundellian rationale of optimum currency areas (OCA), and its interaction and confrontation with the Maastricht Treaty rooted institutional framework legacy, which supports all the European Monetary Union (EMU) building. On the other hand, besides the structural lacunae in the regulatory design of the Eurozone functioning, it has been noticeable the absence of effective political leadership on the EU crisis response, thus not assuring the credibility and reputation of the single currency, and leaving the Member States dramatically exposed to the logic of global financial markets. The Eurozone crisis developed and affirmed itself as a crucial circumstance for the process

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of European integration, such as what happens on it will influence permanently the future of all the EU. So, it is not surprisingly that, facing the lacunae in the governance model of the single currency and its coordination failures of political responses, the EU institutions have looked for better ways to improve the sustainability of the Eurozone, which we profusely discuss in this book. However, even though meritorious efforts in that directions, there remain relevant challenges which must be clearly faced towards a more resilient EMU, namely: (a) the accomplishment of banking union and of the capital markets union with the aim of strengthening the integrity of the Euro and the risk sharing among banks and sovereigns; (b) an higher coordination of fiscal policy, with the goal of reinforcing the stabilization role at the Eurozone level; (c) the promotion of structural reforms in order to create a more efficient and balanced Monetary Union in the way in creates and redistributes wealth. This book discusses and proposes answers to those challenges towards a more viable governance, oriented to a progressive reduction of risk and with its increasing risk sharing pool, in a more European prone approach, in which central and peripheral countries find the way to prosperity and to progress is made easier by common solutions. The book integrates views of economists and political scientists which, revisit and reflect the causes of the crisis and its socio-economic effects. The latest EZ governance model changes are cross-examined, raising also some perspectives on the way yet still to achieve.

THE LONG ROAD TOWARDS THE EUROPEAN MONETARY UNION Born out of the WW II ruins, in 1957, the European Economic Community (EEC) had as main goal to keep peace and security among their members, fostering political cooperation, and reinforcing economic integration, and leading naturally to the European countries solidarity. The initial creation of a Free Trade Area (FTA), and, afterwards in 1968, the Customs Union (CU), promoted the abolishment of tariffs leading to the free circulation of goods and services, establishing a common trade policy towards third countries. Trade integration began as the first milestone at the scale of European market integration, which deepened the countries productive specialization pattern, fostering firm competition and scale economies, which generated strong and lasting economic growth until mid-‘70s. The economic success of the EEC in its early years of life contributed to the attraction of other countries which came to integrate the Community, throughout successive waves of enlargement. Thus, after the first enlargement to the UK, Ireland and Denmark in 1973, EEC accounted for 9 members, and successively evolved to 12 members, after Greece in 1980, and Portugal and Spain in 1986 entry, respectively. On the other hand, whilst across this period occurred episodically ignited economic growth, the Community lived also

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trough moments of instability and assisted to a return of protectionist measures among their members which further conditioned the dynamics of economic integration. In 1970, the Werner Report advanced a hypothesis of a single common currency in the EEC, which predicted until the end of the decade a European Economic and Monetary Union. On the other hand, events such as the collapse of the international financial system set up in Bretton Woods and the oil shocks of the ‘70s led to an economic downturn which led to the suspension of the single currency project. Moreover, facing currency instability in the EEC, there were devised some institutional arrangements, of which one can stress the European Monetary System, created in 1979. So, only around 15 years later, having surpassed these phases of higher economic instability and currency volatility, had project of European integration conceived economic and political conditions to evolve towards a new plateau. In 1986 the first reform of the Rome Treaty took place through the “European Single Act” (ESA) which describe the goal of fulfilling until 1993 the “European Single Market” (ESM), which led to the merger of goods and services markets with factor markets through increased removal of fiscal, technical and physical barriers. The fight to market fragmentation, then subject to national legislations, would allow to reduce production and transaction costs, creating a better resource allocation at European scale. It could further reinforce European firms’ competitive capacity, which they had been losing in the world markets and even in the European arena. Nevertheless, the lack of higher fiscal and monetary coordination, and of an effective currency stability would encourage an environment of uncertainty, distorting agents’ expectations, and creating a less encouraging climate for investment and even the ESM. The conviction that to a market should correspond a currency, motivated the relaunch of the single currency creation project. This happened in a context of member-states fastpaced preparing for the full common market liberalization. The integration process was then showing clear signs of revival, being of notice the levering role of the European Commission led by Jacques Delors.

MONETARY INTEGRATION IN THE VIEW OF MAASTRICHT The Maastricht Treaty, signed in 1992, is the corollary of the single European currency integration process. Beyond merging the three Communities existing until then and formally creating the European Union (EU), it introduced the rules and orienting principles for the future European Monetary Union. Not after broad and lively debates, and difficult negotiations between distinct visions – sometimes, antagonistic – over the fundaments that should anchor and guide the single currency. Thus, one of the main controversies of the

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time was instigated by the decision of the European leaders to define nominal convergence criteria that the single currency candidates should achieve until the formal EMU launch. These criteria were meant to assure that applicants to the future Eurozone would beforehand promote the convergence of their inflation levels, interest rates, budget deficits, and public debt, under a perspective clearly anchored on a monetarist view. By then, the major criticism to this emphasis was based on the complete absence of explicit requisites on the promotion of structural convergence of such different economies. And this would be attained, as such as, by the more synchronized behavior of single currency countries, yielding thus a more effective common monetary policy. The critics of the EZ governance system paradigm emphasized yet the insufficiencies of the legal-political framework of the Treaty; and, then subsequent the Stability and Growth Pact (SGP), tried to assume the true disposable effects due to the needed economic policies coordination to take action, in the single currency area. The confrontation of these distinct views about the fundamental conditions of convergence (nominal versus structural), in order to build a stable and efficient monetary union, did stress the political and academia debate across the pre-Euro age, but did not, yet, alter significantly the underlying fundamental political options in the referred Treaty. The defendants of this institutional framework did sustain the occurrence of spontaneous endogeneity, inherent to the process of monetary integration. Such mechanisms would to trigger the convergence of economic structures and the synchronization of economic cycles in the single currency area, considering as adequate devices the instruments of national policies to deal and tackle the issues of specific asymmetric national shocks. With these premises in sight, most regulatory, financial supervision, and economic policies were kept at national levels, not being, thus, promoted in a more intense way the effective coordination of national economic policies. Economic theory, in a profuse way, has warned to the fact that in the framework of OCA, whenever one of its members is subject to an asymmetric shock, its coping adjustment capacity depends on the intensity of labor mobility, of its higher or lower degree of rigidity in the goods, services and factor markets, and of the alleged stabilizing role of national fiscal policies. Hence, an OCA would be more efficient, as quicker as it promotes national adjustments of countries subject to idiosyncratic shocks, and, thus, avoiding the risk of this contagion to its other full union members. Facing this goal, the coordination of fiscal and budgetary policies and the existence of a common central stabilizing budget for the economy, and for the accommodation of the social adjustment costs, are quintessential elements towards the stability of the optimal currency area. In what the Eurozone concerns, most of the requirements did not be present and the existing governance did not have the means to promote them, so the risk of events having a potential destabilizing effect on the Zone and in the economies of its members was real. In fact, the European Union has been characterized by low labor mobility, with some

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markets showing rigidity in its functioning, which reduces the ability to adjust in the short term. However, according to previous warnings from many authors, it became obvious that the EZ model did not have the resources to support members with adjustment difficulties. Moreover, in the early years of the Euro’s life, because of a lack of political will, the timid attempts to strengthen the coordination of national economic policies and establish common arrangements for action in the event of an emergency were clearly insufficient, as the events which followed confirmed. The coordination of economic policies in several areas and the political-institutional solutions to achieve them must be relevant within a monetary area. In fact, the regime of operation of economic policy is profoundly altered when countries abdicate of monetary and exchange rate autonomy, and their capacity to use budgetary and fiscal policies is also limited. In view of the lack of centralized fiscal capacity, the need for countries to have some flexibility in fiscal policy to allow them to continue economic adjustment with anticyclical measures should be stressed. With regard to the Eurozone, the Maastricht Treaty unified the monetary policy and defined the institutional framework that ensured its operation, as well as the alignment of its objectives in order to preserve price stability. As regards the guidelines on the coordination of fiscal and budgetary policies, the Treaty focuses on the following aspects: 1. Cooperation and coordination procedures, referring to the Council for follow-up, evaluation and recommendations when the countries efforts are far from desirable; 2. Prohibition of financing by the European Central Bank and national central banks to any Community and national institutions of a public nature, which prevents the monetization of public deficits so as not to affect price stability; 3. A clause excusing the EU and its members from commitments by any of them (no bail-out clause), ensuring that a member’s public debt cannot be borne by them; 4. Recommendation for States to avoid excessive government deficits, which should be ensured by meeting the criteria of budgetary discipline. It is clear from this quick remark of the Maastricht Treaty that certain aspects of economic policy deriving from it a reduction in the autonomy of fiscal policy by means of restrictive rules which can be combined with the intention of promoting some coordination of national policies. However, there is a disparity in approach to the interventions of the different macroeconomic policies vis-à-vis the various objectives being proposed. Thus, while the single monetary policy has as its priority orientation to ensure price stability, the reduction of fiscal autonomy makes this policy not so much suitable to respond to specific shocks that cause fluctuations in employment and economic activity. The institutional framework

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thus does not contribute to reducing the heterogeneity of the structural situation of public finances in the EU, nor does it provide a means of alleviating divergences between the economic cycles of its members.

FROM THE CREATION OF THE EURO TO THE SOVEREIGN DEBT CRISIS It was facing this formal framework that the Euro was created on 1 January 1999, and was adopted by 11 of the countries that were then part of the European Union, to which Greece joined in 2001. Since then, other countries have adopted the single currency, so that in 2017 there are 19 Member States of the European Union that are part of the Eurozone. Taking advantage of the favorable economic cycle, there were no major disruptions in the early years of the euro, although signs of tension and divergence between Member States began to be felt. However, after 2007, with the increase disturbance provoked by the international financial crisis on some of the most vulnerable countries in the Eurozone, the debate on the viability of this model of Monetary Union, whose limitations were highlighted by the critics of the vision affirmed in Maastricht, was revived. The unfolding of the global financial crisis and the ensuing sovereign debt crisis in which some Eurozone countries have been involved has significantly exposed the shortcomings of the legal and operational framework on which the European Monetary Union is based, revealing the absence of instruments to prevent or to limit the severe effects of the crisis in some Member States and their spread to other members. In addition, as presented in some chapters of this book, there was an amplification of the negative impacts of the crisis, which resulted from the fact that the countries were integrated into a monetary area that did not have crisis management mechanisms or capacity to coordinate effective plans of action. The sovereign debt crisis in the Eurozone is the outcome of a succession of events that led to the sudden stop of foreign private capital inflows in some Member States. This led to a state of liquidity shortages and a sharp increase in interest rates, putting the banking sectors of these countries under tension and some banks in a situation of pre-insolvency. Eurozone supervision failures and preventive action were notorious for not being able to avoid the accumulation of significant imbalances in some members in the early years of the euro, such as bubbles in real estate markets and unsustainable deficits (and surpluses in others members) in the current accounts of some countries, increasing economic divergence within the Zone. As a result of this process, the most vulnerable countries, in order to avoid the spread of systemic risk to the entire economy, proceeded to socialize private bank debt through the issuance of public debt, assuming the typical role of the Central Bank, as a provider of liquidity of last resort in regimes with own currency. The asymmetry in the transmission of the financial crisis within the Eurozone has contributed

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to amplifying the shocks in the most heavily indebted countries, showing in a remarkable way the difficulties of countries that emit debt in a currency that they do not control, as is the case of the Eurozone. The rapid increase in public debt has reduced its sustainability, with the inherent rise in risk premiums and interest rates in the various sectors of activity, these effects having spread throughout the economy and penalized its performance. International agencies have made deep cuts in the sovereign debt rating of these countries, aggravating the (un)sustainability of public and private debt, making the Eurozone more unstable and dependent on possible changes in the global financial markets. As a result, the very integrity of the euro and its continuity have been called into question as evidence of the exponential rise in the risks of currency redenomination. In short, there is now a consensus, shared by politicians and academics, that the crisis experienced by the Eurozone was due to the absence of mechanisms and institutions to avoid a widening of economic and budgetary imbalances and, as a consequence, making it possible the heaviest effects of economic shocks in the most fragile countries being absorbed. Of course, the weaknesses in the monitoring of budgetary discipline, the lack of an integrated crisis resolution system and of a unified banking supervision and regulation have contributed to prolonging the crisis and have made it difficult to restore credibility and economic recovery. The wrong conception of fiscal discipline permitted some public debts to increase perilously before the crisis while the inability of the ECB to act as lender of last resort to banks, led to explosive debt streams in the most vulnerable Member States.

THE REFORMS IN THE GOVERNANCE MODEL OF THE EURO Faced with the worsening economic recession and the instability of the financial markets that have undermined the sustainability of the Euro, structural changes in the governance paradigm of the single currency have begun to be demanded. It was therefore unsurprising that a number of EU initiatives emerged with the aim of transforming the governance model of the Eurozone, with some retracing old arguments from those who had criticized the Maastricht options on European monetary integration. The year 2012 is probably the turning point in the attitude of the Community institutions towards the crisis that has been disturbing the Eurozone. In fact, three highly significant institutional developments marked this new attitude: first, the creation of the European Stability Mechanism (ESM); second, the announcement by the ECB of the launch of the Outright Monetary Transactions (OMT) program; and, finally, the decision to create a Banking Union. Beyond these measures, which reveal the purpose of stabilizing the financial system in the Eurozone and recovering the reputation of the single currency, mechanisms have been put in place to strengthen surveillance and supervision in order to avoid imbalances in the future.

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The combined effects of these institutional changes may have been decisive in stopping the vicious circle of crisis, namely the causal link between sovereign and bank debt. Thus, since 2013 the Eurozone has stabilized and, although in an uneven way, the economies of its members have resumed a growth trajectory. However, the severity of the crisis was so great that, in 2017, there are still countries that have not recovered the levels of income and employment they had a decade before, i.e., before the crisis began. At a time when economies are recovering from the crisis and there is no reason for further turbulence in the markets, at least in the near future, we believe that it is suitable to reflect on what has occurred, on the underlying structural causes of what has failed in the functioning of the Eurozone, and of course, on what will have to be done to complete monetary unification and improve its effectiveness. Looking at the institutional reforms that have since been implemented and evaluating the remaining weaknesses, under different methodological perspectives and anchored in a multidisciplinary approach, is a purpose shared by the authors who contributed to this book. Helping to build a coherent economic governance framework to put the Eurozone at the heart of European integration is an ambition that encourages us, and if this time of some calm and stability is not harnessed to make the process more robust and balanced, the future of the European Union itself may be compromised in the face of a forthcoming (and inevitable) crisis. Some initiatives already taken seem to go in the right direction, but some loose parts still remain, so that, in the event of a new crisis, the collapse of the European project may actually occur. On the one hand, the linkage between sovereigns and banks has not been completely broken, so completing the Banking Union should be a priority task. On the other hand, the sharing of private risks across capital markets is still incipient, while public risk sharing will only be effective when the fiscal integration are further consolidated. Finally, the process of macroeconomic stabilization remains limited, with the adjustment only on the ECB’s non-conventional monetary policies, which we believe to be scarce. These are key issues that we address in this twelve-part book, which we briefly introduce.

SYNTHESIS OF THE CHAPTERS INCLUDED IN THIS BOOK The book opens with the essay by Vítor Bento that considers that the conceptual framework that underpins the governance of the Eurozone clearly showed its failures, as it did not reveal the capacity to deal with the systemic reality underlying an effective monetary union. In the superficial way in which the crisis of the Euro has been dealt with, serious social and economic consequences have arisen and, according to the author, the necessary lessons must be taken so that the functioning of the European Monetary Union can be improved.

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The poor management of the crisis has also had political effects, especially the gradual growth of a sentiment of animosity between debtor and creditors countries within the Eurozone. In debtor countries the feeling of injustice has spread due to the severe penalties suffered and that will have benefited its creditors, since the external surpluses of these increased during the crisis. A different feeling occurred in the creditor countries for which the indiscipline of debtor’s public finances and the expansionist behavior of consumption were the main reason for the crisis. (Re)building a basis of trust between the two groups of countries is crucial in order to agree on the structural reforms that must be carried out, assuming effectively that in a monetary area adjustments in current balances have to be more symmetrical. In their chapter Carlos Vieira and Isabel Vieira evaluate the experience of the Eurozone, taking into account the direction of the causality of the economic effects when a Monetary Zone is created, opposing two visions: on the one hand, those who defend the need of adjustment mechanisms to react to asymmetric shocks and/or to reduce the probability of their occurrence when the criteria of the optimum currency areas are not satisfied; on the other hand, the approach that supports the existence of endogeneity in monetary unions and which sustains that monetary integration, in itself, promotes real convergence, making national means of adjustment unnecessary. In this context, the validity of these arguments is evaluated empirically, taking into account the evolution in the internal and external imbalances of the Eurozone members. The results eloquently show that the hypothesis that the single currency has approached the economic structures of the member countries has not adhered to the reality, as the evolution during the crisis robustly stated. Thus, those who believed in the automatism of the functioning of the new monetary framework failed and that this dynamic would lead to the convergence of economies. The authors recommend that Eurozone leaders, in addition to common measures to combat macroeconomic imbalances, should recognize that adjustment efforts cannot be undertaken only by countries that have a current account deficit, but also by accumulated surplus positions, making the process of systemic readjustment easier. The synchronization of business cycles is assumed by some authors as a requirement for the effective running of a monetary zone. When the Eurozone was founded, the business cycles of many of its members were not synchronized and the governance model for the single currency seemed ill-suited to adjusting its members if necessary. Thus, José Manuel Caetano, Elsa Vaz and António Caleiro evaluate what has happened since the beginning of the Euro and conclude that after 2007 the degree of synchronization of business cycles in the Eurozone, especially in the peripheral countries, has toughly diminished. On these trends, the authors consider that the events related to the crisis of the sovereign debts spawned different effects on the countries that led to the divergence of structures and of their business cycles.

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As already mentioned, there is some consensus on the reasons for the crisis in the Eurozone, and it is accepted that the implicit causes denote supervision failures, the absence of institutions capable of supporting the absorption of shocks and also gaps in the way the crisis was tackled. For some scholars, the effects of the crisis questioned the viability of the governance of the EZ, from which economic, financial and institutional changes took place. The implementation of the reforms initiated and the progress in areas such as fiscal integration could eventually make the Eurozone sustainable and beneficial to all members by bringing it closer to the criteria for the functioning of an optimum currency zone. In the following chapter Paulo Ferreira, José Manuel Caetano and Andreia Dionísio assume that the effective integration of financial markets is a decisive feature in a process of monetary unification, since the integration of these markets allows a greater sharing of risk among agents and therefore contributes to a better allocation of savings and investment in an integrated space. Thus, the authors assess the evolution of financial integration in the Eurozone and conclude that there has been a gradual and expressive fragmentation of the financial markets, particularly notorious after the onset of the sovereign debt crisis, witnessing the fact that an incomplete monetary unification process is being faced. While recognizing some progress made in the post-crisis period with regard to financial integration, the authors advocate additional reforms to ensure that the smooth functioning of the financial system contributes to the resilience of the Eurozone. To this end, policy options must be clarified and countries must be available to give up some of their sovereignty in return for greater stability in the EZ, ensuring conditions for all members to benefit. There is therefore a need to make progress in reducing risks, notably by improving prudential management and market discipline, but there is also a need to reinforce and share risk, in particular through a deposit insurance mechanism and a solution that enables mutualization in issuance of public debt in the Eurozone countries. Completing the Banking Union and the Capital Markets Union should be a priority, since common supervision and risk sharing will be the central pillars of the financial integration process. The chapter by Brites Pereira and Miguel Rocha de Sousa describes the need for a European Banking Union, both as a reply to the shortcomings of an incomplete Monetary Union, its diagnosis and current accomplishments. It looks forward to a fully-fledged solution of an integrated Banking Union. Its main idea is that a full European Banking Union might be an instrument, by severing the ties between sovereign and bank risk, if properly used, to avert the next euro and global crisis. Thus, being proactive and not only reactive in Banking Union design and its implementation may foster higher returns for Eurozone Stability and all EU. The design of an optimal full Banking Union contemplates three aspects: European Deposit Insurance System (EDIS), Banking Recovery and Resolution Directive (BRRD), European Stability Mechanism (ESM) evolving to a complete European Monetary Fund (EMF). While overcoming identified policy gaps is always politically difficult, there is

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little chance of further progress unless they are addressed by authorities. It is sobering to note that political frictions are now impeding the establishment of a more optimal risksharing arrangement for the Eurozone. The current economic environment also makes the need for more reform efforts less urgent. Lacking favorable conditions, it is likely that only a future crisis will generate enough political impetus to pursue further reforms. The chapter displayed by Paulo Vila Maior and Isabel Camisão focuses on the analysis of the responses of the community institutions to overcome the crisis in the Eurozone, trying to identify which entities were more and less protagonists in this process. According to the authors, there have been changes with some significance and these are shifting the balance of powers in the EU’s organic, proving the emergence of a new institutional balance in the governance of the Eurozone. This ongoing reform, caused by the recent economic and financial crisis, has helped redefine the role of some institutions and the new contours of Euro governance. The ECB and the ‘Eurogroup’ will thus have been the major beneficiaries in terms of skills gains, as the European Parliament has shown only some capacity for influence through informal channels and the European Commission’s role in the solutions and options that have been implemented is something ambiguous and still unproven. It seems consensual that the ECB emerged as a central player in the new governance of the Eurozone, not only for its role in guiding and managing monetary policy, but really because it went beyond this and challenged the separation of powers enshrined in the Maastricht Treaty between monetary policy, of its exclusive responsibility, and the fiscal policies of the countries. Indeed, the Member States’ public debt programs have given the monetary authority the opportunity to extend its influence to budgetary policies. It is not that the ECB played a major role in the design and implementation of these policies, but it seems clear that by breaking the constitutional prohibition on EC intervention in those policies, there is room for the ECB to be given functions close to the liquidity provider to countries under difficulties, whose absence from the Euro model contributed to widening the crisis effects. In this way, a new model of governance of the single currency seems to germinate. On the basis of the European leaders’ renewed commitment at the time of the 60th anniversary of the Treaty of Rome to complete the framework of the European Economic and Monetary Union (EEMU) and the subsequent European Commission reflection texts on the future of Europe and the deepening of the EEMU, Ana Gouveia presents an overview of the most salient aspects of the current discussion, regarding the reform of its model of government. It therefore considers that, despite the recent crisis which has given impetus to improving its governance in economic, financial and fiscal aspects, gaps remain that must be overcome in order to build a prosperous and stable Union. Without masking the differences in the various positions on how to improve the current model, where some focus on market-based market solutions that allow for sovereignty sharing and others require higher risk-sharing among Eurozone members, the author argues

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that there is a common element to the various approaches when everyone recognizes the need to continue the reform of the system, which has not allowed to develop the full potential of monetary unification. Considers, furthermore, that there has been some progress in recent years and that the discussion on the further development of new solutions on the future of the European Union must be pursued by extending the debate to areas such as security, migration and the improvement of the single market, for only a more comprehensive vision can provide prosperity and stability throughout the Union. The chapter presented by Manuel Porto is especially concerned with the general budget of the European Union. In particular, with the recent crisis it should be asked whether it should have a larger dimension and other purposes, in particular being better prepared to have an anti-cyclical intervention, or contributing to a better redistribution of income and wealth. This is a question with the paramount importance and the greatest actuality in the beginning of the preparation of the coming Multiannual Financial Framework (MFF) and when a new proposal for the financing of the budget is expected. This is extremely relevant to attain a fair distribution of costs between central and peripheral countries. Indeed other ways of intervention should be found, some of them are just considered in other chapters of this book. And we should expect a larger dimension for the EU budget, which cannot remain below one percent of the GDP of the Union as a whole. But even with larger resources the EU budget should go on being mainly concerned with the improvement of structural conditions, contributing to narrow the disparities between the Member States and of the European regions. As the recent experience has already shown, mitigating the effective impact of the crisis, this is a realistic and very important way to improve and provide resources for a better Eurozone governance, corresponding to its challenges and benefitting from its opportunities. In their chapter, Annette Bongardt and Francisco Torres start out from the fact that EMU’s governance framework had remained incomplete, which in turn allowed for the building up of competitiveness and fiscal disequilibria in some Member States during its first ten years, and left the Eurozone unprepared to cope with the sovereign debt crisis. While they concede that some of those weaknesses have in the meantime been addressed in response to the crisis, they sustain that EMU’s governance framework is still incomplete to date. As a consequence, EMU – or at least the membership of individual countries – will not be sustainable without further European integration at the Eurozone level and without (creating sufficient) national adjustment capacity and political willingness to implement economic reforms. The authors argue that those reforms are a pre-condition for promoting sustainable growth and thereby a credible exit strategy from the crisis but that they will only happen if the participating countries are committed to the objectives they had subscribed to. In their view, Brexit will facilitate a necessary deepening of European integration by the core Eurozone Member States. However, not all countries seem prepared to embark on completing the economic union side of EMU and undertake the necessary reforms at the

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domestic level. It is therefore conceivable if not desirable that some Member States, which have committed to join EMU but seem now unwilling to do so, may at some point choose to invoke article 50 and leave the EU and remain just members of the European Economic Space. In view of the effects of the crisis on the most vulnerable economies in the Eurozone, unemployment and the population at risk of poverty have increased significantly. This has led to an escalation of the dispute over the European construction project in general and the Euro in particular, which has undermined the political feasibility of this model of monetary integration. Thus, the chapter by José Manuel Caetano and Nuno Rico discusses the rational and the need to include a social dimension in the European Monetary Union, evaluates the initiatives already taken in this area and advances with some proposals, stressing the importance of a centralized macroeconomic stabilization mechanism. The authors acknowledge that, while some interesting initiatives have been taken to strengthen the social dimension of EMU, concrete action to strengthen social cohesion has become less important as the effects of the crisis have been absorbed in the countries of the European center. At the same time, just technocratic solutions have been consolidated, such as the ‘European Semester’ or the legislative packages for policy coordination, which frame a model focused on stability and budgetary control, forgetting other relevant facets of the crisis. Thus, while the bureaucratic-administrative logic, in which each country deals with itself and the EMU coordinates and monitors if it has coalesced, the fiscal integration, the creation of central budget capacity, and the deepening of political integration are waiting for a new opportunity. The chapter presented by António Covas in this book, from a political science perspective, assumes that the permanent negotiating environment that has sustained the complexity of the Community method is a particular case of a process of politicalinstitutional construction somewhere between an international regime and a federal approach. The author extends this reasoning to the rational that supports the political economy of the Eurozone, whose governance will be amidst the adversatorial and the consociational models. However, it warns that the objective of the analysis is not the choice between these models, which embody compromises between national interests and European interests, but rather to dissect the foundations that underpin the compromise between the ‘stealthy federalism’ of the non-elective entities and the ‘cooperative federalism’ of the elective nature and multilevel governance. After analyzing the major restrictions, limits and potentialities of these models, the author considers that the European Union, at this post-crisis stage, in which it has profusely revealed the institutional weaknesses of the governance model of the Eurozone, is in a crucial moment in that it has to make choices on the path it wants to take on the difficult road to building political union. In this way, recourse to the foundations of cooperative federalism and collaborative common goods can help to build an alternative route along a renewed Eurozone and, of course, a new threshold for the European Union as a whole.

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The financial instability arising from the crisis spread throughout the Eurozone and threatened its integrity, for that not being a surprise that there were serious doubts about the future of the Euro and intense debates on the causes of the crisis and ways to correct its framework and complete (and correct) a process that has proved to be limited. Against this background, and given the uncertainty on global economic and financial developments and the political decisions to be taken, António Caleiro and José Manuel Caetano elaborate and discuss several scenarios on the possible evolution of the European monetary integration. The chapter translate the crucial uncertainties about the process and the structural challenges to face, which shape the various responses that can be given at the socioeconomic and political-institutional levels. The possibility of the dismemberment of the EMU, or the withdrawal of some of its members, constitutes a risk and, basically, the reason for this approach. The authors describe the various scenarios that may occur and focus on discussing the conditions necessary to support the scenario they call ‘favorable’ and which, in their opinion, will ensure the continuity of the European integration process. They recognize that when the Eurozone was created it was not an optimal monetary area nor was its governance structure have mechanisms for its efficient functioning. In order to sustain this scenario they defend that the Eurozone will have to gradually approach the conditions of the OCA. This will only be feasible with greater political integration, which should make the process of fiscal integration viable. So far, reforms have continued to focus on the strict application of fiscal rules and on strengthening supervision, and while their relevance to supporting the stabilization of monetary union are not disputed, the authors believe that such a strategy is not enough. Indeed, in a context where the common monetary policy is limited to economic stabilization, it will be crucial that risk sharing has sufficient resources and leverage to play its stabilizing role. Such, can only be done through a superior sharing of sovereignty in fiscal policy.

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ACKNOWLEDGMENTS A book written in times of turmoil and disintegration with Brexit is always keen to try to be a milestone on the Eurozone. Only time will tell our effort to understand the reality. We must thank Nova Science Publishers for continuous support, especially Carra Feagaiga, for putting up with deadlines and having comprehension of our full daily activities. A word of incommensurate thanks for all authors/contributors for keeping up with deadlines, pushing us up to comply with harsh reality. A special word of thanks to António Caleiro and Vanessa Duarte for partial revision and translations, and numerous suggestions. Also a kind word of thanks for all our colleagues of the Department of Economics, at University of Évora for contributing and continuous support. A word of thanks for POCI-01-0145-FEDER-007659 funds from FCT Centre for Research in Political Science (CICP) which allowed financing for Miguel Rocha de Sousa. Also an acknowledgement to the excellent research environment provided by Center for Adavnced Studies in Management and Economics, Évora (CEFAGE) for their collaborators and members to participate in the book. Last but not least, a special thanks to our families for keeping up with our work in holiday seasons and time robbed from our household activities and family fun. Without all of them this would not have been possible. The editors, José Manuel Caetano, Miguel Rocha de Sousa

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In: Challenges and Opportunities … Editors: J. M. Caetano et al.

ISBN: 978-1-53613-474-2 © 2018 Nova Science Publishers, Inc.

Chapter 1

THE EURO MONETARY UNION WITH A FLAWED CONCEPTUAL FRAMEWORK Vítor Bento Nova School of Business and Economics, Executive Education, Lisbon, Portugal

ABSTRACT The conceptual framework underlying the governance of the euro area is flawed and is ill-adjusted to deal with a systemic reality that is much more than just a sum of its parts, as it is the case of a monetary union. Its application to the management of the euro crisis proved its flaws and had serious social and economic consequences, in terms of social welfare (income lost, higher unemployment and increased divergences). If the right lessons can be drawn from the handling of the euro crisis, then the working of the European Monetary Union can be significantly improved.

1. INTRODUCTION After eighteen years – a socially agreed threshold for entering adulthood –, the euro fell short of its promised success. It is true that it has favored convenience and promoted institutional unification in several areas of the political-economic functioning of Europe. But from the standpoint of the final achievements, measured by welfare indicators – growth and employment, in particular – measured in terms of their progress compared to other



Corresponding Author Email: [email protected].

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economic areas – namely, the non-euro group of the European Union and the US – the result is far from what would have been desirable.

Source: AMECO, May, 2017. Note: EA12 refers to the original 12 member of the European Monetary Union and EU refers to the whole European Union (euro and non-euro) Figure 1. Income Per Capita (% Growth, 1998-2016).

The early life of the single European currency shed an illusion of prosperity, fueled by an uncontrolled credit expansion sparked in turn by a concomitant jump in the world savings rate. Imbalances grew unchecked, in spite of very strict rules, whose enforcement was always very lenient. Having been Germany and France the first breakers of the rules on public finances, they were able to use their political clout to be exempted from the corresponding penalties. This undermined from the very beginning the rigor of the governing rules of the monetary union and laid the ground from their more generalized circumvention. So, many and substantial imbalances, financial and macroeconomic, were allowed to build up, notwithstanding the very strict rules designed to keep the union, and its member states, financially sober. Among the imbalances accumulated during those booming times of the early life of the euro, the most relevant were in the national balances of payments. Disregarded – under the unfounded belief that, in a monetary union, national balances of payments had become economic and financially irrelevant because all the financing would be in the common domestic currency –, these imbalances would later be at the core of the subsequent euro crisis.

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Source: AMECO, May 2017. Note: EA12 refers to the original 12 member of the European Monetary Union and EU refers to the whole European Union (euro and non-euro). Figure 2. Unemployment Rate, Average 1999-2016.

2. A MISCONCEPTION ABOUT THE ROLE OF BALANCE OF PAYMENTS The inappropriate comparison made with the US, or any other national monetary union for that matter, led to the belief that a national balance of payments could not pose a financing problem within the European Monetary Union (EMU). This generalized view was well explained, for instance, in the inaugural speech of a governor of the Portuguese central bank, in early 2000, dismissing the rising concerns expressed by some analysts about the growing external current account deficit of the country: “There is no macroeconomic monetary problem and no restrictive measures need to be taken for balance of payments reasons. No one analyses the macro size of the external account of the Mississippi or of any other region belonging to a large monetary union. ... If and when indebtedness is considered too high, expenditure will have to be cut, because the financial system will place limits on credit. The equilibrium will be spontaneously reestablished, through a mechanism of expenditure deflation, and no adjustment policies will have to be implemented. The aftermath of a strong indebtedness situation may have recessive consequences, but it is not a balance of payments problem”1.

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Constâncio (2000), Sworning-in statement given by the Governor (Bank of Portugal), 23 February 2000.

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The comparison with any national monetary union is senseless because the EMU is not part of any politically integrated community, as it is the case of a national state. Furthermore, not being part of a national (or supranational) state, it comprises several national states, politically independent, and it is secession susceptible. This susceptibility creates a risk of fragmentation (i.e., exchange rate risk under disguise) that gets exacerbated under strong financial tensions.

Source: AMECO, May 2017. Figure 3. Current Account Balances (% GDP) – Countries with External Support.

Source: AMECO, May 2017 Figure 4. Government Debt (% GDP) – Countries with External Support.

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There are no automatic mechanisms to compensate for financial and economic imbalances between states, like financial transfers or easy labour mobility, and there is no solidary responsibility among the participants. Which is to say that the union maintains all the ingredients for the development of balance of payments crisis. With the aggravating factor that it has created the illusion that the euro is a common domestic currency for member states, when in fact it works much more as a foreign currency – a currency that national authorities cannot control, namely for purposes of lender of last resort. This economic misconception was reflected in the diagnosis of the ensuing crisis and consequently on the use of an improper therapy.

3. MISDIAGNOSIS, VIRTUES, SINS AND ASYMMETRIES By diagnosing as a public finance problem what was really a problem of balance of payments, the authorities responsible for the governance of the EMU applied an inappropriate therapy that not only wiped out the illusory prosperity that preceded the crisis – which would be inevitable at some extent, given its inherent unsustainability –, but produced also an unnecessary economic slump and a widening of the gap between more and less prosperous countries. Besides ending up by aggravating considerably the situation of the public finances of the most affected countries. This exacerbated a series of internal contradictions in the union, which, if left unresolved, will endanger its integrity and risk the whole process of European integration. At the same time, the sub-optimal economic performance and the said gap deteriorated the political conditions of Europe, feeding back additional difficulties into the working of the union. From this misconception of disregarding the external balances of the participating economies and summarizing every imbalance simply to domestic financial incontinence, derives a very Manichean moralistic view that among other biases identifies deficits with “sin” and surplus with “virtue.” So, even we have to pay attention to the external accounts, only the deficits are problematic and are just a consequence of some domestic sin – on government budgets or wage settings – and should therefore be addressed only by the “sinner,” who should reestablish his domestic financial rectitude. Surpluses, on the other hand, are just the reflex of domestic financial probity, mean no harm by definition, and should raise no concerns or need of correction. Among its fails, this moralistic view has two moral problems: it is not possible for everyone to excel in virtue – as would be desirable for any moral doctrine –, because, pure and simple, surpluses cannot exist without deficits, which means that for some countries to be in external surplus it is absolutely necessary that some others be in deficit; and if only the “sinners” are required to adjust in order to get rid of their external deficits, without any action required from the “virtuous” surpluses, the pain necessary to become righteous, not

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only has to be increased (challenging the fair principle of proportionality), but will have to be spread out to the “virtuous” too. So even the “virtuous” end up being unfairly punished in the process 2. This comes to the old economic problem of asymmetry in dealing with external imbalances that, namely, impaired the working of the gold standard in the 1920s, leading to its implosion and to the exacerbation of the recession of the end of such decade into a major economic depression3. Since then, the issue has been a concern among many economists and political decision-makers. It was the main reason why Keynes opposed the gold standard and it was its main concern underlying its unsuccessful contribution to the conference of Bretton Woods, where the international monetary system for the post World War II was designed. As one of his main followers explains, “[t]he key issue was creditor versus debtor adjustment. The fact that under the gold standard, adjustment … was ‘compulsory for the debtor and voluntary for the creditor’ was the main reason for his hostility to it.” … All Keynes’s plans for a reformed gold standard were designed to make a degree of creditor adjustment compulsory or automatic.”4

Notwithstanding the many reflections and theories developed around it, the problem of asymmetric responsibilities remains unsolved because the restrictions faced by both sides have asymmetrical consequences, there is no incentive for the creditor side to voluntarily assume its own responsibilities and there is no regulatory authority with the power to impose it. So, once again, the burden of adjustment fell solely on deficit countries, while surplus countries kept or increased (considerably in the case of Germany) their surpluses, moving the whole euro area from external balance into surplus5. At the expense of lower growth and higher unemployment. It is true that the euro area is not a closed economy and that its members trade autonomously with the rest of the world. But it is also true that most of the external trade of the member states takes place with their partners within the area. Which means that most of the “foreign demand” addressed to each participating country comes from within the monetary union. Therefore the expansion or contraction in the domestic demand of each member state impacts on the foreign demand of the rest. On the other hand, as all members are tied up in a single currency (a stronger form of a fixed exchange rate regime),

2

It is what some authors call the Old Testament approach to justice (as opposed to the more forgiving New Testament): the venal cannot be left unpunished, even if some innocent have to be left unprotected to the punishing rage. For the use of these analogies see, for instance, Skidelsky (1998) p. 4 and Geithner (2014), p. 162. 3 On the problems of asymmetry involving the gold standard and its implications to the great depression, see Bernanke and James (1991). 4 Skidelsky (1998), p. 3 5 The increase in the external surpluses of Germany alone, between 2007 and 2016, is equal to 60% of the total external adjustment of Ireland, Spain, Greece and Portugal during the same period.

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adjustments in relative prices, if requiring only nominal reductions from one side, can become deflationary and recessive for the whole area. But the asymmetry in the working of the European monetary union has not been limited to balance of payments adjustments. It has been more generalized and has given rise to a feeling of discrimination since the foundation of the euro, as, from the outset, the perception had grown that the rules were applied with a rigor inversely proportional to the political and economic power of the various member states. The episode described in a book recording private conversations with the former French President, François Hollande, which boasts an agreement with the European Commission to circumvent the Community rules on budget deficits, by providing false information, is particularly relevant because of the impudence with which this fact is assumed, publicly and with impunity6. Such discrimination was somehow confirmed by the President of the European Commission, Jean Claude Juncker, who, in May 2016, corroborated that France had been given more room for maneuver (to meet the budgetary rules), “because it is France”7.

4. A FLAWED CONCEPTUAL FRAMEWORK AND THE MIXED-UP MEMORIES But coming back to the euro crisis, it was approached, not as problem of the euro area as a whole, requiring a macroeconomic response at this level, but as a sum of individual problems, requiring individual responses from each affected country. Approach that is well exemplified by the reaction of the German Chancellor, Angela Merkel, reported by the then French President, Nicolas Sarkozy, in 2008, to his proposals for some common measures to be implemented towards the emerging financial crisis: “Elle a dit: ‘chacun sa merde’”8. And so, the conceptual framework underlying the governance of the euro area (and by implication the euro crisis) refused to acknowledge the symmetry of responsibilities – economic, political and moral – between debtors and creditors for the crisis and especially for the obligations to counteract its effects, and resorted instead to the Old Testament kind of approach9. Until the eruption of the 2008 financial crisis, whose shrapnel only hit Europe with some delay, the set of rules and organizations that regulate the euro, that is its institutional architecture, could be considered reasonably appropriate for the functioning of the monetary union, at least under “normal” conditions. It is true that many voices, especially on the other side of the Atlantic, warned against it, but few people conceived the possibility 6

Davet and Lhomme 2016, pp. 959-964. Reuters, Business News, 31/05/2016, http://uk.reuters.com/article/uk-eu-deficit-france-idUKK CN0YM1N0. 8 Broad meaning: “each one takes care of his own shit”. Cf. Le Canard Enchaine, nr 4589, 08/10/2008. 9 See 2 above. 7

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of a crisis with the size and the contours of the one that came to happen and which, even today, is not sufficiently dissected yet. The main failure of that period laid much more in the indulgence and double-criterion with which the rules were applied, and in the lack of timely preventive action, than in the architecture itself. If each country, on one hand, and the common authorities, on the other hand, had done their jobs properly, most of the euro crisis could have been, even if not totally avoided, at least minimized. It was only with the eruption of the euro crisis that the institutional architecture saw the inconsistencies and drawbacks of its conceptual framework being exposed, although they still remain to be acknowledged by most of the inspirers of the framework. Such conceptual framework is basically the German framework, which, being well suited to an individual country – and seems to have underpinned the German post-war economic success – is maladjusted to a systemic reality, composed by several interactive entities, as it is the case of a monetary union. It tends to neglect the cross-effects of the interactions among the members of the system and their impact on the overall equilibrium of the system. The framework so underestimates the systemic consequences when several members of the system undertake the same type of action, at the same time, as it tends to disregard the compounded effects of the resulting interactions. In such a case, the expected total effect on the system cannot be calculated by simply adding the expected results of each individual action. It has to include the compounded effects of all the interrelationships triggered by each individual action on the global system and on each of its members. Which is much wider than the mere sum. This kind of view tends therefore to fall too much into the normative economy, getting shaped with an excess of moralistic contours, as mentioned already. It fails to notice two philosophical realities: what is true for one part of a set of interrelated parts may not be true for the whole set or a subset composed of many parts taken together; and that an excess of virtue, may become a vice. Said in other words, the quality (or nature) of the output of a process may be dependent on the quantity of the (similar) inputs10. For example, saving is an individual virtue, but if all members of an economic system save more than they invest, the system goes into a self-destructive spiral. On the other hand, the German conceptual framework rejects the idea of insufficient aggregate demand in the economy, believing that supply creates its own demand, that any imbalances between the two sides are the result of the dimming of automatic price adjustment mechanisms (including wages), and that any attempt to intervene administratively in the process, in particular through active demand management, will ultimately lead to central planning of the economy.

10

See, for instance, Hegel, Science of Logic, and Aristotle, The Nicomachean Ethics (especially the Doctrine of the Mean embedded into the Table of Virtues and Vices).

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In this way, the best means of ensuring full employment is by ensuring that prices and wages are flexible so as to allow automatic adjustment between supply and demand (whether of products and services or of labour). It is, therefore, a model that rejects the effectiveness of demand policies, considering that they end up generating more disruption, and favors instead policies aimed at making markets more flexible. It should be noted that the fear that administrative intervention in the management of economic demand could lead to the central planning of the economy does not have the unidirectional political connotation that could be assumed at first sight, i.e., of a socialist drift. It is a fear that covers drifts to both extremes of the political spectrum, since the retained experience of such risk is mainly associated with the economic management of the Nazi regime. As for the effectiveness of the model, unfortunately, the functioning of the economy in the real world is more flawed than the ideal implicit in the model, with prices and wages, in particular, being much more rigid downwards than upwards. To rely on the fall of prices and wages to rebalance the economy is very inefficient and carries a very high social and political cost, as abundantly shown by the studies on the Great Depression of the 1930s, of which, by the way, Germany was one of the major victims. For that reason, is it generally accepted among economists today that a recession can be abbreviated, and the inherent social costs mitigated, by an “administrative” injection of State demand into the economic circuit, or by the “administrative” lowering of interest rates by the central bank, in order to induce more private demand. This is, in brief terms, Keynes’s main recommendation after the aforementioned economic disaster and the realization that the downward rigidity of wages can keep the economy working below full employment for a long time. A recommendation accepted by the mainstream of economic thought, but rejected by the German conceptual model11. The fact that many of those who claim to be Keynes’s followers behave like the hammer-man – to whom everything looks like a nail12 –, whose sole recommendation for every economic problem is an increase in public expenditure and a more intense state intervention, validates the fears mentioned above and underlying the German conceptual model, and facilitates the acceptance of this model by many liberal economists on the right and on the left. But if that fact devalues the illegitimate drift of the false apostles, it does not invalidate the essence of the Keynesian contribution to prevent a depression or a prolonged recession13, in the same way that the harmful consequences of the abuse of antibiotics does not lead us to refuse its convenience when properly used or the doctors not to prescribe them when they are actually needed. For the difference between the “German model” and the mainstream of economic thought see, for all, Bratsiotis and Cobham 2016. 12 The case of the “man with a hammer” was generalized by Maslow, in the “law of the instrument”, referring to the overdependence on the tool that the user is most familiar with. 13 See a good sum-up in Skidelsky. 2010. 11

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During the acute phase of the crisis, what the conceptual framework in question led to was the compression of the aggregate demand of the euro zone, putting its economy into “overproduction”, with the consequent rise in unemployment and unnecessarily exacerbating the recession. With the aggravating factor that the exchange rate of the euro was unable to counteract de excesses of demand compression, as all the member states were stuck with a common nominal exchange rate, while real exchange rates were in need of adjusting in opposing directions. All in all, the applied treatment to the macroeconomic imbalances was not much different of the use of bloodletting in medieval medicine, and made the costs of the crisis more asymmetrical. On the other hand, the application of the German conceptual framework to this crisis revealed an intrinsic deficiency that derives from the curious bias of German collective memory. For some reason, Germany retains a very vivid memory of the crisis of the 1920s (hyperinflation), but seems to have completely obliterated the memory of the 1930s (depression), whose economic, social and political consequences were equally, if not more, dramatic. This obliteration of the memory has had, and continues to have, serious consequences in the way the euro crisis has been addressed. Thus, a crisis whose closest parallel is in the crisis of the 1930s – with the Great Depression and the collapse of the gold standard (the exchange rate regime equivalent of the euro in those times) – has been approached with a mental framework shaped by the memories of the crisis of the 1920s, whose nature is quite different. This contradiction, which I had already noted14, was also pointed out by the former President of the European Council, Van Rompuy, in a speech given at the Economic Forum in Brussels on 10 June 2014. There, he said, among other things, that the: “Differences in the understanding of the crisis are deep and should not be neglected, since they impact our response to the crisis. They often reflect different cultural, historical and intellectual traditions, including respective histories of economic facts and economic thought. ... Germany ... vividly remembers the hyperinflation of the 1920s. ... The fact that the Keynesian policies of the 1930s were undertaken by the Nazi regime also left traces. These memories have resulted in a strong skepticism towards economic policy discretion as well as towards policies susceptible to create inflation”15.

It is worth mentioning that the problem with the German memory had also been pointed out in an article published in the blog of The Economist, Free Exchange, in November 2013, which concluded that “A selective memory of the past may prove worse than no memory at all”16.

14

Bento. 2013. Pp. 155-116 Speech by President Herman Van Rompuy at the Brussels Economic Forum 2014 - 4th Annual Tommaso PadoaSchioppa Lecture, (EUCO 127/14, PRESSE 334, PR PCE 117). 16 “Germany’s hyperinflation-phobia”, (25/11/2013), https://www.economist.com/blogs/free exchange/2013/11/ economic-history-1. 15

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5. YOU SEE RECESSION, I SEE INFLATION The mix-up of memories and its biased implication for the conceptual framework of the euro was well reflected in the way the crisis was originally faced by the euro authorities. On 3 July 2008, when the world economy was already on the way down and the signs of the European banking crisis were already visible17, the ECB announced, through its President, Jean Claude Trichet, that: “We decided at today’s meeting to increase the key ECB interest rates by 25 basis points. This decision was taken ... to counteract the increasing upside risks to price stability over the medium term”18.

And on September 17th of the same year (after the collapse of Lehman Brothers), Jean Claude Juncker, then president of the Eurogroup, said: “I do not think the Eurozone is on the brink of the recession ... the main concern we have is inflation.”

The euro area’s GDP virtually stagnated in 2008 and fell by 4.4% in 2009, the biggest drop for the whole group of countries since the Great Depression. Despite the depressed background, the Heads of State and Government of the European Union on 25 March 2010, when announcing the first rescue program to Greece, warned that the objective of the aid mechanism: “Will not be to provide financing at average euro area interest rates, but to set incentives to return to market financing as soon as possible by risk adequate pricing.”19

That is, although Greece was virtually bankrupt and unable to pay anything, aid would be granted at penalty rates to punish Greek “misbehavior.” Those familiar with History will certainly notice the similarities of this moralistic view with the view that pervaded the Treaty of Versailles, with which the Allies sought to punish Germany in 1919. Keynes rightly and timely warned against the consequences of such approach20, which eventually led to the destruction of the Weimar Republic and its emerging democracy. And on May 7th they reiterated that in the fight against the crisis:

17

Interestingly, the 2008 Financial Stability Report of the Bundesbank was never published. ECB, Introductory statement with Q&A to the Press Conference held on Frankfurt am Main, 3 July 2008 (https://www.ecb.europa.eu/press/pressconf/2008/html/is080703.en.html). 19 Statement by the Heads of State and Government of the Euro Area, 25 March 2010. 20 Keynes. 1919. 18

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Vítor Bento “Consolidation of public finances is a priority for all of us and we will take all measures needed to meet our fiscal targets this year and in the years ahead in line with excessive deficit procedures. Each one of us is ready, depending on the situation of his country, to take the necessary measures to accelerate consolidation and to ensure the sustainability of public finances”21 (emphasis added).

In 2011, when the problem originated in Greece was already spreading across the periphery of the euro zone, the concern of the ECB continued to be inflation. On April 7th – after the first rescue program to Greece, the rescue program to Ireland, and when the request for rescue by Portugal was already imminent –, Trichet repeated the litany of 2008: “... the Governing Council decided to increase the key ECB interest rates by 25 basis points ... The adjustment ... is warranted in the light of upside risks to price stability that we have identified in our economic analysis.”22

Three months later, with the periphery crisis deepening, and the monetary union totally fragmented and on the brink of collapse, he announces a new rate increase, with the same refrain: “The further adjustment ... is warranted in the light of upside risks to price stability.”23 And in September, Juncker reaffirmed that “fiscal consolidation remains a top priority for the euro-area.”24

Contrary to the authorities’ concerns, the Eurozone entered a new recession, with GDP set to fall again in 2012 and 2013, and with public finances and the economy entangled in a recessive spiral: the more the authorities tried to consolidate the public finances, the more the economy sank, and the further it sank, the more demanding the consolidation became. Many more examples could be added, but I believe these are sufficient to support the statement made about the mismatch between the evocable crisis to compare the actual crisis with and the memory actually evoked.

6. WRONG DISEASE, WRONG MEDICINE So, with the wrong evocation of the historical memory, the mistakes made in the 1930s – that led to a deepening of what might have been a “normal” recession, and to the collapse 21

Statement by the Heads of State and Government of the Euro Area, 7 May 2010. ECB, Introductory statement with Q&A to the Press Conference held on Frankfurt am Main, 7 April 2011 (https://www.ecb.europa.eu/press/pressconf/2011/html/is110407.en.html). 23 ECB, Introductory statement with Q&A to the Press Conference held on Frankfurt am Main, 7 July 2011 (https://www.ecb.europa.eu/press/pressconf/2011/html/is110707.en.html). 24 http://ca.reuters.com/article/businessNews/idCALDE78G00Z20110918. 22

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of the gold standard (the euro of that time, so to speak) – have now been repeated: (i) excessive recourse to austerity, applied to all the countries at the same time; (ii) imposition of internal devaluations on countries with external deficits – in spite of the aforementioned downward rigidity of wages; and (iii) refusal to require a corresponding internal revaluation from surplus countries, despite the considerable undervaluation of the real exchange rate of Germany. As similar actions, in similar circumstances, produce similar results, no one can be surprised that the same recipe led to similar consequences: (i) deep recessions; (ii) deflation; (iii) tensions in the exchange rate regime (i.e., on the sustainability of the euro); and (iv) growing political extremism. And if the result turned out to be less dramatic than in the 1930s, it was because at least the central bank, after changing its presidency, seems to have learned from the academic work on the Great Depression and has flooded the market with successive waves of liquidity. Creating other risks with this, it is true, but containing the potential ravages of the time.

Source: AMECO, May 2017. Figure 5. GDP per Capita (2010 Prices), % ∆ (2007-14).

Therefore, the macroeconomic outcome of inappropriate policies was, for the euro area as a whole, a very inefficient and socially detrimental combination of: (i) an external surplus (meaning that the whole area saves more than it invests and exports the excess of savings, promoting the creation of jobs abroad); (ii) a very high unemployment rate; (iii) a substantial amount of lost income; and (iv) lower growth potential. All because the policies put in practice, and despite the central bank’s flood of primary money and abnormally low interest rates, drained much of the demand needed to absorb the potential output of the euro area.

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The misdiagnosis of the crisis – as a problem of public finances instead of balance of payments – and the consequent wrong therapy derived from such misdiagnosis, not only led to an unnecessary deepening of the recession, but to a considerable worsening of public debts, in particular for the countries subject to rescue programs.

Source: AMECO, May 2017. Figure 6. Government Debt (% GDP).

In fact, the over-use of austerity – applied to every country, without considering its systemic repercussions, namely the drying out of the reciprocal “foreign demand” originated within the euro area, and on which most of the exports of the members of the system depends – gave rise to a socially inefficient outcome: lower output, higher unemployment and external surplus. The euro area as a whole, moved from a situation with a moderate internal imbalance (unemployment) and an external balance to a situation with a higher internal imbalance (higher unemployment) and an external imbalance (external surplus). While the US, for instance, practically eliminated its external imbalance (current account deficit) with a moderate worsening of the internal imbalance (unemployment still lower than the starting point of EA12) and Japan moved to full balance, internal and external. We can say that in aggregate, the policies implemented by the euro area, based on its flawed conceptual framework, led this economic bloc, as a whole, to increase its unemployment so as to produce more savings to be exported abroad to finance employment elsewhere.

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Source: AMECO, May 2017. Figure 7. Domestic Demand and GDP (2010 Prices) - ∆% (2007-14).

Source: AMECO, May 2017. Figure 8. Changes in External C/Account & Unemployment Rate, 2007-14.

7. THE UNSEEN ORIGINAL SIN There was, though, another flaw in the diagnosis of the crisis, with consequences for the adopted policies, but this flaw was more generalized and is more understandable in view of the misleading appearances in front of decision-makers and analysts. Excessive indebtedness and spending were taken as the major culprits of the crisis, because

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appearances pointed into that way. So, containing and reversing these excesses was seen, in those circumstances, as the appropriate remedy.

Source: IMF (WEO, April 2016) & Own Calculations. Figure 9 World Savings (%GDP, PPS).

Source: AMECO, May 2017, and Own Calculations. Figure 10. Long Term Interest Rates (Synthetic Indicator).

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It turns out that the reality worked exactly contrary to that understanding. There were, most certainly, irresponsible spenders and debtors. But the original sin, so to speak, the first cause behind the financial turbulence that unfolded in the major economic and financial crisis was excessive savings rather than debt. To be more precise, it was the excess of savings, mostly exported through current account surpluses that led to excesses of indebtedness in other countries and not the other way around. If any doubt may arise about this, we can just recall the basic economics framework: if an economic shock produces an increase of the quantity and a fall of the price (of financial resources in this case), the shock is undoubtedly a supply shock.

CONCLUSION The mismanagement of the euro crisis did not have only economic consequences, holding back the Eurozone vis-à-vis other major economic blocs. It also had political consequences, namely disintegrating ones, which threatened the sustainability and integrity of the monetary union, as well as the whole process of European integration. It has led to the accumulation of resentment between the two sides, debtors and creditors, making it more difficult to find common ground to rebuild a more harmonious co-operative environment. On the side of debtors, rose the feeling of having been subjected to unjust suffering to the benefit of creditors whose savings and external surpluses continue to grow, despite the elimination of debtors’ external deficits; on the side of creditors, developed the feeling of being financially exploited by unsustainable spenders. If this gap is not closed and the necessary common ground is not found, the prospects for Eurozone continuity will be rather bleak, notwithstanding the idealisms proclaimed by politicians. To prevent such bleak outcome, an open and serious analysis about the shortcomings of the Eurozone governance and its necessary reforms is required. The recent surprising events in the Western political environment – the Brexit and the election of Donald Trump as US President – may turn out to be the unexpected trigger for a turnaround in the willingness to reform the conceptual framework that has governed the European monetary union. Europe needs to assume greater responsibility for its own defense, which can only be done safely at a supranational level. For that to be possible, the European integration process will need to deepen its political structure. And for that to be viable, more economic and social cohesion will be necessary, which means that many of the rigid German principles will have to be softened and more solidary responsibilities will have to be assumed by all the participants. In exchange for more political integration. Which might close the unsustainable contradiction of the European integration process, open since Maastricht: promoting monetary integration and refusing monetary integration.

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The signal for such change might have been the thought that Angela Merkel let out of her chest last May, after the disappointing visit of Donald Trump to Europe: “I can only say that we Europeans must really take our fate into our own hands.”

REFERENCES Bento, V. 2013. “Euro Forte, Euro Fraco, Duas Culturas, Uma Moeda: Um Convívio (Im)possível?.” [Hard Euro, Soft Euro, Two Cultures, Once Currency: A (n Im)possible life together?] Bnomics. Bernanke, B. and James, H. 1991. “The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison.” In Bernanke, B., editor 2000. Essays on the Great Depression. Princeton University Press. Bratsiotis, G. and Cobham, D., eds. 2016. “German macro: how it’s different and why that matters.” European Policy Center 6497, April. (http://www.epc.eu/pub_ details.php?pub_id=6497). Accessed on November 4th, 2017. Constâncio, V. 2000. “Sworning-in statement given by the Governor,” 23 February 2000. Accessed on December 11th, 2017. (https://www.bportugal.pt/en/intervencoes/ sworning-statement-given-governor), Davet, G. and Lhomme, F. 2016. Un Président ne devrait pas dire ça.... Paris: Stock. [A President should not say that…]. Geithner, T. 2014. Stress Test – reflection on financial crises. Random House. Kindle edition Keynes, J. M. 1919. The Economic Consequences of the Peace. New York: Harper Torchbooks. Skidelsky, R. 1998. “Keynes Road to Bretton Woods – an Essay in Interpretation.” Warwick Economic Research Papers 507. Skidelsky, R. 2010. “The relevance of Keynes,” Cambridge Journal of Economics 2011, 35: 1–13.

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ISBN: 978-1-53613-474-2 © 2018 Nova Science Publishers, Inc.

Chapter 2

THE ENDOGENEITY OF OCA CONDITIONS AND MACROECONOMIC IMBALANCES IN EMU Carlos Vieira and Isabel Vieira* Department of Economics, University of Évora and CEFAGE, Évora, Portugal

ABSTRACT When assessing the benefits of monetary union in Europe, an important debate over the direction of causality of effects emerged. On one side of the argument, the theory of optimum currency areas (OCA) recommended some a priori conditions necessary to ensure the gains from monetary integration. Underlying such conditions was the objective of either ensuring the availability of alternative mechanisms to allow adjustment to idiosyncratic shocks or reducing the probability of occurrence of such events. On the other side, advocates of the endogenous properties of currency unions suggested an inverse direction of causality, a position based on the assumption that monetary integration, by itself, promotes a quick process of real convergence, rendering domestic adjustment mechanisms irrelevant. Almost two decades after the birth of the euro, and in the midst of a prolonged financial, economic and political crisis in the European Union, for which many blame the single currency, there is now sufficient data to contrast both sides of the argument. In this paper, we use OCA indices to investigate the endogeneity hypothesis in the euro area, and to observe whether the dissimilar paths help explain current macroeconomic disequilibria, exposed in mounting internal and external imbalances.

Keywords: monetary integration; OCA endogeneity; international imbalances

*

Corresponding Author Email: [email protected]. "The authors are pleased to acknowledge financial support from Fundação para a Ciência e a Tecnologia (grant UID/ECO/04007/2013) and FEDER/COMPETE (POCI-010145-FEDER-007659)"

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1. INTRODUCTION The economic and monetary integration of Europe has always been more a political than an economic endeavor. This is why, whenever economic theory fails to provide technical support for a desired course of action, it is often either cast aside as irrelevant, or subject to selective interpretation, ignoring inconvenient outcomes and highlighting favorable ones. A typical example was the road to economic and monetary union (EMU). Although the optimum currency area (OCA) theory had long been established as an adequate framework to evaluate the odds of sucessfully adopting a common currency, empirical studies consistently suggesting that many European Union (EU) members were not apt to participate in the euro project were mostly disregarded. As the OCA theory was too relevant to simply ignore, the political resolve to press ahead was eventually justified academically just before the euro by the OCA endogeneity hypothesis of Frankel and Rose (1998), who claimed that OCA conditions were not static and would change with the dynamics of integration. There were therefore two confronting views on the implications of integration for OCA compliance: -

on the one hand, Krugman (1993) anticipated that EMU economies would become more specialized and diverse, and thus less suitable to share a common currency; on the other hand, Frankel and Rose (1998) defended that increased trade flows between EMU members would improve their OCA characteristics.

In a leap of faith, since most trade theories suggested that “economic integration allows regions to specialize,”1 the European politicians anticipated the materialization of Frankel and Rose’s scenario. Therefore, expecting a more homogeneous integrated area, naturally less exposed to asymmetric disturbances, they gave the go ahead to a monetary union lacking alternative stabilization mechanisms capable of replacing the ones lost in the process of integration. In this study, we extend a methodological approach developed in Vieira and Vieira (2012), built on the OCA indices proposed by Bayoumi and Eichengreen (1997), to assess whether members of EMU improved their OCA qualities since adopting the common currency. We show that various countries did not, thus confirming the single currency as an ill-designed project lacking compensating mechanisms. Contrary to the politically dominant wishful thinking, the euro failed to produce economic homogeneity. Instead, it intensified a pre-existing core-periphery pattern and promoted divergent growth paths leading to the accumulation of macroeconomic imbalances between core and peripheral countries. As anticipated by Krugman, whose 1

Krugman 1993, 244.

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1993 text depicts EMU without fiscal federalism as a disaster in waitting, when the first major crisis occurred, the absence of effective shock absorbers converted EMU membership into an impoverishing experience with dramatic consequences for its weakest participants.

2. EMPIRICAL ANALYSIS 2.1. The OCA Indices In the 1980s and the 1990s, most economic assessments of EMU’s potential costs and benefits consisted of some sort of OCA-based analysis. The OCA theory, born in the context of the 1960s debate over the desirablity of flexible exchange rates, points out conditions required for the successful adoption of a common currency by a group of countries. The seminal work developed by Mundell (1961), for whom labor mobility was the key factor, was followed by developments appended by Ingram (1962) - financial integration; McKinnon (1963) – economic opennes; Kenen (1969) – diversification of production structures; Mintz (1970) – political integration; Fleming (1971) – similarity of inflation rates; or Corden (1972) – price and wage flexibility (a thourough survey on the evolution of the OCA theory may be found in Mongelli, 2002). The OCA criteria were established in a perspective of either reducing the probability of asymmetric shocks or ensuring the availability of adjustment mechanisms capable of compensating the loss of domestic monetary and foreign exchange policies. In the logic of European integration, the adoption of a single currency was the natural step after single market completion. The elimination of foreign exchange volatily and of currency conversion costs were expected to enhance benefits from removing tariff and nontariff barriers to trade and thus to promote commercial flows in the integrated area. Trade creation was a crucial factor in this context as it was expected to improve the sychronization of member countries’ business cycles which, in turn, would reduce the utility of autonomous domestic monetary policies (Frankel and Rose 1997, 1998). This way of thinking about the process of European monetary integration, and the relevance of the trade-business cycle rationale, was reflected in Bayoumi and Eichengreen’s (1997) operationalization of the OCA theory. The authors estimated a model of nominal exchange rate variability (equation 1) and used it to compute OCA indices of individual countries against Germany. The factors taken into account to evaluate the desirability of monetary unification were the symmetry of business cycles (reflecting asymmetric disturbances to output), trade linkages, and the scope for using a separate currency in transactions (which is greatest for bigger countries):

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Carlos Vieira and Isabel Vieira sderijt = 0 + 1 sdyijt + 2 dissimijt + 3 btradeijt + 4 sizeijt + eijt

(1)

sderijt is the standard deviation over a ten-year period of the yearly log-variations in the bilateral nominal exchange rate between countries i and j, sdyijt is the standard deviation of the difference in the log of real output growth between countries i and j, dissimijt is the sum of the absolute differences in the relative share of each of eleven chain categories of merchandise trade in each pair of countries, btradeijt is the mean of the ratio of bilateral exports to domestic GDP in both countries, sizeijt is the mean of the two countries’ log of GDP measured in US dollars, and eijt is the stochastic error term. The assumption underlying the use of equation 1 to evaluate readiness for EMU participation was that countries with better OCA characteristics face more stable exchange rates. Thus, all coefficients were expected to be positive with the exception of  3 (as bilateral exchange rates are apt to be less volatile if the other country is an important trade partner). We used this model in a previous work to assess which of the two contrasting views on the OCA endogeneity hypothesis had prevailed in the first years of the euro (Vieira and Vieira 2012). In this chapter we extend that analysis to encompass the tumultuous period after the financial and economic crises. The OCA indices have been computed for the two pre-euro decades and also for two post-euro periods (see Table 1).2 The first, using data up to 2007, reflects the initial impact of the single currency. Most countries in the sample improved their OCA-indices, particularly the northern European countries, including some who are not part of the euro area, as Sweden and Switzerland. The Mediterranean European countries show very small improvements, and Greece and Ireland have even worsened their OCA characteristics. The two columns in the right-hand side of Table 1 exhibit post financial crisis indices. Comparing with the first post-euro decade, all countries, apart from the Netherlands, show worse indicators, reflecting the severity of the crisis. But there are again significant relative differences among the countries in the sample. Apart from the improvement in the Netherlands, Austria and curiously the UK, seem to have been the least affected. On the other extreme, Ireland and Greece continue to be the most diverging economies, followed by the two Iberian countries, Spain and Portugal. The values in Table 1 are replicated in Figure 1 for an easier comparison between countries and between time periods. To help discern the different countries’ paths, the chart

2

Equation 1 was estimated using panel data. For econometric details of the variables and the estimation see Vieira and Vieira (2012). All variables are measured as averages over ten-year periods. 21 OECD countries were considered: eleven EMU countries (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal and Spain), three non-EMU, EU members (Denmark, Sweden and the UK), and seven non-EU countries (Australia, Canada, Japan, New Zealand, Norway, Switzerland and the US). Data on bilateral nominal exchange rates were collected from the IMF's International Financial Statistics; GDP at constant prices in domestic currency and current GDP in US dollars come from the OECD statistical database; trade-related variables were computed from the IMF’s Direction of Trade Statistics and the UN Comtrade – International Trade Statistics Database.

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has been divided in two groups of “core,” with lower index values, and “peripheral” European countries, below. As we can observe in the figure, the Netherlands and Austria alternate as the top ranking country in terms of integration with the German economy, according to this quantification of the OCA theory. Immediately below, Denmark, Belgium, France and Switzerland always rotate between the third and sixth places of the ranking. This group of six countries, excluding Switzerland and including Germany, are for example the core countries most able candidates to integrate at a deeper level and faster pace in an often discussed “variable geometry” or “multi-speed” EU. Finland presents close values, albeit a more volatile path in terms of this OCA index due to the financial and economic crisis endured during the early 1990s. Besides remaining the most integrated countries over the four decades under analysis, they have all ultimately improved in absolute terms with the euro, in spite of the profound instability caused by the financial crisis. Table 1. European countries ranked by OCA index

Note: the index is computed using the regression estimates for the bilateral relationships with Germany, including the estimated unit-specific component of the random-effects model. The values are in ascending order of absolute value for each period and have been scaled by one hundred for easier comparisons.

Below these top “reserved” places we may note more volatility in the countries’ relative placements. The UK and Sweden, two countries outside the euro area, have followed very close paths, both at the bottom of the OCA-index rankings during the first decades examined, partly justifying their decision not to adopt the single currency. Although maintaining relatively stable absolute values across the analysis, they have more recently been replaced at the bottom by the descending peripheral countries more affected by the financial and sovereign debt crisis. Immediately above this duo is now Norway, a country outside the EU, who also displays relatively stable values of the OCA index, although with some relative changes in its position in the ranking.

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Figure 1. The evolution of the OCA index by European country Note: Inverted scale. The top chart displays the core European countries, with lower indices and therefore higher in the index ranking, the bottom chart depicts the less integrated countries according to the OCAindex.

The four countries with higher values (lower ranking) in 2016 are those who have suffered the most with the economic crisis caused by the financial crisis and the ensuing sovereign-debt crisis that have, at some point, threatened the whole European single currency project. The Irish and Greek economies, in particular, seem to have significantly diverged from Germany’s. Both countries’ indices have been systematically worsening since the euro’s inception, although their resulting current economic situation is quite different. These results suggest that the euro had a significant impact on the structure of the economies adopting it. On the one hand, we may observe that the changes in the index are on average much more pronounced after the euro than between the two first periods considered in our sample. On the other hand, all countries outside the EU or the euro area (Switzerland, Norway, Sweden and the UK) display quite stable values of the OCA-index

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across the four decades under analysis. Comparing 2016 with the values before the euro, this group of countries has on average even slightly improved. However, the impact on the euro area members was quite distinct, albeit the almost general negative effect of the financial crisis. While a group of core northern and central European countries now exhibit better indices than before 1999, the more peripheral members (Ireland, Greece, Spain, Portugal and Italy) all display worse values, suggesting they are now less integrated with the EU’s anchor economy, Germany, almost two decades having elapsed after adopting the single currency. The political reassurances that the euro would contribute to approximate the different economies and their populations’ living standards seem to have been largely overstated for this group of countries. The divergent effect of the euro seems to be closely related to the initial conditions, as predicted by Krugman and the traditional OCA theory literature. All countries with economic structures more integrated with Germany have improved the OCA index, even considering the negative impact of the financial crisis during the last decade. All countries starting with less integrated economies have diverged when comparing the current situation with the pre-euro values. In absolute terms, between 1998 and 2016, the average OCAindex improved 1.83 points for the core countries in the top chart, while it worsened 2.94 points for the countries in the bottom chart, 4.95 points when considering only the EU’s more peripheral members. The Frankel and Rose (1998) endogeneity hypothesis does not seem to have been yet confirmed for this group of countries. Figure 2 shows the different countries’ relative position in terms of OCA-indices in the two decades before the euro. With the values in inverted scale, the closer to the origin the less integrated is the country with Germany. Also, all countries above the 45 degrees line have improved their scores in terms of OCA conditions between the two periods considered. We can observe firstly that all points are very close to the 45 degrees line, indicating minor variations between both decades. Spain and Portugal have clearly improved, after joining the EU in 1986. From the bottom of the table in the first decade, together with the UK, both have become more integrated in absolute and relative terms. At the top of the chart, a group of five core members are clearly the more integrated with Germany, more prepared to adopt a common currency according to the OCA criteria. Apart from Finland, whose position at the bottom of the ranking in 1998 is largely explained by the severe banking crisis at the beginning of this decade, all other five countries in the group at the bottom have not joined the euro at its inception, either because they were not part of the EU (Norway), chose not to join (Sweden and the UK) or did not meet the required criteria set by the Maastricht Treaty (Greece). Immediately above these is a group of countries who chose to adopt the euro despite exhibiting low integration indicators, implicitly confident of the endogeneity hypothesis.

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Figure 2. The change in the OCA index, 1988-1998 Note: The horizontal axis represents the value of the OCA index in 1988 while the vertical axis displays the corresponding 1998 values. Inverted scale in both axis. In the 45 degree line the values in both axes are equal. Points above this line indicate an improvement in the index between both periods.

Figure 3 sheds some light on this hypothesis, contrasting the values of the OCA index in 2016 with those estimated for 1998. The figure clearly highlights the divergent effects on two groups of countries. On the one hand is a group of countries, all in the top and to the left of the 45 degrees axis, who have improved their OCA-indices, particularly Austria and the Netherlands. These countries benefited from a currency area, because they were better prepared from the onset, displaying closer economic structures, and because the single currency has endogenously improved their convergence with Germany. On the other hand we observe a group of countries with worse OCA-indices, below the 45 degrees line. These countries had less integrated economic structures with the EU’s core before the euro, and the single currency seems to have worsened their condition. Greece and Ireland, in particular, seem to be now much more distant from an OCA. Comparing figures 2 and 3, we can confirm that the euro has scattered the countries in two opposing directions, suggesting a much lower convergence in their economic structures. In line with Krugman’s (1991) model, the core-periphery pattern that characterized the EU prior to the adoption of the common currency was intensified by the reduction in transaction costs promoted by the completion of the single market and the euro. Moreover, De Grauwe (2013), for example, suggested that the single currency could have exacerbated the divergent economic developments between countries, given the asymmetric effects of a single monetary policy and the weakened automatic stabilizers of budget policies and the central bank’s role of lender of last resort.

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Figure 3. The change in the OCA index, 1998-2016 Note: The horizontal axis represents the value of the OCA index in 1988 while the vertical axis displays the corresponding 1998 values. Inverted scale in both axis. In the 45 degree line the values in both axes are equal. Points above this line indicate an improvement in the index between both periods.

2.2. OCA Indices and Macroeconomic Imbalances With the benefit of hindsight, we can now claim that the values of the OCA-indices could have been a reasonable predictor of the difficulties to come, of the enormous imbalances endured by the EU’s peripheral members. The argument of the traditional OCA literature is that unless a number of conditions are met ex ante, abandonment of autonomous national monetary and exchange rate policies would instigate significant macroeconomic imbalances, public and private, internal and external. In order to assess this claim, we present below a number of charts comparing the values of the OCA index immediately before the euro, and the subsequent developments in these imbalances, particularly the external and government budget ones. This simple empirical analysis opens with fiscal imbalances (Figure 4), the chief concern of the European authorities before (cf. the 1992 Maastricht Treaty convergence criteria and the 1997 Stability and Growth Pact) and after the euro implementation (cf. the 2012 Fiscal Stability Treaty). In terms of the average government budget deficit since adopting the euro, there is a clear connection between the values of the OCA index in the year preceding EMU and the average deficits presented by the euro area countries ever since (the correlation coefficient is very high, at 0.75). In fact, the value of the OCA index

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Figure 4. The 1998 OCA index and average government budget balances Note: Inverted scale in the horizontal axis. The solid line represents a fitted linear regression. Finland has been excluded for being an outlier.

in 1998 would have been a good predictor of the public budget imbalances to come, even considering the more recent strict austerity measures imposed on the countries in the bottom left side of the figure. As stated above, before the financial crisis erupted, fiscal imbalances were the chief concern of the European authorities, not current account imbalances (Mayer et al., 2012), disregarded for being irrelevant in a monetary union. However, after the introduction of the European single currency, external imbalances started to escalate. Low interest rates boosted consumption and the accumulation of large current account deficits in Ireland and in the southern European countries, with corresponding large current account surpluses in the northern European ones. In 2011, the EU introduced a Macroeconomic Imbalance Procedure, to prevent and correct risky macroeconomic developments, exposed by a number of indicators besides the fiscal variables. In terms of the current account, Figure 5 reveals again a strong relationship between the pre-euro values of the OCA index, and the average current account balances in these euro area members (0.77 correlation coefficient). There is again a marked divergence between a group of countries with positive current account balances on average (the Netherlands, Austria, Belgium and France) and a group displaying average negative balances during the whole post-euro period (Italy, Ireland, Spain, Portugal and Greece).

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Figure 5. The 1998 OCA index and average current account balances Notes: Inverted scale in the horizontal axis. The solid line represents a fitted linear regression. Finland has been excluded.

The hefty current account deficits in the southern European countries, mirrored by corresponding fat current account surpluses in the northern European countries, were largely financed by credit granted by the latter to the former (De Grauwe 2013). The cumulated current account deficits in some countries deteriorated their net international investment position. This indicator allows a more general assessment of a country’s imbalances with the rest of the world, including the public and private sectors. In Figure 6 we present the comparison between each country’s 1998 OCA index and the value in 2016 of its net international investment position as a ratio to GDP. The Netherlands, Belgium and Austria are the only net creditors in the sample (recall that Germany, the biggest net creditor of all, is considered in this analysis as the basis economy, against which each country’s OCA index is computed and is thus absent from the graphs). Ireland, Greece, Portugal and Spain have accumulated large deficits and remain at the bottom of the chart, in spite of recent relatively successful efforts to reverse the growing trend. Overall, there is again a strong relationship between both variables (the correlation coefficient is 0.66). Again, the value of the pre-euro OCA index would have been a worthy

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indicator of the difficulties ahead. Before the euro, these imbalances in the now most indebted euro area members represented a much significantly lower share of their GDP. When, in the wake of the financial crisis, all these imbalances had to be addressed, the burden fell mostly on the group of the southern peripheral countries, with a package of austerity measures that caused havoc in their economies, clearly visible in the average unemployment rates exhibited during the post-euro period. Figure 7 compares the values of the OCA index in 1998 with the average unemployment rates in the euro area countries since that year, showing, again, a clear correlation between both measures (the correlation coefficient is 0.85). This effect, resulting from an asymmetric adjustment mechanism, was profusely noted by the traditional OCA literature (cf. Mundell 1961, McKinnon 1963 and Kenen 1969) and later reinforced by, among others, Bayoumi and Eichengreen (1993) and Krugman (1993).

Figure 6. The 1998 OCA index and the 2016 net international investment position Note: Inverted scale in the horizontal axis. The solid line represents a fitted linear regression. Finland has been excluded.

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Figure 7. The 1998 OCA index and the average unemployment rates (1999-2016) Note: Inverted scale in both axis. The solid line represents a fitted linear regression. Finland has been excluded.

CONCLUSION Our empirical analysis of individual countries’ OCA characteristics before and after the adoption of the single currency suggests that the winner of the theoretical debate on whether the process of European integration would promote divergence or convergence is Paul Krugman. Against Frankel and Rose’s expectations, the dynamics of integration did not promote every country’s suitability for currency union membership. On the contrary, integration enhanced the pre-EMU core-periphery divide and fuelled asymmetric and unsustainable developments that emerged with a bang in the aftermath of the 2007 financial crisis. Although we do not attempt to discuss causes and effects, our ex-post assessment highlighted a strong connection between OCA compliance and macroeconomic imbalances. Countries from the onset displaying less favourable OCA indices ended out being in 2016 the ones more heavily burdened by government and current account deficits, higher international indebtedness and unemployment.

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In the tradition of mixing up political convenience and economic rationale, many Eurozone politicians, especially but not exclusively in the northern core, pointed out peripheral countries’ profligacy and rigid labour markets as the causes for the Eurozone imbalances. As a consequence, they defended, and succeeded in implementing, recovery programs that not only assigned the responsibility and burden of adjustment solely to the deficit countries but were also markedly ideological, imposing reforms that, in some cases, went against the will of elected governments (Dodig and Herr 2015, 202). Many economists have nevertheless pointed out that the Eurozone’s troubles reflected not bad behaviour from peripheral countries but EMU’s intrinsic failures following from its defective design. For example, taking the experience of the United Sates as a reference, Krugman (1993) pointed out that Europe would pay a high price if EMU was implemented without some kind of fiscal federal device to allow inter-country transfers in case of asymmetric shocks. Another relevant aspect is the fact that the Eurozone architects failed to recognize the importance of current account imbalances amongst member countries. Before the financial crisis, many academics and politicians believed that such imbalances did not matter, and thus neither did savings-investment balances (Giavazzi and Spaventa 2011). However, as Wyplosz (2017) defends, current accounts do not matter only in full monetary unions where financial integration is complete (“and a common set of financial rules is enforced effectively”) or a lender of last resort exists. None of these two conditions applied in the Eurozone and the earnings generated by core countries’ trade surpluses were carelessly channelled by their banks to finance the socalled profligacy of peripheral countries’ governments and families. The lenders’ excessive risk-taking, in part motivated by low interest rates prevailing since the inception of the euro, but mostly due to a lack of effective financial regulation and supervision, lead to panic and a sudden credit stop when, with the financial crisis, doubts emerged over the capacity of highly indebted agents to honour their debts. In the words of de Grauwe (2013, 17), “financial markets have split the Eurozone in two, forcing some (the southern European countries, the “periphery”) into bad equilibria and others (mainly northern European countries, the “core”) into good equilibria.” As referred at the beginning of this chapter, political determination has played a crucial role in the process of European integration and EMU was more the result of political will then of economic coherence. Taking into account the OCA theory, EMU peripheral countries should not have adopted the euro with its projected framework. They have endured, and are still facing, high social, economic and reputational costs for their decision to participate in the single currency project. However, despite some voices claiming that the Eurozone would be better off without its periphery, the dominant view still appears to be more in favour of Eurozone’s mending than of its dismantling. Domestic political constraints have nevertheless been preventing some necessary reforms. In the sake of the Eurozone’s continuity, its leaders need to find

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once again the political resolve that made them press on with the single currency project against widespread doubting. Monetary union reinforces domestic booms and busts but, in the case of Europe, individual countries do not possess stabilization mechanisms allowing them to deal with such events. It is not expected that the Eurozone becomes a fiscal federation any time soon. But there is the more feasible objective of establishing the European Central Bank as an effective lender of last resort (as defended inter alia by de Grauwe 2013). This would free governments from being called to bail out domestic banks and stop their vulnerability to the pressure of financial markets’ moods, preventing future debt crises. Finally, having acknowledged the need to prevent macroeconomic imbalances, Eurozone leaders need to also recognize, as they seem to be starting to, that there are two sides to an imbalance and adjustment efforts should not be solely shouldered by the deficit side (a view defended by Keynes in the 1944 Bretton Woods conference – Dodig and Herr 2015). Against the dominant political and media view, Eurozone imbalances do not simply reflect the supremacy of its core and the weakness of its periphery. Imbalances accumulated, not because core countries nurtured their competitiveness with frozen salaries while the periphery boycotted theirs with above productivity salary increases (according to Eurostat data, the average work compensation values in the periphery are still near half those registered in core countries), but because the gains of the core current account surpluses have been recklessly used to finance private and public agents in the periphery. Because, as Wyplosz (2017) puts it: “for every risky borrower, there is a careless lender ready to dip and twirl… and it is the lender who will ultimately decide when the music stops,” core countries need to face their share of responsibility in the Eurozone adjustment process.

REFERENCES Bayoumi, T. and Eichengreen, B. 1997. “Ever closer to heaven? An optimum-currencyarea index for European countries.” European Economic Review 41: 761-770. Bayoumi, T. and B. Eichengreen. 1993. “Shocking aspects of European monetary integration.” In Adjustment and growth in the European Monetary Union, edited by F. Torres and F. Giavazzi, 193-235. London: Cambridge University Press. Corden, W. M. 1972. “Monetary Integration.” Essays in International Finance, International Finance Section No. 93. Princeton University, Department of Economics. De Grauwe, P. 2013. “Design Failures in the Eurozone - can they be fixed?” European Economy Economic Papers 491. Dodig, N. and Herr, H. 2015. “Current account imbalances in the EMU: an assessment of official policy responses.” Panoeconomicus 62: 193-216.

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Fleming, J. M. 1971. “On exchange rate unification.” The Economic Journal 81: 467-88. Frankel, J. and Rose, A. 1997. “Is EMU more justifiable ex post than ex ante?” European Economic Review 41: 753-760. Frankel, J. and Rose, A. 1998. “The Endogenity of the Optimum Currency Area Criteria.” The Economic Journal 108: 1009–1025. Giavazzi, F. and Spaventa, L. 2011. “Why the current account may matter in a monetary union: Lessons from the financial crisis in the Euro area.” In The euro area and the financial crisis, edited by M. Beblavý and D. Cobham, 199-221. London: Cambridge University Press. Ingram, J. 1962. Regional Payments Mechanisms: The Case of Puerto Rico. Chapel Hill: University of North Carolina Press. Kenen, P. B. 1969. “The optimum currency area: an eclectic view.” In Monetary Problems of the International Economy, edited by R. Mundell and A. Swoboda, 41-60. Chicago: University of Chicago Press. Krugman, P. 1991. “Increasing returns and economic geography.” Journal of Political Economy 99: 483-499. Krugman, P. 1993. “Lessons of Massachusetts for EMU.” In Adjustment and growth in the European Monetary Union, edited by F. Torres and F. Giavazzi, 241-266. London: Cambridge University Press. Mayer, T., J. Möbert and Weistroffer, C. 2012. “Macroeconomic imbalances in EMU and the Eurosystem.” CESifo Forum 13: 35-42. Accessed July 24, 2017. http://hdl.handle.net/10419/166510 . McKinnon, R. I. 1963. “Optimum currency areas.” American Economic Review 52: 717725. Mintz, N. N. 1970. Monetary Union and Economic Integration. New York: C.J. Devine Institute of Finance, New York University, Graduate School of Business Administration. Mongelli, F. 2002. New views on the optimum currency area theory: what is EMU telling us? European Central Bank, Working Paper 138. Acessed July 24, 2017. www.ecb.europa.eu/pub/pdf/scpwps/ecbwp 138.pdf. Mundell, R. A. 1961. “A theory of optimum currency areas.” The American Economic Review 51: 509-517. Vieira, C. and Vieira, I. 2012. “Assessing the endogeneity of OCA conditions in EMU.” The Manchester School 80: 77–91. Wyplosz, C. 2017. The deficit tango. Project Syndicate. Accessed August 12, 2017. https://www.project-syndicate.org/onpoint/the-deficit-tango-by-charles-wyplosz2017-08?barrier=accessreg.

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ISBN: 978-1-53613-474-2 © 2018 Nova Science Publishers, Inc.

Chapter 3

TRENDS IN BUSINESS CYCLES SYNCHRONIZATION IN THE EMU José Manuel Caetano*1,2, Elsa Vaz1,2 and António Caleiro1 1

Department of Economics, University of Évora, Évora, Portugal 2 CEFAGE-UE, University of Évora, Portugal.

ABSTRACT The synchronization of business cycles is associated with optimal currency areas. Being a prerequisite for membership in such a zone was questioned by the view that the synchronization of economic cycles would result from the very operation of the optimal currency zone. An empirical observation of the business cycles in the Eurozone seems, however, to show that this synchronization has not increased, especially in relation to the so-called peripheral countries, which of course raises questions about that association. The chapter therefore seeks to verify whether the synchronization of the business cycles of the Eurozone countries has actually increased or, if it has decreased, in which countries this has taken place.

Keywords: business cycles, asymmetric shocks, synchronization analysis

1. INTRODUCTION The process of European monetary integration is a unique experience in world terms, not only because of the effects it has had on the countries involved but also because of its *

Corresponding Author Email: [email protected].

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influence on the theoretical frameworks of economic integration. European monetary integration was originally discussed in a stable economic and financial context in the late 1960s, having the Werner report suggested the creation of the European Monetary Union by the end of the 1970s. However, the deterioration of the world economy and the financial instability at the beginning of this decade, as a corollary of the collapse of the Bretton Woods international monetary system and oil crises, made any progress in that process unviable. Only in the second half of the 1980s, after the overcoming of the international economic crisis and the financial and exchange rate instability that had hit Europe, were there political conditions to overcome divisions between the members of the then European Economic Community and reopen the monetary integration dossier. A new plan thus revived the creation of a single currency in Europe, culminating in the Maastricht Treaty that conceived and operationalized the creation of the Euro. This currency appeared in 1999 and since then has been adopted by several countries of the European Union, currently circulating in 19 of its members. The theoretical rationale of Monetary Unions is strongly anchored in the so-called Optimum Currency Areas (OCA) theory, inspired by the seminal contributions of Mundell and his followers. This theoretical framework argues that in an area where several countries have the same currency, whenever one of them registers an idiosyncratic economic shock the capacity of the adjustment will depend on the degree of labour mobility, the flexibility of the markets for goods, services and factors and, still, of the stabilizing effect of fiscal policy. An effective monetary area must therefore be able to generate rapid adjustments in countries affected by shocks and must have the means to prevent the spread of effects among members. This approach thus recognized that European monetary unification should be the corollary of an effective process of economic integration between countries and not just a political chimera. Indeed, the lack of evidence of synchronization of business cycles in the candidates to the euro, the low labour mobility within the EU and the lack of a common budget of sufficient size to support economic adjustment justified the skepticism of many authors over the real sustainability of the Euro. One of the alternatives of economic policy in situations of reduced cyclical synchronization would be a common fiscal model that, together with the higher coordination of national fiscal policies, would allow the necessary discipline and autonomy in order to deal with asymmetric shocks. There was, therefore, some consensus at the pre-Euro stage that the single currency project of the Maastricht Treaty did not meet the conditions required to form a stable and effective monetary union. The synchronization of business cycles thus becomes a requirement for the proper functioning of a monetary union. However, in the case of the Eurozone, neither its members showed convergence in economic structures and in the synchronization of business cycles, nor was adequate the governance model for the single currency to intervene in case of adjustment of its members. Despite the short life of the euro, a number of events took place,

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notably the international financial crisis and the sovereign debt crisis, which generated distinct impacts on the Member States and which exposed the lack of synchronization of business cycles, justifying fears expressed by some authors before the creation of the single currency. Thus, it is the purpose of this chapter to proceed with the empirical evaluation of what happened in terms of the synchronization of business cycles in Europe and look for reasons to understand the causes of the verified trends. The rest of the chapter is structured as follows: Section 2 consists on a literature review on the relevance of business cycles synchronization for a monetary union; Section 3 presents the methodology, which is applied in Section 4, in order to examine the evolution of the business cycles synchronization throughout 1990 untill 2016, whose results are discussed in Section 5, and better justified in Section 6, where the sovereign debt crisis and the amplification of asymmetric shocks is analyzed; Section 7 concludes.

2. LITERATURE REVIEW As is well known, when a country joins a monetary union, the loss of monetary policy instruments at national level creates a cost, especially in the presence of asymmetric economic shocks. This is so because when the acceding countries are affected by these kind of shocks, the dynamics of their business cycles will most likely different, which means that the common monetary policy will be facing an imperfect macroeconomic stabilization. Therefore, the synchronization of business cycles is one of the criteria, among others, to evaluate the appropriateness for a country to participate in a monetary union. In fact, there is a strong consensus on the importance of synchronization of the business cycles of the Member-States in a monetary zone so that it can be considered optimal (McKinnon 1963; Mundell 1961). In fact, if business cycles are synchronized, the asymmetry of shocks’ effects tends to be less evident, facilitating therefore the task to promote economic adjustment via a single monetary policy. In short, it is accepted that countries with more synchronized business cycles are better able to form a monetary union as being less sensitive to asymmetric shocks, make the costs of losing monetary policy being smaller. It should be noted, however, that the synchronization of business cycles is a necessary but not sufficient condition for a monetary union to function in harmonious terms. In fact, a high level of synchronization does not mean that all countries require monetary policy measures of the same magnitude. Thus, since the size of business cycles differs from country to country, even if synchronization is perfect, this make it possible a single monetary policy not being perfectly adequate for all. Prior to the launch of Economic and Monetary Union (EMU) in Europe, there was a heated debate about whether Europe would be a priori in a position to be considered an optimum currency area (De Grauwe 1996). Despite the significant mobility of capital and

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the very large volume of trade among the Eurozone members, labour mobility would still be too low to be able for the foundations of a single monetary policy framework to be applied. Nevertheless, in support of the monetary union creation came the argument that the member countries would become a posteriori more integrated over time and that their business cycles therefore would become more synchronized as a result of the adoption of the common currency (see, inter alia, de Haan, Inklaar and Jong-A-Pin 2008; Rose, Lockwood and Quah 2000). Thus, the criterion for creating an optimal monetary zone should be considered as endogenous. For example, Frankel and Rose (1997, 1998) argued that extensive international trading countries tend to be more synchronized in their business cycles, suggesting that the single monetary policy, leading to increased trade, promote integration, and would soon lead to an ex post synchronization (Schiavo 2008). This optimistic view contrasted with that of Krugman (1991, 1993) who argued that further integration could, however, lead to a specialization of the various countries (Kalemli-Ozcan, Sørensen and Yosha 2001). The arguments presented above were tested, and the contradiction in the results was evident (Baxter and Kouparitsas 2005; de Haan, Inklaar and Jong-A-Pin 2008). For example, Rose and Engel (2002) concluded in favour of the greater synchronization of business cycles, as well as Altavilla (2004), which found that the restrictions resulting from participation in the European Monetary System improved the symmetry of business cycles. Camacho, Perez-Quiros and Saiz (2006), however, contradicted this finding, showing that the Euro did not increase the degree of similarity between the business cycles of the Euro Zone countries. Also, Canova, Ciccarelli and Ortega (2007) concluded that there was no specific business cycle for the euro zone. In a context of similar analysis, although considering a longer period of time and using dynamical network analysis, Matesanz and Ortega (2016) found that an increase in synchronicity did not occur during the early part of the Euro period, although in the 1980s the synchronization of GDP growth rates did indeed occur. (See also Lukmanova and Tondl 2017). In short, with regard to the empirical results on the synchronization of business cycles, possibly as an endogenous consequence of participation in the Euro Zone, they are contradictory. This justifies the continuation by verifying whether the degree of synchronization of business cycles has actually increased after the accession of the countries to the Euro Area and whether this has been unique to these countries and, secondly, whether, after the crisis, the synchronization of business cycles declined and in which countries this was most evident.

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3. METHODOLOGY To measure the degree of synchronization of business cycles, it is usually necessary to determine the time periods in which the time series presents a value above/below the trend or average. Simply observing the data generally shows that the detection of inflection or turning points is not a clear task. Given the nature of the statistical data, a moving average (over time) is more adequate than the simple average for the whole period under analysis. In this case, in order to calculate that average, understood as tendency, it is usual to consider the well-known filter of Hodrick and Prescott (1997)1. As it is known, the Hodrick & Prescott (HP) filter defines the trend or average, gt, of a time series, as the solution to the minimization problem: 𝑚𝑖𝑛 𝑇 2 (𝑓𝑡 − 𝑔𝑡 )2 + 𝜆 ∑𝑇𝑡=2((𝑔𝑡+1 − 𝑔𝑡 ) − (𝑔𝑡 − 𝑔𝑡−1 )) ], [∑ 𝑡=1 {𝑔𝑡 } i.e., the HP filter is intended to minimize the cyclical component (ft – gt) subject to a 'smoothing' condition, which is reflected in the second term of the above expression. The higher the λ parameter, the smoother the trend and the less deviations from the trend will be ‘penalized’. At the limit, as λ tends to , the filter will choose (gt+1 – gt) = (gt – gt-1), which means a linear trend. If, on the other hand, λ = 0, the original series is obtained. Clearly, a key issue when extracting the data trend using the HP filter is the value of the smoothing parameter, λ, to be used. For quarterly frequencies, the value mostly chosen is 1600, as originally suggested by Hodrick and Prescott (1997). When it comes to annual data, there is no such consensus. After Backus and Kehoe (1992), a smoothing parameter of 100 has been widely used in the literature. However, Baxter and King (1999) showed that a value around 10 is much better, while Ravn and Uhlig (2002) show that λ = 6.25 produces almost exactly the same trend as when defining the smoothing parameter of 1600 for quarterly data. In what follows, we applied the HP filter to the annual data, ft, and computed the cyclical component, (ft – gt), for that using a value of λ = 62. After that, following a standard approach, a correlation analysis of that cyclical component is performed in order to study the degree of business cycle synchronization3.

1

Although the Hodrick-Prescott (HP) filter has been criticized and other, (apparently) more sophisticated, methods have been developed and applied (for example, based on spectral analysis), the Hodrick & Prescott filter continues to be widely used, thanks to the robustness of its results (Artis and Zhang 1997; Christiano and Fitzgerald 2003; Clark and van Wincoop 2001; Montoya and de Haan 2008). 2 This task was done using the software Gretl (freely available at http://gretl.sourceforge.net), which, to the best of our knowledge, only allows integer numbers for the parameter . 3 This analysis was done mostly using some R packages (http://www.r-project.org).

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4. BUSINESS CYCLES SYNCHRONIZATION 4.1. The Data The data, whose source is the OECD, correspond to the values of GDP per capita in USD, for the period 1990 to 2016 (OECD 2017)4. In relation to the countries (see the Annex 1), we consider all the member states of the European Union up to and including the 2004 enlargement, i.e., Austria, Belgium, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom which makes up 25 countries. Of these, 6 of them are not (currently) part of the Eurozone, namely the Czech Republic, Denmark, Hungary, Poland, Sweden, and the United Kingdom. As a control group, we also consider 3 non-EU European countries, namely Iceland, Norway and Switzerland. In what concerns the time periods under analysis, the first one corresponds to the years prior to the adoption of the Euro, i.e., from 1990 until 1998. The subsequent second time period goes from 1999 until 2007, i.e., from the creation of the Eurozone until the beginning of the crisis. The last time period runs from 2008 to 20165.

4.2. The Results Let us begin by considering the entire period under review, i.e., 1990 to 2016. Figure 1 plots the correlation coefficients between the cyclical components of the GDPs, added with some clusters. From its inspection, it is evident that, even when considering a high number of clusters, in the case 7, it (still) remains one cluster with a large number of countries, which are characterized by a fairly high degree of business cycle synchronization. Of clear importance is the fact that, this cluster of 19 countries, is made of 2 non-UE countries, namely Norway and Switzerland, 3 non-Eurozone countries, namely Denmark, Hungary and the United Kingdom, as well as 14 Eurozone countries. Given the total number of each of these 3 categories in our sample, it seems that, for the whole period under analysis, being a Eurozone member may represent a causal factor of higher business cycle synchronization but it is also true that for some Eurozone memberstates, namely Cyprus, Greece, Ireland, Malta, and Portugal, that characteristic did not guarantee a business cycle synchronization as high as that.

4 5

Given their public nature, data are available on request. In addition to these reasons, the division of the whole period (1990-2016) into three subperiods of equal temporal duration, i.e. 9 years, also seems to be advisable.

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Closely related to the above, we have the fact that Greece and Ireland are the countries with which the economic cycles of the others are generally less synchronized, as can be seen in Table 1. As is well known, these two countries have been subject to the same kind of austerity policies but have responded in a fairly distinct way. From Table 1 it is also striking the fact that a non-UE member state, namely Switzerland, is the country with which 3 Eurozone member states, namely Finland, Italy and Netherlands are most synchronized, as well as the fact that the Germany and Luxembourg business cycles being the most synchronized with a non-Eurozone country, namely Sweden.

Figure 1. Correlations (with 7 clusters) for 1990-2016.

Plainly, during the whole period several (major) events occurred, namely the creation/implementation of the Eurozone in 1999 and the financial crisis of 2008. For obvious reasons, the consideration of 3 sub-periods, namely 1990-1998, 1999-2007 and 2008-2016, seem to be the proper way of proceeding in order: i) to verify if the synchronization of business cycles increased – eventually in an endogenous way – after the creation of the Eurozone, this being true only for the Eurozone member states, and ii) to assess the consequences of the crisis in the various countries, taking into account their belonging (or not) to the Eurozone or to the European Union.

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José Manuel Caetano, Elsa Vaz and António Caleiro Table 1. Some results on synchronization [1990-2016]

Country

Average Correlation

Austria Belgium Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Iceland Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Norway Poland Portugal Slovakia Slovenia Spain Sweden Switzerland United Kingdom

0.5703 0.5259 0.5199 0.5503 0.6299 0.5790 0.6740 0.6004 0.6330 0.2951 0.4138 0.4322 0.2783 0.6541 0.6348 0.5759 0.6340 0.3894 0.6730 0.4979 0.3183 0.4325 0.6396 0.6799 0.6396 0.6536 0.6807 0.5758

Highest Synchronization Country Correlation Latvia 0.8507 Denmark 0.8037 Italy 0.7950 Slovenia 0.8012 France 0.8164 Latvia 0.9556 Switzerland 0.8958 Netherlands 0.8675 Sweden 0.8730 Spain 0.6707 Slovakia 0.6227 0.6965 Cyprus 0.5796 Switzerland 0.8789 Estonia 0.9556 Latvia 0.9550 Sweden 0.8530 Portugal 0.6284 Switzerland 0.9414 Austria 0.8407 Finland 0.6648 Spain 0.7570 Slovenia 0.8439 Finland 0.8563 Netherlands 0.8335 Finland 0.8884 Netherlands 0.9414 Denmark 0.7635

Lowest Synchronization Country Correlation Greece 0.1391 Iceland 0.0000 Norway 0.2371 Poland 0.2403 Greece 0.2620 0.0890 0.2705 0.2258 0.0702 Poland -0.1383 Ireland 0.0763 Belgium 0.0000 Norway -0.0268 Greece 0.3542 0.2147 0.0913 0.2176 Norway 0.0845 Ireland 0.2118 -0.0268 Greece -0.1383 Poland -0.0418 Ireland 0.2149 0.3432 Poland 0.1702 Greece 0.1359 Ireland 0.2664 Poland 0.1351

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Figure 2. Correlations (with 7 clusters) for 1990-1998.

Let us therefore proceed with the subperiod (1990-1998). As Figure 2 clearly shows, despite the existence of several groups of countries, whose business cycles were fairly synchronized – notably the cluster made of Slovakia, Greece, Estonia, Poland, Switzerland, Iceland, and Lithuania, the cluster made of Italy, Spain, Latvia, Portugal, Ireland, Netherlands, and the cluster made of Germany, Sweden, Cyprus, France and Hungary – there were a general desynchronization of business cycles, before 1999. As can be seen in Table 2, on average, almost all countries presented a fairly small correlation between the cyclical components of their business cycles, most of them even presenting a negative correlation, indicating a desynchronized business cycle with the others. This degree of desynchronization is, in all countries, fairly high, leading to correlation coefficients that are as low as less than -60%, in all cases, and even less than 90%, in 17 out of 28 cases. Considering now the period 1999-2007, it is evident the increase in the synchronization of business cycles, for the generality of the countries in our sample, independently of being a member of the Eurozone or even of the European Union. In fact, as Figure 3 shows, most of the countries have increased their average synchronization but it is also evident, through the analysis of the identified clusters, that the groups of countries most synchronized are a mixture of Eurozone members, (yet) non-Eurozone members and (even) non-European Union countries. For instance, one of the identified clusters – allegedly the one

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characterized by the highest synchronization – is made of Belgium, Spain, Slovakia, Switzerland, Italy, Cyprus, France and Netherlands; see Figure 2.

Table 2. Some results on synchronization [1990-1998] Country

Average Correlation

Austria Belgium Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Iceland Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Norway

-0.0097 0.1607 0.1134 -0.1756 0.0216 -0.0037 0.2077 0.1879 0.0361 -0.0513 0.2276 0.0185 0.2494 0.1201 0.2255 0.0200 -0.0435 0.0978 0.2353 -0.1163

Poland Portugal Slovakia Slovenia Spain Sweden Switzerland United Kingdom

-0.0587 0.2816 -0.1424 0.2291 0.1211 0.0198 0.1300 -0.1546

Highest Synchronization Country Correlation Italy 0.9151 Malta 0.9308 France 0.9507 Luxembourg 0.9154 Norway 0.8644 Poland 0.9826 Latvia 0.9659 Hungary 0.9649 Sweden 0.9740 Estonia 0.9769 France 0.9649 Lithuania 0.9891 Netherlands 0.9969 Austria 0.9151 Finland 0.9659 Iceland 0.9891 Sweden 0.9319 Belgium 0.9308 Ireland 0.9969 United 0.9051 Kingdom Estonia 0.9826 Ireland 0.9681 Greece 0.9586 Belgium 0.8865 Finland 0.9205 Germany 0.9740 Iceland 0.9183 Norway 0.9051

Lowest Synchronization Country United Kingdom Slovakia Slovakia Lithuania Austria Germany Switzerland Slovakia

Correlation -0.8956 -0.7775 -0.9684 -0.9604 -0.8476 -0.9395 -0.8899 -0.8536 -0.9938 Germany -0.9837 Poland -0.6551 Luxembourg -0.9669 United Kingdom -0.7502 -0.9522 Czech Republic -0.8856 Luxembourg -0.9864 Lithuania -0.9864 -0.7180 United Kingdom -0.7931 Spain -0.9675 Cyprus United Kingdom Germany Slovakia Norway Greece Czech Republic Italy

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-0.9189 -0.6019 -0.9938 -0.9385 -0.9675 -0.9715 -0.9072 -0.9522

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Figure 3. Correlations (with 7 clusters) for 1999-2007.

It is also important to notice that Malta, Poland and, in particular, Hungary were countries with idiosyncratic business cycles. This is immediately evident in Table 2, where those 3 countries, as well as Iceland, are the countries with which the others are more/less desynchronized/ synchronized. Of importance is the fact that, by comparing with the previous sub-period, the degree of desynchronization has decreased in a clear way. Interestingly, the degree of highest synchronization also seemed to have decreased, taking the previous period as reference. In short, in the period following the Eurozone’s creation, the degree of synchronization of business cycles indicates a generalized increase, i.e., not restricted to those countries then adhering to the single currency. This generalized increase in the degree of synchronization was mainly due to a (substantial) decrease in the degree of desynchronization.

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Figure 4. Correlations (with 7 clusters) for 2008-2016.

The last period under analysis, i.e., 2008-2016, in a sense, inverts the previous trajectory as the average degree of synchronization has, in general decreased. Notwithstanding this fact, as Figure 4 shows, there are clusters of countries with a fairly high degree of business cycle synchronization which are constituted by Eurozone members, non-Eurozone members and non-EU countries, just as in the previous subperiod. For instance, one of these clusters is made of Switzerland, Netherlands, Latvia, Estonia, Lithuania, Austria and Norway. Also from Figure 2 emerges the fact that some countries, notably Poland, but also, Malta & Portugal, and Cyprus & Ireland, are countries whose business cycles gained idiosyncrasy in the post-crisis period. As a matter of fact, for obvious reasons, Greece also became a country characterized by a clear desynchronization of its business cycle, as Table 4 shows. A simple analysis of Table 4 shows the previously mentioned ‘inversion’ of the trend in business cycles synchronization, in the sense that, in general, the highest values of business cycles synchronization have increased, i.e., some countries became even more synchronized but, on the other hand, the lowest degrees of synchronization have also decreased, i.e., some other countries became even more desynchronized. This fact is a clear evidence of distinct effects of the post-2008 crisis in the several countries, independently of being a member (or not) of the Eurozone.

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Trends in Business Cycles Synchronization in the EMU Table 3. Some results on synchronization [1999-2007]

Austria Belgium Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Iceland Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Norway Poland Portugal Slovakia Slovenia Spain Sweden Switzerland United Kingdom

Average Highest Correlation Synchronization Country Correlatio n 0.6475 Luxembour 0.9281 g 0.6184 Denmark 0.8566 0.6795 Netherlands 0.9290 0.6177 Germany 0.8789 0.6491 Netherlands 0.8964 0.6257 Latvia 0.9753 0.6648 Sweden 0.9175 0.6444 Netherlands 0.9376 0.7073 Switzerland 0.9198 0.5038 Germany 0.7663 -0.0245 Greece 0.4290 0.4142 Slovenia 0.7242 0.6908 Estonia 0.9582 0.6956 Switzerland 0.9513 0.6398 Estonia 0.9753 0.5560 Latvia 0.9446 0.6939 Portugal 0.9390 0.2822 Sweden 0.5283 0.7085 Switzerland 0.9430 0.4613 Denmark 0.8304 0.3529 Sweden 0.6514 0.6581 Luxembour 0.9390 g 0.6955 Switzerland 0.9254 0.6956 Sweden 0.8973 0.7384 Portugal 0.9125 0.7062 Finland 0.9175 0.7378 Italy 0.9513 0.5414 Ireland 0.7914

Lowest Synchronization Country Correlation Hungary

-0.1939

Iceland Hungary

0.1450 -0.0745 0.0744 0.0119 -0.1364 -0.2600 0.1331 0.0809 0.1196 -0.3710 -0.3710 -0.0388 0.2537 -0.1257 -0.0536 -0.2790 -0.2608 -0.0515 -0.2029 -0.1692 -0.0681

Malta Hungary Malta Iceland Hungary Iceland Hungary

Iceland Hungary

Poland

0.2572 -0.2279 0.1259 -0.2483 0.0428 0.0729

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José Manuel Caetano, Elsa Vaz and António Caleiro Table 4. Some results on synchronization [2008-2016]

Austria Belgium Cyprus Czech Rep. Denmark Estonia Finland France Germany Greece Hungary Iceland Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Norway Poland Portugal Slovakia Slovenia Spain Sweden Switzerland United Kingdom

Average Highest Correlation Synchronization Country Correlatio n 0.5661 Estonia 0.9670 0.5435 Germany 0.9069 0.4700 Spain 0.8379 0.6115 0.9616 0.6516 France 0.8999 0.6110 Lithuania 0.9755 0.7340 Italy 0.9444 0.6604 Hungary 0.9108 0.6463 Luxembourg 0.9320 0.2377 Spain 0.7812 0.6927 Luxembourg 0.9178 0.4937 Spain 0.8853 0.1662 Cyprus 0.6395 0.6731 Finland 0.9444 0.6862 Estonia 0.9665 0.6508 0.9755 0.6993 Germany 0.9320 0.4606 Portugal 0.8137 0.6927 Switzerland 0.9616 0.5549 Lithuania 0.9528 0.3497 Italy 0.7282 0.3089 Malta 0.8137 0.7071 Slovenia 0.9104 0.7427 Finland 0.9261 0.6203 Czech Rep. 0.9616 0.6810 Finland 0.9422 0.7101 Netherlands 0.9616 0.6648 Latvia 0.8706

Lowest Synchronization Country

Correlation

Portugal Greece Belgium Poland Greece Portugal Greece Ireland Greece Poland Ireland Poland Norway Greece Portugal Ireland Greece Poland Ireland

-0.1426 -0.2565 0.1228 0.1193 0.1274 -0.0901 0.2212 0.1519 -0.1310 -0.4510 0.1451 -0.0379 -0.2253 0.2225 0.0911 -0.0219 0.1590 0.0105 -0.0069 -0.2253 -0.4510 -0.1426 0.1413 0.2528 0.1232 -0.0558 0.0832 0.1051

Greece Austria Ireland Poland Greece Ireland

5. DISCUSSION The trends in business cycles synchronization in EMU were analysed in this chapter. For the whole period under analysis (1990-2016), there is some empirical evidence supporting the hypothesis that being a member of the Eurozone leads to a higher degree of business cycles synchronization but is also true that some Eurozone member-states do not

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share this characteristic. As a matter of fact, before 1999 there was a general desynchronization of business cycle, which decreased substantially after that date. Nevertheless, in the last period under analysis (2008-2016) there was a mix of results, as, for some countries, business cycles synchronization increased, whereas in some others it decreased. In fact, until the outbreak of the great crisis dominated the optimistic view that anticipated an important influence of the Euro in the synchronization of business cycles and, at least partially, has been identified in empirical studies in a global context, particularly in the late 1990s. Even after the onset of the financial crisis, the synchronization of cycles in the EU countries did not deteriorate significantly while the reactions of the various governments and national institutions were similar. Only after the emergence of truly critical sovereign debt situations did actual desynchronization occur (European Commission 2016). According to the European Commission (2016), after 2011, the dispersion of national GDP reached values just checked before the 1970s, and was particularly large in the countries most affected by the sovereign debt crisis, which only began to be corrected after 2014 displaying that trade growth was not enough to safeguard the synchronization of business cycles in European countries. In accordance to that perspective, Matesanz and Ortega (2016) found that in the last years of the past decade an abrupt change in the way business cycles synchronize. That trend appears to be related to the outbreak of the international financial crisis and its effects in some Euro Zone countries. Lukmanova and Tondl (2017), using a model of simultaneous equations, estimated the direct and indirect effects of macroeconomic imbalances in the pre- and post-crisis period. They concluded that the emergence of differences in the current accounts of member states, government deficit and public debt, private debt or unit labour cost, reduced the synchronization of business cycles, especially after the financial crisis. Plainly, our results have implications in what concerns the fundamental debate about the conditions to be fulfilled in order a monetary union to be optimal. As a matter of fact, it appears to be not so evident the endogeneity of the criterions for creating an optimal monetary zone. However, it seems that the most optimistic results justified the EMU membership option to the current 19 European countries, and can be proven, at least partially, by the evolution of the economies of the euro area countries in the early years of monetary union (de Haan, Inklaar, and Jong-A-Pin 2008), maintaining even some synchronization of business cycles in the euro area in the early years of the financial crisis (European Commission 2016). However, the deepening of this financial crisis and the subsequent sovereign debt crisis in the Eurozone has highlighted that the European Monetary Union has particular characteristics that do not allow to perform as an optimal currency area. This last fact calls the attention for the way the several countries have reacted differently to the 2008-crisis effects (or had to support contractionary policies). Plainly,

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this asymmetry is related to budgetary disequilibria, which call the need to proceed with efforts in the direction of a fiscal union. Furthermore, as the synchronization of business cycles is very important to the stability of an EMU, the common economic governance could be key to the functioning and survival of the Eurozone. As limitations of this chapter, one may mention the fact, as it is traditional, the analysis is of a correlation type. In fact, a causality analysis is to be done in further studies.

6. SOVEREIGN DEBT CRISIS AND AMPLIFICATION OF ASYMMETRIC SHOCKS IN THE EUROZONE As we have seen in previous sections, the creation of the Eurozone did not produce the synchronization of business cycles throughout the life of the single currency, for that being important to seek a better understanding of the role of financial integration in the functioning of monetary unions. In fact, there are two distinct views on this role: on the one hand, the view that greater financial integration promotes better allocation of capital and investments and therefore economic efficiency, and that integrated financial markets ensure risk-sharing by providing endogenously increased protection in the face of asymmetric shocks; on the other hand, the view that greater financial integration leads to productive specialization and reduces symmetry in macroeconomic fluctuations. The evidence on the influence of financial integration on business cycles in the Eurozone is disparate and varies with the period of analysis, which justifies revisiting some events of the Euro lifetime and looking for explanations. The lack of synchronization of business cycles in the Eurozone became particularly noticeable between 2011 and 2013. The biggest reason for this was the global financial crisis with which the Eurozone was confronted and which has generated distinct effects on its members. In fact, some Eurozone countries were in a vulnerable situation due to a series of economic imbalances accumulated before the crisis, mainly debt and deficits in the Current Account (Kang and Shambaugh 2016). Alongside this evidence, the fact that countries were part of a monetary union, therefore limited in their ability to intervene, has aggravated the effects of economic shocks when the financial situation has deteriorated. Until the beginning of the crisis in 2007, an optimistic view prevailed that the Euro would lead to greater synchronization of the business cycles in the Eurozone, through the trade and financial integration and a gradual convergence of economic structures, which has been confirmed by the evidence presented above, for the period up to 2008. Even in the initial phase of the crisis, the cycles will have been aligned within the Eurozone, as almost all registered production and employment breaks. However, during the peak of the crisis, between 2011-2013, divergences in cycles in the Eurozone grew significantly,

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showing that the crisis contributed to consolidate structural differences within the Eurozone. That fact has shaken the belief that trade and financial integration would promote the synchronization of business cycles. It has become clear that countries can be subject to long-lasting asymmetric shocks due to time differences in the form of common shocks transmission, suggesting that the benefits of having a single currency may change depending on the circumstances over time. Thus, a viable monetary union in the first decade of the Euro has been transformed into a process dominated by centrifugal forces that have generated asymmetric shocks, which have jeopardized the stability of the Euro Zone itself and penalized quite a few members. The crisis has thus revealed that trade and financial integration processes are of a different nature and can have different effects on the stability of countries. Aizenman (2016) recognizes that trade impacts are deeper and more structural than the effects of financial integration, which are more volatile and reversible, affecting the countries involved and the monetary union itself. This distinction stems from the intertemporal nature of the financial (debt and portfolio) flows that contrasts with the trade (goods and services) flows, which have a well-defined temporal character. The author argues that the sudden stoppage in capital inflows places the recipient countries in a situation of great vulnerability, which can have serious repercussions on the real economy. This distinct nature of financial flows may lead to asymmetric shocks in some countries, while also threatening the stability of monetary areas when they do not have mechanisms to support the economic adjustment of their members. Creating strong financial ties can expose borrowers to crisis situations when flows are unexpectedly disrupted. Thus, at the stage of financial integration, a synchronization of business cycles can be verified in our results, but debtors are dependent on external capital flows to finance their structural imbalances. When the degree of financial integration regresses and flows stop or reverse direction, the correlation of business cycles of monetary area countries is reduced, as our outcomes also display. As we have seen, the theory of optimum currency areas stresses that, at the functional level, the economies to be integrated must be open to foreign trade (especially in countries with the same currency), must have flexibility for the adjustment processes and must have synchronized business cycles with partners. During the crisis in the Euro Zone there were factors of structural rigidity in some countries, which did not have the flexibility to react to the shocks, along with idiosyncratic issues that prevented the correlation of the cycles. However, the crisis also confirmed that the Eurozone did not have mechanisms to increase flexibility and, contrary to that expected in a process of economic and monetary integration, EMU rules contributed to the increase of shocks, making them more asymmetric and reducing their correlation, as we shall scrutinize below (in agreement with our empirical results).

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There has been a consensus on the causes of the divergence of business cycles in the Eurozone on the basis of two types of argument: on the one hand, the specific imbalances in each country and, on the other, the monetary union rules that have amplified the effects of the crisis and reduced adjustment capacity in the most affected countries. Some detail is then justified in addressing these arguments that attribute the crisis to internal causes of the countries and external causes linked to the Eurozone. The increase in external deficits in peripheral countries has augmented the vulnerabilities of these countries by various means. On the one hand, current deficit financing was based on short-term external bank debt (Lane 2013), exposing borrowers to shocks whenever investors’ expectations changed. On the other hand, a significant part of the loans financed consumption or were applied in non-tradable goods sectors, increasing the risk of debt repayment. Additionally, financial cycles seem more appropriate than the usual business cycles to explain housing price trends and private sector credit (Borio 2014), which were central issues during the crisis. In fact, financial cycles, linked to bank crises, generate more intense recessions and slower returns than normal cycles, as may have happened in the Eurozone (Jordà, Schularick and Taylor 2013). In summary, differences in the degree of exposure of countries to shocks contributed to the cyclical divergences after 2010, but they do not elucidate why the sovereign debt crisis only occurred within the Eurozone. As acknowledged by Baldwin et al. (2015), the distinctive feature of the debt crisis in the Eurozone was the succession of events that led to the sudden stop of external private capital flows as investors moved away from these countries. The asymmetry in the transmission of the financial crisis within the Eurozone has contributed for amplifying the shocks in the most exposed countries. Could these effects of amplifying shocks have occurred in countries with monetary sovereignty? The explanation advanced by De Grauwe (2011) in the answer to the question is unequivocal in considering that the effects would be different. For the author, the sovereign debt crisis stems from the fragility of small economies embedded in a monetary area such as the characteristics of the Eurozone, preventing countries from controlling the currency in which their debt is issued. As a result, the financial markets forced the sovereigns to socialize the private bank debt through the issuance of public debt, and the State assumed the function of the Central Bank as liquidity provider of last resort. This process has increased public debt and reduced its sustainability, with the inherent increase in risk premium and interest rates in the different sectors of activity (Mody and Sandri 2011), with the effects spreading to the real economy and penalizing its performance. In fact, the countries in this situation were affected by the rating cuts of the international agencies on sovereign debt and on the major national banks, setting them with a similar status to that of the emerging economies. This limitation has weakened these countries and made the Eurozone more dependent and unstable due to the possible change of sentiment in the financial markets. In view of the banking-sovereign interdependence,

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and without credible deposit insurance in the Eurozone, the rise in sovereign spreads among Eurozone members has become inevitable and economically and politically unsustainable. As many Eurozone financial companies had invested in sovereign debt of the peripheral countries, rising spreads destabilized the insurance market and the Eurozone banking system, elevating systemic risk and posing serious challenges to regulators. The private sector was forced to de-leverage and generated a strong contraction in the demand that led to the reduction of current account deficits. If countries had their own currency, their depreciation would have made the adjustment intense but faster, mitigating the recessionary effects of the crisis, as happened with Iceland and the United Kingdom during this global financial crisis. The peripheral countries of the Eurozone, hampered by rising credit risks and currency redenomination, struggled with liquidity shortages and rising financing costs and were close to insolvency. The situation was exacerbated by rigid in wages and in nominal prices, generating deep deflationary dynamics, a rapid rise in unemployment rates and a flow of emigration of thousands of qualified young people. This process of “internal devaluation” (Stockhammer and Sotiropoulos 2014) has increased pressures on public debt and aggravated the effects of the recession, illustrating significantly the challenges of countries in an ineffective monetary union with a fragmented banking sector and no real risk-sharing mechanisms. The crisis we have been discussing has shown the importance of structural imbalances and shock amplifiers in the desynchronization of business cycles in the Eurozone, allowing us to reassess the effects of asymmetric shocks in the context of monetary integration. The short life of the Euro has shown that a limited global convergence in the economic structures of its members fosters the emergence of asymmetric dynamics that can amplify real distortions and lead to sovereign and private bank debt crises, penalizing the most exposed countries and making the monetary union itself unfeasible. The immediate causes of the crisis (structural imbalances and lack of means of adjustment) are due to deeper reasons, such as the supervisory flaws that allowed for the widening of imbalances, the absence of institutions to absorb shocks at the Eurozone level, the gaps revealed by the ineffective management of the crisis itself (Jones, Kelement and Meunier 2015). Plainly, some of these shortcomings stem from unforeseen events, while others stem from the provisions of the Maastricht Treaty, which sets the model for governance of the Euro, which were also emphasized in the period prior to the creation of the single currency. Regarding our analysis, we believe that the lack of collective action in the creation of mechanisms to support the absorption of asymmetric shocks has been conspicuous. In effect, there were no provision or institutions in the euro governance model to deal with the type of problems evidenced by the sovereign debt crisis. The lack of common

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mechanisms for absorbing shocks in the Eurozone has caught the Union devoid of any mechanism to prevent the accumulation of negative effects and contagion from recession. In sum, and returning to an issue underlined in the introduction, the Eurozone does not in fact constitute an optimum currency area, in the Mundellian sense and its followers, and has proved to be not equipped to foster the synchronization of business cycles, which ends up neutralizing the scope and the purpose of the single monetary policy. The belief that it is possible to build an effective monetary area only with structural reforms to flexibly the factors and goods markets, reducing the costs of adjusting to asymmetric shocks has been influencing recent policy guidance in the Eurozone. However, it has been forgotten that, while the arguments in favour of flexibility are robust, the so-called structural reforms involving wage reductions, less support for the unemployed, or lowering social norms, leave indelible markings on the credibility and confidence of citizens in the process of integration.

CONCLUSION Despite the short lifespan of the Euro, it was possible to verify the occurrence of the various phases that characterize business cycles, which indelibly marked the existence of different impacts on the Member States and which have jeopardized the stability of the Euro Zone itself. Thus, some lessons have been drawn from the events that occurred in this period, which challenged some beliefs and the regular functioning of the monetary union, exposing the fragility of the governance model and the need to promote major changes. There is currently a broad consensus that EMU is an incomplete process and that its deepening should not only generate stability in the prices of goods and of factors of production, but above all must lead to greater economic and social well-being, based upon inclusive and balanced growth among countries. Being sure that the economic recession and the divergences in their effects between Eurozone countries resulted from accumulated imbalances before the crisis, it was also clear the shortcomings in the way the EMU responded to external shocks, which worsened those effects and prolonged the recession. During the crisis, unemployment reached unsustainable values, wages were adjusted downwards to restore competitiveness and the purchasing power and living conditions of millions of people deteriorated, generating evident symptoms of uneasiness in relation to the single currency. Structural reforms to make economies more resilient to shocks are crucial for accelerating convergence between Member States and restoring public confidence in the European institutions. Progress towards living and income standards is crucial for achieving economic and social cohesion alongside balanced growth and a high and stable level of employment. The lack of mechanisms and incentives that promote strong economic

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and social convergence within the Eurozone is therefore a structural gap that undermines the credibility of the integration process, thus requiring speedy and more effective reforms. Indeed, the question of the convergence of economies in a process of monetary unification was a point of contention in the discussions earlier to the Maastricht Treaty between two views: one that argued that nominal convergence of countries would be enough to build a stable EMU, accepting that the union would endogenously generate economic convergence and another one, that argued that prior convergence of economic structures was necessary to promote the synchronization of business cycles, reducing the possibility of asymmetric shocks and making single monetary policy more effective. As we know, in the definition of the Euro model, it prevailed the orientation that favoured nominal convergence, so nominal variables such as interest rates, inflation and exchange rates, and deficit and government debt ratios were used as a prerequisite for a country to integrate the Eurozone. The economic divergence of the countries in the period of the crisis, evidenced by the lack of synchronization of their business cycles, is strong evidence that the criteria to qualify the countries to integrate the Euro Zone were insufficient and that the mechanisms of support to the adjustment of the countries also did not exist. As we have seen in the preceding section, there is some consensus on the reasons for the sovereign debt crisis in the Eurozone, which resulted from the accumulated imbalances and the lack of crisis management mechanisms, being sure that the implicit causes denote policy failures that allowed accumulation of imbalances, failures of institutions that have been unable to absorb shocks, and also failures in the way the crisis has been managed over time. Naturally, the decisions underlying the Maastricht Treaty help to explain the effects of these institutional and functional gaps, even if there were unforeseen factors. It is important to underline those facts, as future guidelines for completing the EMU building should emphasize more structural aspects such as the building of a stabilization function in the Euro Zone, the creation of a more integrated Banking Union and Capital Market, strengthening fiscal integration or even creating a social dimension that mitigates the social implications of economic recessions and, more proactively, supports mechanisms that promote labour mobility and thereby enhance the flexibility of economies. Let us look at some of these issues that are under discussion and on which decisions are urgently needed. The development of a stabilization function may prove to be very useful in minimizing the effects of asymmetric shocks, if properly articulated with national fiscal stabilizers. This would make it possible to optimize the fiscal effort in the integrated area, ensuring a better balance between stabilization capacity and the necessary sustainability at the national level. The stabilization instrument will enhance the effectiveness of fiscal policies in absorbing shocks within the area, especially when circumstances show the limits of the single monetary policy. Obviously, as a means of crisis management, it should avoid permanent financial transfers within the Euro Zone, safeguarding the fears of moral hazard.

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Furthermore, it should not replicate or collide with existing instrument functions, such as the European Stability Mechanism established in 2012 or the existing Structural Funds in the European Union. In another sense, the monitoring and surveillance processes that have failed to detect risks and the increase in the imbalances in Eurozone countries must assume a less asymmetric nature, not emphasizing only the correction of situations of fiscal or external deficits but also appreciate the need to make adjustments in countries that have surplus positions. The greater symmetry of adjustments, apart from a better allocation of effort between deficit and surplus countries, will surely contribute to a better perception of European citizens that economic interdependence and solidarity go hand in hand. Finally, a brief reference to the role of the Banking Union, which is considered as one of the most structuring reforms of the Euro Zone, given the benefit that can have for the greater risk-sharing among private agents. In addition, the crisis showed that national supervision was ineffective and did not signal, in a timely manner, the imbalances that some banks were accumulating, generating a ‘vicious’ interaction between banks and sovereign entities that contributed decisively to amplify the effects of asymmetric shocks and to reduce the capacity of adjustment by countries. It is hoped that the conclusion of the Banking Union and the establishment of a common deposit insurance system will materialize in the short term as they will be fundamental pillars of the integration of banking and financial markets in the Euro Zone, offering greater protection against specific shocks and reducing risks. Having said that, let us return to an aspect with which we began this work on the importance of the synchronization of business cycles in the Euro Zone, and which has to do with the answer to the question: is, or will it be, the Euro Zone an optimal monetary area in the sense given by Mundell and his followers? Plainly, even before the creation of the single currency in the EU, it became evident that some of the ‘theoretical’ criteria required for the effective functioning of a monetary union were far from being verified by some of the candidates for membership of the Euro, which was evident by the lack of synchronization in the business cycles that had already was evident. Somehow, the early years of the Euro allowed a gradual synchronization of cycles, reinforcing the conviction of those who asserted that nominal convergence, through the endogeneity of integration mechanisms triggered by the single currency, would contribute to a greater structural and cyclical convergence of economies. The severe and disparate effects of the sovereign debt crisis decisively undermined this conviction and launched a deep reflection on the viability of Euro Zone governance, which has already undergone major changes in the economic, financial and institutional fields. The implementation of the reforms initiated and others to be undertaken in areas such as fiscal integration will promote greater flexibility and a better correlation between economies. In the long term, the Euro Zone can be viable and beneficial to all its members,

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gradually approaching the criteria for the operation of an optimal currency zone, so there is the political will to do so.

ANNEX 1. THE SAMPLE OF COUNTRIES Country Austria Belgium Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Iceland Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Norway Poland Portugal Slovakia Slovenia Spain Sweden Switzerland United Kingdom

European Union 1995 Founder 2004 2004 1973 2004 1995 Founder Founder 1981 2004

Eurozone 1999 1999 2008

1973 Founder 2004 2004 Founder 2004 Founder

1999 1999 2014 2015 1999 2008 1999

2004 1986 2004 2004 1986 1995

1999 2009 2007 1999

1973

2011 1999 1999 1999 2001

OECD code AUT BEL CYP CZE DNK EST FIN FRA DEU GRC HUN ISL IRL ITA LVA LTU LUX MLT NLD NOR POL PRT SVK SVN ESP SWE CHE GBR

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REFERENCES Aizenman, J. 2016. “Optimal Currency Area: A 20th Century Idea for the 21st Century?” NBER Working Paper, 22097. https://doi.org/10.3386/w22097. Altavilla, C. 2004. “Do EMU members share the same business cycle?” Journal of Common Market Studies 42 (5): 869-896. Artis, M. J. and Zhang, W. 1997. “International business cycles and the ERM: Is there a European Business cycle?” International Journal of Finance and Economics 2(1): 116. Backus, D. K., and Kehoe, P. J. 1992. “International Evidence on the Historical Properties of Business Cycles.” American Economic Review 82 (4): 864-888. Baldwin, R., Beck, T., Bénassy-Quéré, A., Blanchard, O., Corsetti, G., De Grauwe, P., den Haan, W., Giavazzi, F., Gros, D., Kalemli-Ozcan, S., Micossi, S., Papaioannou, E., Pesenti, P., Pissarides, C., Tabellini, G., and Weder di Mauro, B. 2015. “Rebooting the Eurozone: Step 1 – agreeing a crisis narrative.” CEPR Policy Insight 85. Baxter, M. and Kouparitsas, M. 2005. “Determinants of business cycles comovement: A robust analysis.” Journal of Monetary Economics 52 (1): 113-157. Baxter, M. and King, R. 1999. “Measuring Business Cycles in the UK: Approximate BandPass Filters for Economic Time Series.” Review of Economics and Statistics 81 (4): 573-593. Borio, C. 2014. “The financial cycle and macroeconomics: What have we learned from the crisis?” Journal of Banking and Finance 45: 1. Camacho, M., Perez-Quiros, G., and Saiz, L. 2006. “Are European business cycles close enough to be just one?” Journal of Economic Dynamics and Control 30: 1687-1706. Canova, F., Ciccarelli, M., and Ortega, E. 2007. “Similarities and convergence in G-7 cycles.” Journal of Monetary Economics 54: 850-878. Christiano, L. J. and Fitzgerald, T. J. 2003. “The Band Pass Filter.” International Economic Review 44: 435-465. Clark, T. E. and van Wincoop, E. 2001. “Borders and Business Cycles.” Journal of International Economics 55 (1): 59-85. De Grauwe, P. 1996. “Monetary Union and Convergence Economics.” European Economic Review 40 (3-5): 1091-1101. De Grauwe, P. 2011. “The governance of a fragile Eurozone.” CEPS Working Document 346. De Haan, J., Inklaar, R. and Jong-A-Pin, R. 2008. “Will Business Cycles in the Euro Area Converge? A Critical Survey of Empirical Evidence.” Journal of Economic Surveys 22 (2): 234-273. European Commission. 2016. “Quarterly Report on the Euro Area” European Economy, Institutional Paper 016, 14 (4).

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Frankel, J. A. and Rose, A. K. 1997. “Is EMU more justifiable ex post than ex ante?” European Economic Review 41 (3-5): 753-760. Frankel, J. A. and Rose, A. K. 1998. “The endogeneity of the optimum currency area criteria.” The Economic Journal 108 (449): 1009-1025. Hodrick, R. and Prescott, E. 1997. “Postwar U.S. Business Cycles: An Empirical Investigation.” Journal of Money, Credit and Banking 29 (1): 1-16. Jones, E., Kelemen, D. R. and Meunier, S. 2015. “Failing Forward? The Euro Crisis and the Incomplete Nature of European Integration.” Comparative Political Studies 49 (7): 1010–1034. Jordà, Ò., Schularick M. and Taylor, A. M. 2013. “When credit bites back.” Journal of Money, Credit and Banking, Supplement to 45 (2): 3-28. Kalemli-Ozcan, S., Sørensen B., and Yosha, O. 2001. “Economic integration, industrial specialization, and the asymmetry of macroeconomic fluctuations.” Journal of International Economics 55 (1): 107-137. Kang, J. S. and Shambaugh, J. C. 2016. “The rise and fall of European current account deficits.” Economic Policy 31 (85): 153–199. Krugman, P. 1991. Geography and Trade. Cambridge, MIT Press. Krugman, P. 1993. “Lessons of Massachusetts for EMU.” in Adjustment and Growth in the European Monetary Union edited by Francisco Torres and Francesco Giavazzi, 241-266, Cambridge University Press. Lane, P. R. 2013. “Capital flows in the euro area.” European Economy. Economic Papers 497. Brussels. Lukmanova, E. and Tondl, G. 2017. “Macroeconomic imbalances and business cycle synchronization. Why common economic governance is imperative for the Eurozone.” Economic Modelling 62: 130-144. Matesanz, D. and Ortega, G. 2016. “On business cycles synchronization in Europe: A note on network analysis.” Physica A: Statistical Mechanics and its Applications 462: 287296. McKinnon, R. I. 1963. “Optimum Currency Areas.” American Economic Review 53 (4): 717-725. Mody, A. and Sandri, D. 2011. “The eurozone crisis: how banks and sovereigns came to be joined at the hip”. Economic Policy 27 (70):199-230. Montoya, L. A. and de Haan, J. 2008. “Regional Business Cycle Synchronization in Europe?” International Economics and Economic Policy 5 (1): 123-137. Mundell, R. A. 1961. “A Theory of Optimum Currency Areas.” American Economic Review 51 (4): 657-665. OECD. 2017. Gross domestic product (GDP). (Indicator). doi: 10.1787/dc2f7aec-en (Accessed on 12 June 2017). Ravn, M. O. and Uhlig, H. 2002. “On adjusting the HP-filter for the frequency of observations.” Review of Economics and Statistics 84 (2): 371-375.

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Rose, A. K., Lockwood, B. and Quah, D. 2000. “One money, one market: the effect of common currencies on trade.” Economic Policy 15 (30): 7-45. Rose, A. K. and Engel, C. 2002. “Currency unions and international integration.” Journal of Money, Credit and Banking 34 (4): 1067-1089. Schiavo, S. 2008. “Financial integration, GDP correlation and the endogeneity of optimum currency areas” Economica 75 (297): 168-189. Stockhammer, E. and Sotiropoulos, D. 2014. “Rebalancing the Euro Area: The Costs of Internal Devaluation.” Review of Political Economy 26 (2): 210-233.

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ISBN: 978-1-53613-474-2 © 2018 Nova Science Publishers, Inc.

Chapter 4

THE RISK OF INCOMPLETE FINANCIAL INTEGRATION IN THE EUROPEAN UNION Paulo Ferreira1,*, José Manuel Caetano2 and Andreia Dionísio3 1

CEFAGE-UE, University of Évora, Portugal Polytechnic Institute of Portalegre, Portugal 2 CEFAGE-UE, University of Évora, Portugal University of Évora – Department of Economia 3 CEFAGE-UE, University of Évora, Portugal Universidade de Évora - Departamento de Gestão

ABSTRACT The integration of financial markets is crucial in a monetary unification process, taking into account the ability to foster risk sharing and optimal allocation of savings and investments within the integrated space. After the creation of the single European currency in 1999, the sovereign debt crisis in the Eurozone questioned the model of monetary integration and its architecture because of its disparate impacts on member states, which called into question the viability of the Euro. In this chapter we evaluate the evolution of financial integration in the Eurozone and discuss the causes and effects of the crisis in the process of financial fragmentation. We conclude with identification of the aspects that we consider crucial to reform the paradigm of governance of the single currency.

Keywords: Eurozone, financial fragmentation, financial integration, sovereign debt crisis

*

Corresponding Author Email: [email protected].

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1. INTRODUCTION The adoption of a single currency, as happened in the European Union (EU), presents a number of advantages, but also some associated risks. Regarding the advantages, the most important are related to the reduction of the costs faced by economic agents, such as a lower cost of borrowing and in operations related to the absence of currency conversions, and it is expected to promote a better allocation of savings and/or investments, contributing to increasing the economic performance of the countries involved. However, there are some disadvantages and risks associated with adopting a single currency, particularly the loss of relevant economic policy tools, including monetary and exchange rate policy instruments, which are relevant to stimulate economies and support economic adjustment in the presence of asymmetric shocks. The fact is that a decision to adopt a common currency when countries are not financially integrated can lead to an increase in the economic disparities between these countries. Several empirical studies provide strong evidence that when the single currency was introduced in 1999 some Eurozone countries did not have the perfect conditions to adopt the Euro, due to the lack of financial integration. Countries such as Portugal, Spain, Italy, Ireland or Greece, which have common problems related to their economic and budgetary structures, are just some examples. Following the sovereign debt crisis, Portugal, Greece and Ireland had to resort to support programs with international financial intervention, while in Spain and Italy the need of similar support to overcome difficulties in their banking systems is continuously discussed. Countries that joined the single currency do not have the possibility of using monetary and exchange rate policies, which are currently in the hands of the European Central Bank (ECB). In this context, the economic policy instruments that remain are fiscal policies, but they are also limited, according to the rules of the Stability and Growth Pact (SGP) and its restriction of public deficits and debt as a whole. However, even with these rules, the Pact did not prevent some countries from reaching high levels of deficit and public debt, which led to penalties for the markets, with interest rates reaching exorbitant and unsustainable levels, leading to contagion in the financial sectors of these countries. The architecture of the Euro shows the presence of structural weaknesses and systemic failures, reducing the common currency’s sustainability. These faults revealed the Eurozone’s inability to keep its economic and financial stability during the attacks on the markets. The sovereign debt crisis and the contagion produced in the financial sector and in the real economy of the Eurozone were related to the absence of strong coordination of fiscal policies in the member states and also to the lack of common supervisory mechanisms and bank resolution. Also related was the fact that financial integration was verified in some countries, which increased the problems of the common currency. In this context, this chapter intends to evaluate the degree of financial integration in the Eurozone markets and analyse its

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evolution over time, trying to answer two questions. What was the degree of financial integration at the inception of the Euro and how has it evolved since the crisis? What are the reasons for the financial fragmentation during the crisis and what are the consequences for the most affected countries and for the Eurozone as a whole? The rest of the paper is organized as follows: Section 2 presents a discussion about the relevance of financial integration in the context of an Economic and Monetary Union (EMU). Section 3 identifies how financial integration evolved over time in the Eurozone in different sectors. Section 4 discusses the reasons for the sovereign debt crisis in the Eurozone and seeks to understand the effects of the financial market fragmentation for the Eurozone´s stability. Section 5 concludes and gives some recommendations and advice on policy to improve the governance of the Eurozone.

2. THE RELEVANCE OF FINANCIAL INTEGRATION IN A MONETARY UNION According to the European Central Bank (2013, 53), financial integration is “a situation whereby there are no frictions that discriminate between economic agents in their access to – and their investment of – capital, particularly on the basis of their location.” For Baele et al. (2004), financial integration occurs when all potential market participants share the same relevant characteristics, such as a single set of rules when they decide to deal with financial instruments or services, equal access to the set of financial instruments or services and are treated equally when active in those markets. Although this seems easy to define theoretically, it may not be so easy to understand all the relevance of financial integration, because it includes several different issues. One of the most important is clearly that financial integration is a phenomenon related to financial risk-sharing, and so is crucial for a more stable and sustainable monetary union. The main question is the following: what are the expected results in the case of real financial integration? Firstly, any economic agent, whatever its market basis, will be expected to have equal access to the financial instruments available in integrated markets. Moreover, one of the main consequences is that the interest rates of similar assets will tend to equalize. In fact, the existence of spreads in those assets will only occur due to differences in the risks of those assets (Horny et al. 2016). According to Lemmen (1996), capital mobility and asset substitutability are key features for financial integration. Both elements can be affected by issues such as the risk of financial assets, transaction costs, possible capital controls, and also by political or currency risks or risks of purchasing power parity, among others. As such, these features must be verified in different countries, in order to ensure effective financial integration.

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In a financially integrated area, financing foreign markets is expected to be easier and bring some benefits to members, such as a reduction in the costs of borrowing and better savings’ allocation, which are expected to promote economic growth. This is due to the possibility of firms and households increasing consumption smoothing, supporting risksharing and increased firm productivity. It will also promote international specialisation, enabling countries to reap benefits from enhanced productivity. This was noted, for example, by Ingram (1962) and Papaioannou et al. (2009), stating that financial integration can reduce the need for exchange rate adjustments, Indeed, in the case of asymmetric shocks, areas with financial surplus could lend to others suffering from those shocks, reducing the negative effects on economic activity. So, in an effective financially integrated area, any change in interest rates should cause capital movements across borders in order to avoid major imbalances. Long-term interest rates are then expected to converge between countries. In the setting of a Monetary Union, financial integration is even more important. In fact, in the presence of asymmetric shocks, the diversification of income sources could contribute to mitigating their effects (McKinnon 2004). The problem is not the existence of asymmetric economic structures between countries, but in this context, the most affected areas should benefit from the entry of financial funds from other partners sharing the same currency (Mongelli 2005). However, we cannot forget that the lack of financial integration in a monetary union could mean relevant costs and risks for some of its members, which may be relevant in the event of potential asymmetric shocks due to the loss of economic policy instruments (Lemmen 1996). This is why the adoption of a common currency should be cautious, to prevent the increase of economic disparities between countries. Likewise, in a context of financial integration, these countries are more exposed to the risk of the contagion effect. Therefore, greater macroeconomic discipline is required in countries, rewarding governments which have “good policies” and penalizing those with “bad policies” as argued by Agénor (2003). In consequence, Alesina et al. (2002) sustain that the loss of monetary autonomy could have a severe cost, if there is greater interdependence between countries. This question is related to the conflict between discretion and credibility in the use of monetary policy, and may also be related to some temporal inconsistency of policies. That situation could happen, for example, in electoral cycles, recognizing the possibility that measures are taken in accordance with the election calendar. This possibility tends to disappear, if a monetary policy is given to a supranational entity. An important issue in this context is the possibility of the economic and monetary union being able to cause endogeneity, that is, the single currency itself leads, through the interactions it causes, to greater financial integration, as barriers to financial flows are abolished. This question is addressed, for example, in De Grauwe and Mongelli (2005), who refer to several possible sources of endogeneity in an optimal currency area (OCA): (i) brought about by economic integration and with consequences for prices and trade; (ii)

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caused by the liberalization of capital markets; (iii) resulting from a synchronization of economic cycles and from the symmetry of shocks; iv) the flexibility of markets for goods and services and labour. The possible existence of endogeneity could have disguised somewhat the problems of the Eurozone, as a high level of financial integration may have been apparent, but there was no basis for such solid financial integration to ensure the smooth operation of the EMU. So, despite the relatively simple definition, financial integration is a complex process. This complexity can also be seen in the different possible ways to analyse financial integration, as we will present in the next section.

3. FINANCIAL INTEGRATION IN THE EUROZONE As previously mentioned, one of the objectives of this chapter is the analysis of how the situation of financial integration in the European Union evolved, particularly in the Eurozone, taking into account the degree of financial integration at different periods of time. We start with a subsection dedicated to the evidence of financial integration at the moment the Eurozone was created. A second subsection identifies the state of financial integration prior to the Eurozone crisis. A third subsection analyses the evolution of financial integration after the crisis. Finally, we present a synthesis of the results, as well as some evidence about the current situation. A great amount of literature tests for the existence of financial integration. A major division in the ways to analyse financial integration distinguishes between price tests and quantity tests. In the case of price tests, the most popular are the analysis of parity conditions (covered and uncovered interest rate parities). Still within price tests, there are studies on banking and currency markets and studies on stock markets. Regarding quantity tests, the test of the correlation between investments and savings is the most used. Other tests focus on the correlation of consumption levels and others again deal with the behaviour of flows with foreign countries. Note that the main objective of this chapter is not to treat the different tests, but to scrutinise the existent evidence. So we do not present the different methodologies.

3.1. Financial Integration at the Moment of Creation of the Eurozone The decision of the EU members to create a common currency caught the attention of researchers, in order to evaluate the multiple and complex consequences of that decision.

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Several studies, using different metho-dologies, analyse the degree of financial integration prior to, and at the moment of creating the Eurozone (see, for example, Adam et al. 2003). Using interest parity criteria, the main conclusions of these studies pointed out that countries at the centre of the EU show some evidence of financial integration, namely Austria, Belgium, France and Holland. Geographical proximity, the similarities in economic structures and macroeconomic discipline are some of the reasons that may explain this evidence. Other countries forming the Eurozone had little or no evidence of financial integration. In some EU countries that remained outside the Euro, most of the results show weak signals of financial integration. Nevertheless, Denmark shows some signs of financial integration, while the Czech Republic shows an improvement in the degree of financial integration (Ferreira and Kristoufek 2017). When stock markets are analysed, most studies find an increase in correlations between stock market indices in the 1990s, mainly in more developed markets, which include several of the Eurozone stock markets. Countries like the UK, France, Spain, Germany or Italy, along with other countries like the USA or Japan, had a high level of integration. An increase in integration could be problematic if there is not careful supervision, as this could cause the loss of some intervention capacity if there are problems in the financial markets. However, some studies find low correlation levels in stock returns, which could be interpreted as low financial integration. Some possible causes could be home bias, the sectorial composition of differences in each country or asymmetric shocks between countries and how each country responds to similar shocks (Fratzscher 2002). According to Aggarwal et al. (2004), increased integration can be due to anticipating the effects of joining the Euro. With regard to bank markets specifically, as previously referred to, two types of research are identified: studies on the wholesale bank market, with evidence of almost complete integration, and studies on retail markets, with lower integration levels, due to barriers that remain in force. For example, Kleimeier and Sander (2002a, 2002b) report a lower pressure to the exposure of loans in foreign countries, due to customer proximity, and the fact that most (almost 80%) of loans are private. Still, these findings suggest that the Euro generates convergence, since the common currency has the potential to complete the single market. Centeno and Mello (1999) also report that the integration of retail markets is slower, since local activities are larger, by nature. In a study of different types of banking market products, Cabral et al. (2002) found evidence of a high degree of integration in the wholesale market (interbank deposits and loans), but not in the retail market, possibly due to low liquidity and the segmentation of national markets, which depends on the differences in the legal taxes in countries. Still, the authors point out that the Euro could lead to the convergence of the rates of deposits and loans, but there are still differences in banks’ margins, suggesting a high level of segmentation.

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Analysis of consumption correlations allows researchers to evaluate the possibility of consumption smoothing, but clear evidence of this is rather scarce. This is understood as possible imperfections and deficiencies in the integration of these kinds of financial markets. Sorensen and Yosha (1998) even conclude that the Maastricht Treaty should be relaxed to allow governments to have large deficits temporarily to respond to shocks in the product market. The failure to check the increase in consumption correlations may be related to excessive consumption sensitivity compared to local income and with little correlation between the changes in internal and external consumption. Banks and financial institutions, with whom consumers negotiate almost exclusively, are the main drivers of consumption smoothing (Huizinga and Zhu 2004). Furthermore, even in rich countries, a large proportion of consumers does not have financial assets and has a limited ability to borrow. This implies that the effect of consumption smoothing should be reduced. The lack of diversification of consumption may even be caused by the large proportion of total consumption in non-tradable goods.

3.2. Strengthening of Financial Integration in the Early Years of the Eurozone As seen in the previous section, the evidence of financial integration in the Eurozone was scarce at the beginning. With the advance of the common currency, increased financial integration should be expected. Furthermore, as more countries entered the Eurozone, it might be possible to find those countries showed greater evidence of financial integration with the other partners or, alternatively, showed the same evidence as the first Eurozone countries. Even using different methodologies, the main findings pointed to the inexistence of overall financial integration. Studies using interest parity conditions, which include exchange rates, could only consider new Eurozone countries, but the inclusion of those countries does not change the main results: the same low evidence of financial integration of non-central European countries. The incipient market development in these countries, associated with lower levels of liquidity and the fact that they have different economic structures from other countries, may explain these results. Regarding bank markets, there is still evidence of some integration in the wholesale market, but little in the retail market. For example, Gual (2004) found signs of segmentation between firms’ loans and mortgage credit, both before and after the Euro. Indeed, tests show that price differences have not diminished and that there is little convergence over time. However, in some fields there was evidence of increased integration. Taking asset flow into account, Lane and Milesi-Ferretti (2003) and Pungulescu (2003) find signs that financial integration levels have increased over time. This trend is also true for the Eastern

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European countries that joined the EU later. Although the authors do not find evidence of complete financial integration, they point out that the home bias has been declining, a situation enhanced by membership of the common currency. The major source of segmentation could be the differences in regulation, which prevents institutional investors from investing a large portion of international assets. Studies of stock markets allow similar conclusions. In fact, for this market, there are several analyses of the impact of the Euro. For example, Baele and Vennet (2001) conclude on increased financial integration, related to reduction in the volatility of markets and the convergence of monetary policy. Fratzscher (2002) concludes that the EU is highly integrated. In turn, Scheicher (2001) uses data from emerging economies in the EU (Hungary, Poland and Czech Republic), finding evidence of regional market integration, but also integration with the EU. The reasons for the increased integration in stock markets emphasize factors such as faster transmission of information and technological advances. Furthermore, larger markets have higher levels of integration than smaller ones. These studies, focusing on the beginning of the Euro period, show that increased stock market integration occurred early in the Euro. Although most studies find evidence of increased integration, some indicate conclusions contrary to expectations, that is, diminished financial integration over time (see for example, Pungulescu 2003). The use of different methodologies or samples could be the cause of the difference in the results. Since 2005, a yearly publication from the European Central Bank (ECB) is devoted to the topic of financial integration. From 2005 to 2009, the year of the beginning of the crisis, these successive reports found a high level of integration in money markets. Regarding bond markets, some fragmentation was found, mainly in the case of corporate bonds, which could be related to differences in perceived credit risks, as well as the existence of local factors, like liquidity and differences in those markets’ development. Equity markets were also considered to have reinforced their integration, mainly due to the possibilities of risk diversification. Only bank markets remain with low levels of integration, mainly in the retail market (since in the interbank market, integration was also noted). Of course, some of these results may be due to the endogeneity previously referred to, which is inherent in the progress of integration due to the single currency, especially in a period when there was no major economic and financial turmoil. It should be noted that the existence of financial integration is an important issue when faced with possible asymmetric shocks, especially in the case of a single currency. If that financial integration is not found, those shocks could themselves lead to less financial integration, which could be happening in the case of the Eurozone, as we show in the next section.

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3.3. Financial Integration after the Eurozone Crisis 2009 was marked by the beginning of the Eurozone crisis, with a period of turmoil in the financial markets, which had serious implications for the process of financial integration. As previously mentioned, the ECB provides an annual report about financial integration in the Eurozone. Those reports are the basis of the analysis in this section, which explores four different markets: money, bond, equity and bank. According to these reports, money markets were sent into turmoil, mainly immediately after the beginning of the crisis. Evidence of high fragmentation of these markets was found, with a severe decrease in transactions and an increase in spreads. Nevertheless, it is noted that this was also one of the markets making quick progress in integration, returning gradually to normal functioning. Several policies adopted by the European authorities helped to consolidate this pattern, mainly those of the ECB, in order to reduce market tensions. However, from 2010 to 2012, the authorities found that the pricing of risk was dependent on the geographical origin of the funds. The continued calmness of the money market system was mainly due to the excess liquidity provided by the ECB. Since 2013, in spite of the ECB policies, the market continues to be somewhat fragmented, showing some home bias, but with a decrease in the excess of liquidity. Bond markets were probably most affected by the crisis. Considering the sovereign bond market, since the beginning of the turmoil, spreads vis-à-vis the German benchmark have increased sharply, which is certainly related to the differences in perceived credit risks. The crisis led to some sovereign bonds being considered safe (German ones, for example), while countries like Greece, Ireland, Portugal, Spain and Italy saw their spreads increase. Progressively, since 2012, yields have started to decline, as well as spreads. In fact, in 2013, the ECB considered that the fragmentation in the sovereign bond market had been reduced, influenced by some better expectations about macroeconomic behaviour in the Eurozone. However, this particular market has not recovered pre-crisis levels of integration. Corporate bond markets have also experienced significant tensions since the crisis. In fact, this market is closely related to the sovereign one, so the segmentation shown in the corporate market tended to replicate the behaviour of sovereign bond markets. Besides the turbulence of the equity markets, the indicators provided by the ECB show that these markets do not suffer from fragmentation. This absence of effect of the crisis on the level of market integration is related with these markets’ informational process. Equity markets continue to show some synchronization and even the home bias is reducing over time, benefiting from a diversification effect. For this particular case, the work of Bekaert et al. (2013) identifies an increase in the level of integration in EU countries, even in this final period under analysis. Finally, regarding banking markets, the evidence continues to be similar to previous studies mentioned: retail banking markets continue to display a high degree of fragmentation, whereas the wholesale market (and capital market-related) shows higher

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integration. According to the ECB, this could be motivated by differences in regulation and due to information barriers. The question is that retail market fragmentation increased after the crisis, when compared to the previous period, showing that the crisis undermined confidence in the banking system. The lack of coordination in the retail bank market in the Eurozone is regarded as one of the causes of this behaviour. However, since the middle of 2014 the retail market is found to reduce the home bias, which could be understood as increased integration of this market. These findings are confirmed by Rughoo and Sarantis (2014) and Pungulescu (2015). A recent paper by Brosens (2017) contains some revealing figures on the levels of financial fragmentation in the Eurozone markets: i) deposit rates range from about 0.05% in Belgium, Spain and Portugal, to 0.43% in France; ii) there is a large home bias in bank savings, mainly due to different regulation and payment systems; iii) bank sheets are not similar, when considering the deposit to loan ratio; iv) funding costs are very different between countries; and v) borrowing rates are also very dissimilar, for both firms and households. Some of these findings are not new, as nor did Adam et al. (2002) find evidence of cost convergence, even indicating that some of these charges are maintained throughout the sample at the beginning of the Euro. Strong fragmentation in the Eurozone financial markets could be linked with two different issues: natural causes such as consumer preferences, usually risk-adverse, language, culture or customer loyalty, among others; and policy-induced reasons, such as different tax treatment depending on the nationality or regulation and supervision, among others. We believe that the varied ways in which the sovereign debt crisis hit the different countries and markets is the biggest reason for financial fragmentation, as we will try to highlight in the next section.

4. FINANCIAL FRAGMENTATION IN THE EUROZONE IN THE SETTING OF THE SOVEREIGN DEBT CRISIS As previously stated, the sovereign debt crisis in the Eurozone caused significant fragmentation of financial integration, compared to the situation in the early years of the Euro. In fact, in the pre-crisis period there was no shortage of liquidity in the interbank market, and interest rates for economic activity in the Eurozone showed some convergence. An increase was also noted in cross-border financial flows and a higher degree of external exposure of domestic financial sectors. This movement coincided with a general lowering of interest rates, which benefited economic activity as a whole. However, the crisis triggered a reversal in the direction of financial flows from peripheral countries to the core countries, as the degree of risk and the costs of financing in those countries increased significantly. This situation has dramatically affected the granting of credit to the economy, with households and SMEs being the most affected.

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Discriminatory conditions for companies in peripheral countries have thus been exacerbated by the high level of bank lending in global financing, given the absence of integrated capital markets. This situation, in addition to the implications of economic activity, provoked strong instability throughout the Eurozone and increased the uncertainty about its continuity in the future. Given the relevance of this situation, we will revisit the chain of interactions of the sovereign debt crisis and focus on some of its implications. The main issue of this crisis comes from a succession of events that have led to the abrupt stop of foreign private capital inflows for some Eurozone countries (Merler and Pisani-Ferry 2012), as a reaction from investors who have sold the sovereign debt of these countries, also disturbing the private debt markets. Despite some effects having been minimized by the action of the Target 2 interbank payment system and external financial support, there have been major falls in economic growth, increased unemployment and significant deficits in the current account in the most vulnerable countries (Loublier 2015). A great amount of literature has been produced on this crisis and there seems to be general consensus as to its causes (Baldwin and Giavazzi 2015), recognizing that the major problem was the inability to avoid the crisis spreading to several countries and deal with the halt in capital flows from central countries to the periphery, which highlighted the differences in the levels of indebtedness and in accumulated imbalances (Baldwin and Gros 2015). Authors such as Sapir and Wolff (2015) and De Galhau (2016) understand that the problem does not only reflect the internal imbalances accumulated in the period prior to the crisis and which have subsequently grown. The problem is of a structural nature, and the rules of the Euro and the action of the Community institutions are not exempt from responsibility. In fact, these institutions have been monitoring countries’ debts, albeit without great concern about their levels of indebtedness and the incentives for their sustainability, both at the private and public level. In addition, the countries’ situations were different, because while Portugal, Greece and Italy had problems with their public debt, in Spain and Ireland the difficulty was private debt, which justified different ways of acting. As for public debt, austerity programs were applied and effectively contributed to reducing domestic demand, but at the same time these programs worsened the feeling of recession. In private debt the focus was on restoring the soundness of the banking system. In the cases where public debt was at the core of the problem, there was a retroactive effect of sovereign debt over banking systems, making them weaker due to the spread of successive waves of contagion (Angeloni et al. 2012). These authors calculated the correlation between the levels of the Certificate Default Swaps of private banks and the public debt of their respective countries, the results confirming a strong interdependence of more than 65% in all cases. This evidence illustrates the close relationship that exists

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and justifies systematic risk diffusion in a context of liberalized financial markets, creating a vicious circle between sovereign and bank debts. The authors also recognized the existence of an inverse transmission channel, from sovereign debt to bank assets, in four different ways: (i) the value of sovereign debt assets held by banks decreases when the sovereign risk increases and reduces these securities’ value; (ii), sovereign bonds are used as collateral in the financial markets, so the reduction of their price makes it difficult to access credit; (iii) the decline in the sovereign risk rating is reflected in the decrease in the rating of the banks in that country; (iv) increased sovereign risk affects the value of government warranties to banks, leading to greater risk perception in financial markets. The crisis self-feeding mechanism was based on the sovereign guarantees to national banks, which greatly expanded their balance sheets in the first years of the Euro, without having solid guarantees as to the real viability of some credits. Issuing bank debt securities supported by the states made the sovereign bond/bank nexus stronger faced with the banks’ difficulties in accessing credit. This mechanism for the transfer of banks’ liabilities to sovereign debt reduced the sustainability of public debt in these countries and had a strong impact on the rise of interest rates. The origin of the crisis was linked to the warranties that national governments provided to their banks, some of them in a pre-insolvency situation. Thus, banks issued debt securities guaranteed by the sovereigns and when banks had difficulties in fulfilling their duties towards their creditors, States were obliged to pledge guarantees, aggravating the situation of both the debtor and the guarantor. At the same time, banks with large portfolios of public debt securities accumulated risks resulting from the insolvency of issuers, in particular from the State itself. Eurozone members could not guarantee future reimbursement to bondholders, thereby exposing countries to liquidity crises as a result of market failures in their solvency. Indeed, without the support of the ECB, liquidity provider as the lender of last resort, those countries had to issue debt in currencies they did not control, without guarantees of repayment terms, as happens in situations where the sovereign can force the central bank to provide liquidity (De Grauwe 2011). This proved to be a structural problem arising from the architecture defined to ensure the functioning of the Eurozone and, at the same time limited monetary policy options. The strong linkage between banks and sovereigns in peripheral countries inhibited the functioning of the traditional channel of monetary policy through the interest rate, and in addition, hampered the credit channel that operates through banks’ balance sheets. This caused obstruction of the main channels of monetary policy transmission - interest rates and credit level -, leading to the coexistence of different rates for loans to banks and enterprises in the Eurozone, which expressively testifies the fragmentation of financial markets. As the ECB has to have a single monetary policy, its options were pro-cyclical in

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some Eurozone countries, so this policy was ineffective for the transmission channels and lost efficiency in aggregate terms. In this situation, markets have failed to finance viable projects because they take into account the situation of the country where firms are located, while States have to centralize the risks assumed by banks to ensure their creditworthiness. The relationship that links States/banks/firms has led to a rise in country risk and interest rates, penalizing agents with higher costs of financing their activity. In this context, financial markets’ re-evaluation of the risks of Eurozone countries has reinforced the fragmentation of these markets and punished the countries with the highest budget deficits and the current account. Hence, companies faced greater difficulties in accessing finance, with a chain of effects on economic growth, spreading the crisis across the economy. Given the rapid interest rate hike, it was even harder for countries to seek financial help and accept the inherent adjustment programs. From the peak of the crisis, the situation has improved and financial integration has increased, although the risks of a new crisis persist, as some of the fundamentals underlying the crisis remain unchanged. In fact, the turmoil experienced in the Eurozone had implications for the general degree of financial integration. As described earlier, and as shown by Berenberg-Gossler and Enderlein (2016), the degree of financial integration decreased sharply with the Euro crisis, although the decrease pattern had started previously with the subprime crisis. Since the end of 2012, some increase of integration has been seen, motivated basically by ECB intervention. The question that arises is: being a single market with a common currency, what are the consequences of the non-verification of financial integration? In several countries, the problems in their macroeconomic structures and financial sectors are well known, namely in Southern Europe (Portugal, Italy, Greece and Spain). These countries show the worst results in terms of financial integration within the Eurozone. It is not therefore surprising that these countries have had more difficulties regarding the sustainability of their sovereign debt. The problems with budgetary discipline is one of the reasons that can lead to the failure of capital mobility, as this can lead to agents not considering assets as a perfect substitute (just looking at the spread of sovereign bonds as a risk premium indicator required by investors). However, some improvements have taken place since then, especially following the creation of the Banking Union and a new regulatory framework for the banking sector, which will allow greater control and prevention (and sharing) of risks. Thus, banks’ sustainability ratios have improved and banking activity is subject to greater supervisory scrutiny by a single authority. There is still a strong link between the financing banks’ costs and their respective States. Despite the reforms already undertaken and the attempts to reduce the risks of this dangerous interdependence, the breakdown of the vicious circle of sovereigns/banks continues. Indeed, this is a complex process, mainly due to the high volume of public debt held by national banks, as well as high credit values of defaulted loans in banks’ portfolios,

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which compromise their profitability and solvency. Faced with these features of vulnerability, we consider that we are still far from ensuring there will be no new difficulties on the horizon for greater integration and financial stability in the Eurozone. Despite the efforts to deal with the problem in the countries most exposed to these situations, restoring public debt on a sustainable path and clearing banks’ balance sheets weighed down by doubtful loans requires structural and global measures that will have to be taken at the Eurozone level. So it is a fact that, in spite of the recent progress, further integration is needed to ensure that the financial system will be able to safely handle any future crises. Although financial fragmentation is now less than during the crisis, the degree of integration in the pre-crisis phase has not yet been achieved. This evidence shows that access to investment finance remained limited in some countries, which reflects weak risk-sharing and a lower capacity for the EMU to respond to possible economic shocks in the future.

CONCLUSION The fragmentation of financial markets registered in the Eurozone during the crisis symbolizes the existence of an incomplete monetary unification process. Thus, notwithstanding the progress made in the post-crisis period, additional reforms will be necessary to ensure that the financial system fulfils its tasks and contributes to the resilience of the Eurozone in possible future crises. With the effective functioning of the financial system, essential for the stability of the EMU, European leaders should draw lessons from the traumatic experience of the crisis and take advantage of the momentum of the recent economic recovery to agree on ways forward. It is a question of clarifying the political options on the process of economic integration, so that countries are willing to give up some of their sovereignty in exchange for the greater stability and effectiveness of the Eurozone and, of course, better conditions for all members benefiting from this process. It is then necessary to agree on the aspects that have been discussed and to make progress in risk reduction and how to share this, aspects where financial integration will play a decisive role. It should be borne in mind, however, that financial fragmentation, although mitigated, still persists in the Eurozone, so that the possibility of a new crisis with destructive effects on the integration process has not yet been ruled out. Thus, consolidating the effective reduction of risks will be a necessary condition to sustain greater sharing, between agents and countries. Regarding risk reduction, in order to increase stability in financial markets, the European Commission’s Discussion Paper (2017) on the deepening of the EMU presents proposals for strengthening prudent management and market discipline, while emphasizing

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the importance of completing risk-sharing projects, mainly through deposit insurance and an instrument to allow the mutual exchange of public debt in the Eurozone countries. These are important aspects for transforming the functioning of the Eurozone, as the interaction between weak banks and governments with fragile fiscal situations exacerbated the problems of the most exposed countries and reinforced this causal link. The structural weaknesses of monetary union were evident in the delicate relationship between the banking sectors and their respective sovereigns in some Eurozone countries. So we believe that the creation of the Banking Union is perhaps the greatest structural reform of the Eurozone, because the crisis has shown that national supervision is inadequate and does not prevent imbalances. Against this background, it was not surprising that the idea that a Banking Union would be unavoidable to supplement the sustainability of the single currency was quickly accepted. In order to build this Union and to ensure financial stability, arrangements should be put in place for all members, and an integrated financial framework should be established by: (i) a single banking supervision mechanism; (ii) a joint resolution authority; (iii) a system of financial support to guarantee deposits and the application of bank resolutions. The first two pillars of the Banking Union have been gradually implemented and have been in force since 2016 with the creation of the Single Supervisory Mechanism and the Single Resolution Mechanism, but there is still a lack of clarity on how to implement the third pillar of the Single Resolution Fund. In fact, there has been a lack of consensus among countries in this regard, since such a mechanism could involve some mutualisation of bank risks, implying greater fiscal integration in the Eurozone, which some Member States have reportedly opposed. Despite the prevailing impasse, a solution must be found to conclude the Banking Union. In addition, it has been pointed out that a greater diversification of bank exposure may be one of the means to prevent systemic crises and the subsequent fragmentation of the financial market. Hence the requirements for diversification of sovereign debt exposure by banks are under discussion. However, there are still divergent views on the subjects underlying the implementation of a common regime, notably the risk weighting or the limits on sovereign debt acquisition, but it seems that there are advances to be able to assume a common norm in the time of the Banking Union. Then again, higher risk-sharing by private channels can be achieved through greater integration of capital markets, which will strengthen the role of financial markets in dealing with asymmetric shocks, which are absorbed by external investors. Better allocation of savings to more efficient investments will foster economic growth while at the same time helping to reduce the threats of financial instability with greater risk-sharing at the European level. In this context, the creation of a Union of Capital Markets can give companies access to alternative forms of financing in the Eurozone and reduce the economic cost of keeping

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unsustainable banks in business. In addition, the implementation of the project will require structural reforms at the national level, since, among other things, it will impose common rules for the issuance of securities or for bankruptcy proceedings and may even lead to centralized supervision of capital markets and a form similar to what was stipulated for the Banking Union. A final remark to mention is the relevance of creating a secure European asset that contributes, on the one hand, to preserving governments’ ability to finance themselves at lower costs and to maintain continued market access and, on the other hand, which encourages sound budgetary policies in Member States. In fact, the crisis has shown that the mutual exposure of banks / states has amplified the volatility of sovereign bond markets with effects on the stability of the financial sector of the Eurozone and its members. Thus, breaking this “vicious cycle” is crucial for an ambitious and long-lasting solution that will alter the very structure of European securities markets. In this way, the creation of secure Eurozone asset insurance would facilitate the conduct and transmission of monetary policy and promote risk capital and long-term investment. It is not the time to dwell on the technical peculiarities of an asset of this nature, which is being discussed. However, we believe that this may be a relevant way to support credit risk, liquidity in the market, avoid contagion and provide credit at a low cost. Therefore, such an asset should allow easy assessment by investors, which requires a transparent structure that allows it to become a benchmark in the market, taking into account the specific demand of investors seeking diversification in their portfolios. The euro crisis highlighted the shortcomings of the Maastricht model for the creation of the single currency. Driven by events that endangered its existence, EU leaders and institutions have introduced some reforms in the governance of the Eurozone, recognizing that it is now more equipped to respond to situations of financial instability. However, more changes are likely to occur, since the slowness and complexity of reform processes do not always generate immediate effects and structural changes that underlie existing imbalances. This is a fundamental issue because, given the lack of concrete responses to institutional failures that affect the functioning of the Eurozone, the reaction of the markets will be tremendous and the effects can be devastating for the weakest links, as the sovereign debt crisis has clearly shown. Therefore, to be half way in carrying out reforms is dangerous, because the monetary union remains incomplete, the reason why the persistence of the imbalances can make crises recurrent. So as we have said, a crucial question must be answered, which has to do with the sharing of sovereignty that states are willing to do to accept greater risk-sharing in the EMU and to support greater economic convergence.

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REFERENCES Adam, K., Jappeli, T., Menichini, A., Padula M., and Pagano, M. 2002. Analyse, Compare, and Apply Alternative Indicators and Monitoring Methodologies to Measure the Evolution of Capital Market Integration in the European Union. Centre for Studies in Economics and Finance, University of Salerno. Accessed August, 17 2016. http://ec.europa.eu/internal_market/economic-reports/docs/020128_cap_mark_int_ en.pdf. Agénor, P. R. 2003. “Benefits and costs of International Financial Integration: Theory and Facts.” World Economy 26: 1089-1118. Aggarwal, R., Lucey, B. and Muckley, L. 2004. Dynamics of equity market integration in Europe: evidence of changes over time and with events. IIIS Discussion Paper nº 19. Alesina, A., Barro, R. and Tenreyro, S. 2002. “Optimal currency areas.” NBER Working Paper, No. 9072. Angeloni, C., Merler, S. and Wolff, G. 2012. “Policy Lessons from the Eurozone Crisis.” The International Spectator 47(4): 17–34. Baele, L., Ferrando, A., Hördahl, P., Krylova, E and Monnet, C,. 2004. “Measuring financial integration in the euro area,” European Central Bank 14. Baele, L. and Vennet, R. 2001. “European Stock Market Integration and EMU.” Paper presented at the Conference on Banking and Finance. Accessed August, 17 2016. www.economia.uniroma2.it/ceis/conferenze_convegni/banking2001/papers/mercoled i/Baele%20-Vander%20Vennet-merc.pdf. Baldwin, R. and Giavazzi, F. “The Eurozone crisis – A consensus view of the causes and a few possible solutions.’ VoxEU.org Book, CEPR’s Policy Portal, Accessed on 20th November 2016. Baldwin, R. and Gros, D. 2015. What caused the Eurozone crisis? Accessed August, 20 2017. https://www.ceps.eu/system/files/What%20caused%20the%20EZ%20Crisis% 20RB%20DG%20CEPS%20Commentary.pdf. Bekaert, G., Harvey, C., Lunbald C. and Siegel, S. 2013. “The European Union, the Euro, and equity market integration.” Journal of Financial Economics 109(3): 583-603. Berenberg-Gossler, P. and Enderlein, H. 2016. “Financial Market Fragmentation in the Euro Area: State of Play.” Policy Paper 177. Jacques Delors Institut, Berlin. Brosens, T. 2017. “Financial integration in the Eurozone should not be a tough sell.” CEPR’s Policy Portal, http://voxeu.org/article/financial-integration-eurozone-shouldnot-be-tough-sell. Cabral, I., Dierock, F., and Vesala, J. 2002. “Banking Integration in the euro area.” European Central Bank Occasional Papers Series 6. Centeno, M. and Mello, A. 1999. “How integrated are the money market and the bank loans market within the European Union?” Journal of International Money and Finance 18: 75-106.

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De Galhau, Fr. 2016. Europe at a crossroads: How to achieve efficient economic governance in the Euro Area. Accessed May, 24 2017. http://bruegel.org/ 2016/03/europe-at-a-ssroads-how-to-achieveefficient-economic-governance-in-theeuro-area/. De Grauwe, P. 2011. “The Governance of a Fragile Eurozone.” CEPS Working Documents, Accessed September, 3 2017. https://www.ceps.eu/publications/governance-fragileeurozone. De Grauwe, P. and Mongelli, F. P. 2005. Endogeneities of Optimum Currency Areas: What brings Countries Sharing a Single Currency Closer together? Mimeo. European Central Bank. 2003. European Central Bank Bulletin, October 2003. Ferreira, P. and Kristoufek, L. 2017. “What is new about covered interest parity condition in the European Union? Evidence from fractal cross-correlation regressions.” Physica A 486: 554-566. Fratzscher, M. 2002. “Financial Market Integration in Europe: on the Effects of EMU on Stock Markets.” International Journal of Finance and Economics 7, 165-193. Gual, J. 2004. “The integration of EU banking markets.” CEPR Discussion Paper 4212. Horny, G., Manganelli S. and Mojon, Be. 2016. “Measuring Financial Fragmentation in the Euro Area Corporate Bond Market.” Banque de France 582. Huizinga, H. and Zhu, D. 2004. “Domestic and international finance: how do they affect consumption smoothing?” CEPR Discussion Paper 4677. Ingram, J. C. 1962. Regional payments mechanisms: the case of Puerto Rico. Chapel Hill: University of North Carolina Press. Kleimeier, S. and Sander, H. 2002a. “Consumer credit rates in the Eurozone: evidence on the emergence of a single retail banking market.” ECRI Research Report 2. Kleimeier, S. and Sander, H. 2002b. “European financial market integration: evidence on the emergence of a single Eurozone retail banking market.” Paper presented at 29th Annual Meeting of the European Finance Association, Berlin, August 2002. Lane, P. and Millesi-Ferretti, G. 2003. “International Financial Integration.” IMF staff papers 50: 82-113. Lemmen, J. 1996. Financial Integration in the European Union – Measure-ment and Determination. Centre for Economic Research, Tilburg University. Loublier, A. 2015, “Recent developments in cross-border capital flows in the euro area.” Quarterly Report on the Euro Area 14(1): 7-18. McKinnon, R. 2004. “Optimum Currency Areas and Key Currencies: Mundell I versus Mundell II.” Journal of Common Market Studies 42(4); 689–715. Merler, S. and Pisani-Ferry, J. 2012. “Sudden Stops in the Euro Area,” Review of Economics and Institutions 3(3). Università di Perugia. Mongelli, F. 2005. “What is European Economic and Monetary Union Telling us About the Properties of Optimum Currency Areas?” Journal of Common Market Studies 43(3): 607-635.

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Papaioannou, E., Kalemli-Ozcan, S. and Peydró, J.-L. 2009. “What is it good for? Absolutely for financial integration.” CEPR Policy Portal. Pungulescu, C. 2003. Measuring Financial Integration in the European Monetary Union: An Application for the East European Accession Countries. Accessed August, 18 2016. https://editorialexpress.com/cgibin/conference/download.cgi?db_name=SAEe2013&paper_id=242. Pungulescu, C. 2015. “Real effects of financial market integration: does lower home bias lead to welfare benefits?” The European Journal of Finance 21(10-11): 893-911. Rughoo, A. and Sarantis, N. 2014. “The global financial crisis and integration in European retail banking.” Journal of Banking and Finance 40: 28-41. Scheicher, M. 2001. “The co-movements of stock markets in Hungary, Poland and the Czech Republic.” International Journal of Finance and Economics 6: 27-39. Sorensen, B. and Yosha, O. 1998. “International risk sharing and European monetary unification.” Journal of International Economics 45: 211-238.

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ISBN: 978-1-53613-474-2 © 2018 Nova Science Publishers, Inc.

Chapter 5

TOWARDS A FULL BANKING UNION IN EUROPE: WAITING FOR THE NEXT CRISIS? Luís Brites Pereira1,* and Miguel Rocha de Sousa2 1

Nova School of Business and Economics (Nova SBE), Lisbon, Portugal 2 CEFAGE & CICP and University of Évora (Department of Economics), Évora, Portugal

ABSTRACT This chapter assesses the need for a complete European Banking Union (EBU) given the perceived shortcomings of Europe’s Economic and Monetary Union (EMU), especially the negative banking-sovereign linkages highlighted by the Eurozone crisis. If properly implemented, a complete EBU severs these linkages and strengthens the resilience of Europe’s banking sector. The design of an optimal EBU comprises three components: European Deposit Insurance System (EDIS), Banking Recovery and Resolution Directive (BRRD) and European Stability Mechanism (ESM), which could evolve to a European Monetary Fund (EMF). While such a design encompasses both risk-reduction and risk-sharing features, the former has been favored due to mostly political considerations. Indeed, completing EBU will require significant political will to adopt additional risk-sharing measures, such as a common fiscal backstop and a truly supranational EDIS, amongst others.

Keywords: Bank-Sovereign Linkages, European Banking Union, Eurozone crisis

*

Corresponding Author Email: [email protected].

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Luís Brites Pereira and Miguel Rocha de Sousa

1. INTRODUCTION Since 2007, the Euro’s existence has gone hand in hand with a lingering financial crisis, political turmoil and economic downturn that resulted in a lack of confidence in Europe and its financial architecture. In order to assess the banking-union component of this architecture, we must first understand the shortcomings of EMU itself, which were already evident in the early days of the Euro’s creation. To start off, we consider how the absence of adequate fiscal policy coordination, as well as sovereign-debt mutualization, led to episodes of financial instability that undermined the European banking system through rising risk-premiums and short-liquidity (de Sousa and Caetano 2013). We then assess whether a banking union is a necessary and adequate response to the perceived shortcomings of EMU, as it pertains to Europe’s banking sector. Finally, we look at the issue of the EBU’s implementation, as well as its current challenges and future prospects. Accordingly, this chapter is organized as follows: Section 2 describes the need for the EBU while section 3 looks at how it was implemented. Section 4 addresses its challenges, as things stand at present, and also its future prospects. In the conclusion, we summarize the main points of our assessment while also highlighting the need for political will to establish a complete banking union in Europe.

2. WHY A EUROPEAN BANKING UNION? This section provides a brief overview of the Eurozone’s need for a banking union. To this end, we describe the flaws and shortcomings that led to the financial crisis in Europe. The banking union arises due to need to sever the sovereign-debt home bias in the banking sector and also the need to complement the EMU (Véron 2015). Note that the EMU area entails a common monetary policy that is determined by the European Central Bank but each country banks still has different exposure to risks, arising from differences in sovereign debt ownership. As such, there is a risk-exposure bias that banks face in different EMU countries due to the different frameworks and legal provisions (Elliot 2012; Breuss 2013). The Mundellian paradigm for common currency areas is based on an integrated approach with respect to the optimality conditions to establish such an area (Mundell 1961; Vieira and Vieira, chapter 2, in this book). In particular, the synchronization of economic cycles is seen as crucial in order to avoid asymmetric shocks. This requirement, in turn, implies that labor and factor markets have to become more integrated and flexible across the currency area (Wallenius 2014). Additionally, a more integrated banking sector will help to minimize asymmetries in a currency area, given this sector’s crucial role in

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financing the economy’s firms. By implication, the need for common rules and harmonization in the banking sector becomes inescapable. This leads us to another and obvious question: Is it not true that provisions existed for banking sector harmonization? The answer is that international rules did indeed exist, and applied to almost all banks on a global scale. These so called Basel rules covered the provision of credit risk, the provision of information regarding risk exposure, and also capital leverage exposure. To be sure, most European banks already complied with these requirements. However, this state of affairs did not imply an immediate and full harmonization across Europe. The reason is that the Basle provisions have three different levels of application: Level one, applies to all banks; Level two, only applies to national banks; and, Level three, meanwhile, only applies to a subset of chosen banks, and reflects disclosure and compliance rules within national boundaries (Basle Committee on Bank Stability, BCSB 2010). The need for a banking union stems from the fact the Basle rules are proved insufficient in severing cutting the linkage between the sovereign credit risk exposure and banks. This linkage imposed high financial and economic costs, and was at the core of the Euro crisis’ inception and its propagation. The so-called home bias exposure occurred when sovereigns placed bonds in national banks, which they had difficulties in coping with the associated risk. This was especially true when the sovereigns’ financial reputation was later called into question in international financial markets. Moreover, a bank crisis, in such a situation, leads to a sovereign-bond crisis or easily exacerbates an existing one, thereby contaminating the whole banking sector and so negatively affecting the economy. A bank run not only undermines the local economy but also affects the entire financial sector, and limits the funding for business and long term investment. It might also foster contagion in the wider currency area, as well as capital flight from the distressed country. In countries such as Ireland, Portugal, Greece, Cyprus, banking and also public debt problems ultimately led finally to foreign interventions by the called Troika - the International Monetary Fund (IMF), the European Central Bank (ECB) and the European Commission (EC), which provided bail-outs or rescue-packages in exchange for demanding policy adjustments and structural reforms(more on this on the next section). The most problematic case was that of Greece, which needed five “rescue-packages”. Based on the “TINA” principle – that “there is no alternative” – Greece leaving the Eurozone was not seen as a viable option. This would have jeopardized the Eurozone’s stability by undermining its hard-earned financial credibility, acquired during the long EMU and Euro construction process. Initially, however, both the Greek government and the Troika seemed unwillingly to find common ground and often agreed to the rescuepackages only at last minute.

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While Greece represented a serious challenge to European unity, the real test came unexpectedly from the United Kingdom (UK) in the wake of its Brexit referendum result in 2016, which most pro-Europeans did not see coming (Bongardt and Torres, 2017 for the political rationality behind the UK’s decision to leave the European Union). As for the bailouts, there is a substantial literature on this subject, for the interested reader. Seminal contributions are those of Tirole (2015) and also Farhi and Tirole (2017), focusing on the sovereign-bank linkage. Two relevant questions that they address are as follows: How does a banking crisis lead to the bankruptcy of the sovereign (state), which then results in a default on national debt? What about the insolvency and liquidation of banks? What can, and must be done, when a bank faces liquidity and/or insolvency problems? Turning to the question of banks bailout, the main concern is to determine who should bear their cost. In a typical bailout, the cost of insolvency or liquidation is often borne by another agent, usually the taxpayer. In the case of a bail-in, the bank’s shareholders and selected creditors are called to bear the costs. This raises the question of whether there should be an optimal bailout rule and, if so, how much bail-in should banks effectively support. This issue is studied in de Sousa (2014), for example, who looks at the optimal bailout rule for the liquidation of the Portuguese bank, Banco de Espírito Santo. Using a simple portfolio Markowitz model, the optimal rule is compared with actual resolution model adopted by the Bank of Portugal. In Serôdio and de Sousa (2017 a, b), meanwhile, the societal welfare costs of a weak and costly verification bail-out endogenous rule are tackled using a dynamic stochastic general equilibrium model (DSGE) within a Calvo pricing. In particular, the paper looks at who should bear the liquidation and resolution costs, and specify that bailouts cannot be fully blind, but contingent on specific calibrations. The study also highlights the importance of political will, amongst other non-economic factors, in the design of the optimal bail-out. Other related questions of design include: What is the optimal size of the European Banking Union (EBU)? Who should comprise the EBU? Is it all members of EU, only Eurozone or Eurozone plus other countries that intend to benefit directly and indirectly from this arrangement? How will bail-outs be financed, and to what amounts? What is the role for national arrangements versus supra-national arrangements? What is the role of state intervention versus market discipline? What is the role of risk-reduction versus risksharing? How will remaining risk issues be addressed together with banks’ legacy-debt issues? In the following two sections, we look at some of these questions in more detail.

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3. IMPLEMENTING THE EUROPEAN BANKING UNION The Euro crisis arose when public debt linkages to national banks in some Eurozone countries caused alarm among economic agents. The goal of the European Banking Union is to mitigate or sever these linkages (Jacques Delors Institute 2017). In this section, we briefly explore how the design of the European Banking Union was tackled and what has been achieved thus far. It is predicated on the observation of what has been the response to the crisis, along the lines Generale (2013) and Keunig (2013), so that one may better understand what remains to be done. As alluded to above, the Euro crisis reached its peak with the possibility fo Greece leaving the Eurozone. Since 2010, Greece had had five “rescue-packages”, and when it defaulted on its sovereign debt on November 2010, the country plunged into a chaos. The then Syriza Minister of Finance argued that Greece should leave the Eurozone. For Greece’s detractors, it appeared that the country wanted the gains having the Euro without wanting to bear the associated costs, especially given its apparent unwillingness to undertake the long overdue structural reforms of its economy and public sector. In terms of financial architecture, the Greek crisis laid bare the absence of adequate bank liquidation instruments and an orderly default procedure in the Eurozone, as well as a well-endowed safety net in times of need. This situation negatively affected the whole of the Eurozone by way of enormous economic and political uncertainty, and seriously dented the EU’s credibility. The crisis in Ireland, meanwhile, clearly showed how a well- intentioned sovereign might run into problems when rescuing troubled banks. The country’s net fiscal deficit increased to double digit figures when Irish government rescued banks in distress (namely, Allied Irish Bank, AIB; and Bank of Ireland). In doing so, it violated Maastricht rules. More significant than this infringement, however, was the resulting lack of credibility and also the financial contagion that then affected the Eurozone. Ireland was the first Eurozone member to agree to a Troika rescue-package, in order to assist its banking sector, totaling 64 billion Euros. Ireland was also the first country to successfully exit such a rescue program. As for Portugal, this country agreed to a 78 million Euro package to cover its funding needs once it lost access to international markets. A total of 12 million Euros of this amount was earmarked to address problems in the Portuguese banking sector. Cyprus and Spain, meanwhile, also required assistance as a result in problems in their banking sectors. The assistance to Spain did not entail a Troika-package, however, but was rather specifically geared to the Spanish banking sector. Public and expert opinion in Europe, meanwhile, was divided as to the merits of proausterity policies being pursued, under the auspices of the rescue-packages. Notwithstanding, Europe’s institutions and leaders were able to rise the challenge posed by the Eurozone crisis, albeit more slowly and possibly less incisively that was warranted

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by the crisis. It is to this crisis response that we now turn by looking more closely at the solutions they adopted. First, the Single Resolution Mechanism (SRM) and the Bank Resolution and Bank Liquidation (BRBL) mechanism were put into place by taking into account that the liquidation of banks merits being a full resolution scheme in its own right. The provision of breaking up banks in a “good” and a “bad” one was not a new one but the European Commission set up rules; requiring that state aid should not affect sectorial competitiveness, while also providing support to small deposit holders. This last concern brings us to the second and perhaps most important change. The European Deposit Insurance Scheme (EDIS) was devised, whereby all small deposit holders become fully insured until 100 000€ per deposit, per bank in Eurozone. The nature of financial assets or bonds withheld was and still is on the discussion table. Whenever bank liquidation occurs, European lawyers come to the assistance of the affected banks, and a long-term litigation process ensues. This process entails high costs for the proper functioning of the economy, as litigation tends to undermine the credibility of economic policies. Third, the supervision of banks had to become more effective and centered on two roles: macro-prudential regulation and, the traditional micro-prudential role. In this context, prudency refers to the avoidance of banking crisis while macro-prudential supervision refers to appropriate macroeconomic stability conditions that underpin banks activities. Micro-prudential supervision refers to the role national authorities pursue in order to devise the specific nature of local conditions and prevent a systemic crisis. The newness of macro-prudential (or macro-pru) relates to the fact that banks have higher exposure to national public debt, and may place the sovereign at risk. In a nutshell, not only was a European Banking Authority (EBA) created but other instruments were developed: First, a Single Resolution Mechanism (SRM); Second, the European Deposit Insurance Scheme (EDIS); and, finally, the prudential role with macroprudential that sustains a full-fledged completed banking union. Fourth, and last, the European and Stability Mechanism (ESM) provided assistance for countries facing financial stress via rescue- packages. This has led to a proposal of creating a permanent fund for rescue packages - the so-called and long-awaited European Monetary Fund (EMF) - European Commission (2017). The IMF wanted to exit the Troika arrangements, notwithstanding its role of global lender of last resort, because it disagreed with some of the structural reforms being required by way of conditionality. The European Commission had an executive role and was involved directly in monetary and banking policy. The ECB’s role was more problematic as it only has a mandate to ensure monetary stability. Therefore, the proposed EMF would take the role of the IMF for countries in need of bailouts within the Eurozone, and the EBU would take care of the rest, thus severing the ties between banks and sovereigns, as well as going beyond the aforementioned Basle rules.

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With all these caveats and lingering crisis on the making, this process entailed high political and economic costs. President Juncker (European Commission 2017) has asserted that the Greek crisis has to be a never-to-be-repeated event. In line with this view, the Commission proposed a roadmap for the EMU’s long term stability and resiliency on 6 December 2017, based on stable public finances, a proper banking union with financial market mergers and integration. The proposal includes a role for a Vice-President of the Commission and also for the President of the Euro-group, as a Minister of Finance of Eurozone. In sum, a full banking union encompasses three common and complementary pillars, namely banking supervision, resolution and deposit insurance. Since the Eurozone crisis, Europe has certainly come a long way in developing this important component of its financial architecture in order to be more resilient in the future crisis (Jacques Delors Institute 2017). However this process has yet to be completed. In the next section, we look at EBU’s challenges and prospects in light of stated objectives, as well as some recent developments.

4. CHALLENGES AND PROSPECTS After three years of existence, how has the partial EBU fared in practice? To what extent have its shortcomings affected its functionality? What are the prospects for overcoming existing challenges in the near future? As is to be expected, the jury is still out on many of these questions, given the scant time that has elapsed since implementation. Academic and policy research is starting to emerge, however, that begins to shed light on some of them, together with practitioners’ insights. Beck (2017), for example, provides a good assessment of EBU successes and shortcomings based on the recent resolutions of the Spanish Banco Popular and of two smaller Italian banks – Veneto Vanca and Banca Popolare di Vicenza, which may be seen as a first important test for the partial EBU in effect. In his view, the current architecture is still overly reliant on the use of national money when it comes to banking resolution, albeit within the framework of (new) supranational rules. In the Spanish case, resolution proceedings were swift and no taxpayer money was used. The Banco Popular was taken over by Santander while its equity and junior bondholders’ claims were wiped out. The latter was also true for identical claims in the case of the two Italian banks but, in contrast, their senior bondholders were made whole. This exception violated both the spirit and letter of the Bank Recovery and Resolution Directive (BRRD 2014), which does not allow the use of taxpayer money for bank resolution before senior bondholders are bailed-in. Indeed, taxpayer-funded bailouts were supposed to be replaced with bail-in of equity and bondholders, bank supervision

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strengthened, and the deadly embrace between governments and banks – at the core the Eurozone crisis – was meant to be loosened, if not completely cut. Notwithstanding, the Italian authorities were authorized to provide public support for the bank liquidation process by the European Commission after protracted negotiations. In the end, the Commission accepted one of their main arguments that the liquidation of the two institutions, without any taxpayer support, would have burdened the rest of the Italian banking system with the resulting costs. This situation, in turn, would have triggered further bank failures, and subsequently economic damage in the regions dependent on the banks. Germany was highly critical of this political maneuvering to get around the spirit, if not the letter, of the new Eurozone bank resolution framework and mindset. Beck (2017) argues that this example points to a key core design problem of the current architecture, namely, that there is strong pressure on national governments to step in when no Eurozone-wide deposit insurance scheme exists. Indeed, even the resolution of small banks may be too much for one country, especially if saddled with high sovereign debt levels, as is the case of Italy. Moreover, he defends that a ‘never bailout’ rule is inefficient, and more so in the presence of debt legacy problems. While it may be optimally ex ante to never bail out, there are ex post situations where a (partial) bailout may be optimal (see Beck 2011 and Dewatripont 2014 for technical details). This time inconsistency problem is ultimately behind a supposedly fixed rule of bail-in, which is designed to avoid moral hazard. However, it also creates unnecessary and unrealistic expectations that will have to be disappointed eventually. This inflexibility has also been reflected in a construct on the European level that – when push came to shove – proved to be very flexible, at least politically. Beck (2017) also notes that the resolution process is still purely national, both for small and mid-sized banks. This state of affairs is the consequence of not having Eurozone-wide deposit insurance available, while this national bias is also the cause for political reluctance to move to completing the banking union with a deposit insurance scheme. In other words, the main limitation of the EBU may be interpreted as being its limited risk-sharing across national boundaries. Deeper than regulatory constraints, however, is that there is still a political bias for national banking that will take a long time to overcome. He concludes that, Europe needs to adopt a complete banking union to avoid national solutions. This process will take a long time and new institutions and regulations are only a small step in that direction. As for deposit insurance itself, this EBU pillar has remained a purely national responsibility too, as Gros (2017, 47-8) sees it. While the prevailing consensus is that some sort of common insurance scheme is indispensable, political concerns make moving ahead on this issue difficult. The first concern, espoused by Germany, is that risk-sharing has to go hand in hand with further risk-reduction.

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Specifically, Germany wants to limit the amount of own-government debt that national banks hold. Limiting the concentration of sovereign debt holdings is seen as essential to break the sovereign-bank link, so that the former’s insolvency does not lead to the latter’s bankruptcy with the costs being borne by all Eurozone taxpayers. Italy opposes such a move as it would increase its government borrowing costs while also squeezing the profit margins of its banks due to lower interest earnings from holding less Italian public debt. The second concern is that governments are politically wary of resorting to a bail-in when this implies inflicting losses either on other financial institutions or on voters, as Beck (2017) illustrates using the recent Italian experience. Underlying both concerns is, of course, the problem of an excessive concentration of risk. Gros (2013a) proposes that this concentration risk be mitigated by requiring banks to hold a diversified portfolio of (Eurozone) government debt. In practice, the general ‘large exposure’ rule, which already inhibits banks from being exposed to any one (private) debtor by an amount greater than 1/4th of their capital, could be applied to government debt as well. Moreover, such a diversification requirement need not diminish the overall demand for sovereign bonds, only their regional concentration, which means that governments in peripheral countries need not fear being unable finance themselves due to a sharp drop in demand for their bonds (De Groen 2015). To be sure, the two issues – risk reduction (or rather risk diversification, as Gros (2017, 50-1) emphasizes) and risk mutualization - need to be tackled in tandem for economic and political reasons, but the required solutions are quite different in terms of their legal and institutional requirements. Diversification of sovereign debt holdings can be enforced by a low-level change in banking regulation, as discussed above (and maybe even by the ECB on its own), whereas a common deposit insurance requires the creation of a new institution. The resistance to the loss of interest income, meanwhile, could be lessened by dealing with the issue of deposit insurance. Gros (2017, 52-6) goes on to argue that one public function that national deposit insurance funds are not well equipped to perform is precisely that of maintaining the confidence of depositors when the entire banking system of a country is under stress. In a systemic banking crisis (at the national level), the accumulated funds in the national deposit insurance scheme are likely to be insufficient. But the government of the country in question is likely to be under pressure as well, so the national fiscal backstop is likely to be weak when it is needed most. In his view, this possibility implies that what is needed to complete the EBU is a system to ensure the stability of national deposit insurance system. Nation states are usually able to deal with small shocks themselves, but they need support when the shock is so large that access to the capital market is impaired (Gros 2014). In completing the EBU, one should heed the lessons from the economics of insurance and provide protection against large, systemic shocks, e.g., via re-insurance for large, systemic shocks at the national level. Nation states could remain responsible for deposit insurance in case of the occasional

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individual bank failure but a common fund would provide support (re-insurance) when the shock is so large that it would overwhelm national resources. Under a pure re-insurance approach, national deposit guarantee schemes would continue to function as before, but each would be forced to take out insurance coverage against large shocks. The European re-insurer should be backstopped by the European Stability Mechanism (ESM), which would be a natural evolution of its role, since it was set up to backstop countries and can already now lend directly for banking resolution. Véron and Zettelmeyer (2017, 7-9) similarly note that all deposit insurance remains at the national level, and a proposal made in November 2015 by the European Commission to gradually migrate toward a fully mutualized euro-area deposit insurance system by 2024 has made no progress so far toward legislative adoption. The establishment of a euro-area bank resolution fund, meanwhile, remains a work in progress, especially as the newlyestablished SRF is actually a collection of national and euro-area funds (known as ‘compartments’) that are only scheduled to be fully merged (‘mutualized’) by 2024, if not later. Moreover, the BRRD resolution model also remains partly un-tested, as none of the significant cases of bank resolution or liquidation has involved senior bond bailing-in once the legislation entered into full force in early 2016. Overall, these authors find that much more is still needed to be done even though the bank-sovereign vicious circle has been mitigated since the Eurozone crisis. To be sure, many euro-area banks remain highly exposed to national sovereigns, and individual member states could still be exposed to significant fiscal costs in case of future widespread banking sector difficulties. In addition, national idiosyncrasies have the effect of making bank restructuring highly contentious in local political environments, and as a consequence have delayed or deterred proper crisis management and resolution. In light of this assessment, Véron and Zettelmeyer (2017, 8-9) present a policy program aimed at addressing EBU shortcomings, which is deemed to be legally and politically viable, i.e., within the framework of current EU treaties, and without a full-fledged fiscal union that would entail an autonomous ability to tax, spend and borrow at the European level. The proposed measures encompass both risk-reduction and risk-sharing concerns. Moreover, ‘discipline-enhancing’ reforms (such as tougher regulatory treatment of sovereign exposures or a strong ESM commitment not to bail out unambiguously insolvent countries without accompanying sovereign debt restructuring) are balanced with ‘insurance-enhancing’ ones (such as the creation of a European safe asset, the creation of a European Deposit Insurance Fund and agreement on the ESM as a backstop). For the practitioner González-Páramo (2017), the evidence of the initial three years of the EBU suggests that it is not functioning as well, or as smoothly, as needed. While the common rulebook, supervision and resolution mechanisms are operational, relevant drawbacks need to be overcome, especially in establishing common deposit insurance. The main challenges facing the EBU are seen to be the following:

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Single Rule Book - The European Commission has to guarantee a truly “single” rule book, as well as the harmonized application of EU law in all member states while also improving some of the associated procedures; Supervision - While supervision has come a long way in promoting a unique supervisory culture and framework, it is necessary to avoid national divergences and discretions to ensure its consolidation; Resolution – Existing loopholes that do not respect its spirit need to be eliminated to ensure that taxpayers do not bear the cost of a crisis. Recent experience shows that further work is needed to ensure liquidity, both in pre-resolution stages, and during the actual resolution process; Deposit Insurance - Real steps need to be taken to include a common fiscal backstop for the Single Resolution Fund, and to create a European Deposit Insurance Scheme (EDIS).

The preceding discussion highlights that the fact that complete risk mitigation of the financial banking system in the Eurozone has yet to be realized. To achieve this objective, a complete cut of the bank-sovereign linkages, and also the completion of a Eurozone-wide safety net, are required. As Beck (2017), notes it will take more than a common regulatory regime and supervision, and resolution framework, to get there. In terms of the political-economy dynamics, Gros (2017) sees peripheral governments resisting further risk-reduction via mandatory diversification of sovereign risk for banks, while preferring more risk-sharing through common deposit insurance. Germany takes the opposite position, as the likely largest contributor to any future common insurance scheme. Gros (2017) defends, however, that is possible to have a technical solution that is also politically viable. He sees the package of sovereign risk diversification by banks, and risksharing through re-insurance of deposit insurance, as representing a political compromise that is economically sensible. This is because banks’ sovereign risk diversification would lower the danger of systemic crisis caused by imprudent fiscal policy. In his view, the key problem in breaking the deadlock between the core and the periphery is more one of timing. To be sure, the relative calm in financial markets has made establishing a common deposit insurance - or at least some form of re-insurance of national deposit guarantee schemes – appear a distant need. In the meantime, the banks in the periphery fear an immediate loss of income, which reinforces this perception. On technical grounds, this suggests that a workable compromise could be the gradual introduction of both risk mutualization and sovereign risk diversification on bank balance sheets. Ultimately, however, completing the EBU boils down to the simple question of whether there is the enough political will to move towards a full banking union. The answer depends, of course, on how one reads the current, as well as future, political conditions needed for this to happen.

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CONCLUSION Europe’s partial banking union came about primarily as a response to the Eurozone crisis. Notwithstanding, it represented a significant step in the process of completing its EMU, albeit in a reactive rather than proactive manner. In doing so, Europe followed a process of slow and deliberate incrementalism, coupled with institutionalization, towards an “ever closer union" that has no end-goal specified, as per the Monnet method. In practice, this organic process implied that the Eurozone crisis allowed the EU to tackle unsolved problems of its EMU architecture by improvising first and institutionalizing later. The overall objective of the EU’s crisis policy-response was to ensure that each member state would be able to weather any future sovereign debt event, and to resolve any systemic banking crisis without losing market access. The extent to which the new policies and institutions transform the European banking landscape and improve crisis management will depend crucially on how they deliver, however. To be sure, many regarded the pre-crisis financial architecture to be incomplete since it failed to address the Eurozone’s underlying trilemma, namely that national financial policies, financial integration and financial stability are incompatible under a common currency. As such, any two combinations of these objectives are pursuable but not all three at the same time, as one will always have to give. The Eurozone crisis showed that it was financial stability, as increased financial integration led to cross-border contagion in the face of uncoordinated financial policies at the national level. A full banking union, based on the three pillars discussed earlier, solves this trilemma. Under such an arrangement, supervisory powers, centralized at the supranational level, coupled with banking-resolution and crisis management mechanisms will underpin financial integration. It is this combination of risk-reduction and risk-sharing that is able to break the bank-sovereign vicious circle, promote financial stability, and mitigate the impact of future financial shocks on financial institutions, the real economy and taxpayers. In effect, Europe has clearly overcome the challenge of banking supervision. The SMS goes a long way in addressing the national bias and 'local' capture of supervision (together with the SRM), thereby mitigating the negative bank- government feedback and overcoming cross-border coordination failures. In doing so, the SMS incorporates the supervisory lessons learnt during the Eurozone crisis, namely: 1) a need for independent and timely supervision; 2) a focus on micro-macro supervisory link; and, 3) a focus on cross-border dimension, such as the home-host conflicts of interest as well as the issue of asset risk and quality. As a result, Europe can expect its financial intermediation to be less Balkanized in the short-term, due to improved supervisory effectiveness at the supranational level. In the long-term, meanwhile, it can expect greater mitigation of systemic risks that arise from the interconnectedness of financial institutions and markets operating in different national jurisdictions. As things stand, however, Europe’s incomplete financial architecture does

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not completely sever the remaining bank-sovereign linkages, nor does it ensure complete resilience against future shocks in the European banking sector. The main reason for this partial approach to the EBU is that it reflects a preference for risk-reduction rather than risk-sharing, which has been shaped by the political dynamics between member states. While the EU’s policy-response reflected the need to address EMU’s institutional shortcomings, it also sought to minimize financial commitments for likely paymaster countries. The reduction in risk through the mitigation of moral hazard in bank-sovereign linkages implies lower implicit financial guarantees, and hence payouts, in the event of a future crisis. Risk-reduction is thus interpretable as a strong preference for prevention rather than cure. Interestingly, it also implies a preference for ‘a loss of sovereignty,’ given the transfer of national supervisory and regulatory responsibilities, wholly or in part, to supranational entities at the European level. In contrast, national sovereignty pertaining to banking insurance and resolution remains relatively untouched in the case of risk-sharing, as financial commitments remain a purely national matter. In this regard, Europe clearly could do more, especially when it comes to the creation of a financial backstop for the SRF and the harmonized, but not yet mutualized, EDIS. This step is very difficult to take, however, due to legacy debt issues and the associated political frictions. To be sure, completing the EBU is ultimately a political rather than a technical matter. In the pre-Eurozone crisis period, the reigning political inertia made it impossible to address the shortcomings of EMU, which were well known but largely neglected. The Eurozone crisis not only laid bare these shortcomings but, more importantly, also created the political conditions that allowed policy-makers to respond to them. This policyresponse was not only tardy but also incomplete given the political dynamics at the time, which are not altogether different now. This state of affairs implies that authorities still need to overcome identified policy gaps to ensure further progress on EMU even though this will always be a politically difficult endeavor. By way of example, it is sobering to note that political frictions are impeding the establishment of a more optimal risk-sharing arrangement for the Eurozone. Moreover, the current favorable economic environment makes the need for more reform less urgent. Unfortunately, it appears that only a future crisis will generate enough political momentum for this to happen. Europe need not wait for a crisis to overcome the remaining EMU shortcomings, however, as long as political will prevails. Indeed, inspired and effective political leadership may still allow it to complete what it started, especially in relation to its banking union, and to consolidate what it already has achieved thus far with much effort. Only time will tell which path Europe chooses to follow.

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REFERENCES Basle Committee on Banking Supervision (BCBS). 2010. Basel III: International framework for liquidity risk measurement, standards and monitoring. Bank for International Settlements. Beck, T. 2011. Bank Resolution: A Conceptual Framework. Financial Regulation at the Crossroads: Implications for Supervision. Institutional Design and Trade 12: 53. Beck, T. 2017. “The European Banking Union at Three: A Toddler with Tantrums.” VOX CEPR's Policy Portal, July 04. Accessed November 15, 2017. http://voxeu.org/article/ european-banking-union-three. Bongardt, A. & Torres, F. 2017. “Brexit: Uma questão de racionalidade política.” Universidade Católica Portuguesa; Brexit: a question of political rationality, Catholic Portuguese University, December. Bank Recovery and Resolution Directive (BRRD). 2014. Bank Recovery and Resolution Directive. European Commission. Document Directive 2014/59/EU/. Accessed 23rd December, 2017. https://ec.europa.eu/info/ business-economy-euro/banking-andfinance/financial-supervision-and-risk-management/managing-risks-banks-andfinancial-institutions/bank-recovery-and-resolution_en. Breuss, F. 2013. “The European Banking Union. The Last Building Block towards a New EMU”. In M. Guderzo and A. Bosco (eds.): A Monetary Hope for Europe - The Euro and the Struggle for the Creation of a New Global Currency, 65-95. and in Proceedings of the Inaugural Jean Monnet Conference at the Università degli Studi di Firenze, Dipartimento di Scienze Politiche e Sociali, Jean Monnet Centre of Excellence, Florence, 6-7 May 2013. Accessed on November, 30, 2017. http://fritz.breuss.wifo.ac.at/Breuss_European_Banking_Union_Firen ze_2016.pdf. De Groen, W. P. 2015. “The ECB’s QE: Time to Break the Doom Loop between Banks and their Governments.” CEPS Policy Brief 328. March. Accessed November 18, 2017. https://www.ceps.eu/publications/ ecb%E2%80%99s-qe-time-break-doomloop-between-banks-and-their-governments. de Sousa, M. R. and Caetano, J. 2013. “Será a União Bancária uma solução para a crise do euro?.” (Is Banking Union a Solution to the euro crisis?). Debater Europa 8: 87-110. Accessed November 15, 2017. http://debatereuropa.europe-direct-aveiro.aeva.eu/ images/n8/mrs_jc.pdf. de Sousa, M. R. 2014. “Optimal Bail-out and bail-in policy mix: Lessons from the Banco Espírito de Santo (BES) failure”. CEFAGE-UE Working Paper 2014-16, Portugal. Accessed on November, 30, 2017. https://ideas.repec.org/p/cfe/wpcefa/2014_16.html. Dewatripont, M. 2014. “European Banking: Bailout, Bail-in and State Aid Control”. International Journal of Industrial Organization 34: 37–43. Elliot, D. 2012. “Key issues on European Banking Union. Trade-offs and Some Recommendations”. Global Economy & Development. Working Paper 52. November.

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Brookings Institute. Accessed on November 20, 2017. https://pdfs. semanticscholar.org/3b41/3c136a5319060949daf5b29e4bcc06ea32ca.pdf. European Commission. 2017. “Questions & Answers: Commission sets out Roadmap for deepening Europe’s Economic and Monetary Union.” Memo 17-5006. Brussels, 6 dec 2017. Accessed 6th December 2017. http://europa.eu/rapid/press-release_MEMO-175006_en.htm. Farhi, E., & Tirole, J. 2017. “Shadow banking and the four pillars of traditional financial intermediation.” Working Paper w23930. National Bureau of Economic Research. Generale, A. 2013. The European Banking Union: Where do we stand? Presentation from the Bank of Italy. Accessed on November, 30, 2017. http://slide player.com/slide/9366397/. González-Páramo, J. M. 2017. “Banking Union: The Glass is Half Empty.” LinkedIn Pulse, September 22. Accessed November 15, 2017. https:// goo.gl/Zytk1G. Gros, D. 2013a. “Banking Union with a Sovereign Virus: The Self-Serving Regulatory Treatment of Sovereign Debt in the Euro Area.” CEPS Policy Brief 289. March. Accessed November 18, 2017. https://www. ceps.eu/publications/banking-unionsovereign-virus-self-serving-regulatory-treatment-sovereign-debt-euro~. Gros, D. 2013b. “Principles of a Two-Tier European Deposit (Re-) Insurance System”. CEPS Policy Brief 287. April. Accessed November 18, 2017. https://www.ceps.eu/ publications/principles-two-tier-european-deposit-re-insurance-system. Gros, D. 2014. “A Fiscal Shock Absorber for the Euro Area? Lessons from the Economics of Insurance.” VoxEu.org, March 19. Accessed November 18, 2017. http://voxeu.org/article/ez-fiscal-shock-absorber-lessons-insurance-economics. Gros, D. 2017. “Try Again to Complete the Banking Union!” In Europe’s Political Spring: Fixing the Eurozone and Beyond, edited by A. Bénassy-Quéré and F. Giavazzi, 47-59. VoxEU.org. Accessed November 18, 2017. http://voxeu.org/content/europe-spolitical-spring-fixing-eurozone-and-beyond. Jacques Delors Institute (JDI). 2017. Banking Union: How stable are Europe’s Banks. Bertelsmann Stiftung and Jacques Delors Institut – Berlin, Germany, December. Keunig, S. 2013. Towards a Banking Union - Panel I: Are growth and stability compatible? March, 20, Presentation ECB, Budget and HR ECB responsible. Accessed on November 30, 2017. http://slide player.com/slide/2530778/. Mundell, R. A. 1961. “A theory of optimum currency areas”. The American economic review 51(4): 657-665. Serôdio, P. and de Sousa, M. R. 2017a. Bail in or Bail out. Welfare Implications in a costly state verification framework. Presentation at Macroeconomics Workshop. University of Warwick. UK. July, 2, 2017. Serôdio, P. and M. R. de Sousa. 2017b. Bank Problem – In or Out: Optimal Regulation Policies. Mimeo. Working paper in progress. CEFAGE and Warwick.

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Tirole, J. 2015. “Country solidarity in sovereign crises.” The American Economic Review 105(8): 2333-2363. Véron, N. and Zettelmeyer, J. 2017. “A European Perspective on Over indebtedness.” Bruegel Policy Contributions, 25 September. Accessed November 13, 2017. http://bruegel.org/2017/09/a-european-perspective-on-overindebtedness/. Véron, N. 2015. “Europe’s Radical Banking Union”. Bruegel Policy Contributions, May, 5, 2015. Accessed on November 15, 2017. http://bruegel.org/2015/05/europes-radicalbanking-union/. Wallenius, H. 2014. International Economics Course. Lecture on Monetary Unions. Aalto University of School of Science. Department of Industrial Engineering and Management. Finland. Accessed on November, 30, 2017. https://mycourses.aalto.fi/ pluginfile.php/211110/mod_resource/ content/1/Lecture%206.pdf.

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In: Challenges and Opportunities … Editors: J. M. Caetano et al.

ISBN: 978-1-53613-474-2 © 2018 Nova Science Publishers, Inc.

Chapter 6

EUROZONE GOVERNANCE IN THE AFTERMATH OF THE CRISIS: A PROXY FOR A NEW INSTITUTIONAL BALANCE? Paulo Vila Maior1, and Isabel Camisão2,3,† 1

Faculty of Human and Social Sciences, University Fernando Pessoa, Porto, Portugal 2 Department of Economics, University of Évora, Portugal 3 CICP - Center for Research in Political Science University of Minho and Évora, Portugal

ABSTRACT The chapter addresses the institutional answers to overcome the eurozone crisis. The emphasis is on an analysis that highlights institutional winners and losers. We discuss whether such changes are instructive evidence of a new institutional balance in the Economic and Monetary Union.

Keywords: economic governance, European Union institutions, European Central Bank, quantitative easing, institutional balance

 †

Corresponding Author Email: [email protected]. Corresponding Author Email: [email protected].

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1. INTRODUCTION The economic and financial crisis that hit the European Union (EU) highlighted the vulnerabilities of the European Monetary Union (EMU) but also opened a window of opportunity to rethink its procedures and to adjust its institutional framework. Strengthening regulation and supervision of the financial sector was presented as crucial step to effective crisis response. Ultimately, bigger political changes (and challenges) were ventilated, including deeper Eurozone integration. The chapter looks at events of the Eurozone crisis as well as to their political answers, including the institutional adjustment of the EMU. It examines to what extent the outcome of crisis response is a new institutional balance. To that purpose, section two shows how the flawed architecture of the EMU, notably how asymmetric shocks were ruled out at the outset, paved the way to the crisis and then required an institutional fine tuning to overcome the crisis’ impact. This gave rise to formal (constitutionally-designed) changes, of which the European Stability Mechanism (ESM) is the typical example. In addition (and more importantly), other, non-constitutional changes were hosted as part of the institutional adjustment EMU experienced. Section three focuses on institutional winners: the Eurogroup and the European Central Bank (ECB). National governments reinforced their leverage through the increased powers awarded to the Eurogroup. The ECB is the biggest winner, not only for the greater salience of monetary policy on the macroeconomic performance of Eurozone member states, but especially for its role in stabilizing fiscal policy turbulence through the Outright Monetary Transactions (OMT) program. The chapter discusses i) whether this change prompted a constitutional disruption in the European Union (EU); and ii) whether quantitative easing prompted a new institutional balance when competence assignment within Eurozone economic governance is envisaged. Section four addresses the uncertain position of the European Commission (henceforth Commission): somewhere in-between the winners and the loser, the impact of postEurozone crisis institutional adjustments on the Commission is vague and relies on whether its monitoring role is to be respected by national governments, and pays attention to the institutional loser: the European Parliament (EP). Notwithstanding the EP’s absent voice in Eurozone governance, the Parliament is engaged with the ECB in close cooperation. Whether this is evidence of a modest improvement of the EP’s influence in the institutional system of the Eurozone, or whether questions arise about EP and ECB’s political opportunism, will be discussed in the concluding section of the chapter.

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2. THE (INEVITABLE) INTERPLAY BETWEEN THE EUROZONE CRISIS AND INSTITUTIONAL ADJUSTMENT The literature shows widespread consensus that the crisis on the Eurozone was largely possible because of the flaws that chartered EMU from the onset (e.g., Legrain 2014; Stiglitz 2016). The chapter’s purpose is not so much to examine in detail the rationale of the crisis. What matters, for the ensuing reasoning of the chapter, is to point out that the architecture of EMU helped the acceleration of the crisis’ effects in member states more exposed to one of the negative impacts of the crisis – the deterioration of fiscal policy, notably the aggravation of fiscal deficits and, most importantly, the worsening of public indebtedness. The founding fathers of EMU assumed that intensified economic integration would come with monetary union and, thus, asymmetric shocks were neglected (Sandbu 2015). The single currency would tie national economies into an ever-closer block and it was not expected that future crisis could hit some member states and not others. The belief that only symmetric shocks could affect the Eurozone economy, in turn, explains why the architecture of EMU did not include corrective mechanisms of idiosyncratic crisis. Furthermore, the division of powers in the areas of economic governance heightened the limited potential of EMU to correct, not to mention to offset, asymmetric shocks. While monetary policy was centralized on the ECB (with strong constitutional guarantees of political independence that extracted the monetary authority from political pressures, either from national governments and/or from the other EU institutions), fiscal policy remained decentralized (El-Agraa 2015). National governments’ ability to use fiscal policy was constrained by Eurozone fiscal rules (the Stability and Growth Pact). Albeit many member states did not abide by the fiscal rules of the Eurozone – which is understood as a serious constraint on these rules – their creation acted as a straightjacket over national governments’ capacity to use fiscal policy whenever necessary to correct macroeconomic imbalances and, notably, asymmetric shocks if they were to occur (Patomäki 2012). Since the implausibility of asymmetric shocks lies at the heart of the ontology of EMU, the denial of this implausibility was a huge shock for the Eurozone. First, officials (at EU institutions and national governments) were not ready to face an out-of-the-box crisis. The awareness that the crisis was hitting some member states, and the recognition that affected countries ranked among the most economically vulnerable of the Eurozone (Greece, Portugal, Ireland, Cyprus), alarmed observers and practitioners alike (Hopkin 2015). At some point, the crisis was severely hammering these countries and EMU was not equipped with mechanisms to overcome the crisis and to assist countries mostly exposed. Secondly, and significantly, the perception of the asymmetric nature of the crisis triggered an existential crisis in the Eurozone. Policy action was necessary to fight the crisis and to restore the credibility of the Eurozone, but the rules governing the EMU ruled out such

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action. The constitutional mandate of the ECB prevented the monetary authority to use monetary policy to specifically assist the most affected member states, as the constitutional provision of a single monetary policy aiming at a predetermined target of price stability tied the ECB to the mast (Dyson 2000). The ECB was furthermore blocked from action if bailing out member states was the solution envisaged. In addition, the political-economic rationale based on the unlikelihood of asymmetric shocks also helps to understand why redistribution for purposes of macroeconomic imbalances’ correction was not considered when the EMU constitutional rules were shaped (Hinarejos 2015). Clearly, sensitive political issues (member states facing difficulties subsidized by wealthier member states) were at stake, providing an explanation to absent political willingness to build inter-state compensation at moments of idiosyncratic crisis (Schelkle 2015). From the onset, fiscal federalism (either through inter-state fiscal redistribution, or through the mutualization of public debt) was ruled out. National interests spoke louder. Hence, modifications required for the EMU to be able to overcome the crisis’ negative effects shifted to a modest reappraisal of the Eurozone. Since ambitious solutions had no room to flourish because of absent political willingness at the national level, a second-best solution was devised. It consisted of an institutional fine tuning of the Eurozone. Thus, the shortcomings of the EMU political-economic model were not completely offset. From the standpoint of an external observer (but not certainly from insiders’ perspective), the EMU partially accommodated to the challenges of the crisis (Pisani-Ferry 2014). Yet, this was an attempt to correct some of the misconceptions of EMU. It assumed the mistake of not considering the likelihood of asymmetric shocks and gave a modest answer aiming at equipping the Eurozone with appropriate answers to the current crisis and to future economic shocks. At least, the ontological foundation of the EMU was transformed: finally, even political actors within the governance of the Eurozone admitted that economic shocks could hit selected member states and, thus, appropriate action designed to cushion the effects of asymmetric shocks was envisaged. Institutional adjustment was the political answer to the Eurozone crisis (Jabko 2015). Institutional accommodation to the new political-economic context of the Eurozone was the outcome of a twofold strategy. On the one hand, constitutional amendment bolstered the creation of the ESM. On the other hand, the most important ingredients of institutional change were left outside the constitutional settlement of the EU (see sections 3, 4 and 5 for in-depth analysis). The ad-hoc answer planned to assist the member states firstly struck by the sovereign debt crisis (Greece, Ireland, and Portugal) in 2010-11, through the creation of the European Financial Stability Facility (EFSF), was basically the externalization at the Eurozone level of bilateral financial assistance to those countries (Tsoukalis 2016). It was a provisional mechanism to help countries already hit by the crisis. Soon, negotiations began to extend the purpose of the EFSF towards the future. Henceforth, the Eurozone would be prepared to timely assist countries affected by an asymmetric shock an institutionalized mechanism

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of financial assistance was created. Differently from original rules of the EMU, with the ESM the Eurozone not only recognized the obvious (that crisis might affect some member states and not others) but also that appropriate action must be allowed by the constitutional rules governing the EMU. That was the goal of the ESM. Despite criticisms addressed to the ESM (especially the widespread perception that the stock of funds made available to the ESM might be insufficient in case of a crisis affecting at the same time some Eurozone large member states) (Stiglitz 2016), at least the EMU is prepared to tackle the effects of a crisis. The launching of the ESM brought implications for the institutional balance of the Eurozone governance. The role of the Eurogroup was strengthened, as decisions on financing member states in need of financial assistance require their final say (Fabbrini 2013). Even though the Commission plays a role on the monitoring of rescue packages prepared for member states facing difficulties, this is a secondary role and it is subordinated to the policy direction of the Eurogroup. While the Eurogroup acts as the principal (as the major decisions concerning the ESM belong to it) the Commission is apparently the agent. Since the Eurogroup epitomizes national interests in a joint-decision mechanism, the symbolism of this constitutional change is a shift towards the intergovernmental pole (Bickerton 2015). In addition, other institutional modifications characterize the Eurozone’s political answer to the crisis. Differently from the ESM, such ingredients of the institutional accommodation of the EMU were approved outside the EU’s constitutional settlement. This different pattern is important for two reasons. First, because the most significant institutional changes (explored mainly in section 3) were not given constitutional relevance, suggesting that the constitutional dimension of EMU was mitigated. Secondly, legislative modifications (the ones used to enforce the other ingredients of the new institutional system of the Eurozone) only require qualified majority voting (QMV), in contrast with the changes written in the EU Constitution that require unanimous agreement between member states (and not only Eurozone member states, but all member states of the EU). Thus, the most important aspects of the EMU’s institutional adjustment used a procedure that does not require all member states’ consent. Looking at these changes, and especially at their impact on the Eurozone governance, is instructive of how they represent a backdoor change of the legal foundations of EMU.

3. OUTCOME (I): INSTITUTIONAL WINNERS The Eurogroup and the ECB are among the bodies with reinforced powers after the institutional adjustment of the EMU. They represent interests that are different in nature. While the Eurogroup, as an informal group of the Council of Ministers, subsumes national interests (membership includes national finance ministers), the ECB is an emanation of

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supranational interests (Hodson 2015). On the one hand, the ECB is responsible for the design and implementation of the single monetary policy of the Eurozone. To that extent, the ECB cannot be sensitive to the preferences of specific member states, irrespective of their economic dimension and of their impact on the Eurozone economy. On the other hand, strong constitutional guarantees of political independence, putting the monetary authority as the most politically independent central bank in the world (Howarth and Loedel 2003), reinforce the position of this institution as one that clearly represents the supranational interest of the EMU. The awareness of interests represented by the Eurogroup and the ECB is important so that the global picture on the post-crisis institutional balance is captured by the reader. In the remainder of the section we address the sources of enhanced influence of the Eurogroup and of the ECB, as well as the implications for the institutional system of the EU.

3.1. The Eurogroup The informal nature of the Eurogroup, and how does this echo on the soundness of the institutional system of the EU, is well documented in the literature (e.g., Puetter 2006). Before the institutional adjustment triggered by the Eurozone crisis, the Eurogroup was already a very influential actor in the EMU governance. To some authors, this is a striking feature of the institutional system of the EU, since special prerogatives were afforded to a sub-set of the Council of Ministers without the appropriate constitutional background (Louis 2008). The problem is not so much the leeway afforded to the Eurogroup. What is at stake is whether the extensive powers of the Eurogroup, and the absence of constitutional support of the special position in the EMU governance, challenges the constitutional settlement of the EU. Indeed, this special position, and their strengthened powers following the post-crisis institutional adjustment, suggests that a new institution was created. In fact, the extensive powers of the Eurogroup are unprecedented when compared with other formations of the Council of Ministers. Policy measures designed to react to the crisis, and especially to avoid future fiscal turbulence within the Eurozone, turned into a tight framework upon national governments’ autonomy to carry over fiscal policy. One of the most straightforward measures to prevent future crisis brought fiscal policy monitoring to the center stage. On the one hand, fiscal rules were redesigned and the Fiscal Pact added to the Stability and Growth Pact (Tsoukalis 2016). On the other hand, surveillance tightened to the extent that Eurozone institutions, with an emphasis on the Eurogroup, were given a crucial say on the approval of national budgets’ guidelines prior to national parliaments’ discussion and voting (Auel and Christiansen 2015). In both cases, despite a role was handed to the Commission (mainly on the ex-ante and ex-post monitoring stages), the key role belongs the Eurogroup. This is the forum where decisions are approved. On the one hand, the Eurogroup decides after the

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Commission sends non-binding reports on the evolution of national fiscal policies. On the other hand, the Eurogroup provides the Commission with a legal background for ex-post evaluation of national budgets (when a member state was considered to infringe fiscal rules or its national budget was considered inappropriate vis-à-vis the rules of the European Semester). The strong powers of the Eurogroup have an impact on the institutional system of the EU, and on European integration in general. This is a body that looks after national interests. A combination of national interests, sometimes the outcome of a delicate balance between somewhat divergent preferences, comes to the surface when the action of the Eurogroup is examined. Nevertheless, it is premature to take definitive conclusions. The influence exerted by the Eurogroup must be compared with the influence of the other institutional winner, the ECB, since the monetary authority represents supranational interests. All in all, the reinforced powers of the ECB must be explained and assessed against the influence of the Eurogroup, especially in cases where both institutions show different standpoints concerning the Eurozone governance.

3.2. The European Central Bank It is our understanding that the ECB was the biggest winner in the aftermath of the Eurozone crisis. The salience of the ECB was possible insofar as the monetary authority was given a considerable degree of political independence. The ECB not only enjoys operational independence (as it is standard when central banks enjoy political independence), but also independence of results. Thus, the ECB is free to determine the macro-economic goals of the Eurozone, in accordance with the rather vague mandate of price stability as enshrined in the Treaty on the Functioning of the European Union (article 119, 2), and not only the freedom to design and to implement the appropriate monetary policy consistent with macro-economic goals. Constitutional provisions on ECB’s political independence, together with the huge relevance of monetary policy in the overall economic governance of EMU, sheltered the monetary authority against the temptation of other political authorities to invade the central bank’s powers (Chang 2009). All conditions met to promote the political visibility of the ECB. Yet, until recently the ECB kept committed to a discrete political role within the institutional system of the Eurozone, notwithstanding how crucial monetary policy decisions were to the development of EMU’s economy (especially decisions on interest rates and on money supply). As the Eurozone crisis emerged, and while “typical” political institutions (national governments and other EU institutions, particularly the European Council, the Eurogroup and the Commission), remained prisoners of policy inertia (Copsey 2015), the ECB stepped into the political arena. We address two areas of influence of the monetary authority:

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monetary policy decisions; and the design of the Outright Monetary Transactions (OMT) program.

3.2.1. Monetary Policy Decisions The last years of Jean-Claude Trichet’s tenure as President of the Executive Board of the ECB were marked by reluctance, notably in the period of the Eurozone crisis. Despite formal decisions rely on meetings of the Council of Governors (where national central bankers together with the six members of the Executive Board have a seat) the leadership of the institution is a hallmark for understanding monetary policy decisions (Howarth and Loedel 2003). If anything, the contrast between Trichet’s and Mario Draghi’s leadership of the Eurozone monetary authority is striking. While Trichet opted for a conservative stance of monetary policy (Torres 2013), particularly on what concerns cutting interest rates (in comparison with the sharp decrease decided by the United States’ Federal Reserve and other national central banks worldwide), which raised politicians, markets analysts and academics’ criticism, Draghi took a different approach and interest rates converged with the trend in other industrialized countries (Cukierman 2013) (see Figure 1, below). The ECB is a technocratic institution that decides on a very specific issue (monetary policy) with an impact on economic aspects of life. This vision, however, is partial and biased, offsetting a critical aspect that encompasses the influence exerted by the central bank. Since the political-economic template of the EMU is dominated by price stability, and emphasis falls on monetary policy decisions to achieve predetermined price stability targets, the ECB immediately takes a centripetal position in the economic governance of the Eurozone. In addition, the consequences of monetary policy directly impact on households and companies. Decisions regarding interest rates and how they improve or deteriorate households’ disposable income and companies’ profitability provide instructive evidence.

Source: Kang, Lightart, and Mody (2016). Figure 1. Policy rates: The US FED and the European Central Bank.

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Analysis of macroeconomic performance in the Eurozone economy highlights how critical is the input of the ECB, especially when inflation and growth are at stake. There is empirical evidence that the window of opportunity opened by Draghi’s Executive Board, when they decided to overturn Trichet’s conservative monetary policy, was fundamental to relieve macroeconomic conditions during the most problematic period of the Eurozone crisis (Gerlach and Lewis 2014). Political willingness to keep monetary policy characterized (among other aspects) by unprecedented low interest rates and by a greater latitude to money supply, giving banks more opportunities to feed borrowing, was one important input to change the macroeconomic performance of the Eurozone and to slowly show signs of economic recovery. However important monetary policy decisions were to alleviate the burden of the Eurozone crisis, we argue that the major contribution of the ECB did not came from strict monetary policy decisions, but instead from an orthodox decision that allowed the monetary authority to buy member states’ public debt when necessary to stabilize the Eurozone.

3.2.2. Quantitative Easing Many voices (politicians and academics alike) asked the ECB to take its responsibility within the competences assigned to this institution. Accordingly, the central bank should assist EMU member states facing difficulties to manage public debt. Radical proposals, calling for the ECB to play the role of the helicopter spreading money over the Eurozone (Breuss 2017), ignored constitutional obstacles preventing this measure, notably the nobail out clause (article 125, 1 of the Treaty on the Functioning of the European Union). They also ignored the huge political costs attached to the amendment of the constitutional settlement of the EU, which was a precondition for the successful activation of their idea. Yet, the ECB started to show signs of sensitivity to some of these claims and envisaged an input that could bring the EMU from the brink of collapse. At his famous speech on the 26th. July 2012, Draghi announced that the ECB would do whatever was necessary to save the EMU from the persistent threats of the crisis. A few days later, on the 2nd. August, he offered additional evidence by proclaiming the willingness of the monetary authority to buy member states’ public debt in the secondary market as a measure designed to soften the pressure that markets still imposed on fragile, peripheral member states. The ECB realized two risks: i) asymmetries were aggravated insofar as the gap between the risk premium for fragile, peripheral member states and economically sound member states was rising, which was not consistent with a coherent operation of EMU; ii) due to the huge interconnectedness between markets, notably within the Eurozone, problems affecting one member state’s public debt were hardly idiosyncratic, as the risk of contagious (in case of default) to other member states was high (Henning 2017). Therefore, the sovereign debt crisis was a problem of the Eurozone, and not only a problem that was severely affecting

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fragile, peripheral member states. The ECB should step in and provide an input to clear the air in the Eurozone. The ECB designed a program to buy member states’ public debt in the secondary market (Jones and Kelemen 2014). The purpose was to alleviate the burden attached to the repayment of public debt in those member states that were asked to pay higher interest rates, following negative assessments of rating agencies that, in the end, mirrored distrust in the macroeconomic, and most notably in public finances,’ evolution of these countries. From the moment that the ECB revealed its political commitment to buy these countries’ public debt, a very important signal was conveyed to markets: the risk of default was curtailed, since the ECB accepted to act as the institutional shelter of member states exposed to market pressures (De Grauwe and Ji 2013). Interestingly, the mere announcement of the ECB intentions boosted confidence, as almost immediately interest rates of the more problematic member states’ public debt started to decrease to an acceptable level (The Guardian 2012). Between Draghi’s announcement and the effective creation of the OMT program it was one-and-a-half-month gap (on the 6th. September 2012). What is certain is the consensus about the positive impact of the program and stabilization in member states’ public debt (see Figure 2, below). To this extent, it is established how the contribution of the ECB was decisive to break the chain of persistence of the Eurozone crisis (Tsoukalis 2016). This does not mean that the crisis was over, as economic growth is still sluggish and in many member states longterm negative effects of austerity are still on the run. Nevertheless, the input stemming from the ECB’s decision to buy public debt bonds in the secondary market must be emphasized. As a result, the ECB was given a boost in the institutional balance of EMU, as it is clearly the big winner when it comes to assess the redistribution of internal influence in the institutional system (Hodson 2015). Importantly, the ECB capitalized the gains and it started to position itself as a political institution (Copsey 2015). Furthermore, there is empirical evidence that the central bank took a proactive stance in crucial episodes of the Eurozone crisis (Vila Maior 2013), imposing its position to the European Council and to the Eurogroup (for example: the conditions for the Cyprus’ bailout; the conditions enabling the Greek haircut; political willingness to take a more active participation in the context of the Eurozone crisis as long as political institutions accepted more hard-nosed fiscal rules, thereby leading to the approval of the Fiscal Pact). We find additional arguments that reinforce the claim of the ECB as the biggest winner in the new institutional balance of the EMU. What is at stake are the shadow effects of the decision to create the OMT program, notably: i) the discussion on whether this program is congruent with the constitutional settlement of the EU; and ii) the effects of the ECB buying member states’ public debt on

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Source: European Central Bank (2017). Figure 2. a), b) and c). Long-term interest rate (%) for convergence purposes, 10 years’ maturity denominated in Euro, respectively for Greece, Ireland, and Portugal.

the re-design of the balance of powers (concerning economic policy-making) between the EMU institutions involved in the governance of the Eurozone, on the one hand, and between the EU and member states, on the other hand.

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3.2.3. Constitutional Disruption? Our aim is not to engage on an in-depth discussion about the constitutional implications of the OMT program. Firstly, that debate requires a legal analysis that falls outside the purpose of this chapter. Secondly, the issue is complex and we are not expected to cover all these complexities for length reasons. Having said this, the questions that emerge at the start are the following: is there any legal justification to allow the ECB to buy public debt in the secondary market if there is a constitutional provision that forbids to bail-out member states directly (on the primary market)? If what matters is not only the wording of legal provisions but also their spirit, is there a case to accept that the ECB indirectly buys public debt if it is prevented from doing so directly? In practice (but not formally), is there any difference between going to the secondary market or to the primary market? Legal arguments for the constitutional conformity of the OMT program focus on the literal wording of the constitutional provision that clearly hinders the monetary authority from directly bailing out member states facing trouble (De Grauwe 2016). The constitutional settlement only bans the possibility of buying on the primary market. Hence, if we follow the legal principle according to which only actions clearly ruled out by legal provisions are forbidden, one can take for granted that the ECB is authorized buy public debt in the secondary market since no legal provision rules out this possibility (Dahan, Fuchs, and Layus 2015). Moreover, arguments accepting the constitutionality of this program highlight the instrumental nature of allowing the ECB to indirectly bailout member states of the Eurozone. This intervention of the central bank was envisioned to preserve the EMU and to set it aside from the daunting teeth of the long-lasting crisis (Cafaro 2017). The ECB started to buy member states’ public debt insofar as that was required to save EMU. Since the preservation of the Eurozone is a major political goal, all other actions required to achieve this goal must be considered instrumental. Accordingly, legal hermeneutics should be flexible: doubts about the constitutional appropriateness of OMT are suspended, as if constitutional anesthesia is necessary for the sake of the greater goal (Wilkinson 2015). We have serious doubts about the suitability of this reasoning. Perhaps politicians, economists, political scientists, historians have greater tolerance to flexible legal hermeneutics, but lawyers might ask relevant questions about the method and, thus, challenge the constitutional adequacy of the OMT program (Schmidt 2015). Yet, this chapter is not the proper place to explore the strict legal dimension of the ECB’s decision. What matters, for this chapter’s underlying argument (the new institutional balance in the aftermath of the Eurozone crisis), is the awareness that the ECB was sheltered from legal action following the intervention in public debt’s secondary market. It is not a surprise that political willingness sometimes trumps over strict legal analysis, and the history of European integration is full of episodes of this kind (for example: how constitutional amendment proceeded after one member state failed to internally ratify a treaty amendment). Clearance was given after the German Constitutional Court ruled that the

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European Court of Justice had the power to decide on the constitutionality of the OMT program (Wendel 2014). Having all this in mind, the recognition that the ECB was authorized to extend its remit beyond conventional monetary policy calls our attention. Buying public debt is not the realm of monetary policy. The ECB seized a considerable extension of powers, not only because it went beyond conventional monetary policy, but also because the monetary authority came up as the Messiah of the EMU. Rescuing the Eurozone was the priority. Since traditional political institutions (with an emphasis on the European Council and the Eurogroup) were far from adopting effective decisions for taking the EMU out from its more-than-existential crisis, all eyes looked at the central bank as the rescuer of the Eurozone. The ECB was successful in the venture. All eyes were on the ECB, when the possibility of the central bank not extending the OMT program went to the surface. Ultimately the ECB decided to extend the program until December 2017 (The Guardian 2016). It is as if the ECB takes a centripetal position within the governance of the EMU, which brought a clear political role for this institution and, in addition, spreads the recognition that the future success of the Eurozone largely depends (in the absence of other, more audacious, reforms) on the political commitment of the monetary. The perception that this increased role came against a framework of doubts about the constitutional congruence of the ECB’s action in public debt’s secondary market, amplifies the idea that the ECB ended up by enjoying a considerable strengthening of influence (and effective powers) in the new institutional balance following the Eurozone crisis.

4. OUTCOME (II): THE INSTITUTIONAL LOSERS? Much of the literature on the crisis portrayed the EP and the Commission as the net losers of the (new) EMU institutional balance. But are the EP and the Commission truly in the same boat? Importantly, before we answer this question a clarification is required. In the original institutional balance of the EMU, these institutions had a secondary role (Commission) and no role at all (EP). Thus, the meaning of “institutional losers” must be clarified, so that the reader does not fall into the trap of misjudgment. First and foremost, they did not lost powers on the EMU governance. As far as the Commission goes, in absolute terms the institution can even be considered one of the winners of the crisis (Bauer and Becker 2014) as it gained several competences despite its widely-announced decline. The big question is not however how many powers has the Commission gained but if these powers will translate into political prominence. Also, the Commission could have been afforded with more than monitoring powers if, for instance, proposals to correct the biased governance of fiscal rules were accepted (and, therefore, to correct the partisanship bias stemming from the decision of leaving the approval of pecuniary sanctions in the hands of the Ecofin) (Buti, Franco, and Onghena 1998).

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The assessment about the Parliament is arguably more straightforward. We consider that the outcome of the changes in the institutional system of the Eurozone show that the EP is indeed the net loser, as the EP was not able to seize the window of opportunity to grasp more influence in the design and the implementation of the EMU governance. This outcome impacts on the legitimacy deficit of the EMU which, as some critics pointed out, could have been mitigated by an increased participation of the parliamentary institution (Rittberger 2014). Let’s now look in more detail into the facts that support our reasoning.

4.1. The Special Position of the European Commission The Commission is known for acting as a “purposeful opportunist” i.e., a strategic actor that has clear objectives and aims but is rather flexible on the means to achieve them (Cram 1999, 5). Its opportunistic behaviour allows it to expand its competences without alienating national governments (Camisão and Guimarães 2017). The Commission’s opportunism was clear when the institution proposed the strengthening of fiscal surveillance and the reform of the Single Market (SM) as a two-tier solution to exit the crisis. By linking the deepening of fiscal policy with that of the SM (the Commission’s arena per excellence) the Commission created a window of opportunity for claiming for itself a (central) coordination role in crisis’ response. Nevertheless, the performance of the Commission is assessed in mixed terms in the burgeoning literature on the crisis. While several analyses downplay the institution’s role both as agenda-setter and negotiator, the bulk of the literature acknowledges that the Commission gained wide and deeper powers (Bauer and Becker, 2014; Camisão, 2015; Savage and Verdun 2015), even though the conclusions differ on the real impact that new competences have in the Commission’s overall influence in the EMU. A look at the new procedures shows that the Commission not only kept but has reinforced its powers of monitoring and surveillance (including budgetary surveillance). The annual surveillance procedure begins with the so-called European Semester, which broadly corresponds to the first six months of the year. Under the new rules of the SGP, EU member states should annually present to the Commission budgetary measures that they intend to implement to fulfill their commitments, along with details of structural reforms to boost growth and jobs. The Commission analyses each government’s plans and makes country specific recommendations. This monitoring is even tighter for Eurozone members. Indeed, since the entry into force of the Two Pack (in 2013), Eurozone member states must submit their budgets for Commission scrutiny (draft budgetary plans are also presented to the other Eurozone partners) by October 15 each year. The Commission then assesses the plans as either compliant, broadly compliant, or at risk of non-compliance with EU’s economic governance rules. In practice this means that the institution may request

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member states to revise their budgetary plans if there is non-compliance with the SGP, which is a form of higher and more intrusive scrutiny compared to what existed before. Thus, the Two Pack gave additional centralized powers to the European Commission, which might increase its autonomy regarding the Council. Certainly, member states have the final say. Nevertheless, the public perception favors the idea that it is the Commission who is in charge, with the national media holophotes as much on the Commission as on the Ecofin. On the corrective arm of the SGP, financial sanctions for non-compliance are also tougher and more diversified (Laffan and Schlosser 2015, 4). Despite their technicality, Commission’s tasks are not necessarily without political importance, increasing the Commission’s potential for influencing member states’ behaviour. Yet having “potential” is not synonymous of having results. Indeed, crucial solutions for the crisis were inter-governmental in form, therefore apparently precluding the Commission’s role. This is the case of the ESM and the Fiscal Compact. However, as some authors note, Commission’s action is still crucial to make these intergovernmental decisions work (Bauer and Becker 2014). This might explain why some studies even consider the Commission the main ‘net beneficiary of the crisis’ (Dehousse 2015, 6). All in all, the real impact of Commission’s competences depends on how member states will respond to its policy prescriptions. Also, given that the new governance of the EMU builds largely upon instruments outside the EU legal framework, the Commission’s role may be enhanced if the institution manages to secure for itself a coordination role between the supranational and the intergovernmental levels. In practice, this means that the Commission’s capacity to drive change and to set member states future economic agenda will depend greatly on the Commission’s ability to “operate optimally” i.e., to influence the behavior of member states, ideally the Commission should make proposals “that are well designed technically, with both the common goals of all the members and the specific needs or problems of individual nations taken into account” (Lindberg and Scheingold 1970, 93). Besides the debate on how crisis solutions impacted on Commission’s formal competences another aspect is worthwhile to consider, that of Commission’s influence as agenda-setter for future developments. This is partially offset by the atypical political role this institution started to perform. In many instances, the Commission was the promotor of discussion about future avenues for the reform of the Eurozone. To a certain extent, the role of the Commission is analogous to the political leadership exerted by the European Council. Despite practical differences between both institutions’ roles should be born in mind (the outcome of European Council’s resolutions dictates the political future of European integration, while this is not the case of the ideas the Commission throws into discussion), the impact is noteworthy. With initiatives leading to debate, at least the Commission can attract attention not only from the academia, but, and importantly, from political actors of other EU institutions and national governments. The plea for discussion is a sometimes (and wrongly) underestimated role, as getting attention to one particular

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problem is a chief part of agenda-setting. Yet, per se it is far from giving the Commission an influential role in the governance of the Eurozone. Moreover, it remains to be seen if the institution has an effective political power to act as a counterpart of other institutions involved in the decision-making process of the EMU. For example, proposals to transfigure the member of the Commission in charge of the economic and finance portfolio into the Eurozone finance minister were short-lived and the idea was refused by prominent political institutions of the EU (Schoeller 2017). Overall, the question on whether the Commission is a winner or a loser in the new EMU institutional design does not have an undisputed answer. Some scholars within the renewed intergovernmental strand of the EU literature (the so-called “new intergovernmentalists”) are skeptical about the Commission’s salience not only in the EMU but in the overall institutional architecture of the EU. Others, whom we might call newsupranationalists, are more confident in the Commission’s ability to adjust to and perform well even within the constraints of the new institutional design. In our opinion, regarding specifically the EMU, the ability of the Commission to translate technical competences into political influence will be the biggest test to the institution. Ultimately, how the Commission scores in this test will upgrade it to the “first class” of winners or downgrade it to the group of losers.

4.2. The European Parliament as the Institutional Loser The role of the EP in the EMU governance is much less visible that in other areas of EU’s competences (Rose 2013). The parliament is not involved in policy formulation as it is in other areas, which puts the EP as an almost absent partner of Eurozone governance. Recently, informal events paved the way to slightly change this status. The EP’s position was not changed as an outcome of constitutional or legal modifications of the EMU rules. EP’s increased salience was possible after the ECB showed political willingness to interact with the EP in the context of parliamentary hearings attended by members of the Executive Board of the central bank (Torres 2013). Despite the members of the ECB have no legal obligation to meet the EP, recent experience shows how willing the ECB is to cooperate with the parliamentary institution. This brings some political visibility to the EP while at the same time does not change its practical position in the institutional system of the Eurozone and its influence in the EMU governance. Thus, despite the EP was given a role after the ECB decided to interact with it, this is a very modest role. Cooperation between the EP and the ECB is also a case study of political opportunism and it must be treated accordingly (Peroni 2017). Viewed from the angle of the EP, this is a chance to at least discuss with prominent members of Eurozone governance issues related with the monetary union. In a sense, this represents a gain for the EP. Before the ECB decided to engage with the EP in this cooperative game without binding effects, the EP

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was absent from the governance of the Eurozone. The EP still lacks influence in the decision-making process of the EMU governance. However, through parliamentary hearings where members of the ECB report to the EP and answer to questions addressed by members of the parliament, this institution could build some place for itself, notwithstanding the absence of effective means of influencing policy-making. If anything, the EP could grasp political visibility. The additional advantage is the subtle mantle of democratic legitimacy for the EMU (Hix 2015). Yet, this is deceptive as the interaction between the EP and the ECB did not increase the parliament’s role in the Eurozone governance. Thus, issues of weak democratic legitimacy are still a major criticism of the EMU. The standpoint of the ECB is also an instructive evidence of political opportunism. It suggests the political calculation of embracing a strategic coalition with the EP, especially because members of other relevant EMU institutions refuse to cooperate with the EP in the same way the ECB does. Thus, the ECB seized the opportunity to show a different stance vis-à-vis the EP, which has the potential of clearing the air of the central bank as far as harsh criticisms of absent accountability and limited democratic legitimacy are concerned (Collignon and Diessner 2016). In doing so, the ECB collects the following benefits: i) the political commitment to report to the EP (although the outcome of dialogue with the EP is non-binding for the ECB); ii) the monetary authority uses the proximity with the EP to build its own public relations campaign towards the citizenry, as its political salience is enhanced after accepting to cooperate with the institution perceived to be the most democratic of the institutional system of the EU. The gains reported to the EP lack substance, anyway. To this extent, we consider the EP as one loser of the new institutional balance in the post-crisis scenario.

CONCLUSION: EUROZONE GOVERNANCE: A NEW BALANCE OF POWERS? The reform of the Eurozone governance triggered by the economic and financial crisis redefined the role of some EU institutions and bodies. As far as competences’ gains is concerned, the ECB, the Eurogroup were arguably the net beneficiaries of the crisis, whereas the EP remains the outsider, thus heavily dependent on its ability to influence the other stakeholders through informal channels. The Commission lies in an uncertain position, since the real impact of the reform on the Commission’s overall influence remains to be established. What is sure is that the ECB emerged as a central player of the new Eurozone governance. Such prominence, along with the marginal role of the EP, might jeopardize the existence of appropriate “checks and balances,” ultimately leading to the

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need to rebalance the yet unbalanced institutional design of the new European economic governance. The key to understand the question is the assumption that the ECB overstepped monetary policy. Buying member states’ public debt opens the possibility for the monetary authority to expand its influence on an area that usually is ruled out from the action of central banks: fiscal policy. Not that the ECB has a proper role in the design and implementation of fiscal policy. Looking at the distribution of economic policy-making powers according to the constitutional provisions of the EMU, there is a clear separation between the ECB (the sole responsible for monetary policy) and national governments (in charge of fiscal policy, despite they face the straightjacket of Eurozone fiscal rules). This constitutional separation of powers was challenged when the ECB was given powers to indirectly bailout member states. When the ECB estimates that a member state needs assistance to curb down public debt’s interest rates, the monetary authority is giving a helping hand to this country. Public debt is a critical factor of fiscal policy soundness. If the country is forced to pay an interest rate that aggravates the public debt/GDP ratio, thereby deteriorating public debt’s sustainability, one possible reading is that the outcome of fiscal policy (the public deficit) went too far and markets mistrust national authorities. They might estimate a strong likelihood of default. All in all, this is a symptom of fiscal misbehavior. Whenever the ECB is called into action and absorbs a parcel of a member state’s public debt, the monetary authority provides an oxygen mask to the country. Thus, the ECB isolates the country from markets’ misgiving, as the intervention brings back credibility to the country as issuer of public debt – and, crucially for the reasoning behind the intervention of the monetary authority, to protect the whole Eurozone from turbulence that, in the limit, is hazardous enough to threat the survival of the EMU. The intervention of the central bank is a decisive boost to an important ingredient of member states’ fiscal policy. Contrafactual evidence is important here. If the ECB assumes that buying public debt from a troublesome member state isolates the country from markets’ pressure and is an input to restore fiscal policy credibility, at the end of the day the action of the monetary authority lies within the realm of fiscal policy. This raises important questions as to the dismantling of the original balance of competences’ assignment between the actors responsible for monetary policy and for fiscal policy, and crucially, doubts on whether the original separation of powers is still respected. This also puts the question of whether national governments might realize that the OMT program acts as an emulation of de-responsibility, since the intervention of the ECB will help to bring back credibility even in those cases where fiscal profligacy is outstanding. Finally, the issue of moral hazard is also at stake, as an uneven scenario comes to the forefront where lenient member states receive the rewarding intervention of the ECB while member states that stick by fiscal discipline are not qualified for the assistance of the ECB – and how, in limit cases, the former group of member states might envisage this as an incentive

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to fiscal misbehavior, possibly bringing the ECB to the exhaustion as the lender of last resort institution. These are important questions that deserve careful analysis. Yet, they fall outside the purpose of the chapter and, therefore, they were outlined as questions waiting for answers in a different context. Again, what is worthy of examination is the awareness that the ECB ended up in a privileged position when the Eurozone institutional balance in the post-crisis context is assessed. In fact, we understand that the ECB has already a role in fiscal policy, while in the previous EMU institutional system the monetary authority was forbidden to act in this area of economic policy-making (and, looking to the rhetoric of the central bank’s practitioners, they were not interested in that). Interestingly, the constitutional settlement of the Eurozone was clear to ensure the separation between monetary and fiscal policy, and to include constitutional provisions that secured the monetary authority’s political independence. At the time the ECB was granted a substantial statute of political independence, commentators stressed it was necessary to prevent the intrusion of political authorities in the design and implementation of monetary policy (first and foremost, national governments; but also from EU institutions permeable to national influences, as it is the case of the European Council and the Council of Ministers) (de Haan and Eijffinger 2000). No parallel measures were deemed necessary to protect national governments from the (at the time, not more than hypothetical) intrusion of the ECB in fiscal policy. Maybe this omission was an outcome of providence. Without falling into metaphysical considerations, it seems that a surge of divine justice commanded the architects of the constitutional settlement of the EMU, since a window of opportunity was open for a future participation of the ECB in fiscal policy insofar as that intervention was considered crucial for national governments themselves. The irony is that national governments are still totally outside the formulation of monetary policy, but the opposite ceased to be true. The ECB gives a helping hand to member states’ fiscal policy (especially in cases of trouble). Thus, the separation of powers is no longer a tenet of the EMU constitutional template. The possibility for the ECB to provide a positive input to member states’ fiscal policy is, if anything, revealing of the special position of this institution in the governance of the Eurozone.

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ISBN: 978-1-53613-474-2 © 2018 Nova Science Publishers, Inc.

Chapter 7

COMPLETING THE ECONOMIC AND MONETARY UNION: WHAT ECONOMIC AND FISCAL GOVERNANCE? Ana Fontoura Gouveia Nova School of Business and Economics, and Portuguese Ministry of Finance, Lisbon, Portugal

ABSTRACT On 25 March 2017, at the occasion of the 60th anniversary of the signature of the Treaties of Rome, the European leaders reiterated their commitment to completing the Economic and Monetary Union (EMU). While the recent crisis provided a decisive impetus to the enhancement of the EMU economic and fiscal governance, important shortcomings remain. Addressing them is a necessary condition to create a more stable and prosperous Union. In this chapter, we provide an overview of the current setup and of the avenues to reforming it, weighing risk reduction and risk sharing. We conclude by discussing the scope to introduce reforms in the EU.

Keywords: Economic and Monetary Union, economic governance, fiscal governance, risk sharing, risk reduction, EU institutions

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Corresponding Author Email: [email protected].

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1. INTRODUCTION The establishment of the Economic and Monetary Union (EMU) was not able to sustain neither real nor cyclical convergence in the euro area (Diaz del Hoyo et al. 2017; Auf dem Brinke et al. 2016; Allard et al. 2013). The low cross-country labour mobility, the existing structural rigidities and the risks of sudden reversals of capital flows, in a context where the exchange rate channel is not an option and there is a single monetary policy, leave countries vulnerable to the still frequent asymmetric shocks (Pisani-Ferry 2012; Van Beers et al. 2014). Vulnerabilities are even higher for highly indebted countries, whose fiscal policies are also severely constrained (Corsetti et al. 2016). By not having control over the currency in which they issue their debt, countries risk being priced out of the market, even when solvency is not at stake. These shocks can easily propagate across the other EMU members, in particular during downturns, as the high trade and financial integration creates cross-border demand and financial spillovers (Blanchard and Leigh 2013). Furthermore, the sum of the individual actions may not be optimal for the euro area as a whole, leading to pro-cyclical policies at the aggregate level. This was the case during the recent crisis (Bénassy-Quéré et al. 2016), harming the economic recovery and the sustainability of the EMU. There is thus a clear rationale for well-designed, effective economic and fiscal governance at EMU level, allowing “countries [to be] more stable and prosperous than they would be if they were not members” (Draghi 2015). However, opinions diverge on how to achieve this, both in the academic and policy debates. While some consider that an efficient functioning of the EMU depends only on effective risk reduction, taken as a substitute for risk reduction (e.g., Gern et al. 2015), others argue that the two are in fact complements and can only be effective together. In practice, risk sharing among euro area countries – being it private or public insurance - is currently very limited, in particular when compared to that of the United States (Milano and Reichlin 2017; Alcidi and Thirion 2016; European Commission 2016; Van Beers et al. 2014). This reality is exacerbated during crisis periods when risk sharing is needed the most (Thirion 2017). Therefore, the potential for additional private risk-sharing is undoubtedly large, namely via the completion of the Banking Union and the Capital Markets Union (BénassyQuéré et al. 2016; Gros and Belke 2015; Véron and Wolff 2015) and, also, via further improvements of the Single Market (Mariniello et al. 2015; Auf dem Brinke et al. 2015)1. 1

On the improvements of the Single Market, the President of the European Commission, Jean-Claude Juncker, advocated, in the 2017 State of the Union speech, a change in the decision procedures: “When it comes to important single market questions, I want decisions in the Council to be taken more often and more easily by qualified majority – with the equal involvement of the European Parliament. We do not need to change the Treaties for this. There are so-called “passerelle clauses” in the current Treaties which allow us to move from unanimity to qualified majority voting in certain cases – provided the European Council decides unanimously to do so. I am also strongly in favor of moving to qualified majority voting for decisions on the common

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In any case, the effective smoothing of sizeable shocks may still imply some form of public risk sharing (Tabellini 2017), working also as a catalyst for further private insurance (Allard et al. 2013). The EU budget, as it currently stands, is not used for stabilisation purposes and falls short of the resources available in existing federations (Bénassy-Quéré et al. 2016). In the remaining of this chapter, we discuss the EMU economic and fiscal governance framework and the options to reform it. We conclude by arguing that there is now a reform momentum, allowing for decisive action.

2. THE STARTING POINT The current economic and fiscal governance in the EMU is considerably different from that enshrined in the 1997 Stability and Growth Pact and the (not credible) no-bailout rule foreseen in article 125 of the Treaty on the Functioning of the European Union.2 In the buildup of the crisis, the market discipline that should have worked in a context of rulesbased, decentralised fiscal policy failed (ex-ante) because the no-bailout rule was not credible ex-post (Allard et al. 2013). In such a setting, the EMU was hit by the crisis with no framework to adequately manage it, which ended up providing a decisive impetus for reforms3. A key reform area relates to economic and fiscal rules and policy coordination. The establishment of the European Semester gave rise to a framework for the coordination of economic and fiscal policies among EU countries. There was also a revamp of the existing fiscal rules and the creation of the Macroeconomic Imbalances Procedures, through the legislative initiatives under the so-called six-pack, two-pack and fiscal compact. Despite the improvements, the current framework is considered too complex (European Commission 2017; Leino and Saarenheimo 2016; Juncker et al. 2015), lacking credibility and enforceability and failing to provide sufficient ex-ante incentives to reforms. The lack of symmetry in the treatment of negative and positive imbalances induces pro-cyclical policies and does not allow for intra-euro area adjustments.

consolidated corporate tax base, on VAT, on fair taxes for the digital industry and on the financial transaction tax.” 2 Article 125 of TFEU states that: “1. The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.; 2. The Council, on a proposal from the Commission and after consulting the European Parliament, may, as required, specify definitions for the application of the prohibitions referred to in Articles 123 and 124 and in this Article.” 3 For an overview of the changes introduced, please refer to European Commission (2017a) and Ioannou et al. (2016). For a discussion on the institutional setup, please see Fabbrini (2016).

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Another area of significant changes was crisis management. In 2012, temporary rescue funds were set up – in the context of the European Financial Stabilisation Mechanism and the European Financial Stability Facility – tasked with supporting member states with no market access. They were later transformed into a permanent intergovernmental institution - the European Stability Mechanism -, providing financial assistance to crisis countries in exchange for strict conditionality, a form of the so-called federalism by exception. The ESM Treaty also introduced Collective Action Clauses for issuances of euro area sovereign bonds that, albeit considered insufficient, aimed at a more credible no-bailout clause (Martinelli 2016). The lending capacity (maximum of €500 billion in 2016) was critical to provide assistance to Cyprus, Portugal, Spain, Ireland and Greece (on-going) but may prove to be insufficient in the face of large future shocks. Regarding the decision process, the ESM relies on unanimity at the Eurogroup – an informal group whose members are national finance ministers, responding to their national parliaments - and requires, in some countries, direct involvement of national parliaments4. This translates into late and unpredictable decisions (Tabellini 2016), not necessarily reflecting the interest of the euro area as a whole. In parallel, the European Central Bank announced, in 2012, the Outright Monetary Transactions (OMT) programme, to tackle denomination risks. Although never actually used, the announcement proved to be very effective in reducing sovereigns’ spreads5. However, given the difficulties in distinguishing liquidity and solvency crisis, OMT imply that the ECB is de facto the lender of last resort for sovereigns, without proper democratic legitimacy. Going forward, the political dimension involved in the definition of the type of crisis a country is experiencing – as illustrated by the case of Greece – reduces the credibility of actual action by the ECB in the face of future turmoil (De Grauwe and Ji 2016). Finally, the enhancements to the economic and fiscal framework – mostly a set of adhoc responses to the on-going crisis - were coupled with the creation of common supervision and resolution rules for euro area banks (Single Supervisory Mechanism, Single Resolution Mechanism and Single Resolution Fund), in the context of the so-called Banking Union. The rules for deposit insurance were also harmonised. These steps were determinant in reducing the risks of the banking sector, with improvements of capital ratios and liquidity buffers. There are still critical steps to be taken, in terms of risk-reduction but in particular concerning risk sharing. The setting up of a European deposit insurance scheme and a common fiscal backstop for the Single Resolution Fund is essential to break According to art. 4 of the ESM Treaty, “an emergency voting procedure shall be used where the Commission and the ECB both conclude that a failure to urgently adopt a decision to grant or implement financial assistance (…) would threaten the economic and financial sustainability of the euro area. The adoption of a decision by mutual agreement (…) requires a qualified majority of 85% of the votes cast.” Also, in line with art. 5, a number of decisions, such as terms of accession of a new member to the ESM, appointing the Managing Director and approving the annual accounts, are taken by qualified majority voting. 5 For more details on the economic and financial effects of the OMT announcement, please refer to Altavilla et al. (2014). 4

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the feedback loop between banks and sovereigns. Moreover, it is crucial to take action – both at national and EU level - on “non-performing loans” that weight on banks’ balance sheets. The home bias embedded in banks’ large exposures to home sovereign bonds also needs to be tackled, namely via the introduction of regulatory changes and the creation of a safe asset, contributing towards the credibility of the no-bailout clause6. Departing from the flaws and limitations of economic and fiscal governance in the EMU, we now proceed to the options to overcome them7.

3. THE ROAD AHEAD: NOW AND THEN 3.1. The Short-Run The decision on how to enhance the EMU fiscal and economic governance requires a careful assessment of the optimal balance between risk-sharing and risk-reduction, taking into account the desired goals. As the solution is most likely a complex one, there is the need to define a long-term plan of action. Still, there are some fine-tuning measures that have been proposed in the literature and which can improve the effectiveness of the current setup in the shorter-run. A common criticism to the existing framework is that it is not symmetric (both across time and across countries), as it triggers actions when excessive fiscal or external deficits arise but not in the face of excessive surpluses. Also, fiscal rules have been inducing procyclical policies, by forcing countries to implement fiscal consolidation in times of crisis, with important economic and social consequences8. In the face of asymmetric shocks, the single monetary policy further exacerbates this procyclicality, given that a common interest rate is too high for crisis countries and too low for those experiencing expansions (Bini Smaghi 2015). Some consider that the current fiscal and economic framework is not flexible enough, as for instance the flexibility already envisaged in the Stability and Growth Pact (SGP) – namely concerning structural reforms and investment applies only to those countries under the so-called preventive arm, not to those under the corrective arm; others argue that the large number of flexibility clauses renders the system too complex and opaque (Claeys et al. 2016). In this context, measures that simultaneously foster flexibility, transparency and symmetry can improve the statu quo. Concerning fiscal governance, Bénassy-Quéré et al. (2016) suggest the creation of adjustment accounts that would allow countries to shift 6

In Section 3, we refer to the different options being discussed for the creation of a safe asset, from the establishment of a borrowing capacity at supranational level to the joint issuance of mutualized debt. 7 For a discussion on the Financial Union, see, for instance, Yiatrou (2016), Petit and Monti (2016) and European Commission (2017a). 8 For a discussion of the procyclicality embedded into the rules and the effects of the 2011 reform, please refer to Prammer and Reiss (2016).

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incremental investment and unemployment spending from good to bad times, thus fostering counter-cyclical policies. Enderlein et al. (2016) also call for a revamped SGP, with more precise guidelines on the interpretation of the rules and where reform efforts are duly taken into account, together with the quality of public spending and the position over the business cycle. Bugaert (2016) proposes a change in the rules to better account for investment. Claeys et al. (2016) suggest the elimination of the structural balance rules and the introduction of a new public expenditure rule, arguing that while the current setup could, in theory, provide for stabilisation, the implementation flaws – in particular due to forecast errors and the difficulties in measuring structural balances – render it ineffective. In terms of economic governance, Bini Smaghi (2015) stresses that the EMU represents a large fraction of the world economy and thus the external deficits of some euro area countries are, at least to some extent, the counterpart of the surplus of other euro area members. This implies that symmetric intra euro area adjustment is crucial. In the current framework, even considering a certain degree of de jure symmetry embedded into the Macroeconomic Imbalances Procedure, inducing surplus countries to adjust is certainly a challenge. But if external imbalances are coupled with internal imbalances, then it is in the country’s best interest to do such adjustment (Bini Smaghi 2015). In any case, even with the implementation of these changes, SGP and economic governance rules remain limited in the face of severe crisis and fail to promote risk-sharing across countries. The European Commission started publishing Recommendations for the euro area as a whole in 2015, but they lack enforceability and clearly entail more in-depth changes to the institutional set-up. We deal with these longer-term challenges in the next sub-section. A second common criticism is that the existing mechanisms are not promoting convergence. Coeuré (2017) argues that this is linked with important differences in institutional quality (“the range of social and legal frameworks that shape the conditions in which households and businesses operate”), rendering the countries more vulnerable to asymmetric shocks and reducing social cohesion. Given the role of structural policies, in particular in the context of the EMU where other national policies are non-existent or severely hampered, some authors call for enhanced incentives for reforms, ensuring that countries effectively take ex-ante action. The priorities in the Country Specific Recommendations proposed by the European Commission are, in the EU programming cycle of 2014-2020, already linked with European Funds. However, this can be further enhanced by linking co-funding rates with the economic cycle (European Commission 2017a) and by providing positive incentives targeted at best practices and effective implementation. Investment in exchange for structural reforms is an idea that was already put forward in the “contractual arrangements” initially proposed by Van Rompuy et al. (2012), with investment channelled to weaker countries willing to implement reforms (Enderlein and Pisani-Ferry 2014).

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But the notions of what are the desirable structural policies and of an effective policy design need to be improved, taking into account the appropriate sequencing, bundling and prioritization of measures and building on the extensive literature on the impact of structural reforms that was produced in recent years (see, for instance, Bouis et al. 2012; IMF 2015; OECD 2016). Reform plans must take into account both efficiency and equity considerations - e.g., Juncker et al. (2015) and European Commission (2017a) advocate for a stronger focus on employment and social issues - and also address the possible short-term costs and heterogeneous effects across different households and firms (for an overview, see, for instance, Auf dem Brink and Enderlein 2017). Given that there is no one-size-fitsall, national preferences over normative issues need to be duly taken into account. This is why Coeuré (2017) calls for convergence in institutional quality rather than for convergence in institutions, putting the emphasis on results and not on the exact means to achieve them. Finally, reform processes are by their very nature multi-annual processes, and thus incentives and surveillance mechanisms must have a longer-term perspective. This also implies that national reform efforts need to be appropriately acknowledged at the EU level, as otherwise citizens may feel that they are constantly lagging behind and that no effort would ever be enough, promoting reform fatigue and reducing support for Europe.

3.2. The Long-Run A robust answer to the main challenges of the EMU, effectively delivering shared prosperity and stability across the Union, may entail longer-term, deeper reforms. Different paths have been outlined on how to achieve this. A number of authors consider that, given the existing political constraints (Andritzky et al. 2016a; and Fuest et al. 2015) and the reduced size of externalities across countries (Eichengreen and Wyplosz 2016), a decentralized market-based model where decisions are kept at national level is the best and only feasible way forward. Such a system, with decentralized decisions, entails decentralized responsibilities, whose credibility hinges critically on the availability of liquidity provision in exceptional situations, ensuring that the minimum functions of the government - such as social security, minimum public services and financial stability - are not at stake and, also, on an insolvency framework for sovereigns. The solutions to deliver a credible no-bailout rule are necessarily complex (Andritzky et al. 2016a; Martinelli 2016; Gianviti at al. 2010) and imply an effective plan to deal with legacy debt (see the proposals in Paris and Wyplosz 2014; Tumpel-Gugerell 2014; and Corsetti et al. 2015) and to firmly break the banks-sovereigns nexus, reducing the home-bias and thus avoiding contagion (Delatte et al. 2017). This would, in turn, further enforce market discipline for sovereigns, as they would no longer be able to resort on home banks as buyers of their debt (Véron 2017). It is thus clear that even when keeping

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coordination to a minimum, some form of fiscal union is always needed, with actions at the EU level. Some authors agree with this minimal view on risk–sharing, but consider that enhanced fiscal cooperation is a necessary condition for the EMU to function properly. Sapir and Wolff (2015) argue that “fiscal federalism by exception” creates the appropriate setup to ensure fiscal sustainability at the national level, also allowing to duly taking into account the euro area fiscal stance. The authors suggest the creation of a Eurosystem of fiscal policy and a Eurosystem of competitiveness councils, responsible for fiscal policy and competitiveness issues at euro area level, with powers to force national parliaments to change their policies, in the face of large national or euro area shocks. One may argue that those losses of sovereignty are only politically acceptable if coupled with joint responsibilities and that broader risk-sharing mechanisms are a complement to those entailing risk reduction, in particular in the face of severe shocks where local actions may not suffice. It is in this context that the creation of a euro area stabilisation function has been widely discussed, allowing countries to deal with asymmetric shocks (cross-country stabilisation) and/or with common shocks affecting the entire euro area (inter-temporal stabilisation). There are several options for the stabilisation mechanism such as a rainy day fund, where disbursements in bad times are linked with the provisioning of funds in good times (possibly having also a borrowing capacity); an EMU-wide basic unemployment scheme or a reinsurance unemployment mechanism, replacing or adding to the national schemes (and thus requiring convergence of labour markets9); an investment protection scheme, guaranteeing that national investment projects in areas such as infrastructure or skills are not reduced during downturns; and a fully-fledged euro area budget, considerably enlarging the current own resources and promoting stabilisation spending10. In all cases, the crucial feature is that funds are earmarked for counter-cyclical policies (e.g., unemployment benefits) and target long-term growth (e.g., investment in infrastructures, training and education). One of the main concerns with the implementation of a euro area stabilisation function is moral hazard, as countries may have fewer incentives to avoid or solve crisis when such mechanisms are in place. Tackling these concerns is crucial to ensure the political feasibility of the proposal. Strict conditionality upon access, meaning that countries need to comply ex-ante with certain criteria in terms of institutional quality – in addition to the compliance with existing economic and fiscal rules (European Commission 2017a) - reduces moral hazard by reducing the scope for asymmetric shocks to be generated endogenously from policy

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For a discussion see Claeyes et al. 2014. For an overview and discussion of the different proposals please refer to Rubio (2015), Thirion (2017), Allard et al. (2013), European Commission (2017a,b).

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choices (Bénassy-Quéré et al. 2016). However, some authors question the effective compliance with these rules, in light of past experiences (Leino and Saarenheimo 2016). The introduction of clawback clauses can also be effective in reducing moral hazard and avoiding redistribution (Claeyes et al. 2014; Bénassy-Quéré and Keogh 2015). However, this comes at the cost of lowering the stabilisation capacity, inducing procyclical contributions (Dolls et al. 2014) and eliminating the advantages of risk sharing across countries, by transforming the funds into implicit debt (Rubio 2016). In any case, as shown by Allard et al. (2013) and Dullien (2013), all euro area countries would receive transfers from a stabilisation mechanism at some point in time, with their relative magnitude depending on the exact features of the implemented scheme. This allows redistribution concerns to be addressed from the onset. Also, as noted by Rubio (2016), redistribution – which, as a principle, is in any case already embedded in the EU budget - may not necessarily reflect moral hazard as, for instance, smaller countries are more vulnerable to shocks for the same level of institutional quality. Tabellini (2017) adds that the possible asymmetric benefits (as there may be more substantial benefits for weaker and indebted countries) are also coupled with asymmetric losses of sovereignty. More broadly, these differentiated benefits are already present in other EU dimensions, such as the Single Market. Therefore, benefits cannot be solely measured by net contributions and payments to the stabilisation mechanism, as there are significant gains to all members from a better functioning EMU. Besides, there is broad consensus on the use of the stabilisation mechanism only to smooth large shocks, i.e., only under exceptional circumstances (see, for instance, Gros 2014; Rubio 2016), reducing the likelihood of moral hazard. These severe shocks are the situations with which national policies cannot cope with, where externalities are larger and where monetary policy is more likely to be exhausted, warranting action at the supranational level. The effectiveness of stabilisation hinges on an appropriate trigger that activates the mechanism. Enderlein et al. (2012) suggest national output gap vis-à-vis the euro area, a relative measure for the case of asymmetric shocks; Dulbeque (2013) and Furceri and Zdziencka (2013) propose national output gaps (an absolute measure) as the criteria for common shocks. However, the output gap is subject to measurement errors and delays, possibly rendering unemployment figures as a better option (Thirion 2017). Still, as one can argue that unemployment also reflects structural differences among countries, an alternative is to rely on a measure of short-run unemployment, less endogenous to national policy options and more closely related to the economic cycle. On top of the selection of the relevant indicator, an additional issue relates to the definition of what is an exceptional circumstance and what is the appropriate time frame to measure it – one may consider only large drops from one period to the other or also include smaller losses that cumulate over time (Rubio 2016). Finally, once an exceptional

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circumstance is identified, it is necessary to take timely action. Delays in implementation may render intentions very different from results (Cimadomo 2012). In terms of financing, there are different options being discussed. Relying on national contributions, based on VAT or GDP, has the disadvantage of maintaining the net return logic, whereby countries assess how much they are contributing and how much they are receiving at what are usually short-time frames, thus harming the political sustainability of the system. Another possibility is to rely on a direct tax capacity, for instance related to corporate taxation, environmental taxation or financial transactions taxes11. As noted by Tabelinni (2017) and Ubide (2015), there is no need for a very large tax capacity; what is important is ensuring that it is kept for a long time. If extra funds are needed, the fund has the credibility to borrow against the future revenue stream, something that cannot be achieved at national level, particularly in the context of already very high public debts. A borrowing capacity has the added advantage of creating a safe asset, although in this set up it may fall short of market needs. The discussion on the creation of a safe asset is closely linked to that of joint debt issuance, the so-called Eurobonds, which featured highly in the debate during the peak of the crisis (see, for instance, Claessens et al. 2012). As discussed by Thirion (2017), one of the advantages would indeed be the creation of a safe and liquid asset, allowing for a better transmission of monetary policy via the reduction of banks’ home bias. But the overall benefits are much broader, such as grasping economies of scale, reducing financing costs and securing access to markets, thus weakening the case for a centralised stabilisation function for asymmetric shocks (Rubio 2016). Economic consideration aside, joint debt issuance is challenging from a political point of view. It entails transfers among countries, as some see their costs being reduced due to the credibility of the others; and there may be further transfers ex-post, in case of default. Limiting moral hazard is thus of particular relevance. A proposal by Enderlein et al. (2012) entails restricting the access to the jointly issued bonds so that countries remain partially responsible for their debt. If sustainability is at stake, the limit is relaxed but at the cost of increasing losses of sovereignty (Enderlein and Haas 2015). Brunnermeier et al. (2011) and Beck et al. (2011) propose tranching debt issuance, dividing it into senior and junior tranches. De Grauwe and Moesen (2009) suggest a framework where access to the market is guaranteed via the joint issuance of Eurobonds but prices are those faced at the national level, keeping the incentives for countries to pursue sound economic and fiscal policies. Delpla and von Weizäcker (2010) advocate that only the first 60% of debt should be jointly issued, rendering its actual implementation difficult due to the legacy of the crisis. In all settings, Eurobonds are only politically feasible if countries deal with the high levels of cumulated debt12. 11 12

For a discussion on own resources, please refer to European Commission (2017b) and Monti (2016). As discussed before, see the proposals in Paris and Wyplosz (2014); Tumpel-Gugerell (2014) and Corsetti et al. (2015).

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4. A GLIMPSE AT INSTITUTIONAL IMPLICATIONS The current institutional framework is mostly the result of ad-hoc responses to the economic and financial crisis (Fabbrini 2016), pushing the limits of intergovernamentalism and lacking basic legal structure (Fabbrini 2013 and Kilpatrick 2016). Institutional changes are therefore warranted, in particular if countries agree on further risk-sharing. One option entails the creation of a supranational Treasury (European Commission 2017a), possibly encompassing the European Stability Mechanism – which would become the European Monetary Fund in case there is an agreement to issue debt – and taking on the responsibilities envisaged in the new agreed framework. The Treasury would be headed by a European or euro area finance minister, having a double hat as president of the Eurogroup and as a member of the European Commission (Enderlein and Haas 2015; Enderlein et al. 2016). A key task of the minister would be to ensure that the interests of the euro area as a whole are duly taken into account, on top of the legitimate national interests. A difficult balance needs to be sought when sustainability at national level and euro area interests (e.g., reaching a positive fiscal stance) are at odds. Also, the Treasury – or the recently created European Fiscal Board - would be in charge of the assessment and the promotion of fiscal sustainability during normal times (for instance managing the use of the national adjustment accounts proposed by Bénassy-Quéré et al. 2016), in a context of strong and independent fiscal and economic surveillance at national level. Additionally, it would be responsible for defining exceptional times, following clear and commonly agreed rules. This would trigger the stabilisation tool, under ex-ante conditionality, or – depending on the model adopted - would, for instance, allow for the limits for joint debt issuance to be relaxed, with progressive losses of sovereignty. In limit situations, there would be the possibility to veto national budgets. Even with risksharing, and in particular taking into account legacy issues, a debt restructuring mechanism for sovereigns would need to be established. Operationally, and irrespectively of other institutional changes, the decision mechanism by a formal Eurogroup needs improvement, with the elimination of the current asymmetric influence of national parliaments and relying on qualified majority voting. To better account for the social dimension, Katrougalos (2017) calls for the establishment of a Eurogroup in Labour and Social Affairs ministers’ formation. Overall, improvements of democratic legitimacy are paramount. The European Parliament (EP) - possibly in euro area formation, including representatives from national parliaments and/or including members of trans-European lists - should take added responsibilities on the scrutiny of the implementation of the governance framework and the definition of policy priorities. It should also reinforce the oversight of the European Council, the Eurogroup and the European Central Bank (Enderlein et al. 2016; Alcidi et al.

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2014; Kreilinger 2013)13. The introduction of a lead candidate (Spitzenkandidaten) in the elections for the European Parliament, whereby European political groups nominate candidates for the position of President of the European Commission, can foster electoral participation but the impact in the 2014 elections was limited (Alcidi et al. 2014). Gattermann et al. (2016) argue that information is crucial to change this, given its role in shaping voters’ support for the candidates. In any case, the lead candidate may raise issues of further politicisation of the European Commission. The full implementation of these institutional reforms requires treaty changes and faces significant legal challenges (Leino-Sandberg 2016; Fabbrini 2017a; Piris 2012). While Fabbrini (2017b) points to Brexit as an opportunity for broader constitutional reform, Beukers and Fasone (2016) add that on top of the current EU legal framework, national constitutions may also require amendments. The interplay and coherence between EU and EMU institutions and frameworks need to be carefully considered14, also in the broader context of a multi-speed and variable geometry Europe (Fabbrini 2017)15.

5. SCOPE FOR REFORM? The momentum for re-thinking the EMU is building-up as confidence in the EU is restored (Lamy et al. 2017). Support for the euro is at a record high, reaching 73% in euro area countries (Standard Eurobarometer 87). Though the UK’s June 2016 decision to leave the EU was seen as a major drawback, with fears that others would follow, it actually provided a boost for support for the European project. De Vries and Hoffman (2017) argue that it “sparked off more positive feelings about the EU as a whole.” Support for being a member of the EU increased five percentage points from March to August 2016 (Hoffman and de Vries 2016), with increased support for Europe even in the UK (Lamy et al. 2017). A closer look at this evidence makes it clear that while most citizens do support their country’s membership in the EU - and even support further integration - they are not satisfied with the current policy direction (de Vries and Hoffman 2017) and differ on their judgment of major economic changes (Lamy et al. 2017). Two-thirds of the Europeans do

These measures improve input-legitimacy. As argued by Alcidi et al. (2014), output legitimacy can be fostered “by strengthening the ability of EMU to reduce the emergence of negative externalities and to mitigate their impact, through market and fiscal risk-sharing mechanisms.” This would thus be the result of the enhancements introduced to the framework itself. 14 On this distinction, the President of the European Commission, Jean-Claude Juncker, stated in his 2017 State of the Union Speech that “If we want the euro to unite rather than divide our continent, then it should be more than the currency of a select group of countries. The euro is meant to be the single currency of the European Union as a whole. All but two of our Member States are required and entitled to join the euro once they fulfill the conditions. Member States that want to join the euro must be able to do so. This is why I am proposing to create a Euroaccession Instrument, offering technical and even financial assistance.” 15 Katrouglous (2017) warns against the risk of creating a “club Europe” instead of a “Europe of choices.” He advocates for no “escape from existing obligations” but also no “flexible solidarity.” 13

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call for reforms but cannot reach an agreement on the way forward (de Vries and Hoffman 2016). Tackling this lack of consensus is of paramount importance to proceed and, for this to be possible, information is essential. Europeans are not informed about the EU (Auf dem Brinke et al. 2016) and many empirical applications show the role of information on building support (e.g., de Vries and Hoffman 2016; Gouveia 2017). The media certainly have a role to play but, given the distrust in traditional media16, one needs to devise alternative communication strategies, acknowledging the fact that the framing of the debate matters for public perceptions (Dolls and Wehrhöfer, forthcoming)17. Another critical step is the fostering of national ownership. As stated by the President of the European Commission, Jean-Claude Juncker, in his 2017 State of the Union Speech “Unemployment is at a nine-year low. Almost 8 million jobs have been created during this mandate so far. (…) The Commission cannot take the credit for this alone. Though I am sure that had 8 million jobs been lost, we would have taken the blame.” This divide between perceived EU and national interests and goals, sometimes conveyed by national politicians themselves and by media coverage on the EU which focuses almost exclusively on the national dimension, is harmful to the sustainability of the EU project. The problem is only aggravated by the rise of populism. While the recent fears of populism in Europe did not materialise (Böttcher and Wruuck 2017), the increasing influence of populist parties is a longer-term trend18. Even if not winning elections, populism has an important impact on politics, leading to lengthier processes, changing the debate style and content and, in some cases, reducing the scope for reforms, in particular those that entail short-term costs (Bertelsmann Stiftung 2017). Therefore, social issues need to take a more central stage in EU policies19. Unemployment is still the top concern at the national level (Standard Eurobarometer 87). Poverty and social exclusion continue to be an important issue in Europe, with many countries lagging behind pre-crisis opportunity levels (Schraad-Tischler and Schiller 2017). In addition to growing inequalities across the very rich and the others, there is evidence of growing inequalities across generations20. The link between, on the one hand, 16

In the Special Eurobarometer 461, only 34% of the respondents state that they trust the media. The authors conduct online experiments eliciting attitudes of German voters towards two key reform proposals: an EMU-wide unemployment insurance and a sovereign insolvency mechanism. By providing randomized “argument treatments,” they show that subjects’ attitudes are elastic. In particular, providing arguments related to moral hazard, permanent transfers, rising risk premia and self-fulfilling prophecies increases rejection (or decreases approval). 18 Mounk and Foa (2016) argue that “[the growing] disaffection with the democratic form of government is accompanied by a wider skepticism toward liberal institutions. Citizens are growing more disaffected with established political parties, representative institutions, and minority rights. Tellingly, they are also increasingly open to authoritarian interpretations of democracy.” 19 For an overview of the governance of social issues, please refer to de la Porte and Heins (2016). 20 This is an overall tendency across advanced economics. Dobbs et al. (2016), argue that “between 65 and 70 percent of households in 25 advanced economies, the equivalent of 540 million to 580 million people, were in segments of the income distribution whose real market incomes—their wages and income from capital—were flat or had fallen in 2014 compared with 2005. This compared with less than 2 percent, or fewer than ten million people, who experienced this phenomenon between 1993 and 2005. Government transfers and lower tax rates reduced 17

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populism and fears of globalisation and, on the other hand, reduced support for the EU (Dustmann et al. 2017; de Vries and Hoffman 2016) reinforces the need to tackle inequalities. Acknowledging that globalisation does not work for all (see, for instance, OECD 2016) and acting accordingly would provide a boost in support for the EU and the needed reforms (de Vries and Hoffmann 2016). There are certainly on-going initiatives that go into the right direction – such as the European Pillar of Social Rights or the Youth Guarantee – but there is scope for further improvements, including by deepening cooperation in the field of taxation and by further potentiating investment.

CONCLUSION The European Commission’s White paper on the future of Europe, published in March 2017, and the Reflection paper on the deepening of the Economic and Monetary Union that followed (May 2017), paved the way for a broad-based discussion on the EMU economic and fiscal governance framework. In this chapter, we departed from the current setup, with its merits and shortcomings, to then discuss the way forward. There are many proposals on how to enhance the existing framework. Some focus on market, rules-based solutions, others entail more risk-sharing among euro area members. Common to all approaches is the need to reform the current system, which is not delivering the full potential of the EMU. Some would argue that, at the current juncture, there is no scope for such reform in the EU. The recent decades show that, time and again, the European project was able to substantially progress forward. This was the case with the creation of the Single Market, the Schengen Agreement or the single currency. More recently, the steps toward the Banking Union were a prime illustration of the ability to reach an agreement and give up national sovereignty, in an area as sensitive as the financial system. There was a “major institutional quantum leap” in recent years, “which probably very few would have anticipated when the Maastricht Treaty was signed” (Dorrucci et al. 2015). All in all, the discussion on the future of the Economic and Monetary Union cannot be disentangled from the broader discussion on the future of the European Union, including in areas such as security, migration and the Single Market. Only an encompassing view can deliver shared-prosperity and stability across the Union.

the effect on disposable incomes: 20 to 25 percent of households were in segments of the income distribution whose disposable income was flat or down between 2005 and 2014, compared with less than 2 percent in 1993– 2005.”

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ACKNOWLEDGMENTS The views are those of the author and not necessarily those of the institutions. The author would like to thank the comments from Federico Fabbrini (Dublin City University - School of Law & Government and Brexit Research & Policy Institute) and Johannes Lindner (European Central Bank). Part of this work was presented at the ADEMU Conference “How Much Fiscal Union for the EMU” at Banco de España on 18-19 May 2017 and at the inaugural event of the DCU Brexit Institute “Which Brexit After the UK Elections” at Dublin City University on 14 September 2017; the comments from the participants are thus gratefully acknowledged. Any errors and omissions are the authors’ own responsibility.

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Schraad-Tischler, D. and Schille, C. 2016. “Social Justice in the EU – Index Report 2016.” Social Inclusion Monitor Europe. Bertelsmann Stiftung. https://www.bertelsmannstiftung.de/fileadmin/files/BSt/Publikationen/GrauePublikationen/Studie_NW_Social -Justice-Index_2016.pdf. Tabellini, G. 2016. “Building common fiscal policy in the Eurozone.” In How to fix Europe’s monetary union - Views of leading economists. Edited by R. Baldwin and F. Giavazzi. VoxEU ebook. Tabellini, G. 2017. “Which fiscal union?” In How to fix the Eurozone. Edited by R. Baldwin and F. Giavazzi. VoxEU ebook. Thirion, G. 2017. “European Fiscal Union: Economic rationale and design challenges.” CEPS Working Document 2017/01. January 2017. https://www.ceps.eu/ system/files/WD2017-01GT%20FiscalUnion.pdf. Ubide, A. 2015. “Stability Bonds for the Euro Area.” Peterson International Institute for International Economics 15-19. October 2015. https://piie. com/publications/pb/pb1519.pdf. Van Beers, N., Bijlsma, M. and Zwart, G. 2014. “Cross-country insurance mechanisms in currency unions: an empirical assessment.” Bruegel Working Paper 2014-04. March 2014. http://bruegel.org/wp-content/uploads/imported/publications/WP_2014_04.pdf. Van Rompuy, H., Barroso, J., Juncker J.-C. and Draghi, M. 2012. Towards a genuine economic and monetary union. June European Council. http://welingelicht unlimited.net/wu/wp-content/uploads/2012/06/Brief-van-Rompuy-juni-20121.pdf. Véron, N. 2017. “Europe’s fourfold union: Updating the 2012 vision.” Policy Contribution 23. Bruegel. September 2012. http://bruegel.org/2017/09/europes-fourfold-unionupdating-the-2012-vision/. Véron, N. and Wolff, G. 2015. “Capital markets union: a vision for the long-term.” Bruegel Policy Contribution. April 2015. http://bruegel.org/ 2015/04/capital-markets-union-avision-for-the-long-term/. Yiatrou, M. 2016. “Bank resolution credibility and economic implications.” ADEMU Working Paper 2016/038. May 2016. http://ademu-project.eu/ publications/workingpapers/.

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In: Challenges and Opportunities … Editors: J. M. Caetano et al.

ISBN: 978-1-53613-474-2 © 2018 Nova Science Publishers, Inc.

Chapter 8

WHAT CAN AND SHOULD WE EXPECT FROM THE EU BUDGETARY POLICY? Manuel Porto University of Coimbra, Coimbra, Portugal and Lusíada University, Lisbon, Portugal

ABSTRACT The budget of the European Union has had specific characteristics, being mainly concerned with the support given to structural policies, as well as with a significant participation in the Common Agricultural Policy. The performance of the other two purposes usually assigned to a public budget, a better distribution of income and of wealth and a counter-cyclical role would require a much larger dimension; being clear, realistically, that we cannot foresee that the countries will accept the allocation of much larger resources. It is therefore better, for all reasons (in this way cyclical crises also being avoided), to concentrate the attention on the reinforcement of structural policies, leading to the approximation of the economies of the Union; contributing in this way to a better performance of the Eurozone governance, and in a better way responding to the challenges and benefitting from the opportunities of the market.

Keywords: EU budget, subsidiarity, structural policies, anti-cyclical policy, own resources

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1. INTRODUCTION The European Union is an interesting case study, in what concerns budgetary policy: Specific problems have arisen arising concerning the purposes of a public budget and the ways of financing it. Other chapters in this book being concerned with specific mechanisms for monetary policy, in this chapter we are concerned with the general budget of the European Union. In particular, with the recent crisis it should be asked whether it should have another dimension and other purposes. This is a question with the greatest importance and with the greatest actuality, in the beginning of the preparation of the coming Multiannual Financial Framework (MFF) and when a new proposal for the financing of the budget is expected (following the research conducted by the High Level Group on Own Resources). In particular, it is extremely important to have a fair repartition of costs between central and peripheral countries. Public budgets have, in general, three main purposes (Musgrave 1959 and 1989, with Peggy Musgrave): contributing to a better redistribution of income and wealth, having a counter-cyclical role and having an allocation role. But up to now, the EU budget has not had, or had only to a very small extent, the two first purposes; having been to a great extent concerned with the purpose of contributing to the improvement of structural conditions for less developed countries and regions, together with a large allocation of resources for the Common Agricultural Policy (CAP). Doubts about this situation arise nowadays particularly in the euro area, with suggestions in the sense of having a budgetary intervention (at the EU level or at the Eurozone level, with a specific budget for this area; or through other ways), with more resources, to support monetary policy. It is however interesting to see whether we should or whether we can expect a budgetary intervention in the EU similar to the budgetary intervention at national levels, even in federal countries. In particular, it is interesting to see to what extent the most recent documents, e.g., European Commission documents, point out or open the possibility for this kind of intervention. The EU budget remaining mainly concerned with the improvement of structural conditions, it should be seen whether in this way it can contribute to avoid crises, such as the recent crisis, contributing to a better governance. On the other hand, having the euro is area performed well in general, with by far the biggest greatest world surplus in the current account balance, there are great differences between the member countries. The improvement of the general conditions and the approximation of the different areas is therefore a prerequisite for the success of the euro, the recent experience having shown the important role of the structural funds attenuating cyclical difficulties.

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The promotion of structural conditions is therefore a realistic and very important way of contributing to the Eurozone Governance, corresponding to its challenges and benefitting from its opportunities.

2. THE EU LOGIC OF DECENTRALIZATION WITH A REGULATORY ROLE Before considering other reasons, it must be taken into account that the process of European integration follows the principle of subsidiarity. Starting from the beginning, it has been reinforced in the revisions of the Treaties; now appearing, in the Treaty of Lisbon, in Article 5º of the TUE and in Protocol n.21. Increasingly, the EU is having a greater regulatory role, with a significant part of the laws and activities of the States being determined by the EU2. It is therefore certain that many responsibilities will remain at the national levels; with the acknowledgement that, even at the national levels, much better results have been achieved throughout the years in the more decentralized countries. With this experience, it would not make sense to transfer to the European level that which even at the national level is better performed at the regional and at the local levels (Stigler 1957 and Oates 1972, more recently Gaspar and Antunes 1986, and Pereira and al. 2016, 319-48). On a more political perspective, with countries having their own peculiarities and traditions (indeed, with well known cases of separatism…), there is of course a better acceptance of the process of European integration being a project which does not remove or reduce the role of the States3. For these and other reasons, we cannot ignore that it will never be possible, the member countries will never accept it, to have a budget similar to national budgets, even similar to the federal budgets of federal states, in the European Union. Bearing in mind the increasing regulatory role of the EU, it can be said that “the expansion of regulatory policies was an alternative to establishing extensive fiscal resources at EU level, which reflected a view which limited the role of public finance in integration” (Laffan and Lindner 2015, 194)4. 1

See Quadros (2012(18), 36-8) and also for example Buettner and Thone (2016, 7-8) and Lipatov and Weicherieder (2016, more concerned with the implications of the principle for the revenues of the EU budget). 2 This increasing role is well expressed in the title and in the contents of a book of Majone (1996), Regulating Europe (see also for example Camisão and Lobo Fernandes 2005, Pitta e Cunha 2008 and on the EU regulatory agencies Calvão da Silva 2017; with other references see Porto 2017, 334). 3 To a great extent, in particular medium and small countries have their “national” role even increased being active members of the European Union, e.g., increasing their role at the world level (being participants in the euro, they have an important role “internally”, in the Eurozone, and at the world level, the euro being by far the second currency of the world: see for example European Commission, 2017a, comparing the role of the euro with the role of the US dollar and of the Japanese yen in world payments, loans and reserves). 4 And it can be added that some reductions to budgetary intervention in the last decades did also take place at the national levels, a new philosophy of intervention prevailing. Again in the words of Laffan and Lindner (2015,

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But on the other hand, being realistic, it is clear that an organization with the responsibilities of the European Union cannot go on with such a small budget, a budget corresponding to less than 1 percent of the GDP of the Union. And it is a budget with a dimension that has been decreasing throughout the decades. Three decades ago, at the time when Jacques Delors was President of the European Commission, there were attempts, for the Delors I Package, to have a budget corresponding to between 1.34 and 1.37 percent of GDP5, finally settling at 1.27. But since then, despite the increasing challenges to which the European Union should correspond, there has been a general decrease in the Multiannual Financial Frameworks: with a percentage of 1.18 percent of EU GDP in 1993-99, of 1.06 percent in 2000-06, a very slight increase in 2007-2013, to 1.07 percent, and again a decrease, to 0.98 percent, in 2014-2020. It is not acceptable that we remain at this level, even being aware that it will not be easy to move to much higher levels.

3. THE NEED TO HAVE A NEW PHILOSOPHY OF INTERVENTION: CONSIDERING THE VALUE ADDED WITH EU INTEGRATION It has been difficult to go ahead with larger budgets because the positions of the countries have been that they require a monetary return similar to the amount paid to the budget. It is the situation which did lead to the “rebates” to the UK and other rich countries of the Union6. But recently is being strongly stressed, and rightly so, that the benefits of being a member of a union such as the European Union are not only, or not mainly, financial returns coming from the budget. There is a value added well above these values. The need to have a new paradigm was strongly highlighted in the First Assessment Report of a High Level Group on Own Resources (2014)7, a group chaired by Mario Monti and integrated by three members indicated by each of three EU Institutions, Council, Commission and Parliament, “with the purpose to continue and further the reflection and provide new input to this sensitive and difficult issue when it comes to reform it”.

224), “the view that there could be no strong Community government, with limited financial resources, gained ground in the 1980´s, as Keynesian economic policies were discredited in favour of monetarist approaches. The Keynesian economic paradigm privileged the role of budgets in macro-economic management, whereas the monetarist paradigm did not accord a central role of public finance”. 5 Well below the values between 5 and 7 percent of GDP proposed in the McDougal Report (1977), in the seventies (Calado Lopes 2007 and Silva Lopes 2008, 265-6). 6 With a table showing the “operating budgetary balance” in 2013 see High Level Group on Own Resources (2014, 27-8) and with tables showing the “operational budgetary balances” in 2000-06 and in 2007-13 see Ferrer et al. (2016, 23-5). 7 But it should be remembered that the need to go in this direction had been already stressed earlier, in particular by members of the European Parliament (see for example Colom I Naval 2000a, 2000b and 2005; and also Porto 1999, 103-4).

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In this first report, published in December 2014, the very important critique was made, that the system “is commonly described as a means of burden-sharing between Member States or caricatured as a European financial zero-sum game with winners and losers”. Having this critique in mind, the Final report and recommendations of the High Level Group on Own Resources, of December 2016 (following an Inter-institutional Conference with the National Parliaments two months earlier, in September), again stressed that there is a value added to be taken into account: “What is striking and unsustainable is that, when it comes to the basic data that each Member State uses to define its position in budgetary negotiations – its budgetary balance - European value added, with economic synergies, cross-border effects and positive external outcomes is completely ignored” (p. 7; pp. 2735 it is shown how European added value can be appraised and increased with EU expenditure). “This would not only be more accurate, but would hopefully overcome the just retour dilemma which has transformed the EU budget, and by extension the EU, into a zero-sum game” (e.g., with the rebates) “instead of the win-win arrangement, seeing into which extent it is expected to win”. The “false perception that the value of the EU budget to a Member State can be measured by the net balance of contributions made and funds received” (European Commission 2017b, 6), resulting into some extent from the fact that it was “mostly based on contributions from Member States”, “ignores the essence of a modernized EU budget: the value added that results from pooling resources and delivering results that uncoordinated national spending cannot. These broader economic gains are all too often ignored, as is the wider value of belonging to the largest economic area and trading power in the world”. In the words of Schratzenstaller (2016, 34), there is the “tendency of Member States to support the preservation of expenditures categories promising to maximize their individual country specific transfers received from the EU budget, instead of pushing for an expenditure structure from which maximal benefit for the EU as a whole (“European value added”) may be expected. In this context, it should be recalled that the financial resources at the disposal of the EU also serve to finance various “European public goods”, e.g., goods or activities with positive cross-border external effects and with European value added”. And, as stressed by Bordignon and Scabrosetti (2016, 77), “investments in ´true´ European public goods are probably sub-optimal, because the present system incentivizes too much the ´just retour´ behavior. However it is an open question whether without this ´inefficient´ EU budget funding system, the progress that has been made even on more European wide public goods would have been possible at all” (see also for example Heinemann 2016 and Wolf 2017). It should be stressed, as well, that “EU value added also fits with the principle of subsidiarity and proportionality. The EU should not take action unless it is more effective than action taken at national, regional or local level. EU action has to be additional or

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complementary to national or regional efforts, but should not fill in gaps left by shortcomings of national policies. Added value may also be in the form of avoided costs and indirect benefits” (European Commission 2017b, 9). And we must follow this approach in particular because in quite important cases the “value added” is to a much greater extent value added for the more powerful countries. As expressed by Moussis (2015, 47), “some common policies of the European Community/Union are clearly in the interest of the stronger and wealthier Member States. This is the case notably of the internal market, competition and taxation policies, because they open the markets of the poorer and less developed Member States to their products and services. Therefore, some other policies are needed to balance the benefits of the integration process, by operating capital transfers in favour of the poorer Member States: e.g., agricultural, regional and social policies. These transfers of capital are also in the interest of the wealthier Member States, since they allow their poorer partners to buy more of their products and services. This balance of the benefits of the Member States, which distinguishes, inter alia, a multinational integration scheme from a free trade area one, is organized by the Union budget”. It is within this correct framework that we should evaluate and hopefully have the expansion of the EU budget. That being said, can we expect to have enough resources to correspond to the needs of monetary policy? And, not having a much larger amount of resources, should we reduce the support to the structural policies?

4. TRENDS AND CHALLENGES ON THE EXPENDITURE SIDE On the expectations which we can have about the expenditures it is interesting to see the positions which are now being taken by the European Commission and by other entities; as well as the positions already taken before, seeing to which extent we should have a drastic change in the strategies to be followed. Going back two decades ago, we can see that in the budgetary perspectives (Multiannual Financial Frameworks) for 2000-2006 and for 2007-2013 the greatest shares were for “preservation and management of natural resources”, being 44.5 and 43 percent, respectively (the agricultural expenditures being included here), followed by “cohesion for growth and employment”, with 38.4 and 35.6 percent: so, these two destinations having 82.9 percent in total in 2000-2006 and 78.9 percent of total in 2007-2013. The other destinations were much lower, with “competitiveness for growth and employment” having 6.1 percent of the total in the first case and 8.6 percent in the second case, administration 5.1 and 5.7, and “the EU as a global player” 5.1 and 5.7; followed by “citizenship, freedom, security and justice”, with 0.8 and 1.2 percent. The need to have Sustainable Development Goals (SDGs) was also, and increasingly so, at the heart of the Strategy Europe 20-20, for 2014-2020, determining the spending

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programs to have “smart”, “sustainable” and “inclusive” growth (for example Porto 2012a). These purposes did lead to the current allocation of resources: 39 percent for “sustainable growth, natural resources” (including the payments for agriculture), 34 percent for “economic, social and territorial cohesion”, 13 percent for “competitiveness for growth and jobs”, 6 percent for administration, 6 percent for “global Europe” and 2 percent for “security and citizenship”. The most recent document of reflection on new demands for the expenditures of the EU is the “Reflection Paper on the Future of EU Finances” (European Commission 2017b). In part 3, on “Trends and Challenges”, part 3.1 is dedicated to “security and safety for the citizens of the Union”: having in mind possibilities regarding terrorism, with the requirement for improving the “control of external borders, strengthening robust information networks, reinforcing the support provided by the agencies, or tackling the increased instability in our neighborhood”; but with requirements also for example for environment and food products. These are indeed new challenges, or challenges nowadays with new requirements. The following part of the document, part 3.2, is concerned with “economic strength, sustainability and solidarity”, being stated that “sustainable development has long been at the heart of the European project”, but nowadays with new challenges. In another stage it is recalled that “any public budget” has “three basic functions”, investment in public goods, re-distribution and macro-economic stabilization, being added that “the EU budget performs these functions albeit to different degrees”. Public goods are financed through programs “managed directly at the European level” or for example “together with Member States and regions through the investment co-financed under cohesion policy”. Re-distribution is achieved “through cohesion policy, which promotes economic convergence as well as social and territorial cohesion”, and also with support for rural development and to “the income of farmers under the Common Agricultural Policy”. And in the third place it is recognized that “the stabilization function is only covered indirectly. The EU budget has some stabilizing effects for some Member States, notably due to its stability over seven years, which provides a constant level of investment independent of the economic cycle. At the same time, Member States´ contributions are related to economic performance, so that contributions to the budget will go down in a recession. However, the EU budget was not conceived to provide for economic shock absorption”. So, some stabilization function (and into some extent a re-distribution function) is performed, not with specific funds dedicated to this purpose, but with funds of structural policies. The question arises again in part 4.1, with the following title: “what should the future EU budget focus on?”

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As we should expect, one part of the document, part 4.1.2, is on “reforming the common agricultural policy”, a policy which for a long time had the largest percentage of the budget. It has been an inappropriate policy, a protectionist policy, leading to higher prices, which throughout the years have burdened consumers, of course to a greater extent poorer consumers, and all economic activities using agricultural products in their productions; on the contrary, benefitting into a greater extent richer agricultural producers of richer countries (on these inequities see recently European Commission 2017b, 17). But we should acknowledge that an appropriate agricultural policy is required, e.g., to “enhance its efficiency and fairness while achieving its unchanged objectives to ensure safe and healthy food, a competitive sector, a fair standard of living for the agricultural community and protection of our natural resources, our landscapes, the environment and the climate action”. Probably this requires a smaller share of the EU budget, but we should acknowledge that an improved agricultural policy requires important funds8. Part 4.1.3 is dedicated to “reforming cohesion policy”; a policy which has always been an appropriate policy, with general social and economic benefits, in the interest of the whole of the Union. The suggestions made (together with other improvements) are therefore welcome: for example making it “more flexible to face new challenges”, with “faster implementation” and “a smoother transition between programming periods”, and improving “administrative capacity”. The questions are raised, on whether “the levels of national co-financing for cohesion should be increased”, and on “whether cohesion policy funding should be available to the more developed countries and regions”. But it is certain that it will be a policy always justifying the allocation of very important resources of the EU budget. In part 4.1.1 had already been stated, anticipating what we are just seeing, mentioned in part 4.1.3, that “reducing economic and social divergences between and within Member States is crucial for a Union that aims for a highly competitive social market economy aiming at full employment and social progress”; adding that this is “of vital importance for the Eurozone, where divergences put at stake the sustainable development of EMU in the medium term”. So, it is once again, and rightly so stressed that more economic and social convergence is of “vital importance” for the sustainability of the euro area.

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Fuest, Heinemann and Ungerer, of course as many other authers, are specially critical of the Common Agricultural Policy, arguing (2015, 4) that “the EU spends its money in the wrong policies”, that “some of the largest spending items in the EU budget are difficult to justify”, and that “this includes in particular the huge share of spending on agriculture”, and that “there is no convincing reason why the EU should spend 40 per cent of its budget on a sector of declining importance”.

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5. IMPLICATIONS FOR THE REVENUES OF THE BUDGET It has been stressed that the problems of expenditures and revenues are not separate problems. It must indeed be so because we must have revenues enough to correspond to the expenditures. But it has been also stressed that revenues should be related to expenditures. Following other statements in this sense, in the recent “Reflection Paper on the Future of EU Finances” (European Commission 2017b, 27) it is stated that “there is a close link between decisions about what the EU budget is used for and choices about how the EU budget is funded”. “The reflection on the reform of the expenditure side of the EU budget should therefore be accompanied by a critical assessment of how the budget is financed –the own resources system – and how this system can be reformed to be more efficient and provide stronger support for policies”9. The main purpose of this chapter is not to take a stand about the best choice or the best choices regarding the revenues of the EU budget, but of course, it cannot avoid some indications on this issue. Our main purpose is to show the difficulty of having a much larger budget, perhaps giving the opportunity to have to a great extent not only allocation purposes, also anticyclical or redistribution purposes: without the possibility of having required consensus on new revenues or on the enlargement of the revenues raised with the present resources. The evolution up to now with the resources raised and with proposals presented, as well as the critiques and oppositions which have been raised, clearly show the difficulty or even the impossibility of having consensus on the creation of new resources; in an area in which unanimity of the Member countries is required. And, as recalled in the First Assessment Report of the High Level Group (2014), “reforms have been blocked for decades”, to some extent as “own resources are an issue which can only be confronted together by all Member States and by all institutions”. For example, resources which are more clearly “own resources”, or more connected with policies of the Union, can perhaps not be fair, not be able to give great amounts of revenue, or reduce the competing capacity of the economy of the Union; or, also for example, one resource with a more fair distribution among the countries and among the citizens may not be well accepted by the citizens and the politicians of the countries which have a higher burden, perhaps with the “argument” that it is not a “Community” or “Union” revenue, e.g., connected with policies of the EU…

9

And in a critique of the present system it is added: “The current approach to financing is over-complicated, opaque and riddled with complex correction mechanisms. In the future, the system should be simple, fair and transparent”. Haug and al. (2011, 3) go to the point of arguing that “fully funding the EU with independent sources of revenue is the only way to put an end to the fair return approach”. But we will see that different ways can be followed (commenting on that statement see Heinemann 2016, 96).

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In these experiences and proposals, it is clear that the positions of the countries are quite different, with quite different and even contradictory interests: some revenues being acceptable only for some countries and other revenues only acceptable for other countries. So, we cannot expect a great enlargement of the budget, eventually opening the way to counter-cyclical (or re-distribution) policies. To see the difficulty of making choices among different purposes, with antagonistic interests and positions among the countries, it is worth seeing the rich and diversified experiences which we have had up to now, as well as the proposals which have been made. After having been financed initially with transfers from the national budgets, since 197110 the EEC (and the EURATOM; the European Coal and Steel Community having been since the beginning financed in a “Community” way, with a tax on the products of coal and steel) was financed with own resources, the “traditional own resources”, composed of the duties of the External Common Tariff and of the agricultural levies of the CAP, to which was added the VAT resource, on the taxed value of this tax, up to a fixed amount; with the addition, in 1980, of a new resource, the so called 4th resource, connected with the GDP (more recently the GNI) of the countries. But the prevalence for many years of indirect taxes and of a resource based on an indirect tax (the VAT) lead to a situation which it is worth paying close attention to: showing into a great extent quite different, even conflicting, values and interests. It is the situation resulting from the observation of the figures in Table 1. We cannot indeed forget the inequity which we had for decades: with revenues having a highly regressive distribution, representing a much higher percentage for the citizens of the poorer countries. How can it be acceptable, for example, that in 1993 a German citizen was taxed 1.18 percent of his per capita GDP, a Luxembourg citizen 1.13 or a Danish citizen 1.09; while taxation of a Greek citizen represented 1.37, of a Portuguese citizen 1.40 and of an Irish citizen 1.49 of his per capita GDP? In another evaluation, the contributions were estimated between 1.96 percent of GDP in Portugal, the country with the highest level of the burden, and 0.54 percent of GDP in the UK, the less harmed country, followed by Luxembourg and for example by Germany in 4th position (see European Parliament 2007). This situation was rightly criticized in 1992, in the Protocol on Economic and Social Cohesion of the Treaty of Maastricht, with the Member States declaring “their intention of taking greater account of the contributive capacity of individual Member States in the system of own resources, and of examining means of correcting, for the less prosperous Member States, regressive elements existing in the present own resources system”.

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With a Council Decision of the 21st April 1970, following the Luxembourg Agreement, but with Charles de Gaulle, President of France, being against budgetary or any other forms of integration (for example Vila Maior 1999, 512).

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Table 1. Own resources/GDP per capita 1993 1997 Belgium 1.45 1.41 Denmark 1.09 1.07 France 1.11 1.12 Germany 1.18 1.20 Greece 1.37 1.09 Holland 1.59 1.50 Ireland 1.49 1.08 Italy 0.99 0.96 Luxembourg 1.13 1.22 Portugal 1.40 1.17 Spain 1.14 1.13 United Kingdom 0.87 0.77 Source: Data taken from Coget (1994, 83) and Haug (1999, 27)

With the increasing role of the GNI resource (the 4th resource) there was already the decrease in regression in 1997 seen in Table 1; and there is of course a fairer situation nowadays, with the increase in the role of this resource, increasing to 41% in 1998 and an estimated 71% in 2018 (European Commission 2017b, 6). This evolution was nevertheless criticized, even by the Commission itself, suggesting (European Commission 2004) that the “own resources system” should move “from a financing system mainly based on national contributions to a financing system which would reflect better a Union of Member States and the European people”. It should be so as an answer to reported critiques on “lack of transparency for the citizens of the European Union, on “limited financial autonomy”, on “complexity and opacity of the system”; the recent critiques made in 2017, mentioned below, being anticipated in this way11. Following this critique, seven years later the Commission (European Commission 2011) made a Proposal for a Council Decision on the System of Own Resources of the European Union. This is the only formal proposal, with concrete figures for the revenues, presented since then and up to now12 (in the following years we have the important studies which we are going to analyze, but without the choice of the revenues to be finally proposed, and of course without the indications of revenues which could be collected in each case). And statements were made, saying that “solidarity practices of the Community” would take place “through the expenditures side in the budget of the European Union” (European Commission 1998). We have however been quite far from this situation, specially with the inequity resulting from the expenditures with the CAP; as mentioned before, until quite recently with the biggest share of the expenditures of the budget and benefitting to a greater extent richer countries and richer farmers, with larger productions. 12 And not followed by the Council (Bordignon and Scabrense, 2016, 65). Earlier, there were proposals or suggestions from Spain (supported by Portugal), of the European Commission (1998), of the Austrian Chanceler Wolfgang Schussel, in 2006, of a study group formed in the European Parliament (2007) (see Porto 2012b, 2015 and 2017, 505-15). 11

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Special attention should therefore be paid to the proposal presented in 2011, with the figures indicated in Table 2: According to this proposal, in 2020 traditional own resources would give 18.9 percent of the total revenues of the EU budget, a new VAT resource 18.1, the taxation of financial transactions 22.7 percent and the GNI resource 40.3 . Table 2. Estimated evolution of the structure of EU financing (2012-2020)

Traditional own resources Existing national contributions of wich VAT-based own resource GNI-based own resource New own resources of which New VAT resource EU financial transaction tax Total own resources Source: European Commission (2011, 5)

Draft budget 2012 % of EUR own billion resources 19.3 14.7 111.8 85.3

2020 EUR billion

% of own resources

30.7 65.6

18.9 40.3

14.5 97.3 -

11.1 74.2 -

65.6 66.3

40.3 40.8

131.1

100.00

29.4 37.0 162.7

18.1 22.7 100.00

This last resource would therefore still have an important role to play. But probably it would not be enough to avoid a generally regressive distribution with the whole of the revenues (and until 2020, according to Article 4 of the proposal, there should be a deduction in the GNI resource for four of the richest countries: UK, Germany, Netherlands and Sweden…). And it should indeed be asked why is the GNI resource to be blamed: a resource which, besides being fair, is easily applied and always gives the required resources. In a recently organized workshop (De Feo and Laffan, ed., 2016) the first session addressed the question “Do we need a reform?”; in the words of Monti (2016, 2), “an obvious question, since the present system has undeniably functioned in a satisfactory way from a sufficiency and stability point of view”13 (also Bordignon and Scabrosetti 2016, 65 ss., stressing that “it works”…)14. The author adds an also quite interesting reflection: “Moreover, the fact that the system is mostly intergovernmental, rather than federal, will be considered an asset – rather than a deficiency – by many who want to exercise “control” over the EU budget”. 14 When the author of this chapter was a member of the European Parliament (for some time Vice-Chairman of the Budget Committe), concerned with equity considerations, did admit the hypothesis (indeed with difficulties) of a resource connected with the personnal incomes of the EU citizens (see Porto 1999, with his vote declaration on the Haug Report, in 1999). 13

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We can indeed understand that public opinion does not easily accept a transfer from the national budgets to the European Union, of resources which are needed in different areas, such as education and medical services, which are needs closer to home, felt more strongly by the citizens. But the main opposition to the present system, which impacts on the way to be followed, is from richer countries, paying to a greater extent into the budget. And we can also understand the benefit of having resources connected with activities and purposes of the Union, e.g., environmental or energy policies. But this cannot be the only criterion to be taken into account, we must see whether with them equity and competing conditions are not harmed, conditions also at the core of EU concerns. On the other hand, in what these last resources and policies are concerned, attention must be paid to the circumstance that with them we can have a conflict of interests, once for example the achievement of the purpose of reducing the use of energy conflicts with the purpose of raising revenue. As stressed by Begg (2011, 11) “another concern about energy or carbon tax is that there could be conflict between their role in deterring energy use and their reliability in funding the budget”15. If the purpose of saving energy is fully achieved, without any spending in energy, nothing is collected… Recently, special atention should be given to the analysis and to the suggestions from the High Level Group on Own Resources, by way of accomplishing what is detemined in Article 311 of the TFUE (comments on this article, Porto 2012, 8). In the mandate given, in December 2013, it was stated that “the Group will undertake a general review of the Own Resources system guided by the overall objectives of simplicity, transparency, equity and democratic accountability”. These were the primary indications given. But it is interesting to stress the number of criteria considered in the Final Report (2016): equity/fairness, efficiency, sufficiency and stability, democratic accountability and budgetary discipline, focus on European added value, subsidiarity principle anf fiscal sovereignty of Member States, and limited political transaction costs; quite different criteria, at different levels of analysis, corresponding of course to quite different and in many cases conflicting interests. It is with all these criteria in mind that the High Level Group makes an evaluation of the traditional own resources (TOR) and of “candidates for new own resources”: CO2 levy/carbon tax, motor fuel levy (taxes on fossil fuels/excise duties), electricity tax based own resource, an EU Corporate Income Tax (CIT), a Financial Transaction Tax (alternatively, a bank levy or financial activities´ tax), a reformed own resource based on VAT, or/and the revenue made from issuing currencies (seignoriage); without quantifying the revenues expected and wihout taking a final decision, proposing any of them. As expected, together with these “semi-official” proposals, there has recently been a rich academic research, considering different criteria to be taken into accout and suggesting 15

“Thus, to protect revenue, the tax should be set at the level that produces the highest yield, but if the objective is deterrent, the rate should be set to achieve a desired level of change in behaviour, such as a target for lowering emissions. For something as sensitive as the EU budget, the revenue considerations would have to come first”.

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different sources of revenue for the budget, already existing resources and new resources. In particular, reference can be made to quite recent contributions made by Benedetto (2013), Cipriani (2014), Fuest, Heinemann and Ungerer (2015), Ferrer, Le Cacheux, Benedetto and Saunier (2016), Begg (2017) and articles by various authors included in Buettner and Thone, ed. (2016) and in De Feo and Laffan, ed. (2016)16. Some of the different possibilities considered, namely by the High Level Goup, are mentioned in the recent document by the Commission, the Reflection Paper on the Future of EU Finances (COM(2017)358 final, of 28 June 2017), considering options for an “own resources” system, but without taking position on them, so, without making a concrete proposal. The door remains open therefore, with hesitations amongst quite different criteria and resources, some of them burdening into a greater extent some countries, other burdening into a greater extent other countries. It is therefore difficult or even impossible to expect that a much greater amount of revenue can be collected : with the reaction of the countries more harmed with resources proposed, in a process which, we can never forget, requires unanimity. These circumstances clearly show the difficulty or even the impossibility of having a much larger budget, with much more money, even if those responsible for the countries affected are convinced, as mentioned in this document of the High Level Group, that “by pooling resources at European level, Member States can achieve more than they could by acting alone”. And it is in this realistic framework, the only realistic framework, that a choice must be made, on the main purposes of the EU budget : remaining a budget mainly purposed with improving structural conditions (even in the agricultural sector, with a new and correct policy), or having as well significant counter-cyclical or re-redistributive purposes. In this framework, we agree with Rubio when she says (2015, 11) that “today, there is general consensus on the need to embark on a new convergence process”; adding, however, that there is a mainstream view according to which “ there is no need for such a budgetary support ”, sustainable convergence requiring “the reduction of co-competitiveness divergences within euro-area member states” (this being “done through the monitoring and controlling of wage developments at the national level, the adoption of tailor-made structural reforms and, eventually, the establishment of common binding standards” “on labor markets, competitiveness, public administration or taxatio, for instance”). We are not convinced on this point of view : greater budgetary support (with a correctly financed budget) to structural reforms being indeed required for a convergence process. And only with this will it be possible to correspond to the challenges and to the opportunities for the Eurozone governance, as the recent crisis has shown. 16

And reference should be made to the contributions given in earlier years for example by Haug (1999), Begg (2010 and 2011) and Haug, Lamassoure and Verhofstadt (2011), with their own proposals or evaluating proposals made (see again for example Porto 2017, 505-15).

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CONCLUSION It is clear that the EU budget will never be a large budget, similar to national budgets, even the budgets of federal states. Economic and political reasons show that we should have and we will have a decentralized system, according to the principle of subsidiarity, the European Union having to a great extent a regulatory role to play. But it is also clear that it will not be possible to keep the budget with the present dimension, representing less than 1 percent of the Union GDP, a percentage which in general has been decreasing throughout the decades. It must be so because it is necessary to go beyond the position which, to a great extent, prevailed until now, with the countries not recognizing the value added resulting from being members of a reality as the European Union: being confined to a comparison of what they pay with what they receive from the budget, without taking into account the value added, e.g., resulting from economic synergies, cross-border effects and positive external outcomes, in particular with the provision of public goods. The difficulty would of course be overcome if it were advisable and possible to substantially increase the volume of the budget. However, experience has already shown very clearly, with the resources of the budget of the Union, as well as the studies made and the proposals presented, that there are conflicting interests, for example revenues with regressive impact can be welcomed by the richest countries but not by the poorer countries, and vice-versa; and revenues which, being connected with policies of the Union, for example energy and environmental policies, can perhaps have iniquity effects or diminish our competing capacity (and not giving much revenue, if the extra-tax objective, for example the objective of reducing into a great extent the demand for energy, is attained). The difficulty of choosing and of having large revenues is reflected in the more than ten possibilities under discussion, e.g., in the reports of the High Level Group on Own Resources (2014 and 2016) and in the most recent document of the Commission (2017b); showing that it is not easy or even possible to anticipate the way to follow. With all suggestions having oppositions and the approval of new resources requiring unanimity in the Council, we cannot expect a great increase in the resources of the budget. And, that being so, a choice must be made between having important resources for an anti-cyclical policy or continuing with more relevant structural policies, leading to “economic strength, sustainability and solidarity”: with good reasons to follow this second path. And the recent crisis has revealed the capacity of the structural funds to attenuate cyclical difficulties, substituting the lack of national means for investment. So, realistically, we should go on strengthening and approximating the countries and the regions, preparing them for all challenges, including the challenge of globalization and, closer to us, the challenge of monetary crises (in particular, the repetition of a crisis like the recent crisis).

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REFERENCES Begg, I. (2010). Rethinking How to Pay for Europe. SIEPS (Swedish Institute for European Policy Studies). Begg, I. (2011). An EU Tax. Overdue Reform or Federalist Fantasy? Friedrich Ebert Stiftung. Begg, I. (2017). Rethinking How to Pay for Europe. SIEPS (Swedish Institute for European Policy Studies), European Policy Analysis, Stockolm. Benedetto, G. (2013). “The EU Budget after Lisbon: Rigidity and Reduced Spending?” Journal of Public Policy, 345-369. Cambridge University Press. Bordignon, M. & Scabrosetti, S. (2016). “The Political Economy of Financing the EU Budget”. In Buetner and Thone (ed.), The Future of EU-Finances, cit., 63-90. Buettner, T. & Thone, M. (ed.). (2016). “The Future of EU-Finances”. Working Papers for the Brussels Symposium on 14 January 2016. FiFo (Finanzwissenshaftliches Forscungsinstitut an der Universität zu Köln), FAO (Friedrich-Alexander Universität, Erlangen-Nurnberg) and Bundesministerium der Finanzen, Cologne. Calado Lopes, A. (2007). A Estratégia de Lisboa e a Modernização da Economia Europeia. Instituto Nacional de Administração (INA). Oeiras. [The Lisbon Strategy and the Modernization of the European Economy]. Calvão da Silva, J. N. (2017). Agências de Regulação da União Europeia. Gestlegal. Coimbra. [Regulatory Agencies of the European Union]. Cavaco Silva, A. (1999). União Monetária Europeia. Funcionamento e Implicações. Verbo. Lisbon (Brasiian edition, S. Paulo, 2006). [European Monetary Union. Operation and Implications]. Camisão, I. & Lobo-Fernandes, L. (2005). “Construir a Europa. O processo de integração entre a teoria e a história”. Principia. Cascais. [Building Europe. The integration process between theory and history]. Cipriani, G. (2014). Financing the EU Budget. Moving Forward or Backwards? Centre for European Policy Studies, Brussels. Coget, G. (1994). “Les Resources Propres Communautaires”. Revue Française de Finances Publiques (French Journal of Public Finances), 45, 51-96. [The Community Own Resources]. Colom I Naval, J. (2000a). “El Presupuesto Europeu”. In Morata, F. ed. PolíticasPúblicas en la Union Europea Ariel. Barcelona., Chapter 1, 31-86. “The European Budget.” In Public Policies in the European Union. Colom, I Naval, J. (2000b). “El Presupost de la UE en l´Horitzó de la Propera Década”. In Revista de Economia da Catalunha. [The EU Budget in the Coming Decade. Journal of Economics of Catalonia].

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Colom I Naval, J. (2005). “La Betalla del Pressupost Europeu e El Pressupost de la UE”. Fundació Centre d´Informació I Documentació Internacional a Barcelona, 96, 18-24. [The Fight of the European Budget and the EU Budget]. De Feo, A. & Laffan, B. (ed.) (2016). EU Own Resources: Momentum for a Reform? European University Institute, Robert Schuman Centre for Advanced Studies, Global Governance Program. European Commission. (1998). Financing the European Union. Commission Report on the Operation of the Own Resources System. (COM (1998)560 final, of 7.10.1998). European Commission. (2004). Financing of the European Union. Commission Report on the Operation of the Own Resources System. (COM (2004)505 final, of 14.7.2004, corrected on the 6.9.2004). European Commission. (2011). Council Decision on the System of Own Resources of the European Union. COM (2011)510 final, of 29.6.2011. European Commission. (2017a). Reflection Paper on the Deepening of the Economic and Monetary Union. COM (2017)291 final, of 31.5.20177. European Commission. (2017b). Reflection Paper on the Future of EU Finances. COM (2017)358 final, of 28.6.2011. European Parliament. (2007). “Future Own Resources. External study on the composition of future own resources for the European Parliament”. Directorate General for Internal Policy (PE 390-718). Ferrer, J. N., Le Cacheux, J., Benedetto, G. & Saunier, M. (2016). Study on the Potential and Limitations of Reforming the Financing of the EU Budget. CEPS, Université de Pau et des Pays de l´Adour, LSE and Deloitte, Brussels. Fuest, C., Heinemann, F. & Ungerer, M. (2015). Reforming the Financing of the European Union: A Proposal. Centre for European Economic Research (ZEW), Mannheim, June. Gaspar, V. & Antunes, A. J. P. (1986). “A Descentralização das Funções Económicas do Estado”. Desenvolvimento Regional. Boletim da Comissão de Coordenação da Região Centro [“Regional Development. Bulletin of the Coordinating Commission of the Central Region”], 23, 9-37. Coimbra. [The Decentralization of State Economic Functions]. Haug, J. (1999). Report on Own Resources presented in the European Parliament (A40105/99). Haug, J., Lamasoure, A. & Verhofstadt, G. (2011). (With the collaboration of D. Gros, P. De Grauwe, G. Ricard-Nihoul and E. Rubio. Europe for Growth. For a Radical Change in Financing the EU. Brussels. Heinemann, F. (2016). “Strategies for a European EU Budget”. In Buetner and Thone (ed.). The Future of EU-Finances, cit., 91. High Level Group on Own Resources. (2014). First Assessment Report. Brussels, 17, 12, 2014.

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High Level Group on Own Resources. (2016). Future Financing of the EU. Final report and recommendations of the High Level Group on Own Resources. Juncker, J. C. (in cooperation with D. Tusk, J. Dijsselbloem, M. Draghi and M. Schulz, European Commission, Bussels), Five Presidents Report. 2015. “Completing Europe’s Economic and Monetary Union”. European Commission, Brussels. Kotsogiannis, C. (2016). “European Union and Own Revenue Resources: (Brief) Lessons from Fiscally Decentralized Economies”. In Buettner and Thone (ed.). The Future of EU-Finances, cit., 49-62. Laffan, B. (2016). “Own Resources: The Need for a Reform”. In De Feo and Laffan (ed.). EU Own Resources: Momentum for a Reform? cit., 6-8. Laffan, B. & Lindner, J. (2015). “The Budget. Who Gets What, When and How?”. In H. Wallace, M. A. Pollack, and A. Young (ed.). Policy Making in the European Union, 7th ed., Oxford University Press, Oxford, 191-2121. Lipatov, V. & Weichenrieder, A. (2016). “The Subsidiarity Principle as a Guideline for Financing the European Budget”. In Buetner and Thone (ed.). The Future of EUFinances, cit., 17-31. McDougal, D. (McDougal Report). (1977). “Report of the Study Group on the Role of Public Finance in the European Community”. In Economic and Financial Series, A(14), April. Majone, G. (1996). “Regulating Europe”. Routledge. London. Monti, M. (2016). “Summary Statement of Mario Monti´s Keynote”. In De Feo and Laffan (ed.). EU Own Resources: Momentum for a Reform?, cit., 1-5. Moussis, N. (2015). Access to the European Union. Law, Economics, Policies. 21st ed., Intersentia, Cambridge (UK). Musgrave, R. (1959). The Theory of Public Finance. McGraw-Hill, New York. Musgrave, R. & Musgrave, P. (1989). Public Finance in Theory and Practice. 4th ed. McGraw-Hill, New York. Oates, W. E. (1972). Fiscal Federalism. Harcourt Brace Javanovich, New York. Pereira, P. T., Afonso, A., Arcanjo, M. & dos Santos, J. C. G. (2016). Economia e Finanças Públicas. 5th ed., Escolar Editora, Lisboa. [Public Economics and Finances]. Pitta e Cunha, P. (2008). “A Função Reguladora da União Europeia”. In Elisabeth Accioly (ed.). Direito no Século XXI. Livro de Homenagem ao Professor Werter Faria ] Juruá. Curitiba., 633-44. [The Regulatory Function of the European Union. Law in the 21st Century. Book in Honpur of Professor Werter Faria]. Porto, M. (1999). A Europa no Dealbar do Novo Século. Intervenções Parlamentares. Grupo PPE (EPP Group) (PSD), distr. Almedina, Coimbra. [Europeu in the Beginning of a New Century. Parliamentary Interventions]. Porto, M. (2012a). “A Estratégia 2020: Visando um Crescimento Inteligente, Sustentável e Inclusivo”. In Livro de Homenagem ao Prof. Doutor José Joaquim Gomes Canotilho, vol. IV, 549-72. Coimbra Editora, Coimbra. [The Strategy 2020: With the purpose of

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having Smart, Sustainable and Inclusive Growth. Book in Honour of Prof. Doutor José Joaquim Gomes Canotilho]. Porto, M. (2012b). “O Orçamento da UE: Dando Resposta às Exigências do Presente e do Futuro?”. In Livro de Homenagem o Prof. Doutor Aníbal de Almeida 187-208. Coimbra Editora, Coimbra. [The EU Budget: Corresponding to the Requirements of the Present and of the Future? Book in Honour of Prof. Doutor Aníbal de Almeida.] Porto, M. (2012). (8). Comment of Article 311 of “Tratado de Lisboa…”. In Porto and Anastácio (coord.), “Tratado de Lisboa…” [Lisbon Treaty…], cit., 1099-1102. Porto, M. (2015). "Budget Challenges for the European Union". Europe (s), European Law (s). A University Passion. Liber Amicorum in Honor of Professor Vlad Constantinesco. (Brussels). Porto, M. (2017). Teoria da Integração e Políticas da União Europeia. Face aos Desafios da Globalização. 5th ed. Almedina, Coimbra (English and Chinese editions, of the 3rd edition). [Theory of Integration and European Union Policies. Facing the Challenges of Globalization]. Porto, M. L. & Anastácio, G. (coord.). (2012). (English edition in 2018). Tratado de Lisboa. Anotado e Comentado. Almedina. Coimbra. [Lisbon Treaty. Anoted and commented]. Quadros, F. (2012). (7). Comment of article 5º of TUE. In Porto and Anastácio (org.), Tratado de Lisboa… [Lisbon Treaty…], cit., pp. 36-8. Quelhas, J. M. (1998). “A Agenda 2000 e o Sistema de Financiamento da União Europeia”. In Temas de Integração 5: 53-109. [The Agenda 2000 and the Financing System of the European Union. Themes of Integration]. Rubio, E. (2015). Federalising the Eurozone: Towards a True European Budget? IAI (Istituto Affari Internazionali), Rome, December. Schratzenstaller, M. (2016). “Which Options for a Reform? The Problems and Shortcomings of the Current System of EU Own Resources”. In De Feo and Laffan (ed.), EU Own Resources: Momentum for a Reform? cit., 33-40. Silva Lopes, J da. (2008). “A União Europeia. A Caminho de um Orçamento Federal”. In P. Pitta e Cunha and L. Morais, (org.). A Europa e os Desafios do Século XXI, 263-87. Almedina. Coimbra. [The European Union. In the Way to a Federal Budget. Europe and the Challenges of the 21st Century]. Stigler, G. (1957). “Tenable Range of Functions of Local Government”. In Joint Economic Committee, Sub-Committee on Fiscal Policy, Federal Expenditure Policy for Economic Growth and Stability, Washington. Vila Maior, P. (1999). O Modelo Político Económico da Integração Monetária Europeia. Universidade Fernando Pessoa, Porto. [The political and Economic Model of European Monetary Integration]. Wolff, G. (2017). Eurozone or EU budget? Confronting a complex political question. Blogpost.

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In: Challenges and Opportunities … Editors: J. M. Caetano et al.

ISBN: 978-1-53613-474-2 © 2018 Nova Science Publishers, Inc.

Chapter 9

COMPLETING EMU, DEEPENING THE EU* Annette Bongardt and Francisco Torres European Institute, London School of Economics and Political Science, London, UK

ABSTRACT The fact that EMU’s governance framework had remained incomplete allowed for the building up of competitiveness and fiscal disequilibria in some member states during its first ten years and left the Eurozone unprepared to cope with the sovereign debt crisis. While some of those weaknesses have in the meantime been addressed in response to the crisis, EMU’s governance framework is still incomplete. As a consequence EMU will not be sustainable without further European integration at the Eurozone level. The chapter discusses recent proposals to complete a banking union and to further enhance other Eurozone institutions, reinforcing their effectiveness and accountability and, not the least, the EU’s identity. Those changes need the cooperation of all member states. They should all be prepared to embark on completing the economic union side of EMU (accepting that risk reduction and risk sharing go hand in hand) but also to undertake the necessary reforms at the domestic level (in order to avoid new crises and ending up in a bad equilibrium as permanent laggards). Brexit will facilitate a necessary deepening of European integration by the core Eurozone member states: firstly, the UK will no longer be permanently blocking from within; secondly, other member states, which have committed to join EMU but seem now unwilling to do so (and seem also to be diverging in terms of other major institutions of permanent structured cooperation), could also choose to invoke article 50 TEU and leave the EU and remain on a lower level of integration like the European Economic Area (as is the case of Norway).

*

This paper builds on previous work by the authors on the Eurozone crisis and on Brexit. We would like to thank, without implicating, Lorenzo Codogno, Paul De Grauwe, Jeff Frieden, Russell Kincaid, Jorge Braga de Macedo and participants at our presentations at the LSE, Oxford University, King’s College London, the College of Europe in Bruges, the University of Düsseldorf, Católica Lisbon School of Business and Economics and the Law Faculty of Lisbon, for valuable comments and discussions.

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Keywords: EMU governance, national reform capacity, EU integration, Brexit

1. INTRODUCTION By many accounts, Economic and Monetary Union (EMU) enjoyed a rather successful first decade. However, EMU’s incompleteness – rooted in an incomplete institutional model beyond monetary policy – implied persistent institutional fragilities and allowed for the building up financial, fiscal and competitiveness disequilibria (Torres 2015). The lack of national reforms in some member states also contributed to growing intra-EMU macroeconomic imbalances.1 In the EU, the increase in economic integration to a monetary union had brought about a qualitative change, in which different member state varieties of capitalism (different conceptions of the mixed economy, with different state-market relations), when in contradiction with additional monetary union requisites on the economic side, became no longer sustainable. Albeit to different degrees, member states – especially those which were to experience severe problems later on in the sovereign debt crisis – failed (some of them significantly) to internalize what living in a monetary union meant, let alone to internalize the challenges posed by globalization, and delayed long-due reforms. Any proposed remedies – as it were, even more so under time pressure – would necessarily be more ‘intrusive’ in member state affairs. After all, a country’s permanence in EMU requires it to comply with those commitments that it made under constrained decentralization, needed to sustain EMU. The combination of the absence of market pressure during EMU’s first decade – when financial markets failed to differentiate between the sustainability of public debt and external imbalances among participants – and non-binding and not enforceable commitments in the case of the Lisbon Strategy and binding but not enforceable rules in the case of the Stability and Growth Pact (SGP) contributed to the procrastination of some of those (economic and institutional) reforms. The same holds true for the announced objectives (various times voted in national and European elections) to which various governments and political parties had subscribed and which were poorly implemented. It is therefore hardly surprising that economic policy coordination, effected through the Lisbon Strategy and the SGP, failed to deliver during EMU’s first decade. The lack of national reforms in some member states in conjunction with the incapacity of financial markets to distinguish between Eurozone sovereigns paved the way for increasing intra-EMU macroeconomic imbalances. Apart from its weak enforcement, the Lisbon Strategy also lacked any specific EMU dimension to address the increased 1

As Bongardt and Torres (2013) argue, most EU countries had failed to internalize the established common objectives of fiscal (SGP) and economic and social governance (the Lisbon Strategy and its successor, the Europe 2020 Strategy).

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interdependencies between members of a monetary union. This was mainly due to the fact that not all EU member states were members of EMU. EMU’s incompleteness in the economic union part left its (financial, fiscal and economic) governance institutions unable to encompass increasing policy interdependence, let alone capable of dealing with the cumulative effects of the financial and sovereign debt crises. EMU institutions, already affected by the 2008 global financial crisis, were unable to deal with the sovereign debt crisis that began in 2010, as there were neither financial backstops for stressed sovereigns or strained banks nor for countering sudden stops in financial flows (Mongelli et al. 2016).2 The EU did move towards increased coordinated financial supervision in response to the global financial crisis but it was insufficient. The subsequent sovereign debt crisis became a Eurozone crisis. The large negative spillovers, originating in the economic part of the union where there had been insufficient financial, fiscal and economic policy coordination and domestic adjustments to prevent macroeconomic instability and imbalances, affected the monetary side (Torres 2015). They came to put at risk even the survival of the monetary union. The sovereign debt crisis thereby added urgency to the completion of the economic union side of EMU. Member states responded by seeking to address the causes of the crisis, namely banking sector fragilities, budgetary disequilibria and competitiveness differentials between member states.

2. ATTEMPTS AT COMPLETING EMU DURING THE CRISIS The process of creating new institutions and mechanisms displayed significant political and institutional resilience in the face of the crisis. The crisis triggered advances in economic governance that took place through a multitude of successive steps, driven by market pressure and motivated by the need to ensure the survival of EMU. As a result, since 2010 different measures have been adopted with a view to strengthening fiscal discipline and economic coordination, which have come to address some of EMU’s fragilities. These responses, together with the creation of the European Stability Mechanism (ESM) as a permanent rescue fund, new arrangements for financial regulation and supervision and better tools for macro-prudential supervision, arguably reduce the risk of future crises and strengthen the capacity for crisis management.3 However, as pointed out by Sapir and Schoenmaker (2017), the turning point came in 2012 with the creation of the ESM and the first step towards a European banking union, as they paved the way for

2

The Maastricht Treaty had no common provisions to deal with a banking crisis or with a sovereign debt crisis. Besides monetary union and the European Central Bank (ECB), there was only a surveillance and correction mechanism, the SGP, which as we stress above was not enforceable, and non-binding commitments through the Lisbon Strategy. 3 See Torres (2015) for a review of the main adopted measures.

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the ECB’s ‘whatever it takes’ stance and for the creation of the Outright Monetary Transactions (OMT) facility. This latter facility allows for the purchase of government bonds on the secondary market by the ECB (conditional on an ESM adjustment programme or a precautionary credit line). Still, the ESM cum OMT can only cope with liquidity crises and not with insolvency crises. The EU presidents’ reports (Van Rompuy et al. 2012; Juncker et al. 2015a and 2015b) and more recently the European Commission’s Reflection Paper on the deepening of EMU (European Commission 2017) set out to address EMU’s design flaws. Generally speaking, those derive from the fact that the functioning of an economic and monetary union, as compared to a stand-alone economic union, makes additional demands on the economic union side (notably on labour, product and financial markets with regard to flexibility and coordination requirements), which were previously unaccounted for. The presidents advocate the necessity to respond to the Eurozone crisis by completing EMU’s economic union part by creating a ‘genuine EMU’ (GEMU). It is composed of four strands (the first three of them economic), constituted by a banking union, an integrated budgetary framework, an integrated economic policy framework and enhanced democratic legitimacy and accountability of EMU governance. The necessary convergence of preferences for a GEMU was already difficult to achieve in light of increasing EU membership numbers and more heterogeneous member states, but progress was further complicated by the fact, already referred above, that membership in the Euro area sub-club – where interdependencies are larger and the completion of EMU governance is more urgent – has remained smaller than the EU club’s. The announced departure of the United Kingdom (UK) from the EU leaves only one member state with an opt-out from EMU, namely Denmark, which however shadows the Eurozone. All the other (present or future) member states are to join EMU at some time, upon fulfilling the prerequisites (or at least they so committed when they joined the EU).4 So far, however, efforts to create a GEMU have only made limited progress. Fiscal integration did not progress much since 2011. On the other hand, financial integration (banking union) progressed substantially, although one-and-a-half of its three pillars are still missing. And with regard to an enhanced democratic legitimacy and accountability of EMU governance, the institutional steps taken during the crisis appear not to have been significant. One should however point out that a non-negligible informal bottom-up process of political integration has been occurring through the substantially increased politicisation of multi-level governance (Begg et al. 2015; Torres 2015). That notwithstanding the crisis has so far not mobilized governments and citizens around a new impetus for European integration.5 4

With the exit of the UK, Denmark is the only member state that has an opt-out. All the others will have either to join EMU at some point or re-think their permanence in the EU, possibly moving to a lower integration stage, with lower political commitments and sovereignty sharing, such as the European Economic Area (EEA). 5 A notable positive exception is France’s new stance on the need to reform and complete EMU since the election of President Macron.

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Among GEMU’s four strands, it was the integrated economic policy framework that has progressed the least during the crisis and especially so since 2012 (Mongelli et al. 2016; Bongardt and Torres 2016a); it is still far from the level required to sustain EMU. One can therefore argue that the resilience of EMU is conditioned on the one hand by the completion of EMU governance (which the UK’s exit from the EU, Brexit, a priori will facilitate) but that it still hinges on the creation of sufficient adjustment capacity (and ownership of reforms) at the member state level, where preferences (not least due to a negative narrative of scapegoating the EU in national debates) have been slow to converge. We argue that these two sides of the reforms (new and more accountable European institutions and national adjustment capacity) are mutually reinforcing, contributing to a stronger EU identity, built around its core, the Eurozone.6 Member states that are not prepared to go along with these two lines of reform will become ever more peripheral and may well come to trigger article 50 of the Treaty on European Union (TEU) and leave the EU at some point.

3. WHAT IS MOST IMPORTANT IN THE NEXT PHASE OF INSTITUTIONAL REFORM? A growing consensus has formed on the causes of the crisis (Baldwin et al. 2015) and also on EMU’s fragilities.7 There is also some agreement on the necessary steps to complete EMU8, which in general include: completing the missing one-and-a-half pillars of the currently incomplete banking union; breaking the feedback loop between banks and their over-indebted sovereigns; securing Eurozone-wide risk sharing for dealing with Europe-wide shocks and coordinating fiscal policy/national fiscal policies while reinforcing discipline at the national level; some sort of sovereign debt restructuring mechanism for the Eurozone in order to redistribute the burden of legacy debt (“cleaning up the legacy debt problem”); and advancing structural reforms to push the Eurozone more towards an Optimum Currency Area (OCA) or at least a sustainable currency area (SCA).9

6

As pointed out by Alesina et al. (2017), the main impediment to further European political integration has not been heterogeneity of tastes or of cultural traits, but other cleavages like parochial national identities. See also Bongardt and Torres (2017b and 2018) and Jones and Torres (2015). 7 Academics had called attention for EMU’s incompleteness from the very beginning – see for instance Giavazzi and Wyplosz (2016). 8 See for instance Baldwin and Giavazzi (2016), Bénassy-Quéré and Giavazzi (2017) and Buti et al. (2017). 9 For a discussion of the concept of a SCA in contrast to an OCA, see Torres (2009).

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At the same time, there is an on-going debate on whether fiscal policy needs to be centralised or not10 and on the role of the ECB as a lender of last resort11. However, the legacy debt problem seems to be the most important political obstacle that stands in the way of most of the other necessary corrections. There are various proposals for a limited set of measures to be implemented as fast as possible, without any need for deepening political or even economic integration for which there has been little appetite.12 However, all of these proposals encompass the creation of some fiscal space at the level of the Eurozone and some sort of (more or less limited) programme of debt consolidation/restructuring. An important political obstacle, emphasized by Sapir (2016), is the resistance to creating Eurozone-wide risk sharing for Europe-wide shocks (begging for increased fiscal integration) for fear that structural weaknesses in some countries, in particular in the functioning of labour markets, may lead to structural rather than temporary fiscal transfers. There is therefore a need to bring together the ideas of risk reduction and risk sharing. As pointed out by Buti et al. (2017), while risk sharing without a strategy of risk reduction may foster moral hazard and increase risk, the absence of risk-sharing arrangements can also result in higher risk of market instability. That is why the European Commission’s Reflection Paper on the deepening of the EMU (European Commission 2017) proposes to complete a genuine financial union as the more urgent task, and only thereafter to achieve a more integrated economic and fiscal union and to strengthen Eurozone institutions and their accountability. The priority is therefore to agree in 2019 on a backstop to the Single Resolution Fund (SRF), in order to make the new EU framework for bank resolution effective, and the setting up of the European Deposit Insurance Scheme (EDIS), to protect bank deposits across the Eurozone in the same way. Those two pillars of the banking union should be in place and fully operational by 2025. At the same time, member states should agree and implement a comprehensive strategy to reduce the non-performing loans and further develop the capital markets union. A more integrated EU capital market will contribute not only to increased risk sharing through private channels, with financial markets absorbing shocks in the Eurozone, but also to redirecting savings in surplus countries to the rest of the Eurozone through equity rather than debt, thereby reducing the risk of financial instability (Buti et al. 2017). Although it seems more or less consensual among academics, policy makers and politicians that the one fundamental ingredient (and priority) for a sustainable monetary 10

See De Grauwe and Ji (2016a and 2016b) and Tabellini (2016) for arguments in favour of the need for fiscal centralization and Eichengreen and Wyplosz (2016), Gros (2016) and Sandbu (2017) for arguments in favour of fiscal decentralization. The two latter authors argue that a banking union would suffice to sustain EMU. As put by Sandbu (2017), it ‘mimics a fiscal risk-sharing that surplus economies of northern Europe resist and peripheral deficit economies demand’. However, a European-level stabilisation policy would still be lacking. For the different economic and institutional views on completing EMU, see Macedo (2017). 11 See De Grauwe (2013), Eichengreen (2014), Torres (2013) and Feld et al. (2016) for a discussion. 12 Corsetti et al. (2016) put forward a mechanism to redistribute the burden of legacy debt over time and only to a minimal extent across countries, which does not require debt mutualisation or a joint debt guarantee.

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union is the completion of the banking union13, the question is whether it is not necessary or at least desirable to move towards increased fiscal integration at the same time.14 It may be possible to rely on a hard no-bailout clause to prevent moral hazard and a fully functioning banking union, although there will be no European-level stabilisation policy, which is arguably a suboptimal solution. In any case, as put by Wolff (2017), fiscal policy in the Eurozone is and will remain a difficult balancing act between national politics and European interests. In a second phase (2020-25), the Reflection Paper recommends completing EMU’s architecture with a European safe asset as to allow for market discipline (in case of excessive exposures to sovereign bonds) but reduce the risk of sudden stops, and a change in the regulatory treatment of sovereign bonds. It also proposes a central fiscal capacity in the Eurozone to improve macroeconomic stabilisation of the monetary union15, which would add up to (a simplified) SGP and a fiscal backstop for the SRF. Beyond a stabilization function, a specific Eurozone budget or a reinforced European budget (an idea also proposed by France and in principle accepted by Germany) could also promote convergence in the Eurozone, which would require a stable revenue stream. The EU/Eurozone budget should then be reformed to focus on European public goods. At the same time, democratic accountability can and should be reinforced. The relevant provisions of the Fiscal Compact can be integrated into EU law, as agreed by 25 EU member states when they concluded the Treaty on the Stability, Coordination and Governance in the Economic and Monetary Union (TSCG), which will be easier after Brexit. Without a euro-area safe asset (as proposed by the 2017 European Commission reflection paper; see also Buti et al.) the ESM cum OMT remains crucial for solving the problem of self-fulfilling debt crises (liquidity crisis). Turning the ESM into a European Monetary Fund (EMF) has already been agreed between France and Germany. Still, two rather different if not opposing perspectives on what should be the role of the EMF would have to converge in order to have a common blueprint that works.16 Therefore, to work well and to be politically acceptable for both parts involved, this risk sharing function of the EMF must go hand-in-hand with the reduction of the risk of sovereign and banking crises (Sapir and Schoenmaker 2017; Bénassy-Quéré et al. 2017). 13

See Baldwin and Giavazzi (2016), Eichengreen and Wyplosz (2016), Gros (2016), Gros and Belke (2016), European Commission (2017) and Sandbu (2017). 14 Eichengreen and Wyplosz (2016), Gros (2016) and Sandbu (2017) favour a banking union without a fiscal union while De Grauwe and Ji (2016a and 2016b), Tabellini (2016), the European Commission (2017), Buti et al. (2017), Sapir and Schoenmaker (2017) and Wolf (2017) defend some elements of a fiscal union. 15 This function can take the form of different (non mutually exclusive) options, such as a European Investment Protection Scheme, a European Unemployment Reinsurance Scheme and/or ‘a rainy day fund’. 16 As in other cases, the two countries, which represent a Eurozone divide, see it from different perspectives: as a way for risk sharing, in the case of France, or as a means for risk reduction, in the case of Germany. Sapir and Schoenmaker (2017) stress that the EMF could achieve a balance between market discipline and risk sharing as it would have an increased capacity to intervene early in a sovereign or banking crisis rather than to act only as a last resort, as was the case of the ESM.

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The EMF should act as a fiscal backstop to a complete banking union. Furthermore, as suggested by Sapir and Schoenmaker (2017), it should deal with both sovereign debt crises (restructuring sovereign debts without a banking panic) and banking crises in order to effectively prevent sovereign-bank ‘doom loops.’ Doing so, it would go beyond the ESM cum OMT (liquidity) programme and would be a permanent fiscal counterpart of the ECB. As for the governance of the EMF, it would clearly benefit from being integrated into the EU legal framework, as defended in the Commission Reflection Paper, as to allow the EMF to be also accountable to the European Parliament (Buti et al. 2017). Moreover, the EMF, even if it remained an intergovernmental institution, should be able to decide by qualified majority and not by unanimity (Wolff 2017; Sapir and Schoenmaker 2017) that seriously affects its (or currently the ESM’s) capacity. A Eurozone finance minister, an idea that has also gathered some consensus between France and Germany, could be the permanent chair of the Eurogroup. The European Council, subject to the approval by the European Parliament, would appoint the finance minister, who would represent the interests of the Eurozone and would regularly appear before national parliaments and the European Parliament.17 The Eurogroup itself should be developed into a Eurosystem of fiscal policy (EFP) as the centre of Eurozone fiscal governance along the lines suggested by Sapir and Wolff (2015) and later on be integrated into a European Treasury, which would have additional competences. The unification of the Eurozone's external representation should also proceed. What is however very important at this stage is the dynamics, symbolism and politics of the model of integration that the EU is pursuing. In our opinion, a reform of institutions that is too modest (and apolitical, without increased accountability) tends to backfire, as citizens fail to understand (and dislike) such half-hearted (technocratic) solutions without clear political objectives. European politicians need to dare to take more risks and engage in explaining the objectives and merits of further integration, as seems to be the case of President Macron in France. Paralysis or (even worse) mimicking a Eurosceptic stance of rival populist parties for fear of losing votes tends just to benefit the latter, as people tend to prefer originals to copies. Brexit is a good example: between a ‘pro-remain’ Eurosceptic camp and a more genuine ‘pro-leave’ Eurosceptic camp UK voters chose the latter. In our opinion the outcome of the referendum (to leave the EU) is less damaging for the EU and for Europe (and thus also for the UK) than a victory of the ‘pro-remain’ camp (based on the infamous EU-UK agreement of February 2016, a rather undemocratic capitulation of the European Council in the face of UK prime minister Cameron’s anti-EU demands) would have been, which would have led to an amplification and continuation of UK exceptions, red lines and permanent obstruction from within the club and to the demise of the European project.

17

The dialogue between the European Parliament and the other institutions acting on behalf of the Eurozone should also be extended and formalized.

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4. WILLINGNESS TO REFORM AT THE NATIONAL LEVEL Apart from the completion of a banking union and progress towards fiscal integration and other necessary changes, any attempts at moving the Eurozone closer to an OCA, or to at least transform it into a SCA, require reforms in areas where competencies have remained national. For the time being, it is therefore only possible through structural reform and adjustment capacity at the member state level. It follows that next to the above-referred necessary institutional changes, adjustment capacity and the willingness to implement economic reforms at the member-state level remain crucial for a better functioning monetary union. In fact, the above-mentioned EU presidents’ reports advocate that policy adjustment in the Eurozone cannot rely on macroeconomic policies alone, and that economic integration would have to be pursued along the lines of creating stronger incentives for structural reforms in low-productivity countries. This would allow the Eurozone to better meet the economic requirements of a currency union by improving the overall stability of EMU to macroeconomic shocks. The issue remains how to achieve structural reform, given that competences and policy instruments are in the remit of member states. In the sovereign debt crisis, market pressure and conditionality have provided additional enforcement mechanisms for softly coordinated economic reforms. The new crisis-enacted mechanisms and the conditionality-linked availability of funds (for those countries that were cut off from capital markets for their financing needs) seem to have positively affected the implementation of structural reforms.18 On the other hand, while ECB actions have had the effect of buying time for the implementation of reforms at the national level, this has simultaneously alleviated market pressure on member states to reform. In a context where fiscal policy is also constrained by the need to ensure a proper fiscal adjustment, which is due to the need for an enduring correction of the budgetary imbalances, economic reforms are even more important. The reason is that structural reform can increase the credibility of the adjustment programme whereby a more gradual fiscal adjustment can be achieved (Bini-Smaghi 2016). As Draghi (2016) emphasizes, even supporting demand is not just a question of the budget balance, but also of its composition, especially the tax burden and the share of public investment; put differently, fiscal policy can be used as a microeconomic policy tool in that it can enhance growth even when public finances require consolidation.

18

This is true even for Greece, at least until 2014 (Schmieding and Schulz 2014; OECD 2015).

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4.1. Sustainable Growth A sustainable growth strategy with structural reforms at the national level emerges as a pre-condition for a credible exit strategy and a durable recovery, with a view to higher potential growth (Draghi 2015 and 2016) and therefore for dealing with legacy costs and for successful crisis exit. According to the ECB (2015), the smooth functioning of EMU warrants growth that is sustainable in the long run, which implies that any economic recovery from the crisis needs to be durable. Sustainable – not only economically but also environmentally (that is, environmental damages and resource depletion and long-term, inter-generational effects have to be internalized) – growth thereby offers both a crisis exit strategy and adds to the wider benefits from EU integration, and only in that case it is also politically sustainable. EMU can be sustained both in the more immediate crisis context and in the long run as part of a political sustainable integration project, which envisages high-quality growth and respects longer-term budgetary challenges (Begg et al. 2015). The problem is that whereas appropriate structural reforms are growth enhancing in the long run, they often fail to bring about immediate benefits (IMF 2015), while causing frictions at a high political cost when they collide with entrenched interest groups or affect vulnerable social groups. With the sovereign debt crisis, the common objectives to which member states committed under the Europe 2020 Strategy have come to encompass increasingly salient political and distributional issues, not only in but also between member states. Since competencies (and instruments) have remained national, the enforcement, under market and peer pressure and conditionality, of reform objectives to which the member states had already previously committed carries the risk of being perceived as intrusive. In the case of monetary policy, the European Central Bank, to which the conduct of monetary policy has been delegated in the EU, has consistently stressed the importance of structural reform for EMU’s smooth functioning (see for instance ECB 2015).19 While ECB actions – just like a more expansionary fiscal policy stance in the Eurozone – can buy (and indeed have bought) time so that member states can address their structural problems, they cannot solve them (monetary policy can smooth cyclical shocks but it is unable to solve structural problems). Structural reforms are therefore a precondition for generating sustainable growth and for putting countries on a higher potential growth trajectory (ECB 2015; Draghi 2016). With regard to budgetary constraints, one should note that a fiscal stimulus (even if feasible) as such is unlikely to give rise to quality growth, unless it deals with the causes of competitiveness problems and provides the right incentives. Incentives for growth can be provided not only through the level but also and perhaps more importantly by means of

19

As stressed in Torres (2013), the ECB became a guardian of EMU given that the EU’s political system per se seemed incapable of providing timely and consistent solutions.

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the composition of expenditure and incentives on the revenue side, notably taxation (Giavazzi and Wyplosz 2016; and Begg et al. 2015; Bongardt and Torres, 2016a; Draghi, 2016). In addition, regulation (market rules) can be used to foster private green investments without incurring fiscal expenditure. Taxes carry a double dividend, in that they discourage inefficient behaviour and also provide receipts for the state.20 The abolition of incentivedistorting inefficient subsidies (negative taxes), like the ones on coal, likewise reduces government expenditure and improves the state of the environment by lowering carbon emissions. The use of economic instruments (like taxes and transferable emission licences) that have dynamic efficiency properties promotes innovation and provides least cost abatement of pollution; as such they are very much in tune with the Europe 2020 Strategy goals of (green) growth.

5. THE EUROZONE AS AN ANCHOR FOR DIFFERENTIATED INTEGRATION AFTER BREXIT As we have argued elsewhere (Bongardt and Torres 2016b), it is in the interest of both the EU and discontent member states that do not wish to contribute to (participate in) the club’s public goods (institutions), apparently also the case of some other EU members besides the UK, to leave the EU. The fundamental lesson from Brexit is that the EU will need to focus and deliver on EU common goods in order to be sustainable. There are therefore limits to what differentiated integration can achieve, as a loose intergovernmental arrangement to accommodate all different preferences would come at the expense of the Eurozone and in consequence it would mean the end of the European integration project as an ‘ever closer Union.’21 For the EU to function the Union needs a political core and a shared identity and destiny, and it is the Eurozone that has established itself as the core circle of European integration. As a consequence it should not be the EU that has to adapt to permanent divergent preferences of given countries (some of them joined the EU upon the condition to join all of its institutions such as the Euro but seem to have changed their intentions) but rather those countries that have to decide whether they want to stay in the Union (and fulfil their commitments) or to leave it, possibly for a lower (and less political) level of integration (for instance the EEA, as is the case of Norway). That is why it is important to have explicit provisions not only for entry but also for exiting the EU. 20

However, EU level fiscal instruments still require voting by unanimity in the Council of the EU. Member states are free to impose taxes or cut subsidies at the national level but they are reluctant to do so if that implies competitiveness (cost) disadvantages in the internal market. 21 In our view, differentiated integration is only sustainable if anchored to the EU’s (economic and political) core, which is the Eurozone.

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In an EU club whose integration objectives have advanced since the Maastricht treaty to EMU, the UK had been harbouring preferences for a stand-alone (and incomplete) economic union. Once the Eurozone became established as the de facto core of European economic and political integration, those different UK preferences became untenable. During the global (economic and financial) and especially the Eurozone sovereign debt crisis, the UK’s stance started to collide with the need to make European monetary union work. It became clear that further integration and institution building were needed in the economic union sphere to impede the unravelling of monetary union, and with it of European integration achievements like the single market (as it cannot be treated as static with regard to EMU requirements, notably with regard to financial services). The UK’s stance had not only been limited to maintaining the country at the margin of economic governance advances during the global financial and especially the sovereign debt crisis but it also actively tried to impede them, even by employing its veto. Because of the UK’s veto, the TSCG could only come to life as an intergovernmental treaty outside the EU legal framework. The UK did not participate in the Euro Plus Pact and in the European Banking Union either. Moreover, the UK did not wish to constructively assist any of the member states whose economies underwent adjustment (bailout) programmes either. It did not participate in the European Financial Stability Facility (EFSF) or the ESM, having made an exception only for Ireland, to whom it was in the UK’s national interest to provide bilateral loans in light of financial sector interdependencies (Bongardt and Torres 2017a).22 Paradoxically, the UK has benefited significantly from (been free-ridding on) the Eurozone, most notably because of a high proportion of euro-denominated financial activities taking place in the City of London23 and because of privileged access of UK banks to the ECB’s liquidity operations during the global financial crisis. Still, even after the UK triggered article 50 TEU in March 2017 to leave the EU, the ‘Remain’ camp kept pushing for the UK to stay in the single market while adhering to policies of its choice, which is not reconcilable with the need to pursue institutional reform in the Eurozone to make it sustainable. Needless to say, such a pretension is also not acceptable for the other member states. Brexit will therefore make it easier for the Eurozone to go ahead with necessary institutional reforms to complete EMU, notably to bring intergovernmental economic agreements into the Community framework at some stage. The departure of the UK opens up the perspective to gear financial regulation in the single market better towards the Eurozone’s public good of financial stability, thereby reinforcing the economic union in a crucial area for the monetary union.

22

The same did not happen in the case of Greece, where the UK even insisted on guarantees that it would be exempt from loan guarantees granted against the EU budget. 23 This is unlikely to continue after Brexit, as normally these (potentially financially destabilizing) activities should be done inside the regulatory area under the control of the ECB.

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CONCLUSION EMU is a political project that has triggered and still requires further integration. Making monetary union work requires completing EMU’s economic union side so that it can sustain the single currency and deliver on the EU’s wider objectives. The single market can therefore not be seen as static, as it has to be deepened to make EMU sustainable in light of the increased interdependencies between its members. Doing so requires not only a political willingness for meaningful structural reform at the member state level but also for significant advances on EU-level governance. These two sides of the reforms (national adjustment capacity and new and more accountable European institutions) are mutually reinforcing, contributing to a stronger EU identity, built around its core, the Eurozone. On the other hand, the EU’s capacity to shape globalization in line with citizens’ concerns (not merely growth-oriented but in a more inclusive and greener manner, in line with the Lisbon and Europe 2020 Strategies’ objectives) will be critical for the support of the project. The dynamics, symbolism and politics of the model of integration that the EU is pursuing are key. In our opinion, a reform of institutions that is too modest (with apolitical and unaccountable institutions) tends to backfire, as citizens fail to understand (and dislike) such half-hearted (technocratic) solutions without clear political objectives (trying to somehow hide or downplay the necessity to share sovereignty in order to achieve the common good). The same is true for national adjustment capacity and reform willingness – it cannot be half-hearted (playing the anti-austerity mantra for the median voter) but has to correspond to clearly stated political objectives. Member states have to decide what model of society they want to build and whether they want to do it inside the EU cum EMU with the objective of an “ever closer Union” or outside the European integration project. Member states should therefore be prepared either to contribute to those aims or to seek alternative forms of association with the Union (perhaps as members of the EEA, like Norway). European politicians need to dare to take more risks and engage in explaining the objectives and merits of reforms and of further integration. Paralysis or even worse, mimicking a Eurosceptic stance of rival populist parties for fear of losing votes, tends just to contribute to economic crisis and on top of it to backfire, as people tend to prefer originals to copies.

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Van Rompuy, H. with Barroso, J. M., Juncker, J.-C. and Draghi, M. 2012. “Towards a Genuine Economic and Monetary Union.” Four Presidents’ Report - Report by the Presidents of the European Council, European Commission, Eurogroup and the ECB). Brussels, 5 December. Wolff, G. 2017. “Beyond the Juncker and Schäuble visions of Euro-Area Governance.” Policy Brief 6, Brussels: Bruegel, November.

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ISBN: 978-1-53613-474-2 © 2018 Nova Science Publishers, Inc.

Chapter 10

DOES THE EUROPEAN ECONOMIC AND MONETARY UNION REQUIRE A SOCIAL DIMENSION? José Manuel Caetano1,* and Nuno Rico2 1

CEFAGE-UE, University of Évora, Portugal Department of Economics, University of Évora, Portugal 2 DECO, Proteste –Defesa do Consumidor, Portugal

ABSTRACT The economic and financial crisis that gripped Europe after 2008 had negative effects in some Eurozone countries, displaying structural flaws in the EMU’s design. These effects have threatened their social systems, undermining the political viability of European integration. In this context, at the end of 2012 the social dimension entered the political debate through the Five Presidents report, which brought new elements to ensure the Euro´s stability. Since then, other initiatives have taken place, recognizing that the Euro´s governance is still incomplete. The article discusses the need to include the social dimension in the EMU, evaluates the initiatives that have been taken in this area and approaches the conditions to enable central macroeconomic stabilization mechanisms to absorb specific shocks and improve resilience in the EU.

Keywords: European Union, economic integration, social dimension, structural reforms

*

Corresponding Author Email: [email protected].

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1. INTRODUCTION Europe was still rising from the rubble of World War II when on 9 May 1950 Robert Schuman presented European leaders at the time with a Statement for an ambitious project to ensure peace and harmonious development in Western Europe, joining the opponents of the conflict which had ended 5 years before. This Statement is considered the beginning of the project of economic integration in Europe, unprecedented in the world, and only through concrete achievements could effective solidarity among countries be created. These were the guiding principles of the European Economic Community (EEC) created in 1957 by the Treaty of Rome, which has promoted peace and welfare in Europe over the last decades, based on concrete initiatives. The EEC began as a Customs Union, when six countries1 decided to abolish the tariff barriers between them and create an external common customs tariff. Sixty years later, the project has evolved into an Economic and Monetary Union (EMU), in which 19 of the current 28 members of the European Union (EU) share the same currency – the Euro. To achieve this process, it was necessary to coordinate some macroeconomic policies and centralize others in supranational institutions, transferring competencies to the new entities created. Despite the advances and setbacks that have occurred over the last decades, we can conclude that the project of economic integration has been successful. It played a decisive role in the economic and social progress of the EU Member States, generating synergies that have spread to countries which are not members and contributed to political stability and socio-economic progress in Western Europe. Through community policies in various areas, among which we highlight structural and cohesion policies, the EU has influenced citizens’ well-being and created some feeling of belonging to a common project. The successive enlargement shows states’ commitment to the principles underpinning the sharing of sovereignty in favor of a more prosperous and secure society. Despite these achievements, there are still significant economic disparities between Member-States. The global economic and financial crisis, that has hampered the EU since 2007, in particular some countries in the Euro Zone, and problems with the functioning of the European Union, have resulted in disturbing symptoms of contesting the European project. Recent years have witnessed the propagation of waves of populism and nationalism throughout the EU, contesting openly the economic integration process. This crisis, which started in the United States, quickly spread to Europe and showed the weakness of the EMU project, due to the high levels of public debt in some countries in the Euro Zone and its effects on some countries’ financial sustainability and on the single currency itself. The crisis exposed the weak convergence in Member-States’ development, also showing some structural differences in the process of European integration. 1

France, Federal Republic of Germany, Italy, Belgium, Netherlands and Luxembourg.

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Nevertheless, it was not just at the economic level that the crisis exposed the weaknesses in the European construction process. The hesitant and delayed reaction of the community institutions to the crisis revealed the limits of the EMU provided by the Treaties, confirming the warnings that have emerged since the 1990s, questioning the viability of this model of EMU. Economic theory has stated that in a monetary zone in which several countries have the same currency, due to the possibility of asymmetric economic shocks, the ability to promote adjustment will depend on the degree of labor mobility, the flexibility of markets, production factors and those of goods and services, and also the capacity of the budget policy to stabilize the economy. Therefore, an efficient monetary zone must support the adjustment of countries affected by these shocks and have the means to prevent the spread of its effects among its members, allowing economic stabilization. Euro Zone countries are very heterogeneous and show reduced synchronization in their economic cycles, exposing some countries to asymmetric shocks. Furthermore, there is low labor mobility within the EU and little market flexibility. In this scenario, with the absence of central mechanisms to support and stabilize the economy, the countries suffering the most adverse financial and economic conditions find it difficult to recover. For reasons that will be presented later, the effects of the crisis were greatly felt at the social level, especially in the most vulnerable countries in the Euro Zone. The austerity measures taken to fight the crisis exacerbated these effects, reinforcing pressure for the inclusion of a social dimension in the EMU, in parallel to the economic, budgetary and banking features. The social pillar was assumed by EU leaders recognizing that the Euro Zone had structural flaws, preventing the most fragile countries from being protected and threatening their social systems. In this context, the report “Towards a true economic and monetary union” (European Council 2012) has brought to the political debate the search for solutions to safeguard the stability and integrity of the Eurozone. The document indicates self-criticism regarding the failures of the Eurozone architecture, in view of the risks to which its members were exposed in the sovereign debt crisis. Recognition that the EMU was incomplete, and Europeans’ growing skepticism regarding the European project, led to new institutional and academic initiatives to discuss sustainable models for the that project. Following on from the European Commission’s White Paper on the Future of Europe ((European Commission 2017-c), this entity presented a series of reflections on the future of the EU, notably the following documents: The Social Dimension of Europe (European Commission 2017-b) and The Deepening of Economic and Monetary Union (European Commission 2017-c), which we will address later. In view of the above, this chapter aims to achieve the following objectives: identify some flaws in the monetary integration process and the reasons that justify the inclusion of a social dimension; evaluate the proposals to achieve the social aspect, reconciling the defense of the “Social Europe” heritage with the need for budgetary rigor inherent in the

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EMU; and finally discuss the creation of financial mechanisms to support structural reforms and absorb the effects of specific shocks with a view to improving the social and economic resilience of the Eurozone.

2. THE FINANCIAL CRISIS REVEALED AN INCOMPLETE EUROPEAN MONETARY UNION Different theoretical frameworks can be considered as a basis for the existence of an EMU, with Mundell’s theory of optimal currency areas (OCA) being the classical reference. This theory holds that, in order to take advantage of a common currency in a group of countries, there must be strong symmetry in the economic structures of these countries and in the synchronization of their business cycles. However, in the case of the Eurozone, the asymmetries in structures and business cycles remain, even after the creation of the Euro (Lukmanova & Tondl 2017). At the same time, the degree of fiscal coordination and fiscal integration remains low (Andrle et al. 2015). Given the constraints on national economic policies, economic symmetry and convergence among EMU members is central to ensuring system-wide stability. The absence of symmetry leads to asymmetric shocks, which deepen economic divergences between countries, undermining the integration process. In the case of the Eurozone, the means to respond to exogenous economic shocks, such as those occurring after 2008, were limited and could only be applied with common policies, which can indeed produce disparate effects when economies are at different stages of their business cycles. The Stability and Growth Pact (SGP), established in 1997 and revised in 2005, lays down rules for coordination and discipline of budgetary variables in the EMU. Its main objective is to obtain member-states’ commitment to budgetary discipline, avoiding policies that undermine the Zone’s macroeconomic stability. At an early stage, the SGP has already promoted some sustainability of national public finances. However, in 2003, its credibility was affected when France and Germany saw the application of financial penalties suspended after their budget deficits had exceeded their target limits. In 2005, some SGP rules were modified, giving it more flexibility, but without great practical effects on the public finances of the Eurozone countries (Schuknecht et al. 2011). Over the years, non-compliance with the SGP has continued in a number of countries, with Community institutions complacent in applying penalties to offenders. In 2016, the European Commission’s sanctions against Portugal and Spain for excessive deficit are an example of some discretion in the application of these rules. When the subprime crisis began in 2008, after the collapse of Lehman Brothers in the US, its implications for the economies of the Eurozone were not imaginable. Indeed, the crisis has caused enormous instability in European financial markets, undermining the

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soundness and viability of many financial institutions which had in their portfolio many ‘bad’ loans and high amounts of sovereign (national) public debt. The erratic and belated way in which the European institutions dealt with the crisis allowed it to spread. Only after the phase of major financial turmoil in the US had passed did the European Council acknowledge that the crisis could have serious implications for the EU’s financial stability. With European leaders focusing solely on the euro, Greece, Ireland and Portugal no longer had access to external debt financing. However, even in the face of such signs, the crisis was understood as having originated in the deficiencies of the Euro’s architecture. The situation was considered a debt problem of countries with high budgetary indiscipline, opting to punish defaulters, despite the risk of impending contagion to the remaining Eurozone. With no support from the European Central Bank, as a liquidity provider and lender of last resort, Eurozone members had to issue non-controlling currency debts. As a result, these countries’ governments did not guarantee conditions for debt repayment, such as when they had sovereignty to impose liquidity on the central bank (De Grauwe 2011). In this way, reinforced budgetary discipline in the EU was through harsh austerity programs (Sapir et al. 2014). It is essential to understand the logic of the “Troika” concerning Greece, Ireland and Portugal after 2010, as these procedures had the novelty of being applied in countries integrated in world financial markets and members of a Monetary Union, that is, they did not have their own currency. This gave rise to limitations different from those applying to countries with exchange and monetary sovereignty. Laeven and Valencia (2012) analyzed the different expressions of financial crises, assessing the specificities of their occurrence within an EMU, admitting that the financial turmoil can originate in three types of crises: banking, sovereign and balance of payments (BP). First, bank crises can occur in any currency and currency regime. In the case of the Eurozone, an institution should have been provided as a “lender of last resort” to provide the necessary liquidity and support countries in crisis situations, avoiding the contagion between bank debt and public debt (Buiter and Rahbari 2012). In the EMU structure, national central banks no longer have this function and the ECB has not exercised it since the beginning of the process, limited by its statutes and by political pressure from the most influential countries in the Eurozone. Consequently, the contagion effect was not avoided (Enderlein et al. 2016). Secondly, in the sovereign debt crisis, the greatest difficulty concerns the prohibition of monetary financing of public debt. However, the EMU architecture had no structure to deal with the crisis management function, as Eichengreen and Wyplosz (1998) pointed out. Despite financial integration in the early years of the euro, responsibility for prudent supervision and crisis management was at the national level. This has resulted in insufficient coordination of responses from the EU and its members. Finally, BP crises were considered unlikely in an EMU, assuming that funding would be provided by private actors and that States would not be exposed to speculative attacks.

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In this sense, the One Market, One Money report, which lays the foundations for the creation of the single currency, acknowledged that, with the EMU, BP restrictions would no longer weigh on Eurozone countries (European Commission 1990). Despite the IMF’s experience in dealing with financial crises, Pisani-Ferry et al. (2011) acknowledge that the “Troika” entities were not prepared for a sovereign debt and BP crisis in the Eurozone. In fact, member-states, as the ultimate guarantors of the solvency of private agents under their jurisdiction, especially banks, have centralized their risks. At the same time, banks with a lot of sovereign debt in their balance sheets accumulate risks of possible issuer insolvency, especially the State itself. The interdependence between the State and banks has led to a rise in a country’s risk, penalizing agents with increased costs of financing their activity. Financial markets reassessed their exposure to the Eurozone countries with the largest budget and BP deficits, raising risk premiums and reducing lending in these countries. Companies located in those countries have harsher financing conditions, with chain effects on the productive structure and economic growth, thus expanding the crisis of public financing to the rest of the economy. In sum, the situation in the Eurozone resulted from the combination of a fixed exchange rate system with total capital mobility, so that without debt monetization and imbalances in the BP, some countries were left without liquidity and no means of action. The measures should have been different from those defined by the Troika, as the biggest problem were the restrictions on financing sovereign debt, since the Eurosystem can ensure support for BP. As proved by the IMF’s recent independent evaluation (IMF 2016), adjustment programs were ineffective, aggravating the social and economic consequences of the crisis. Traditionally, exchange rate adjustment leads to reduction of the real exchange rate, to a level consistent with the external balance. However, with the impossibility of using such policies in the Eurozone countries, the recovery of external competitiveness was based on the adjustment of real costs, which made the process of internal devaluation very arduous at the social level, through so-called social devaluation, as we shall see below.

3. THE IMPACTS OF THE ECONOMIC CRISIS AND THE NEED FOR A SOCIAL DIMENSION Given the impossibility of exchange rate devaluation, the financial aid programs applied to Eurozone countries set an unprecedented benchmark and implied the adjustment of external and budgetary deficits. In 2007, Blanchard affirmed that in the face of a possible crisis in BP in Portugal, a result similar to exchange devaluation could be achieved by reducing nominal wages and the prices of non-tradable goods (Blanchard 2007). The author predicted that the success of internal devaluation would depend on the unions’ resistance,

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not advising another alternative due to low productivity growth and the accentuated trade deficit and unemployment. He suggested resorting to budgetary policy to compensate for the recessive effects on domestic demand resulting from the consequent fall in purchasing power. But the emphasis the EU put on consolidating public finances prevented adjustment programs in the euro countries from adapting to what Blanchard said, since there was no scope for anti-cyclical fiscal policies. In practice, EU rules prevented the compensation effects of austerity measures. Despite successful cases based on this type of intervention, they had not occurred in contexts of generalized economic crisis like that of 2008, which jeopardized this strategy’s success, as was confirmed. With the decline in public sector wages and pensions, conditions were sought for labor reform with a loss of union power. However, the recessive effects and social implications were higher than expected. Alesina and Ardana (2009) defended this strategy, convinced that fiscal consolidation would promote the expansion of economic activity, but this did not occur and there would have been indeed an overvaluation of fiscal multipliers in the adjustment policies applied (Cugnasca and Rother 2015). The severity of the economic recession has left deep economic and social marks in the countries concerned. Theoretically, it is assumed that, in the initial phase of a recession, agents adjust consumption and savings patterns in the short term, but structural changes rarely occur in the medium and long term. In the absence of results, the response of Community institutions was to aggravate austerity measures, creating recessive effects, in a chain of negative impacts on business structure and purchasing power. The effects on unemployment, especially long-term and concerning young people, were also serious, which encouraged emigration and led many qualified young people to leave, reducing the potential for growth. In the peripheral countries of the Eurozone, GDP has fallen considerably, company bankruptcies have increased and there has been an exponential increase in the unemployment rate and poverty levels. Household income declined sharply, falling back, in some cases, to lower levels than at the beginning of the century. Governments have restricted spending, especially at the social level, in order to meet the targets set in the adjustment programs. Thus, there were no conditions to apply measures to stimulate the economy and promote a rapid recovery. This cumulative process has been accentuated by the fall in labor costs, as wages have been reduced by rising unemployment in the countries most affected and the phenomena of social exclusion has increased. This has led to deteriorating economic conditions, prompting some social unrest and open defiance and a loss of confidence in European institutions in some countries (Dotti & Magistro 2016). Due to the Single European Market and the inherent free movement of people and factors, the economic effects were not confined to the countries initially affected and spread across the EU. The search for greater competitiveness, through reduced social protection

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and wages, has led some countries to take measures to safeguard their competitiveness. There has been some “downgrading” of social norms and policies in the EU, with detrimental effects on the European social model (Bush 2013). Thus, due to the misaligned response to the crisis and the lack of coordinated measures, an internal issue of countries with difficulties in financing their public debt has become an EU-wide problem, with the EMU model being unable to respond to crisis. This defensive reaction by some countries, known as “social dumping” (Maslauskaite 2013), aimed at improving competitiveness and boosting exports by reducing production costs, leading to an improvement in the balance of trade. However, such measures in the medium and long term will only be associated with severe social consequences, above all for those most unprotected, which can lead to increased poverty, accentuating the existing asymmetries within the EU. Due to wage reductions and job insecurity, countries have devalued their economies, seeking to strengthen competitiveness with the same effects as a depreciation of the exchange rate, but with more drastic social consequences. Unemployment and labor flexibility reduced incomes and made thousands of people dependent on social emergency measures with little access to basic services. Besides these economic and social effects, there was a greater separation between the central and northern countries of the Eurozone, not only because of the social effects of the crisis, but also because of the different reaction capacity. Although present since the founding of the EU, the social dimension has become politically and institutionally relevant due to the social impacts of austerity policies. In fact, measures to deregulate and reduce social protection have thrown some countries into a spiral of impoverishment, undermining confidence in the European project and the legitimacy of community institutions (De Angelis 2017). The characteristics of this crisis clearly showed the existence of a “social deficit” in the monetary integration project and that its institutions were not prepared for a comprehensive and effective response based on the means at their disposal. In this context, it has become inevitable to make progress in the social field in order to complete the EMU. Fernandes and Maslauskaite (2013) argue that the primary reason for including a social dimension is because the increasing economic asymmetries in the Eurozone have blocked its functioning. Instead of promoting convergence, the EMU has led to greater economic divergence among its members. The social dimension should promote better EMU functioning, with greater synchronization of business cycles, improving the supervision and coordination of policies to reduce structural differences between countries. Greater social convergence, covering education and training, can improve convergence between countries and support competitiveness (Auf dem Brinke 2015). Also, greater labor mobility can reduce the social effects of unemployment, since according to recent data only about 3% of the EU population lives and works outside their country of origin (European Commission 2017),

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which contrasts with the USA, where greater labor mobility mitigates the social effects of economic adjustment processes (Beyer and Smets 2015). In addition, the idea that the Euro has helped to undermine national social security systems has been countered by social competition between countries seeking to regain competitiveness. Competition between countries, when oriented towards innovation, is useful, but when it promotes the reduction of social norms, it can affect the basis of countries’ social models. The conviction that budget adjustment has been at the expense of disinvestment in public social protection systems, challenges the sustainability of the process. Strengthening the social dimension with the creation of common standards and a greater capacity for central intervention in social aspects such as youth unemployment and poverty are crucial to give credibility to the European project.

4. INSTITUTIONAL INITIATIVES TO STRENGTHEN THE SOCIAL DIMENSION IN THE EUROZONE In recent years there has been widespread disbelief in the European project and less popular support for, and trust in the integration process and its institutions, reflected in greater electoral support for anti-European parties and movements. Academic and political figures have also advocated the organized dissolution of the Eurozone and / or the exit of countries from the zone to overcome economic and social problems. Stigliz (2016), a critic of this model of monetary union, says that the Euro had an ill-conceived structure, being a brake on economic growth. He even argues that only the overhaul of its structure can guarantee the success of the EMU. As we have seen, the social consequences of the crisis have brought the social dimension of Europe to the political agenda, as while financial and macroeconomic stability is vital to the credibility of the single currency, social stability is also crucial for citizens’ support for the European project. Concern about social issues has always been present in community policies, and since its genesis this has been a distinctive feature vis-a-vis other regions of the globe. In addition to the rules of the Treaty of Rome, the European Social Fund was set up as early as 1958 to support policies to promote employment and vocational training, especially in lessfavored regions. This was followed by the Cohesion Policy which was instrumental in helping the economic and social convergence of the EU’s poorest countries in the preSingle Market period. In the Eurozone, financial issues have been given priority over other areas, especially social aspects. Despite some EU co-ordination, social policies are the responsibility of national states, and there is no effective European social policy. Therefore, as a consequence of the crisis and adjustment, measures were taken with implications for the most unprotected people, generating growing discontent. Thus, if in the first phase of the

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crisis, European leaders’ attention focused on economic and financial stabilization, from 2012 onwards they became aware of the need to intervene in other areas in order to correct the shortcomings in the EMU’s functioning and mitigate some of the most harmful effects. The publication of the so-called Five Presidents Report 2015, Completing Economic and Monetary Union, (Juncker et al. 2015) was the basis of this change of attitude, launching the institutional discussion on how to complete the EMU. The report suggests steps for this process and changes the type of approach by advocating the creation of instruments to absorb shocks (risk sharing) and strengthening the role of markets to encourage fiscal and financial discipline (risk reduction). A number of documents emerged indicating solutions to structural failures in the architecture and functioning of the EMU. Among other aspects, mention is made of the urgency of ensuring the sustainability of public finances (Delatte et al. 2017) and of creating an automatic stabilization mechanism in the Eurozone that supports the European Social Model and EMU resilience. There was growing consensus that the full functioning of the EMU requires a sound basis and that a budgetary union and a banking union should be the pillars of economic governance in the Eurozone. Despite some disagreement about the priorities and options to choose from, there is currently high consensus in political and academic circles about the need to take additional measures to complete the EMU. Regarding the social dimension specifically, in 2013 the Commission presented an initiative to model this dimension of EMU based on three aspects: strengthening the monitoring and coordination of social and employment policies; defending employment and encouraging labor mobility; reinforcing social dialogue. It has even been suggested that the Council of Ministers for Employment and Social Affairs be given the status and position of ECOFIN in the governance structure of the Euro in order to strengthen coordinated action on social issues. However, the initiatives taken since 2012 only became relevant after the Rome Declaration of 2017, on the occasion of the 60th anniversary of the EEC. This declaration states that “in these times of change, and aware of the concerns that plague our citizens (...) we commit ourselves to work toward: (...) a social Europe: a Union based on sustainable growth that promotes economic and social progress, as well as cohesion and convergence. A Union that will fight against unemployment, discrimination, social exclusion and poverty” (European Council 2017:1). Also in March 2017, the Commission presented the White Paper on the Future of Europe”, which identifies the possible scenarios for the evolution of the European project, and the social issue referred to as vital for ensuring European cohesion. In April 2017, the Commission proposed to reflect on Europe’s social dimension, emphasizing the social legacy as a unique element of the EU in the world context and indicating ways to reinforce the social dimension in the EMU. In fact, social protection in the case of unemployment and illness is higher in the EU than in the US and Japan, but within the EU there are substantial disparities between countries and between regions, which have worsened with the recent crisis. The role of social protection systems and tax

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systems in Europe’s post-war recovery, which helped to reduce income disparities, is recognized. During the recent crisis, however, the reduction in family incomes and the emergence of “social dumping” have called that legacy into question. Given that social and employment policies are a matter for Member States and the enormous challenges in the areas of employment and the sustainability of social security systems, the Commission proposes alternatives to this. Empowering citizens to compete in an ever-changing labor market, and good practice in some countries is crucial to the convergence of standards and social performance in the future. The recent creation of the European Pillar for Social Rights will surely be a landmark for social and employment policy at national and Community level in affirming the European social model. In that White Paper, the Commission assesses possible forms of the social dimension in the EMU, ranging in the degree of integration that member states are willing to accept. In the first scenario, it reduces the social dimension to management of the free movement of people in the EU. Therefore, the Community achievements in the social field would be transferred to a national jurisdiction. The different levels of social protection could lead to competition between countries, given that answers would more easily be defined for the specific problems of each country. However, such an option would certainly exacerbate social differences between Member States, contributing to reduced support for the European project, which could adversely affect consolidation of the European Single Market itself. In the second scenario, based on the experience gained in cases of enhanced cooperation, where groups of countries can advance to higher levels of integration in some areas, defense mechanisms can be created to protect cases of unemployment and / or illness in the member states. This option of “variable geometry” could consolidate rapid progress in some social areas, with a catalytic effect on the other members. However, there is a risk of this path serving to legalize possible situations of “social dumping” and anti-competitive practices in countries that decide not to integrate common initiatives, exacerbating the differences between countries. Finally, the scenario of further development of integration in the social sphere for all States would allow the strengthening of Community financial resources for social policies and a gradual harmonization of social rights in the EU. As the Commission suggested in its Communication of 2013, an indicator panel would be set on the social dynamics and labor market, serving as an observatory for the rapid detection of adverse trends in this area. This option would allow deepening of the single market and enhance citizens’ support for the European project, designing the EU’s role as a reference in this area. Although only proposals for discussion of social issues in the EU, we believe that the alternatives indicated and their implications for the social dimension are a useful and stimulating exercise. A priori, the latter scenario seems to be desirable for the future of the integration project, but appears to be the one most difficult to accomplish. There have been many examples in recent years of obstacles to agreement between the Member States on

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structural options for the problems arising from the crisis. Therefore, there will be difficulties in reaching consensual options and policies and instruments to achieve them. In addition, it is not enough to have indicators showing the problems in due time, but it is necessary to have the resources to implement policies. It will be frustrating if the process is limited to observing reality and revealing discrepancies if Community institutions and Member States have no real capacity to intervene. In fact, we share the vision of Fernandes and Vandenbroucke (2017) that the enhancement of labor mobility in the single market will mitigate the effects of specific shocks, absorbing some unemployment, and increase unfair competition between countries. Factors such as the lack of coordination between pension and social protection systems, lack of information about job offers and the recognition of professional qualifications are obstacles to labor mobility. So, legislative progress to ensure the portability of acquired rights of migrant workers in any EU country is noteworthy, as well as the recognition of qualifications and more information on cross-border employment opportunities. Given the structural changes in labor markets, investment in human capital should be a priority in social policy guidelines. Moreover, the pressure on social security systems to extend the life of professional careers due to longevity should be taken into account. Social protection systems must be adapted to the realities of the labor market, encouraging flexibility and learning throughout life, without jeopardizing rights and social protection.

5. FINANCIAL MECHANISMS TO SUPPORT THE SOCIAL DIMENSION IN THE EUROZONE As we saw in the previous section, the EU will have to concentrate on the principles of the European Social Pillar and on the Commission document on the social dimension to model a new reality for social policies in the EU. Several approaches are possible to respond to the social impacts of the crisis, especially strengthening the surveillance and coordination of policies, greater fiscal integration and the creation of capacity in the EU budget. Meanwhile, possible financial mechanisms to support structural reforms are beginning to be considered. It is this aspect that we analyze in this final section, discussing the need to create a specific budget for the Eurozone. The creation of a separate budget for the euro area has recently been considered in the Reflection paper on the Future of the EU (European Commission 2017-d), proposing the creation of a specific budget for this area. Of course, this is a relevant political issue because it means that the Eurozone and the EU as a whole have different needs, which may justify the existence of separate budgets. The question reveals the debate in the Commission between different views on the future of the EU and the Eurozone, i.e., on which of these views is the real core of the process of economic and political integration.

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In an original approach, Musgrave (1939) advocated that public finance and its budget fulfill three essential functions in the economy: resource allocation, income redistribution and economic stabilization. Taking this into account, Wolf (2017) considers that only the economic stabilization function has distinct characteristics in the EU and the Eurozone. The redistribution function refers to the allocation of fiscal resources between agents, being a political choice based on collective preferences, where each country chooses the appropriate level of redistribution. According to this logic, it will not be easy to transfer the role redistribution of countries to the central level, given the different views on the role of the nation-state that have crystallized over time. But the EU level can supplement national tax regimes. The EU redistribution function has been used to consolidate the single market, and removing barriers to economic flows is not neutral regarding the distribution of income. The Single Market has created the free movement of skilled labor, capital, services and products, and the removal of obstacles causes tensions between countries with different levels of income. The EU has supported the reduction of economic disparities, clearly an aspect related to the EU’s functioning. Having said that, a question arises: has the introduction of the euro meant additional social implications for the single market, justifying a specific budget for the Eurozone? The Commission defined the aspects to be included in the social pillar of the EMU, but did not explain the reasons for its choice, so we deem it useful to investigate the issue further. The single currency increased market integration by removing the exchange rate uncertainty, so that the single market entails a redistributive function, consistent with the requirement of strengthening this function in the Eurozone. But there is little evidence that the Eurozone registers greater integration in the markets of factors and goods and services than other EU members. It is a fact that governments can issue debt if they have unlimited access to this option. The risk for the investor depends on the exchange rate and inflation, but not the nominal value of the investment. Indeed, the EMU has changed this relationship by removing the exchange rate instrument and the ability to use monetary policy to avoid insolvency. It follows that national governments were limited in the use of fiscal policy as a means to stabilize, which is an argument for the existence of a budget for the Eurozone. Using the redistributive function to compensate for the negative effects of the euro makes sense, because the crisis has accentuated the economic and social disparities within the Eurozone. In fact, without the exchange rate, the real adjustment has been slow, high imbalances in current accounts remaining over time, with no form of visible adjustment (Kang & Shambaugh 2016), so that recourse to the redistributive function of a common budget makes perfect sense. Redistribution can then make lasting imbalances between countries. Conversely, there are also reasons of a political and economic nature for the non-centralization of this function. Politically, lasting transfers in the EMU are unsustainable for taxpayers and in

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economic terms these can help to crystallize imbalances. Wolf (2017) considers that the correction of imbalances should be a priority and exercised through pro-active policies and reforms. Thus, the support of structural reform programs to facilitate market adjustments, or even to strengthen the provision of infrastructure, may be relevant. In this context, we emphasize that in assessment of the adjustment programs in Eurozone countries in difficulty (European Commission 2016), the results show some success of the measures to strengthen competitiveness by reducing production costs, especially by sinking wages. Some countries have made reforms in the labor market to give them flexibility and promote the liberalization of specific sectors (Auf dem Brinke and Enderlein 2017). However, countries have not reduced the social effects of liberalization and improved long-term productivity through active employment policies and reform of education and training systems. According to Rubio (2013), two reasons justify this difference: firstly, despite the reforms being crucial to sustain economic and social adjustment, they are undervalued by the financial markets, whose risk perception is based on a short-term perspective; secondly, legislative reforms to liberalize the economy do not require major financial resources, as opposed to what happens to the labor market or the capacity of social policy, which require significant resources and strong coordination of different entities. Thus, the shortage of resources and poor coordination are critical to the absence of effective structural reforms, especially in labor markets, justifying specific funding to support these reforms. Although the adjustment programs solve short-term issues, they do not seem the ideal solution for the biggest problem in these countries. In fact, there is an incentive system to help structural reforms, but the euro area would benefit from a mechanism for temporary financial assistance to promote socially demanding adjustments, as advocated by Delors (2013). The justification for such intervention would be the structural weaknesses of the EMU that led to financial instability and economic deterioration in some of its members. If there had been means to signal and act on the divergences in competitiveness, there would never have been such dramatic situations requiring severe internal devaluation processes. A temporary support instrument, which differs from existing EU funds, could apply to Eurozone countries subject to austerity programs and without budgetary conditions to make costly structural reforms. The purpose would be to support measures to improve the structural competitiveness of these countries’ economies and mitigate the effects of liberalization. With different goals and subject to the Troika program, this support could have flexible provisions for implementing reforms, according to what exists in the structural and cohesion funds. From the reflections of academic and community institutions since 2012 it seems consensual that a response to the social effects of the crisis is to consolidate the European Single Market, particularly the free movement of workers and strengthening the training of human capital to meet the new challenges of the labor markets. Thus, Brinke and

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Enderlein (2017) consider that the EMU will need to enhance investment capacity and apply structural reforms to promote employment, competitiveness and economic growth. One aspect that the Commission focuses on, and that may be relevant in the future, is the creation of a European system of unemployment benefits. Hence Dullien and Fichtner (2013) consider that such a system would have advantages over other types of financial transfers. In fact, the system would depend on short-term unemployment dynamics and generate automatic transfers according to the situation of each country in the business cycle, preventing any country from becoming a permanent net contributor or beneficiary. This stabilizing device would give an immediate response to the social impact of economic shocks to ensure a minimum level of social protection. In short, although Community institutions admit that the social effects of the crisis and adjustment measures have reduced public support for the European project, much remains to be fulfilled. So far, only the guiding principles of social policies in the area are being discussed in terms of financial support mechanisms and ways to finance them. This means that the project supporting structural reforms in the Eurozone seems far from responding to the challenges of these countries in terms of adjustment and stabilization, requiring greater commitment by European leaders.

CONCLUSION Following the Maastricht Treaty, many political voices and academics warned of the risks of the monetary union model contained in this Treaty. These voices warned of the risk of creating a monetary area without conditions for greater fiscal and political integration in the EU, given the lack of real convergence of the economies to be integrated. However, as the business cycle did not bring major setbacks in the early years of the euro, just before the economic crisis of 2008, discussion began on ways forward to complete the structure of the EMU. Politically, in a context of serious economic and social effects in some countries, Community institutions and their leaders assumed that the architecture of the Euro would have to be rebalanced with the inclusion of other aspects, stating the need to build an “effective and genuine” EMU. In this context, discussion has been focused on new aspects to give another setting to monetary unification. Thus, issues such as establishing a Banking Union, Eurobonds, the creation of a fiscal union and the creation of a specific budget for the euro area were brought to debate. Lately, given the effects of austerity on social imbalances in Eurozone countries, strengthening the social dimension of the EMU was the proposed target for Community institutions. While some discussions have not promoted concrete initiatives, another economic governance of the Eurozone was being proposed, with more demanding regulation, ex-ante monitoring of national economies and greater coordination of member-states’ economic

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and budgetary policies. This development led to the gradual transfer of national sovereignty to the central level, not always with the necessary democratic legitimacy and transparency in decision-making processes. The gradual distrust of Community institutions caused increased support for nationalist movements in various countries, casting doubts on the European project itself. Despite some encouraging signs on initiatives to complete the EMU, as the effects of the crisis were being absorbed in the countries at the center of Europe, the efforts to create an effective EMU have decreased. The German preference for a union focused on stability and budgetary control has deprioritized the Commission’s initiatives to strengthen fiscal integration, the common issuance of debt or the creation of a fund to support the restructuring of the debt of countries in difficulty. Thus, concrete initiatives to strengthen the social aspect are reduced to sterile disputes without visible results. Instead, technocratic solutions have emerged, such as the European Semester and legislative packages for coordination of policies for which the EMU’s management model has been adapted. While this model affirms itself, based on a bureaucratic-administrative logic, where each country decides by itself and the EMU coordinates and monitors, the issues of fiscal integration, creation of central budgetary capacity and greater political integration await another opportunity. Only at the end of 2012, during a European summit, was inclusion of the social dimension addressed, after an attempt by France, so that the Commission should rebalance the EMU and the European social model. However, concrete steps to strengthen this dimension faced practical difficulties in relation to the underlying framework of the model of stability that has been built. Fiscal integration and the EU’s budgetary capacity to intervene in solving social problems are inherent to any lasting solution to complete the EMU coming close to the optimal conditions set by Mundell. The Social Pillar and the concept document on the social dimension in Europe are, however, positive aspects, but are far from being achieved. The lack of common financial arrangements and the lack of political decision on the future of the integration process indicate the way to go. In fact, Community institutions are still locked to the limits defined by the Treaties and fears of “moral hazard” of financial transfers between countries, requiring mobilizing solutions to reverse the growing sense of disbelief in the European project. We believe that social and economic disintegration of the EU will certainly have higher costs than the consolidation of an effective social dimension. The strengthening of this multidimensional dimension must be present in the various fields of integration, being central to a more competitive and inclusive Europe. We recall the words of Schuman who understood that only concrete achievements and solidarity mechanisms could build a new Europe. This is the time to give a new direction to EU policies and member-states must accept their responsibilities.

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In: Challenges and Opportunities … Editors: J. M. Caetano et al.

ISBN: 978-1-53613-474-2 © 2018 Nova Science Publishers, Inc.

Chapter 11

THE POLITICAL UNION AND ITS EUROZONE FUTURE: CONFLICTUAL AND COLLABORATIVE COMMONS GOVERNANCE António Covas* Faculty of Economics, University of Algarve, Faro, Portugal

ABSTRACT European integration is now 60 years old in accordance with the Treaty of Rome (1957). For this “Non-identified political entity” (NIPE) the negotiated environment of its complex community method is a particular case of an institutional and political building process somewhere between the international regime and the federal approach. The same reasoning can be used concerning the political economy of the Eurozone which is somewhere between the adversatorial and the consociational models of governance. We are now over the red line that opens the door to European political union. With respect to the polity, the policy and the politics of this NIPE we think that cooperative federalism and the collaborative commons can provide a helping hand in seeking the European third way.

Keywords: Adversatorial and consociational models of governance; cooperative federalism; collaborative commons; polity; policy and politics

*

Corresponding Author: [email protected].

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1. INTRODUCTION TO THE DECADE’S HERITAGE: 2007-2017 We are on the border between intergovernmental economic policy and federal economic policy. Given the great economic heterogeneity among member states, the major question is this: should European institutions acknowledge this heterogeneity and accept a multi-speed Europe (Intergovernmental Europe), or should they promote further political integration and work on a new economic policy (Federal Europe) inside this political union? We are yet to find out whether these two Europes can work together peacefully, for instance as a single market and a Eurozone, under the same political authority in spite of the problems raised within the multi-speed approach. It is not easy to put an end to the political conflict between the European consociational regime (the common interests) and the national adversatorial regime (the national interest) (Fitoussi 2002). Similarly, we have a two-sided integration process: on the one hand, a functional need of an Eurozone budget, and on the other, a new federal governance for the launching of the “European commons.” In order to understand the new European challenges we must bypass the old dichotomy of intergovernmentalism versus federalism and create a new public sphere far beyond the traditional concepts and judgements. Using a well-known trilogy – polity, policy and politics - the recent past can be summarised as follows: a new “European polity” from 2007 with the signing of the Lisbon Treaty, was immediately outdated as a result of the 2007/2008 global crisis; “European policy” was faced with economic emergency and adopted austerity programmes and measures; finally, “European politics” was captured by the “intergovernmental directory” in alliance with the high bureaucracy of Brussels and Frankfurt. This alliance gave birth to many important regulatory instruments, some of them outside the European treaties. Within these regulations, I would say, a certain kind of “European macroeconomic algorithmic” is being worked on as a “rule of law.” I would like to mention the stability and growth pact (SGP), the stability, coordination and governance treaty (SCGT) known as fiscal compact, the European stabilisation mechanism (ESM) and the so-called “Six and Two Pack” regulations, which, all together, form the “general theory of macroeconomic conditionality” a truly European algorithm to put national fiscal policies in order. This kind of “algorithmic governance” (Sadin 2015) based on rules and procedures was the formula envisaged by German unilateralism (Beck 2014) to overcome the deadlock in the European political system, being hostage to domestic political cycles. As a response, the European institutional system reversed the terms of the political equation, changed the policy goals through policy instruments and placed itself in the hands of “non-elective executive entities” which do not have the political legitimacy to carry out European policy. A truly “stealthy federalism” is at work.

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Here we have the major irony of this deadlock. The European Central Bank (ECB) is often accused of having a single monetary policy objective concerned with price stability. This time, the ECB is accused of pursuing a non-conventional monetary policy called quantitative easing, aiming at the opposite objective, that is to say, an inflation rate around or slightly above the 2% goal. This major policy is a milestone of this period but, at the same time, will reveal the high risks of pursuing a European monetary policy without the support of a European budgetary policy as demanded by the Political European Union. From here, my “rationale” from a political science viewpoint can be outlined in the following terms: A stealthy approach via “silent regulations” for the fiscal deficit, public debt and macroeconomic imbalances or a clear and transparent political approach through a suitable set of checks and balances in the framework of cooperative federalism?” (Covas 2013, 19). To put it differently, the main purpose of this paper is not the choice between the consociational (the national interests compromise) and the adversatorial (the European interest coalition) models. Instead, it is about the major compromise between the “stealthy federalism” of the non-elective entities and the cooperative federalism of the elective nature and multilevel governance. Concerning the table of contents, the first chapter is about the paradoxes and contradictions of European governance in the last decade 2007-2017. The second chapter is about the heritage of the Lisbon Treaty and the hybrid nature of the European political system. In the third chapter, we address the doubts and mysteries of political federalism at a time of crisis. In the fourth chapter, we approach cooperative federalism and its multilevel governance and, finally, in the last chapter, we present the European single act proposal having the “European commons” as the main subject matter. We end the paper with some final remarks. One final remark is that this paper is an outcome of a research project on “Federal Europe.” As a result of this project, four books were published and these are the main sources of the paper:    

A Europa Federal e a Quarta República Portuguesa (Covas 2011), [Federal Europe and the Fourth Portuguese Republic]; Dez teses sobre a Europa Federal (Covas 2012), [Ten theses on Federal Europe]; União Europeia, os bens comuns da futura federação europeia (Covas, 2013), [European Union, the common goods of the European Federation]; A contingência europeia (Covas 2016), [The European contingency].

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2. THE PARADOXES OF THE EUROPEAN INTEGRATION PROCESS Several paradoxes are at work in the European political scene as a result of the collusion between different interests and legitimacies, the ones expressed by the European and national democracies. In the last decade, we can observe some of these paradoxes in full operation (Covas 2011, 2012, 2013, 2016). Firstly, the loss of state centrality and the inability to rebuild civil society. Notwithstanding, domestic political radicalisation recovers the central state as if we were “state orphans.” Secondly, geopolitics are not popular in Europe, but everything points to the great return of history, geography and territorial politics. Thirdly, most of the Union’s own resources are spent on domestic affairs, but given the new geopolitics of the near future, there is no doubt about the main causes of political reforms in the European Union, that is to say, they will come from the outside. The best examples are well known: Russia and Ukraine, the Middle East, Turkey, Northern Africa, but also Brexit and Trumpolitics, to mention only the most important. This external boost will have a major impact on external, security and defence policy reform, in all its dimensions, which includes refugees, energy and frontier policies. This great political reform will entail more budgetary resources for the ESDP. Fourthly, and obviously, this external dimension will have strong implications for European policy, and mostly for the economic and monetary union, particularly over the rules concerning the European semester, the stability and growth pact, the fiscal compact, which can be subject to deep changes in the framework of a Eurozone budget as underlined by the new French presidency. Fifthly, a new political model for budgetary policy entails having a surplus of political democratic legitimacy. This is the proposal of the French presidency concerning the creation of a European Assembly for the Eurozone and also a finance minister of the Eurogroup and responsible for European fiscal policy. The main goal is to have more legitimacy and authority side by side with the ECB and therefore a truly effective European economic policy. Sixthly, on the one hand, we have the de-territorialisation of national policies, and on the other, we observe the formation of negative external effects on what we can call “European extra-territoriality.” This is why the European Union needs to create a European Public Prosecutor in order to fight financial and fiscal crimes. The European citizen will be able to acknowledge this surplus of political legitimacy. Seventhly, the European Union cannot allow Brexit to create a high risk of internal political division; indeed, a bad starting point for negotiations can create a “precedent theory” and stimulate new exits post-Brexit.

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Eighthly, and similarly, the European Union cannot allow “enhanced cooperation” allowed by the treaties to turn into a serious political division among member states and the risk of a multi-speed European Union, which can be understood by the Visegrad Group, for instance, as a discriminatory political measure. In this sense, the Eurozone budget and new fiscal compliance can be a source of political division. Ninthly, the European Union has permitted several treaty revisions through intergovernmental agreements and the creation of non-elective political entities. This political option has discredited European institutions and European citizenship, as observed, for instance, in the turnout rates in European elections. Finally, the European Union cannot allow the “automatic society” (Stiegler 2015) and the “algorithmic governance” (Sadin 2015), through regulations and procedures, to replace the legislative process and political deliberation, that is to say, we need to distinguish between governance and government. These paradoxes are at work in a battlefield where the main stakeholders are the global market, domestic democracies and European democracy. This game is asymmetric as the great power lies beyond frontiers, being extra-territorial and captured by the market. The extra-territorial domain is capitalism’s golden heart and nothing can stop transnational capitalism as we can see now with digital capitalism and its extra-territorial hypercompanies. In this sense, de-territorialisation and control of the extra-territorial negative effects are the main challenges for the European Union in the next decades: we cannot forget cybercrime, the cloud computing economy, Big Data management, the magic universe of technological platforms, the special de-territorialisation of the illegal economy and the war economy, among many other examples. It is very clear that the great paradox of our time is the transnational global market counteracting and opposing the national domestic and fragile democracy and, as a consequence, the growth of the “extra-territorial abyss” facing us. It is up to the European Union to reduce this “extra-territorial abyss” and all the more so as we do not have global governance (Held 1995) able to internalise and regulate those extra-territorial effects.

3. THE LISBON TREATY’S HERITAGE AND THE HYBRID NATURE OF THE EUROPEAN POLITICAL SYSTEM In the present European context, the main question is the following one: are we going to build a Federal Europe by the back door through intergovernmental treaties according to German and French conveniences, or are we going to open up the European public sphere and start the debate on the “European Convention” for the next decades? Once again, I recall the French proposal of national conventions paving the way for a European Convention.

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Let us have a look at the recent past and look back on the Treaty of Lisbon which came into effect on 1 December 2009. Since then, European problem-solving has deeply evolved and the treaty has been tested and evaluated several times, not only in formal and juridical terms, but also in terms of policy-problem and mainly concerning the political and institutional innovations linked to the Eurozone policies and politics. Briefly, we are in a political and institutional system with several presidencies: the European Council with its own elected presidency, the Foreign Affairs Council of Ministers under the presidency of the High Representative, the Sectorial Council of Ministers under the semester presidency of the member-states and, finally, the Eurogroup Council under its own elected presidency. The political evidence tells us that the former Council of General Affairs lost part of its role to the European Council, and the Council of Economic and Finance Ministers, known as (ECOFIN), lost part of its leadership to the Eurogroup Council (19 members). This evidence means that the Lisbon Treaty did not change the past trend, that is to say, intergovernmental supremacy as expressed in the several councils, in spite of the institutional reinforcement of the European Parliament and the reduction in the Commission’s role. Concerning the European Parliament, the co-decision process and new budgetary powers respond to the democratic deficit but even so its legislative power is further limited and its own resource capacity is very much dependent on national contributions. In fact, we are witnessing the old question of the political relationship between the intergovernmental and community methods of European governance. Besides, the “non-identified political object” (NIPE) and its methodological hybridism are very much appreciated by political scientists and will be so in the near future. In another paper (Covas 2013, 153), I have written that every discussion around institutional reform suffers from a fundamental misunderstanding, which is to consider the institutional mechanism as the heart of the reform and in a secondary position the democratic quality of the inputs and outputs used and transformed by the institutional machine.” Besides, it is my understanding that the European Union should review its present sectorial federalism, taking charge of the high politics at the institutional centre and transferring responsibility for low politics to the periphery, to the states, the Euro-regions and city networks. All together, this “decentralised governance networking” holds a promising “federal inspiration” (Covas 2013). In this context, the only certainty, at this point, is a double pressure. International and domestic political pressures have generated the growth of radical parties and movements and, obviously, European politics will probably acquire a defensive standing and more conservative policy-making decisions.

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Table 1. The hybridism of the European political system Regimes’ Interests Interests’ consociation (the supremacy of national interests and the respect for smaller countries)

Intergovernmental Europe The classical institutional triangle and the balance of power in favour of smaller countries

Community/ Unionist Europe  The “three Councils” hegemony.  Balance of power between elective and non-elective entities  Government Directory

Federal/Confederal Europe  Federalism “à la carte,” by sector  Enhanced cooperation  Stealthy Federalism  Non-elective entities  European algorithm

Adversatorial interest: the supremacy of a common and/or a federal compromise

Parliament and Commission supremacy “against the Councils”

 Cooperative Federalism and multilevel governance  Balance of power and due accountability between elective and non-elective entities.

 European Congress (Two chambers)  European government  European Administration networking  European Regional networking

Table 1. shows us the main elements of the hybrid European political system. Here, we have to take three interests into consideration: the national interest or intergovernmentalism and the “three councils hegemony,” the community interest as represented by the European Parliament and the European Commission but also by the non-elected entities, and finally, the European interest as a federal political aspiration that we can approach through a “European commons” programme. Nowadays, the European political system is a “three-regime output” and a set of shared competences located at different levels of political governance. This fact is very relevant, as within this governance networking there is no direct and foreseeable relationship between the structure and the outcome. In this case, the most relevant element of the political system is the ability to deal with the policy-process and the policy-procedure, what I called here the “European algorithm.” My thesis in this paper confirms cooperative federalism as the best set of processes and procedures to deal with mixed regimes, shared competences and complex institutional negotiations. Let us see the doubts and mysteries raised by the federal political system at a time of European crisis.

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4. THE FEDERALISM EMERGENCY: DOUBTS AND MYSTERIES AT A TIME OF CRISIS Facts speak for themselves. The impact of Brexit, the political radicalisation of Visegrad countries (Hungary, Poland, Slovakia, Czech Republic) the launching of a twospeed Europe (single market and Eurozone), the critical issues of external policy (security and defence), can create the risk of “policy-decision fragmentation” and a “Europe à la carte” with unforeseeable consequences. In this sense, we are in a state of emergency and the European Union can well be the battlefield of a “commons tragedy” (Garrett 1968), as supported by the literature on the global and systemic risks (Beck 2007). As far as the European political system is concerned, what can we learn from the community experience and the emergent cooperative federalism? As we have previously said, the theory of federalism is developed around the criteria of organisations’ interests. We know very well the two main currents of thought. The republican current says that the “general interest” should be promoted and regulated by an upper level above private interests (Habermas 1998). The liberal current says that the “common interest” should be pursued in consultation and close cooperation with coregulation and auto-regulation entities and in the framework of the so-called social neocorporatism which is the distinctive feature of these societies’ political culture. The doubts and misunderstandings around European federalism have much to do with the “bureaucratic federalism scarecrow” as the radical political parties very much like to remember. The same misunderstanding is applied to the European commons theory as if it was going to push the European Union into an Unitarian and bureaucratic federal republic. For future reference, here we have some Unitarian and bureaucratic capital sins (Covas 2013, 154):    

Firstly, the “constitutional risk” as happened in 2005 with the European constitution; Secondly, the “weberian risk” under the power of an enlightened, unfailing and omnipresent European administration; Thirdly, the “normativist risk,” that is to say, the excessive normalisation and supranational juridification which generates counterproductive reactions; Fourthly, the “processual and procedural risk” through the multiplication of policy-networks and pressure groups.

These theoretical references are important at this time in order to understand the present difficulties of the European political system. In 2016 and 2017 some member-states tightened their political stance concerning refugees and the Schengen free movement of people. In this context, “the principle of reality” has been raised to the status of a categorical

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imperative and, for that reason, it is easily manipulated in order to distract minds and delay the necessary political reforms. Nowadays, breakthroughs in European politics mean further sovereignty losses which are perceived as very suspicious by national public opinion. Once again, the 2005 European constitutional treaty is a good example of this structural suspicion that, I would say, the peoples of Europe hold against the United States of Europe (Habermas 1998 and Ferry 2000). When addressing all these doubts and mysteries which are legitimate with regard to intergovernmental directory and stealthy federalism, it is worth returning to the inspiring principles of cooperative federalism, which, in my view, celebrates the European specificity (Covas 2013, 2016), and stresses “the ever-closer union between nations”:         

The Union is a free association of European states, under the political principle of a “limited government”; The Union benefits from the relationship between national parliaments, through a second chamber in the European parliament; The Union benefits from the relationship between national administrations and the European administration instead of a supranational bureaucratic administration; The Union benefits from the cooperative and collaborative commons between the European regions and cities; The Union benefits from the relationship between European political parties in line with more and better participative democracy; The Union benefits from a better relationship between parliaments and courts concerning the supervision and regulation of legislative, fiscal and banking issues; The Union benefits from the creation of a European general-prosecutor, but once again, cooperation among national services can replace new bureaucracies; The Union benefits from the evolution of the social and regional committees to an economic and social council with greater proactive European competences; The Union benefits from a larger public administration network addressed to each European policy under a specific policy organisation, for instance, small mission structures supported by a public administration network.

These are the main principles of cooperative federalism, subsidiarity and decentralisation as the gate-keepers of limited government. Besides, we all know that shared competences, in practice, do not depend on juridical and formal policy measures. Indeed, we must ask who has the power of political initiative, who knows stakeholders best on the ground, who is in charge of policy-making decisions, who has the power to lead the winning coalition, who has the sense of political opportunity, and so on. This is why, probably, in a long transition period towards political union, national administrations are obliged to form “learning and cognitive policy communities.” Meanwhile, the shared

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competences will be like case-studies or a “learning community” for the multilevel governance network. In other words, and this is the practical principle of cooperative federalism, it is not the programmatic principle of subsidiarity which decides the level of competence, but rather the nature, complexity and urgency of the policy-problem which sets the policy-framework and the policy-making of the political issue (Covas 2007).

5. COOPERATIVE FEDERALISM AND THE MULTILEVEL GOVERNANCE SYSTEM An excellent example of these shared competences and the multilevel governance system is the case of the “macroeconomic stability programmes” that each national government has to present in April in the framework of the so-called European Semester. It is also a good example of the “general conditionality” theory which gives European Commission services and European non-elective entities a large number of formal and informal powers aiming to influence, condition and reverse national decisions and procedures (Covas 2007). As the European Union is not yet a fully federal political organisation, the labyrinth of processes, procedures and regulations is seen as a set of intergovernmental checks and balances one might describe as a kind of “European macroeconomic algorithm” which places a general restriction and maximum interdependency concerning domestic policies. This means, for instance, that local financial policy-reform is conditioned by the stability programme and the fiscal compact, just to mention these two main policy-instruments. In practical terms, this political conditionality generates critical deadlocks in several policyareas. The Troika programme in Portugal has blocked local and regional policies and everything concerned with territorial policies and infra-national decentralisation. This evidence is a good reason for further cooperative and collaborative territorial policies between Euro-regions and Euro-cities aiming to preserve local and regional economies. Furthermore, the new technological platforms are well suited to dealing with these new “European commons” (Covas 2013). For a better understanding of the ground where cooperative federalism is at work, let us take a brief overview of the best known federalisms: German cooperative federalism and dual American federalism. Afterwards, we will make a small analogy with the more pragmatic and functional European federalism (Covas 2007, 104-107). Firstly, German cooperative federalism, historically well defined, is embedded in the doctrinal current called the “social market and common interests economy” in a neocorporatist negotiated environment with many pressure groups and a good networking administration. Its main features are the following:

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It is a vertical administration of governance in accordance with the old principle of “law hierarchy”; States are represented in the Federation in a second chamber (Bundesrat) by their governments following the population criteria; Main political initiatives demand the Federation’s approval and that of the majority of States as well as strong social and political consultation; Fiscal revenues are shared between the Federation and the States and complemented by a strong financial perequation made by the federation; Political parties favour and promote the common interest, either territorial or sectorial.

German cooperative federalism is based on a strong social and political commitment, with most of the negotiated environment being created inside the political parties’ networking and within social neo-corporatist organisations. Secondly, and in a different timeframe, space and society, we have the dual American federalism which is embedded in a doctrine currently called “private interests market economy and its social responsibility.” Its main features are the following:     

It is based on a sectorial and horizontal division of competences in accordance with the “law parallelism” principle; States are represented in the Senate with the same number of senators, regardless of their population; senators represent the people and not the state executive; States cooperate with the Federation through intergovernmental conferences; States have their own tax power autonomy and spending power; State interests represented by the executive and the sectorial interests represented by the senators are competing and very often conflicting.

As is easily observed, dual American federalism is clearly “less unitarist” than German neo-corporatism. It is “less integrationist” due to law parallelism and does not have any similarity with the German state and the European social state which are, with the social market economy, the hallmarks of post-war European society. Besides, dual American federalism is historically identified with a “minimal state” where general and common interests are very often in great difficulties vis-à-vis public administration. As far as European proto-federalism is concerned, let us have a look at the possible analogies (Schutze 2013). In what measure could the German “bundesrat” or the American “Senate” inspire European proto-federalism? In analytical terms, we have the following picture:

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The European Union and the member-states share a large number of policy-areas and the Union needs the states’ approval to take decisions, with the exception of the European central bank system; Member states are seated in the Council of Ministers with different weights and votes; the peoples are represented in the European Parliament depending on their population but this is not yet a bicamaral parliament; The European model of a “negotiated environment” is based on a consociative political culture where the smaller countries benefit from interinstitutional negotiation, even after the successive enlargements; The European Union does not have tax power, the budget is very small, the fiscal policy has a very limited redistributive capacity and even the cohesion policy is not, as such, a public finance policy-instrument; In the European Union, the integration and conciliation of sectorial interests is based mostly on the Commission and the Parliament’s consociative and regulatory practices, since European political parties do not have the power and capacity to fulfil that crucial role. At the national level, governments and administrations play that role working on the integration of social interests; Concerning the economic policy-instruments in the European Union, we observe many “non-elective entities” which suffer from a lack of accountability and a deficit of political legitimacy, as shown in Table 2: Table 2. European economic policy: Squaring the circle

Policy-instruments ECB EP/EC/Budget ESM/EMF UB/EBA EC/DG/Competition EC/DG/Financial

Main Policy Reforms European monetization European taxation European mutualisation European resolution European regulation European debt

Political legitimacy Not Elective Partially Elective Not Elective Not Elective Not Elective Not Elective

In the present European context, there are not enough political conditions to reveal the stealthy federalism produced in the background by European institutions, as outlined below:  

The European Central Bank (ECB) carried out “quantitative easing” but it is forbidden to generate a European budgetary deficit; The European Parliament has the power to approve the budget, but does not create the political conditions for a truly budgetary policy, that is to say, an autonomous tax power and additional own resources and spending capacity;

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The Banking Union and the European Banking Authority (EBA) have the power to carry out banking supervision, but at the same time, privatised the banking resolution process, while we all await the achievement of the banking union’s third pillar, common bank deposit guarantees; The European Commission, through the Directorate-General for Competition, has the specific power within the single market, but at the same time, we all hope that the regulatory policy will be a more comprehensive policy-instrument in the framework of the economic and monetary union; The European Commission, through the Directorate-General for Economic and Financial Affairs, has many policy-instruments at its disposal, but at the same time, we all hope for a more effective financial instrument in the framework of a federal European budget.

Here we are, in 2018, facing the most resilient paradox, stealthy federalism. In fact, growing “European institutional weariness” should avoid the emergency of the “nonelective entities,” but apparently, the opposite happens as shown in Table 2. The political duplicity is obvious. In the national capitals, politicians try to comfort and convince domestic opinion calling for national sovereignty and democratic legitimacy, but in Brussels and Frankfurt there is a great political consensus to create a growing number of “non-elective executive entities,” hoping that it will be a mere transition period towards a political union. For these reasons, it is not an easy task to go from stealthy federalism to cooperative federalism. My proposal is a “European Single Act,” like that of 1986 which created the single market. This time, the Federal Act will celebrate the institutional organisation of cooperative federalism and political constitution of the “European commons” in order to prevent the next “common tragedy” (Covas 2013, 2016).

6. A FEDERAL ACT TO A “EUROPEAN COMMONS” GOVERNMENT SYSTEM We have already said that the European Union’s proto-federalism is functional and pragmatic in nature, in what we could call “the federal governance third way.” In accordance with (Schutze 2013, 345-353): 

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As far as competences are concerned, it is much closer to German cooperative federalism and it is hard to foresee a return to shared competences; furthermore, smaller countries would not agree to this policy change; As far as state representation is concerned, the opportunity of a 2nd chamber is open and the European Council or the Ministers’ Council could be that 2nd

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chamber; in that connection, it is important to remember that shared competences demand state participation at the highest political level and therefore it has major political legitimacy; The negotiated environment and the political commitment to consensus, even when a majority vote is required, work in favour of shared competences and more political legitimacy; As far as budgetary matters are concerned, European federalism is more American than German, that is to say, a strong budgetary and financial perequation is needed in order to be accepted by the poorer member-states and so the political union will depend very strongly on a federal budget.

At this stage, European democracy is more a deliberative democracy than an organic one. This is our starting point, political diversity: several political domains and public spheres, a multilevel governance system, several administrative patterns and social and sectorial corporatism, many principal-agents, several territorial and regional political organisations. We are most likely searching for a meta-democracy and a new operative political system if we are to face all these conventional democracies within national states. One example of this deliberative democracy in the near future: the “lateral power” of territorial cooperation. Cooperative federalism will include “state-enhanced cooperation,” macroregions’ cooperation, transfrontier cooperation, inter-regional cooperation and euro-cities’ cooperation (Covas 2014, 2015). We are in 2017 on the eve of the German elections. Beyond the muddling through of the European negotiation, my belief is that the “spirit of the European commons” will emerge.

7. A FEDERAL SINGLE ACT FOR A “EUROPEAN COMMONS” GOVERNMENT SYSTEM Nowadays, European polity is a very sensitive balance between a governing structure of vertical powers and a governance structure of horizontal powers. Notwithstanding European institutional complexity and probably a long transition period towards political union and cooperative federalism, I believe that the “spirit of the commons” (Ostrom 1990 and Coriat 2015), along with heavy pressure from the outside world, could be the ultimate causes of the reform of European political treaties. In this case, my proposal is a Single European Act. Table 3 sums up the key elements of this proposal. The general principle of this proposal is the coexistence of elements from the “three political regimes” or theoretical approaches. In the present international context, a “coup d´etat” would be necessary to constitutionalise European polity as a federation or a federal

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state. At this stage, the most important aspect is the direction of the European movement and, in this regard, the various councils, shared competences, enhanced cooperation and non-elective bodies are the lowest common denominator or the practices of “European mitigation.” Facing a double divergence, global and regional, and lacking the resources and the political organisation for the best solution, the European Union has chosen the second best, “the general conveniences of political ambiguity.” That is why we need the best political philosophy and the best theoretical approaches for a huge practical problem like the European Union has today. As I said beforehand, the spirit of territorial decentralised cooperation and European collaborative commons (Rifkin 2014) are a good starting point and a new political approach to European cooperative federalism. Let us sum up the general principles of these “European spirits” (Covas 2011, 2012, 2013, 2015). Table 3. European commons and cooperative federalism European Commons Our proposals  Deliberative democracy  European Prosecutor  New Eurozone Architecture  Mechanism for Global Risks  Mechanism for Public Debts  Authority for Digital Market  Architect Security and Defence  Mech. Regional Perequation  Mech. External Cooperation  - Mech. Financial Integration

Stealthy Federalism (Non-elective entities)  Informal Summits, Councils  Executive boards (ECB)  Standing committees (EC)  General-directions (EC)  Several Funds  Several Mechanisms  Several Authorities  Enhanced cooperation  (entities created “horstraités”  (Executive bodies), etc.

Cooperative Federalism Our proposals  European congress (2 houses) or a Parliament Network  European Government  Eurozone Budget  European Treasury  European General Prosecutor  European Regulators  Economic and Social Council  European Banking Authority  European Network of Pub. Adm.  European Regional Network

Today, the European Union does not meet the political conditions to be an organic or adversatorial democracy in line with the political organisation of a nation-state; the “mixed polity” of the European Union is closer to a sui generis democracy, more deliberative and regulatory in nature. The European single act can set the terms of this European common good and the necessary steps for further political and democratic institutional legitimacy. European citizenship is a cognitive building as the European citizen plays numerous roles and the digital society extends their individual capacity; this increasing individual capacity, on the one hand, and the increasing European difficulties in dealing with huge

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technological platforms on the other, is something which should be reviewed, because as we all know, big platforms very often abuse and violate privacy and the rights of the European citizen. This European paradox must be clarified very soon and the creation of a European general prosecutor can be a good solution. The European single act can set the terms of this European common good and the necessary steps for this political innovation. The social market economy and the benefits derived from the regulatory state are a common good and a European Union hallmark. These positive external effects of the European social model are a common good which must be preserved within the framework of the digital single market. In that context, the European single act can set the terms of a new structural policy-instrument concerning the new social market conditions of the digital society and the market employment policy. The single currency is one of the greatest achievements of the European Union, but its negative external effects can be very damaging to less developed countries. The ECB performs important monetary functions but does not have a full monetary policy to deal with the double economic divergence, global and regional, of the European Union The European single act can set the terms of a new architecture for economic and monetary union, in particular, the terms and limits of the monetary-budgetary-financial connection. The European Union has fiscal policy rules, but a very small budget, which is very asymmetric concerning the structure of its own resources, that is to say, the European Union has a budget but does not have a policy and politics around the budget. Most importantly, we have many doubts as to policy effectiveness concerning the next policycycle, the one linked to the external and internal requirements of cooperative federalism. The European single act can set the terms of the monetary-budgetary-financial connection, and in this context, the new policy-goals of budgetary stabilisation and redistribution, and the missions of new institutions such as the European treasury and the European monetary fund. The European Union does not have a “European people” of its own and the same can be said for the “European territory” or the “European territoriality.” In this context, we all know that the European territory is rescaled every day and hence will have a multi-scale territory and a network of macro, meso and micro decentralised territories. The European single act can set the terms of an “European decentralized territoriality” and a policyinstrument for some sort of regional compensation mechanism within cooperative federalism (Keating 2013). The European Union is a very fragile open space within the “global disorder” and without a systemic approach to management of global risks. In order to support its political legitimacy, the European Union does not only need a democratic mechanism, but also a risk-security mechanism, a truly European common doctrine on social and public protection. The European single act can set the terms of a common mechanism for systemic risk and through this procedure reinforce the political and democratic legitimacy of cooperative federalism.

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The geopolitical risk of the European Union affects domestic politics’ everyday life. Similarly, the external policy-making decision is always influenced by the mutual influence of high and low politics. Indeed, the external effects of the Security and Defence policy are so unforeseeable in the near future that it will take a “European security council” to control the damage and protect other political priorities of the budget. The European single act can set the terms of this security council and the general framework of the “structured and enhanced cooperation” for Security, Defence and Development and, most particularly, for the Mediterranean and Sub-Saharan regions. The ongoing digital revolution (Stiegler 2015 and Serres 2012) and the emergency of a strong collaborative commons economy (Rifkin 2014) are an excellent pretext for reinforcing the political and democratic legitimacy of the European Union and to stimulate creativity and culture in civil society The European single act can set the terms of “digital free movement and the creative commons” (Coriat 2015), the next political and juridical battlefield between private property rights and free creative commons (Coriat 2015). In the near future, the European Union could have a huge financial problem in its hands. We do not know all the external effects of public debt, private debt, quantitative easing, non-performing loans in the banking system, the effectiveness of the anti-cycle effects of European fiscal and budgetary policies, the deposit common guarantees banking policy or the proliferation of financial policy-instruments. The European single act can set the terms of this monetary-budgetary-financial structural connection and the institutional linkage for its financial policy consolidation. Here we are in 2017 learning from the crisis in capitalism and awaiting the German elections. Nowadays, we know that the search for a European identity is doomed to failure. Unfortunately, for the European citizen, the European Union is not a dream come true, but more modestly, an everyday life experience. Here we face a new European paradox at work: humble citizenship in everyday life, on the one hand, and the great political and technocratic enlightenment, on the other. In line with this moderate way of thinking, we recall the basic principles of this modest European polity and politics. The Union is a free and voluntary association of nation states. The Union is based on the principles of limited government and delegated competences. We have a better Union with national parliament networking than with a second chamber in the European Parliament. We have a better Union with national administrations networking than a European bureaucratic labyrinth. We have a better Union through the active participation of the European citizen than with an over production of European law. We have a better Union with a good accountable political system than with stealthy federalism. Finally, in the European digital society, we have a better Union if we are able to mix online and offline communities, rather than design a cyber society without a true symbolic political communication. Otherwise, European “politification” (Innerarity 2010, 2011) in the public sphere is somewhere between governing and governance, on the one hand, and government and networking on the other.

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At this stage, we must face the continuous rescaling of the European state, the making of territory and the rise of the meso (Keating 2013), be it the European macro-region, interregional cooperation, the transfrontier euro-region or the euro-cities network. With this rise of meso-government in mind, institutionalisation of the European space could be described as follows (Covas 2007, 2011, 2013). The European Congress or the Interparliamentary Union (IPU), with active legitimacy to review the European treaties, elects the European Union President to act in a reserved legislative field. The European Congress would be composed of members of European and National Parliaments. Concerning the European Council and the Council of Ministers, the European Council will continue to be, in the near future, the intergovernmental supreme political council, while the Council of Ministers will act as a legislator, probably as a second chamber of the European Parliament or Congress, and the European Commission as the next European executive or government. The equilibrium between councils becomes more complex as we add the third council, the eurogroup council. With enhanced cooperation provided by the treaties, the risk of “specialised councils” is higher and so is the political role of mediation by the European Council The Union Security Council (USC) means that high politics and global regulation are top priorities in the European political agenda and a European common good which prevails over domestic politics. The direct impact on budgetary policy will require a major financial and political reform of European treaties. In the European Executive (the former European Commission), or the upgrading of all European institutions, as the European political system adopts the “European Federal Single Act,” the executive president would come from the European Parliament’s (EP) largest group and, invested by the EP, the president would have the power to appoint its ministers. The European Monetary Fund (the former European stabilisation mechanism), as a new policy-instrument of the monetary-budgetary-financial connection and aiming to combat asymmetrical shocks, would mutualise national debts and the “new public European debt.” The European Economic and Social Council (EESC), aiming to reform the present European committees (economic and social and regional committees) by giving them further active legitimacy and more effective power concerning the executive proposals would, at the same time, provide stronger linkages with similar national councils. The European Network of Public Administration (ENPA), aiming to create cooperative connections inside the “European policy-communities,” that is to say, “policy-areas of learning communities” where the spirit of cooperative federalism is at work, will be an infrastructure of the European executive and the field of new European governance networking.

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The European Network of Territorial Cooperation (ENTC), which is the most promising European common good and the ground for the growth of digital society collaborative commons (Rifkin 2014). We should acknowledge the special role of regions and city networks as decentralised territorial cooperation has great potential, allowed by technological platforms and start-ups. As I said beforehand, the rescaling of the European state and the making of the meso is at the heart and spirit of cooperative federalism. The European political momentum does not favour a global revision of treaties through European conventions and intergovernmental conferences (artº 48º, nº2, EUT). Within the treaties we can also use simplified revision and enhanced cooperation. The French President’s proposal begins with national conventions as public debate fora for European issues. Beyond the treaties, member-states come to an agreement on diplomatic and intergovernmental procedures. For the moment, there is no clear political agenda for the revision of treaties, since we are half way between the French and German national elections while waiting for a political consensus on the Eurozone architecture. New fiscal rules and own resources, a monetary fund, a European treasury and partial European mutualisation, a finance minister for the Eurogroup should be on the agenda. Care should be taken. The Eurogroup’s institutionalisation through a Eurozone budget could be the beginning of major political fragmentation in the European Union (Covas 2016).

CONCLUSION Three final remarks. The first, to report a huge paradox in national and European politics. On the one hand, we suffer from “institutional weariness,” that is to say, we do not believe in state institutions to mediate European policy and politics. On the other hand, we suffer from “state orphanhood” as the state is the centre of domestic politics’ radicalisation. We need the national state to coordinate the rescaling of the European state on three levels: domestic politics, European macro-regions and transfrontier border regions as is the case on the south and east of the Mediterranean Sea. The second remark confirms that external geopolitical factors will be the main cause for reforming the European Union politically: the examples come from Russia, Ukraine, the Middle East, Turkey, North Africa, but also Brexit and Trumpolitics, to mention just the more relevant ones. This strong external political driver draws the European Union’s attention to the “negative effects of European extra-territoriality.” The European Union is compelled to decide on the best Security and Defence policy-making decision which includes not only the conventional drivers but also refugees, the energy policy and also competition problems such as offshores, fraud and evasion, and fiscal harmonisation.

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The third remark is about the external impact on the economic and monetary union and particularly on the Eurozone architecture as such. European Security and Defence policy could generate different political alignments among member-states and the same could be said about the Eurozone architecture. We face two lines of European political fragmentation: the “external alignment” (a war intervention for instance) and the “internal alignment,” for instance, the acceptance of a new budgetary compact concerning the Eurozone architecture. The political outcome of this “double alignment” could be potential conflict among the “three councils”, since some member-states would interpret the Eurogroup as “Europe’s first division” and the multi-speed approach as a discriminatory factor against the less developed countries. A last remark concerns the procedural modus after the German elections at the end of 2017. In accordance with the European treaties (European union treaty, EUT, and European union functioning treaty, EUFT), as we have already said, the revision policy-process could include: an ordinary revision (artº 48, nº2, EUT), a simplified revision (artº 48, nº6, EUT), enhanced cooperation (artº 20 and artº 42 to 46, EUT and artº 326 to 334, EUFT). Beyond the treaties there is always the possibility of intergovernmental agreements, as European practice shows us. The most relevant question in this case is, once again, to know whether or not “inspiring cooperative federalism” has the power, tools and the principal-actor, to win over stealthy and pragmatic federalism. Since it coincides with the Brexit negotiations and the Trumpolitics uncertainties, we will never know. Finally, we could say that whatever happens in the near future, European institutionalism will accomplish its mission again, that is to say, it will transform critical problems into chronic ones.

REFERENCES Beck, U. 2014. A Europa alemã, de Maquiavel a Merkievel. Lisboa: Edições 70. [The German Europe, from Maquiavel to Merkievel.] Beck, U. 2007. “World at risk.” Cambridge: Polity Press. Coriat, B. (Dir). 2015. Le retour des commons. Paris: Éditions LLL. [The commons return]. Covas, A. 2016. A contingência europeia. Lisboa: Sílabo Editora. [The European contingency]. Covas, A. 2013. União Europeia, os bens comuns da futura federação europeia. Lisboa: Editora Colibri. [European Union, the common goods of the European Federation: 1819, 153-154]. Covas, A. 2012. Dez teses sobre a Europa Federal. Faro: Edição da Universidade do Algarve. [Ten theses on Federal Europe]. Covas, A. 2011. A Europa Federal e a Quarta República Portuguesa. Lisboa: Editora Colibri. [Federal Europe and the Fourth Portuguese Republic].

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Covas, A. 2007. A governança Europeia. Lisboa: Editora Colibri. [The European Governance: 104-107]. Ferry, J. M. 2000. La question de l’État européen. Paris: Gallimard. [The European State Issue]. Habermas, J. 1998. L´intégration républicaine. Paris: Fayard. [The Republic integration]. Habermas, J. 1998. Après l’État-nation. Paris: Fayard. [After the nation-state]. Hardin, G. 1968. “The tragedy of the commons.” Science review 162, 3859:1243-1248. Held, D. 1995. Democracy and the global order: from the modern state to the cosmopolitan governance. London: Polity Press. Innerarity, D. 2011. O futuro e os seus inimigos. Lisboa: Editora Teorema. [The future and its enemies]. Innerarity, D. 2010. O novo espaço público. Lisboa: Editora Teorema. [The new public space]. Innerarity, D. 2009. A sociedade invisível. Lisboa: Editora Teorema. [The invisible society]. Keating, M. 2013. Rescaling the European state. Oxford: Oxford University Press. Ostrom, E. 1990. Governing the commons. Cambridge: Cambridge University Press, UK, 1st Edition. Rifkin, J. 2014. A terceira revolução industrial. Lisboa: Bertrand Editora. [The third industrial revolution]. Rifkin, J. 2014. The zero marginal cost society. New York: Palgrave Macmillan. Sadin, É. 2015. La vie algorithmique. Paris: L´ Echappée Éditions. [The algorithmic life]. Schutze, R. 2013. From dual to cooperative federalism. Oxford: Oxford University Press: 345-353. Serres, M. 2012. Petite Poucette. Paris: Le Pommier. [Little Poucette]. Stiegler, B. 2015. La société automatique, l´avenir du travail. Paris: Fayard. [The automatic society].

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ISBN: 978-1-53613-474-2 © 2018 Nova Science Publishers, Inc.

Chapter 12

ON THE SCENARIOS FOR THE FUTURE OF THE EUROZONE António Caleiro1,* and José Manuel Caetano1,2 1

Department of Economics, University of Évora, Évora, Portugal 2 CEFAGE & CICP and University of Évora (Department of Economics), Évora, Portugal

ABSTRACT The adoption of a common currency by several European Union countries involved multiple social and economic costs and benefits. The sovereign debt crisis that struck Europe from 2009 onwards has revealed flaws and structural weaknesses in the institutional costs of the Euro, which have contributed to a set of negative systemic reactions. The insufficient coordination of fiscal and monetary policies, coupled with the absence of central supervisory mechanisms and banking resolution, has allowed the effects of the financial sector crisis to spread to the rest of the economy and between the various Eurozone countries. In this context, different scenarios have been advanced on the future of this monetary zone, which is now at a crossroads and facing challenges that require adequate socio-economic and political-institutional responses. The chapter presents and discusses the feasibility of some of the scenarios with which the Eurozone is confronted, based on the trends and fundamentals that anchor the stability of a monetary union.In particular, the conditions necessary for the favorable scenario to be presented as the most likely scenario are discussed.

Keywords: international coordination, scenarios

*

Corresponding Author Email: [email protected].

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1. INTRODUCTION The creation of the single currency in the European Union was the culmination of the post-war integration process that gradually took place step by step, always subject to its own vicissitudes and marked by political-institutional crises and waves of economic and financial turmoil to which Europe was subject. The wide and deep debates prior to the creation of the Euro drew attention to the appearance of possible difficulties in countries that would adopt this currency if they did not meet some structural conditions considered necessary and also if the integration process itself did not assume centrally some stabilization and adjustment functions to compensate the Member-States for the loss of the exchange rate and monetary policy. Some aspects then emphasized the importance of high convergence in economic structures and, consequently, strong synchronization of business cycles within the Eurozone, in order to promote the greatest benefits of using a common currency for all its members and to ensure the effective functioning of monetary union. Indeed, the reduction of transaction costs due to the extinction of national currencies would foster the mobility of goods and production factors within the zone and their better allocation, enhancing economic growth and well-being. Thus, the integration of financial and labor markets would be crucial to the success of the project. However, most studies at the time revealed that this was far from being the case, suggesting that difficulties in some countries would be felt in the event of economic and financial crises. Another critical element then referred to was the inability to intervene by the use of a small Community budget and tied to rigid criteria for allocating funds, which did not foster the flexibility that an economic policy instrument of this nature should have as a stabilizer and buffer against economic shocks. In addition to this, the passivity with which some procedures and mechanisms created to control national budgets have been applied, which will have contributed to stimulate situations of heavy indebtedness, both public and private, in some countries of the Eurozone. In the face of such a process of monetary integration with these structural constraints and flaws, it was not surprising that the recent global financial crisis fell sharply on the more vulnerable economies of the Eurozone and that its systemic effects had gradually spread to other countries and sectors, threatening the sustainability of public finances in those countries and the survival of the Eurozone itself. Of course, the severity of the crisis and the inability to counteract the effects of contagion are factual evidence of the structural weaknesses of the Eurozone, avoiding it to deal with such situations. In reality, the insufficient and imperfect coordination of budgetary and fiscal policies and the absence of centralized supervision and banking resolution mechanisms allowed the spread of the public debt crisis to the banking sectors and to the rest of the real economy.

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In this context, it is no wonder that the future of this model of monetary union and heated discussions in academic and political circles on the real causes of the crisis and on how to correct its layout and operating rules have begun to emerge, in order to complete a process which has strongly proved to be very limited. Under this background, serious doubts have been raised about the Eurozone’s ability to continue if its leaders do not show the ability and boldness to correct in a timely manner what the experience has shown to be bad options. In a process such as this, marked by uncertainty, as a result of overall economic and financial developments and political decisions, the development of scenarios on the possible evolution of the monetary integration process in Europe has been the subject of a number of studies carried out in recent years. In fact, these studies make it possible to explain the crucial uncertainties that surround the process and the structural challenges to be faced, which shape the various responses that can be given at the socio-economic and political-institutional levels. The inevitability of an eventual dismantling of the Eurozone, or the withdrawal of some of the current members, if the reforms already initiated are not completed and deepened, constitutes a real risk and that, in the end, constitutes the reason that motivates us to revisit and reflect on the scenarios under discussion, advancing at the end with our perspective on the subject. In this context, this chapter presents and discusses the feasibility of some of the scenarios that the Eurozone is currently facing, based on the economic and institutional trends since the creation of the Euro, in light of the rationality and the fundamentals that must sustain a viable and effective Economic and Monetary Union in Europe. The rest of the chapter is structured as follows: Section 2 provides a critical analysis of the scenarios which, in general, for the European Union, and, in particular for the Eurozone, the literature has been presenting; Section 3 presents our own perspective about the theme; Section 4 concludes.

2. THE PROPOSED SCENARIOS Given the current date, it is interesting to start by referring to Estella (2008), where some possible scenarios for the European Union in 2017 were presented. According to this author, of the 6 possible scenarios, namely: (1) termination; (2) variable geometries; (3) status quo; (4) incremental integration with variable geometries; 5) incremental integration without variable geometries; and (6) political union, the most likely would be for the European Union to be (in 2017) somewhere between scenarios (2) and (3), i.e., a free market zone associated with policies reflecting variable geometry. The higher likelihood of this prospective situation would result from the more probable evolution for the factors that, according to the author, would be decisive, namely: (1) future enlargements; (2) the degree of diversity implied by such enlargements; (3) the, somehow

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associated, increase in the heterogeneity of interests resulting from those eventual enlargements; and (4) the delegation of nuclear competences to the EU by the several member-states. The above example is methodologically interesting for several reasons: a) by distinguishing the possible scenarios from the most likely scenario(s), due to the greater probability associated with the determining factors, which are therefore duly identified; b) to illustrate the possibility that the most probable scenario is somewhere between two possible scenarios; c) considering the status quo situation as a possible scenario. Taking into account these aspects, we propose as a working methodology the following. Let us symbolically consider that a scenario can be characterized by a set of relevant variables, y, which result from a combination of, say, internal – in the sense of controllable – factors, x, and of, say, external – in the sense of non-controllable – factors, z. Assuming two possible states for internal and external factors, namely favorable and unfavorable situations, there may be four possible sets of scenarios: (1) favorable, when both factors present favorable situations; (2) unfavorable, when both factors present unfavorable situations; (3) problematic, when external factors present a favorable situation, and internal factors present an unfavorable situation; (4) difficult, when the external factors present an unfavorable situation, and the internal factors present a favorable situation. See Figure 1, where it is assumed that x is measured in the horizontal axis, whereas z is measured in the vertical axis.

Difficult scenarios

Favorable scenarios

Unfavorable scenarios

Problematic scenarios

Figure 1. The four quadrants of possible scenarios.

Figure 1 illustrates a relevant aspect in these matters, which gains relevance in a temporal perspective, in which controllable, though exogenous, factors, x, can be used, as a reaction, to an unfavorable evolution of external factors, z. A problematic scenario can thus become a favorable scenario – where the problem has been resolved – if the European Union's (internal) response is the most appropriate to deal with this unfavorable situation of non-controllable factors.

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The Figure above also illustrates another relevant aspect, which is the role of chance in difficult scenarios, i.e., those where, appropriate European Union’s policies are combined with unfavorable external circumstances. The transformation of this difficult scenarios into favorable ones depends only on the chance of external factors changing to (more) favorable situations. From Figure 1 it is also possible to clarify an issue, which is of extreme importance. Assuming the current situation – identified in Figure 1 with the origin, from where x and/or z may evolve in a positive or negative way – its consideration as a status quo scenario should not be confused with the well-known natural scenario, which considers a, possible different, future situation by the external factors, z. To put it clear, a natural scenario, being the consequence of (previous) status quo policies combined with the most likely scenario for the non-controllable factors, can be positioned in any of the 4 quadrants of Figure 1. As an application of the above, let us consider the 4 scenarios presented in Boostra et al. (2017)1. According to these authors, the current situation (status quo), identified as being of muddling through, is considered to be unsustainable in the long run, giving rise to a favorable scenario – as a result of greater cooperation and more Europe – or an unfavorable scenario – as a result of less cooperation and less Europe – or a difficult scenario – which will involve more cooperation but less Europe – i.e., a two-speed Europe. In fact, even in official documents of the European Union (European Commission 2017) it is recognized that the current settlement needs to be transformed into another one where the determining factors present themselves in a more favorable situation2. With regard in particular to the Economic and Monetary Union (EMU), its economic component seems to represent a greater challenge in the future. It is therefore recognized that EMU remains incomplete and falls short of expectations. As proof and cause of this recognition, one can mention the economic and social divergences arising in the wake of the crisis, the associated breach of confidence in the European institutions, and the recognition that, of course, EMU is not immune to external shocks. The success of EMU as a determining factor in the success of the European Union is well evident in the recent Rome Agenda (March 25, 2017), which recognizes the importance of a strong and stable framework of the single currency for growth, social cohesion and competitiveness, in a more integrated European Union, from an economic and political point of view, where there is a convergence of economies. It remains to be seen whether the Eurozone will function as an optimal currecy area, where a single monetary policy is the most convenient for all, requiring, for example, real 1

In a sense, the studies of Rodrigues (2012) and Dirksen et al. (2013) are in close agreement with this methodology, by taking into account the possible evolution of the determinants factors, whether external or internal, in order to determine the possible scenarios (for the Eurozone). 2 It is interesting to note that ‘muddling through’, understood as a process of making flexible economic policy, adapting to sometimes unexpected evolutions of external factors, is not by itself a wrong strategy (Lindblom 1959). Indeed, “Policy-making is a process of successive approximation to some desired objectives in which what is desired remains to change under reconsideration.” (Lindblom 1959: 86), may be the right approach. In considering the ‘muddling through’ situation as unsustainable, it is recognized that something substantial should change.

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synchronization of business cycles inside the area. Naturally, if this is not the case, the scenarios that will be set can range from the dismemberment of the Eurozone to the creation of a European Union of variable geometry, for example through a hard core, forming the Eurozone, and a peripheral set of member-states remaining outside the euro area. In fact, the coexistence of the present composition of the Eurozone with a scenario characterized by a European Union scenario at two (or more) speeds seems to be incongruent, as sooner or later the lower speed countries will have to leave the euro area. This will be especially true if, for structural (for instance, of budgetary nature) or cyclical (for instance, negative exogenous shocks) reasons, the lowest speed countries present levels of growth substantially below those of the fastest countries. Taking that into account, it is of importance to further explore the scenario corresponding to a possible extinction of the Eurozone. Starting with the obvious, which is not without interest, the Eurozone will be extinguished if the European Union is extinguished. The European Union, in turn, can be extinguished if, as a result of a muddling through scenario, external factors lead to the implosion of the Eurozone. For example, the failure of fiscal integration could contribute to reinforce divergences among the economies making it impossible, at worst, for the single monetary policy to be the most convenient for any member of the Eurozone or, at best, to be the most convenient for a narrow group of countries, in a scenario of a two-speed/variable geometry European Union. As a matter of fact, the circularity of the argument presented above, calls (again) the attention for the relevance of right decisions taken by the European Union member-states, making it possible a higher level of integration through the delegation of power, namely at the fiscal policy level. This scenario, in a sense, would transform some, for the moment, exogenous factors into (more) controllable ones, which is essential for the success of the Eurozone, therefore also for the success of the European Union as a whole. Assuming a pessimistic outlook, the scenario of the extinction (gradual or instantaneous) of the Eurozone has been studied by several authors, giving it greater or lesser plausibility (Rodrigues 2012, Sapir et al. 2013, Dirksen et al. 2013, Sapir 2013, Straubhaar 2011). Among those who considered the extinction of the Eurozone more likely to stand out are Sapir (2013) and Sapir et al. (2013). According to these authors, the Eurozone would be far from constituting an optimal monetary zone, being rather a set of countries with unequal levels of development and distinct cultures, languages and even political options. As is well known, the 2008 crisis affected the overall growth of the EU as a whole but did so in an unequal way, given that, in an economic context of contraction, some countries were forced by the creditors to implement austerity policies. This immediately had as a consequence a lost of credibility and a breach of confidence in the European institutions and in particular of the advantages of belonging to the Eurozone, given the lack of a devaluation exchange rate policy that could restore the competitiveness of the economy.

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Assuming the natural scenario of worsening structural deficiencies of the Eurozone, Sapir et al. (2013) considered three evolution scenarios for the euro area: H1: a controlled dissolution of the Eurozone; H2: a division of the Eurozone into two parts (roughly, one Southern Euro and one Northern Euro); H3: an uncontrolled dissolution of the euro area. Plainly, to all these three cases would correspond somehow different consequences at various levels, namely for the functioning of the financial markets3. Straubhaar (2011) also considered the possibility of an unfavorable scenario, corresponding to the implosion of the Eurozone, as well as a favorable scenario, corresponding to advances in fiscal union and transfers, but, more interesting than that, is the scenario corresponding to the restructuring of public debts, as an essential factor to promote the necessary approximation of economies. Not putting aside the hypothesis of the dissolution of the Eurozone, but being more optimistic than that, Rodrigues (2012), followed by Dirksen et al. (2013), considered 4 possible scenarios for the euro area in 2020:    

(Scenario 1) Member-States continue to make small strides in managing the crisis, which could lead to the collapse of the monetary union; (Scenario 2) In another variant, further declines in political integration are possible; (Scenario 3) A particular combination of factors could lead to a two-speed Europe around a hard core; (Scenario 4) Under pressure from some Member-States, the Union is supplemented by a budgetary and political Union.

The muddling through scenario is again viewed as difficult, from the point of view of the monetary union, allowing for some European hierarchy and differentiation among coutries. An unfavorable scenario consists on the fragmentation and disintegration of the European Union. On the positive side, a two-speed Europe scenario may still be problematic in what it requires in terms of a unique monetary policy. Finally, a favorable scenario would correspond to a delegation of budgetary decisions by the member-states, sharing a unique political perspective. Those four scenarios were reproduced in Dirksen et al. (2012). Assuming as crucial the evolution of determinant factors such as the growth rates, the public debt, the unemployment rate, the role of some institutions, such as the FMI and the ECB, the engagement of citizens, the willingness to delegate decision powers at a budgetary and political level, etc., four scenarios can be considered: 3

With regard to the 4 scenarios proposed in Dirksen et al. (2013) - based on Rodrigues (2012) - namely Scenario A: Muddling-through the Crisis, Scenario B: Break-up of the Eurozone; Scenario C: Core Europe, and Scenario D: Fiscal Union Completed, Sapir (2013) draws attention to the importance of Germany's position, which could be, through a concerted dissolution of the euro zone, to lead a hard core in the European Union.

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





Scenario A: Muddling-through the Crisis – In Dirksen et al. (2012) own words, this corresponds to “A House without a Roof”. Plainly, the inexistence of a ‘roof’ makes the ‘house’ quite vulnerable, especially when the ‘weather’ conditions are problematic. Scenario B: Break-up of the Eurozone – This corresponds to “The House Falls Apart and the Neighbourhood is Affected”. This unfavorable scenario calls the attention for the consequences of the Eurozone implosion, not only for the Eurozone member-states. As a catastrophic consequence, it may lead to the European Union dismantlement. Scenario C: Core Europe – This corresponds to the “Construction of a Smaller and Stable, but Exclusionary House”. This scenario, in a sense, is put in opposition to the (political) ideal behind the European Union as it may mean a diminishment of the number of member-states4. Scenario D: Fiscal Union Completed –This corresponds to the “The Roof is Repaired and Construction Completed”. This favorable scenario requires further integration and budgetary discipline, which seem difficult in some countries, given the level of public debt.

In a sense, the 4 scenarios referred to above are also those considered in Morgan Stanley (2012), i.e., 





4

The “European Renaissance” scenario, corresponding to an increase in economic convergence, accompanied by steps towards the Fiscal/Political Union. This favorable scenario would correspond to the “good” one; The “European Divorce” scenario, corresponding to an increase in economic divergence, accompanied by setbacks in relation to the Fiscal/Political Union. This unfavorable scenario would correspond to the “ugly” one, in particular by having the break-up of the euro as a consequence; The “Italian Marriage” scenario, corresponding to some moves towards the Fiscal/Political Union but, at the same time, an increase in economic divergence being observed. This difficult scenario would correspond to, in a sense, an European Union (economic) division into some core and peripherical groups of member-states, which would, in fact, involve some difficulties in the engagement towards higher integration, particularly on the part of the non-core countries;

As a matter of fact, some authors have been calling the attention for the increased difficulties resulting from a European Union with such a great number of member-states (Esella 2008, Bongardt & Torres 2016). In a debate in Rome on the state of the EU in May 2016, the President of the European Commission, Jean-Claude Juncker, said: “We have too many part-time Europeans.” (http://www.bbc.com/news/world-europe-36224839; accessed on August 11, 2017). Obviously, in this case, the number is important but, more importantly, is the fact that they are part-time Europeans. This statement is, a sense, related to the existence of diverging national interests, which overlap EU interests, undermining the possibility of the EU being an optimal political area (Alesina et al. 2017).

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The “Staggering On” scenario, corresponding to an increase in economic convergence but also failures in the fiscal integration. This problematic scenario, which is considered to be the most probable by Morgan Stanley (2012), at least in the short term, would mean, in a sense, an economic success of the ‘muddling through’ but is also a failure from a political point of view.

3. OUR PERSPECTIVE TO ANCHOR A FAVORABLE SCENARIO In this section, we will present our perspective on some possible scenarios for the Eurozone, which are to be related with the correspondent scenarios for the European Union. In doing so, the methodology behind Figure 1 will be used. As ‘internal’ factors we will consider the decisions taken, in particular, by the European Central Bank, and those taken, in general, by the other institutions of the European Union. As ‘external’ factors we will consider the decisions taken, at a national level, by the member-states, as well as all the other non-controllable factors. The combination of all these internal and external factors leads to possible changes in the objective variables, such as economic growth rates, public debt levels, and unemployment rates, external account balances, inflation rates, etc., which are decisive for the scenarios shown in Figure 25.

Figure 2. Four scenarios for the future of the Eurozone and of the European Union.

Taking into account the four scenarios, as defined above, in a theoreticalmethodological setup, we will briefly present the main characteristics of each one and the set of conditions that should be resolved in the context of the Eurozone so that the “favorable scenario” can be considered (the most) plausible (one).

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In a sense, this is also the approach considered in McKinsey Germany (2012). Of interest is also Meyer (2016), where the importance of economic growth rates is emphasized.

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In this way, we believe that any of the remaining three scenarios present significant risks to the continuity of the European construction project, which, through different channels, will double the matrix that has always characterized this project during its 60 years of life: on the one hand, deepening the strands of economic and political integration, which are inseparable aspects, so that all members can benefit from this process and, on the other hand, the gradual enlargement to the European countries which share principles and objectives considered essential since the constituent Treaties and which have gone through this arduous path. Of course, and because we believe that the recent crisis has provided an opportunity to redefine the governance model and practices of the Eurozone, making its benefits extensive to all its members, we will focus in some detail on the critical issues on which to decide to make possible and credible the scenario that we consider to be desirable. In line with the conviction shared by the authors who contributed to this publication, we believe that only going beyond the timid institutional responses registered so far and consensualizing effective structural reforms in the governance of the Euro, the European Union will be able to build an economically and socially consensual project at the political level. In what concerns the unfavorable scenario, it seems unlikely given the high costs related to the extinction of the Eurozone or even of the European Union. From a certain perspective, these costs would correspond, at the very least, to the existing benefits of, for example, the existence of common currency – despite all the evident limitations of the Eurozone – or to the existing benefits of, for example, the existence of a common market – despite not being totally achieved. With regard to the difficult scenario, i.e., a variable-geometry Eurozone it seems unsustainable, given the difficulties that would imply at establishing unique monetary policy that would be compatible with the interests of the Eurozone member-states as a whole. Furthermore, the existence of two (or more) partitions of the Eurozone would contribute to distinct paces of evolution by the European Union member-states. In what concerns the problematic scenario, which becomes more relevant given being the natural scenario. In fact, staggering on, if transformed into correct muddling through, can also be the scenario where, by handling the problems, through the right decisions, can better adapt internal factors to the evolution of external factors. Indeed, in what concerns to the scenario appointed as the more favorable to the continuity and deepening of the European construction process, it is recognized that, when the Eurozone was created, it was not an optimum currency area (OCA), neither the institutional and functional structure allowed to set up conditions for the monetary area to function effectively and to ensure its viability. The disparate social effects of the recent economic and financial crisis on its members are abundant evidence of this situation, which is confirmed by the persistent structural divergence and the different dynamics in the economies of the Member States during the crisis.

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Thus, in order to achieve this favorable scenario for the Eurozone, to approach the optimal Mundellian conditions for the effective functioning of the European Monetary Union (EMU) will only be possible if there is significant progress in the area of political integration, which inevitably has to be linked to the development of (some)a model of fiscal integration. To this end, the current reluctance of States to share risks and sovereignty, delegate decision-making powers and transfer skills and means to a central level will have to be overcome. It is a fact that in the wake of the crisis that has affected the economies of the Eurozone in recent years, its design and its economic governance have been the target of a number of institutional reforms with some relevance, which have contributed to improve its resilience to external shocks. However, there are still major challenges to face in the future, which naturally require consistent policy decisions. The proved progress in macroeconomic and fiscal policy is not enough so that, in the event of economic crises, Member States are not forced to resort to pro-cyclical policies again. The European Stability Mechanism (ESM), which was created in 2012 and had a prominent role at the time to calm the turbulence of financial markets, is a conditional instrument aimed at financial stability, but it does not appear to be as an effective automatic stabilizer of the economy. The Eurozone still needs the means to intervene in case of systemic crises, for even if the Banking Union is completed, its ability to break the pivotal link between banks and sovereigns will always be limited if it is not complemented by adequate budget support and specific measures to reduce the exposure of national banks to their sovereign debt. This question seems to us crucial, since the roots of the recent crisis and much of the reasons for its excessive prolongation in time and the inherent difficulty in recovering reside in this perilous relationship, as abundantly is evidenced in this publication. Thus, although the capacity to absorb economic shocks can be strengthened with the creation of the Banking Union and the Capital Markets Union, which are mechanisms still far from being fully implemented, the specific nature of national fiscal policy in the context of monetary unification of a centralized fiscal mechanism that can be triggered in case of difficulties of access to financing in foreign markets. In this context, also the possible issuance of some kind of common debt in the Eurozone can ease the pressure on national governments during recessions, improving the financial stability of the Zone and the very operation of the single monetary policy. Therefore, despite the theoretical framework recommending greater integration and cooperation in the fiscal field, in favor of the macroeconomic stability of the Eurozone, the main challenges remain require effective responses on the content and the way in which fiscal capacity strengthening at central level should assume, which depend on distinct political positions and which have hitherto blocked any structural solution. The discussion on strengthening European fiscal integration is not new since, after the MacDougall Report of 1977, the issue has been addressed in the Community institutions,

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in special by considering it as a precondition for a higher monetary integration, as was the case at the time of the Maastricht Treaty. The academic and political visions on the best model of fiscal union, aiming to coordinate fiscal policies and/or assume additional competences in the Eurozone, cover a wide range of issues, which, according to Gnath and Haas (2015) can be synthesized in two perspectives: the sharing of sovereignty and the sharing of risk. Those who argue that the road to a fiscal union should be anchored in the sharing of sovereignty advocate greater oversight of national fiscal policies with the inherent strengthening of the capacity of the Community institutions and a strong incentive to discipline national public finances. The imposition of sanctions on non-compliant States, in the light of the objectives set out in the Treaties and the central political guidelines, will result directly from the supervision tasks of the Member States’ fiscal policies. Hence, with regard to the causes of the recent sovereign debt crisis, this line explicitly argues that it was the poorly responsible management of budgetary policies in some countries that led to financial instability and the consequent loss of access to external financing. It is also believed that the strategies pursued by the European institutions to withdraw sovereignty from national fiscal policies have not been successful, thereby reducing confidence in the effectiveness of current European budgetary rules, notably in the Stability and Growth Pact. In a distinct viewpoint, emphasizing the need for greater risk-sharing among member states, it is advocated another direction to consolidate a fiscal union. In fact, this line believes that it was the specific shocks in each country that fueled the spiral of contagion that spread the crisis to other Member States and launched uncertainty on its integrity and jeopardized its future sustainability. In this context, a new model of fiscal union should provide the EMU with a system of mutual support that allows risk sharing between its mambers, which will help to reduce the occurrence of generalized and systemic effects within the Eurozone. The specific proposals to consolidate a more risk-sharing system, which appear elsewhere in other chapters of this book, range from anti-cyclical shock absorption mechanisms based on a common unemployment insurance system to, for example, the issuance of common debt bonds in the euro area. There are plenty of stimulating discussions going on about specific features that the various solutions can take, which can be noticed in Thirion (2017). In our view, anchored in results presented in some chapters of this book6, the fiscal framework reforms that have been implemented so far and which remain, almost

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For example, in the chapters by Caetano, Vaz and Caleiro, and Ferreira, Caetano and Basilio, it is shown that the crisis in the Eurozone showed that it was unable to prevent some countries from becoming too exposed to the turbulence of international financial markets. Indeed, the shortcomings of the Eurozone have contributed to the amplification of the effects of the absence of synchronization of economic cycles and the fragmentation of financial markets, so that the limited national instruments to deal with the crisis have had a particularly severe social impact.

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exclusively, centered on the sharing of sovereignty of fiscal policy are scarce to create a more effective and balanced monetary zone. In reality, both the Fiscal Pact and all the legislative strands built to strengthen the Stability and Growth Pact’s capacity (such as the “European Semester” and the “Six-pack” and “Two-pack” measures prove) are intended only to strengthen oversight of the ex-ante and ex-post budgets of Member States in a more comprehensive way, in order to reduce the deficits in the presence of more credible threats on the imposition of sanctions. We do not deny that stricter fiscal rules can help stabilize a monetary union. A country with controlled debt levels has more leeway to apply anti-cyclical policies in case of crisis. However, stricter and, perhaps, more efficient budget surveillance alone will be insufficient to create stability throughout the Eurozone. Indeed, in a context where the scope of the common monetary policy is limited to pursue economic stabilization, it will be crucial that risk sharing between countries and actors be anchored in suitable tools and with sufficient resources to exert this stabilizing function. At the same time, mechanisms should be put in place that can gradually promote the synchronization of economic fluctuations in monetary union over time. Only through the strengthening of the Union’s fiscal capacity can ensure that a fiscal transfer mechanism, timely used, can have an automatic stabilizing effect and minimize the impact of fluctuations in economic activity on the employment in Member States. Naturally, the degree of flexibility of labor markets and the sensitivity of unemployment to economic cycles will decisively influence the effectiveness of a tax transfer system. The existence of a gradual convergence in the structural policies that affect employment markets in the Eurozone will also be a relevant feature in order to meet the requirements of an optimal monetary area. In short, if we want the euro to become a pillar of European independence, Member States will have to make concessions in terms of their autonomy, sharing it through the adoption of clear and well-founded rules.

CONCLUSION In this chapter we have presented and discussed some scenarios that stand out for the future of the Eurozone, taking into account the evaluation of what has been the course of this project in 20 years of life. Of these, four scenarios were considered to be possible:    

Favorable: Eurozone as an OCA and, eventually, a Fiscal/Political Union; Unfavorable: Extinction of the Eurozone and, eventually, of the European Union; Difficult: Partition of the Eurozone and, eventually, of the European Union; Problematic: Staggering on by the Eurozone and, eventually, a muddling through by the European Union.

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Of course, the institutional model that supported the conception of this Monetary Union, based more on political will than on arguments of an economic nature and, therefore, the subject of critical criticism at the time of its creation, had its most demanding test during the crisis of sovereign debt. The turbulence in this period and the difficulties experienced by some Member States have revealed the shortfalls of the architecture of the Eurozone, which have even jeopardized the continuity of the single currency. Against this background, we have reviewed the possible scenarios for the evolution of the Eurozone and outlined the conditions that, in our opinion, will ensure the scenario considered favorable to the European integration process. Due to the complex historical context in the post-World War II period, the process of European integration has emerged and has been consolidating over decades as a result of political objectives and motivations, relegating economic arguments and motives to a secondary level. Perhaps for this reason, economic theory has not provided suitable support for the guidelines taken to be anchored on sound foundations. This led to the decision-makers opportunistically taking advantage of the positions of the various theoretical approaches, so that outcomes were sometimes discarded, recommending ways that were not acceptable at the political level, and at other times some results served to selectively justify options. One expressive example of this discretion in the use of economic theory to support political choices was surely the way forward for building European Monetary Union. Indeed, on the one hand, the theory of optimal currency areas has been widely recognized since the 1960’s as a proper framework for assessing the structural conditions for countries to successfully share a common currency. On the other hand, several empirical studies have alerted for the risks posed by some candidates to join the Eurozone if the Monetary Union model envisaged at Maastricht was to go ahead. In any case, it is certain that this theory and the subsequent warnings were devalued in the framework of the decisions then taken. In addition, in order to counteract the prominence that OCA theory had already acquired, which could hardly be ignored, Frankel and Rose (1998) argued for endogeneity in the process of creating a single currency. In fact, by arguing that the conditions of OCA were dynamic and that its impact would gradually promote the structural convergence of the members, it was accepted that the automatic functioning of the economies in this monetary framework would induce convergence within the Eurozone. As Vieira and Vieira eloquently display in this publication, the hypothesis of endogeneity in the single currency bringing the countries economic structures closer together was a kind of mirage, as the evolution of the Eurozone during the crisis has been showing in a striking way. It has been recognized that there are multiple synergies and complementarities between the development of the European Monetary Union and the OCA’s theoretical framework,

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even though since the seminal study of Mundell in 1961 considerable progress has been made that has shaped a new theoretical framework for Monetary Unions. We also believe that, given the lessons learned from the recent crisis and the gaps revealed by Eurozone governance, alongside the loss of relevance of the European Union on the global stage, there is currently a different political perception about the effective nature of monetary union, emphasizing less the costs of losing macroeconomic instruments and increasingly valuing the potential benefits of sharing a common currency. As Mongelli (2013) claims, when the European Monetary Union was designed, the framework of the OCA was not very operational nor provided a basis for a clear political orientation. In addition, the implementation of measures for the Single European Market, which took place simultaneously with the discussion on the single currency project, did not help to adopt strategic guidelines on the role of common markets for economic convergence between Member States. It was not surprising, therefore, that while the financial markets had progressed rapidly on the path of integration (at least until they triggered the crisis), the remaining markets, especially labor markets, continued fragmented and the objective conditions for labor mobility and flexibility were not formed. As stated above, political determination has been the fundamental motive of European integration, and therefore Monetary Union has been more a result of the political will of States than of the economic coherence of the choices made, or of the controversial nominal convergence criteria that qualified the candidates, either in the design of the governance model itself. The recent past has revealed without much contention that some countries in the current Eurozone should not have adopted the common currency with the structure defined by the Maastricht Treaty given the high economic, social and reputational costs they have borne and will continue to bear. Although there are still different opinions on the interest in maintaining these countries in the Eurozone, there is a majority expression of those who maintain that the benefits of this will outweigh the costs to be borne by the Member States, and its operating framework should be preserved and improved with the necessary reforms, widely discussed in this book. However, the internal political constraints persist in some countries, which have limited some major reforms to bring the functioning of the Eurozone closer to the conditions inherent in an optimal monetary zone. As we argued in the previous section, the desirable scenario will include strengthening the process of fiscal integration in the Eurozone, anchoring a model that accommodates mechanisms for sharing sovereignty and risk among Member States, corresponding political and fiscal integration. The principles on which the fiscal policy pursued by the Member States should be governed would be focused on the following: it must be countercyclical, consistent with the long-term sustainability of public debt, and with simpler rules; it should also be supplemented with a well-designed transfer system which

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could take the form of a European unemployment insurance scheme or a strict stabilization fund. These orientations are crucial, not only for redistributive reasons, but because this would benefit all Eurozone members. In spit of we recognise that the Eurozone is not expected to become an effective fiscal union within a short time, we believe that there are concrete initiatives under discussion that can mitigate some of the gaps revealed during the crisis. In addition, the attitude of the ECB, which is relevant in solving some of the blockages to which some Member States have been exposed, has assumed itself as the ultimate provider of resources, mitigating the vulnerability of countries to the financial markets and avoiding the risk of liquidity crises. In fact, in a chapter of this publication, Vila Maior and Camisão argue that, in response to the crisis, the intervention of the ECB has been gradually supporting the fiscal policy of the Member States through public debt acquisition programs. However, the main goal of ECB’s intervention is to support the credibility of profligate Member States’ fiscal policy, reducing the pressure of financial markets. We must recognize then that the sphere of action of the monetary authority is progressively entering the field of fiscal policy, which indicates a significant change to the original balance of the division of powers between the actors responsible for monetary and fiscal policies. In short, the dynamics of the behavior of the Community institutions during and after the crisis may be contributing in an objective, and perhaps even irreversible, way to change the correlation of forces and the separation of powers, opening space for new solutions and future changes in the very constitutional scope of the Treaties of the European Union. We believe that consolidating the European integration will also require stronger political coordination at the central level, going beyond mere intergovernmental coordination, which has so often tied to unanimity requirements in key areas, has led to deadlock in decision-making. A final word goes to the inevitable limitations of this chapter. By its nature, for example the subjectivity inherent in the greater or lesser likelihood of the scenarios corresponding to the determinant factors, the limitations of this chapter are unavoidable. One of the possible ways to improve our analysis is, therefore, the attempt to determine the trend, and its subsequent use to project the future, of those determinant factors.

REFERENCES Alesina, A., Tabellini, G. and Trebbi, F. 2017. “Is Europe an optimal political area?”. National Bureau of Economic Research, Working Paper 23325 (Available at http://www.nber.org/papers/w23325; accessed on July 04, 2017). Bongardt, A. and Torres, F. 2016. “The Political Economy of Brexit: Why Making It Easier to Leave the Club Could Improve the EU”. Intereconomics 51(4): 214-219. (Available

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at https://archive.intereconomics.eu/downloads/getfile.php?id=1007; accessed on July 04, 2017). Boonstra, W., Badir, M., de Groot, E., Prins, C., van Schoot, D., Smit, H., Vrieselaar, N. and Wijffelaars, M.. 2017. “Four scenarios for Europe: A struggling Europe in a changing world”. (Available at https:// economics.rabobank.com/Documents/ 2017/februari/The_uncertain_future_of_European_integration-201702-totaal.pdf; accessed on July 04, 2017). Dirksen, U., Hacker, B., Rodrigues, M. J. and Velt, W. 2013. Scenarios for the Eurozone 2020. Scenario Team Eurozone 2020, Friederich Ebert Stiftung, Berlin, March. (Available at http://library.fes.de/pdf-files/ id/ipa/09723.pdf; accessed on July 04, 2017). Estella, A. 2008. “European Union Scenarios for 2017”. Real Instituto Elcano. Working Paper 39/2008. (Available at https://www. researchgate.net/publication/239603111_ European_Union_Scenarios_ for_2017; accessed on July 04, 2017). European Commission. 2017. Reflection Paper on the Deepening of the Economic and Monetary Union. (Available at https://ec.europa.eu/ commission/sites/betapolitical/files/reflection-paper-emu_en.pdf; accessed on July 04, 2017). Frankel, J. A., and Rose, A. K. 1998. “The Endogeneity of the Optimum Currency Area Criteria”. The Economic Journal 108(449): 1009-1025. Gnath, K., and Haas, J. 2015. “A Fiscal Union for Europe – Building Block and Not a Magic Bullet.” Jacques Delors Institute. Spotlight Europe, October. (Available at http://www.delorsinstitut.de/2015/wpcontent/uploads/2015/10/20151014_Spotlight_Fiscal-Union_Haas_ Gnath. pdf; accessed on November 20, 2017). Lindblom, C. E. 1959. “The Science of “Muddling Through.” Public Administration Review 19(2): 79-88. (Available at https://faculty. washington.edu/ mccurdy/SciencePolicy/Lindblom%20Muddling%20Through.pdf; accessed on July 04, 2017). Meyer, H. 2016. “Reviving the Promise of Prosperity in the European Union.” Hans Böckler Stiftung: Macroeconomic Policy Institute. Research Essay 10. December. (Available at https://www.socialeurope. eu/wp-content/uploads/2016/12/RE10Meyer.pdf; accessed on July 04, 2017). McKinsey Germany. 2012. “The future of the euro – An economic perspective on the Eurozone crisis.” McKinsey & Company, January. (Available at https://www.mckinsey.de/files/The%20future%20of%20the%20euro_McKinsey% 20report.pdf; accessed on July 04, 2017). Mongelli, F. P. 2013. “The Mutating Euro Area Crisis: Is the Balance between ‘Sceptics’ and ‘Advocates’ Shifting?” ECB Occasional Paper 144, February. (Available at https://ssrn.com/abstract=2217605; acessed on November 22, 2014).

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Morgan, S. 2012. “Euro Area Scenarios: The Good, the Bad and the Ugly.” (Available at http://www.morganstanley.com/institutional/research/pdf/GMA05022012.pdf; accessed on July 04, 2017). Rodrigues, M. J. 2012. Which scenarios for the future of the Eurozone? Friedrich Ebert Stiftung. (Available at http://library.fes.de/pdf-files/bueros/paris/09553.pdf; accessed on July 04, 2017). Sapir, J. 2013. [Reprise] What future for the Eurozone? (Available at https://www.lescrises.fr/quel-futur-pour-la-zone-euro/; accessed on July 04, 2017). Sapir, J., Murer, P. and Duran, C. 2013. Scenarios of Dissolution of the Euro. Res Publica Foundation. September. (Available at http://www.fondation-res-publica.org/ docs/etude_euro_respublica.pdf; accessed on July 04, 2017). Straubhaar, T. 2011. "Three scenarios for the future of the euro". Economic Life - Economic Policy Review 11: 30-33. (Available at http://dievolks wirtschaft.ch/content/uploads/ 2011/11/10F_Straubhaar.pdf; accessed on July 04, 2017). Thirion, G. 2017. “European Fiscal Union: Economic rationale and design challenges”. CEPS Working Paper 2017/01. January. (Available at https://www.ceps.eu/ system/files/WD2017-01GT%20FiscalUnion. pdf; accessed on November 20, 2017).

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ABOUT THE EDITORS José Manuel Caetano, holds a PhD in Economics from the University of Évora (Portugal) and currently is Associate Professor in the Department of Economics (University of Évora) and is a collaborator of the Centre for Advanced Studies in Management and Economics (CEFAGE-UE). His research interests are international economics and European economic integration. In the last years he was focused on the determinants of intra-industry trade and Foreign Direct Investment and on the process of European Monetary Integration, on which he published several articles in international journals and books. He was vice-rector of University of Évora and Head of the Scientific Council of Departmental Area of Economic and Business Sciences in that University. He coordinated some Portuguese research teams in international projects, as “The Eastward Enlargement of the Eurozone - Ezoneplus” in partnership with Freie Universitat Berlin (Germany), Institute for Economic Research (Slovenia), University of Tartu (Estonia), Government Institute for Economic Research (Finland), Università di Bologna (Italy) and Warsaw School of Economics (Poland).

Miguel Rocha de Sousa holds a PhD in Economics from the University of Évora (Portugal) and a BSc and MSc in Economics from Universidade Nova de Lisboa (Portugal). He is Assistant Professor and Economics Department Head (University of Évora). He is a researcher of the Centre for Political Studies and a collaborator at the Centre for Advanced Studies in Management and Economics (CEFAGE-UE). His areas of research are Economic Development, International Macroeconomics, and Quantitative Methods in Economics and International Relations, with a focus on Latin America and Europe. He is Vice-executive president of Research Committee 35 (Technology and Development) of International Political Science Association (IPSA), and Associate of Society for Advancement of Socio Economics (SASE), American Economic Association

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(AEA) and Associação para o Desenvolvimento Económico e Social (SEDES). He has recently co-edited: (2017) Globalization and Agriculture: Redefining Unequal Development.

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ABOUT THE CONTRIBUTORS Ana Gouveia is an economist specialized in public policy and political economy. She holds a PhD in Economics from Nova School of Business and Economics and is currently the Head of the Economic Analysis, Research and Forecasting Department at the Portuguese Ministry of Finance and an invited Assistant Professor at Nova School of Business and Economics. She is member of different international fora, namely from the European Commission and the OECD, in the fields of structural reforms, economic governance and productivity. She has worked for the Portuguese Ministry for the Economy, the European Central Bank and Banco de Portugal.

Andreia Dionísio holds a PhD in Management, Quantitative Methods. She is Assistant Professor at the University of Évora (Portugal) and full member and vice-director of Center for Advanced Studies in Management and Economics of the University of Évora (CEFAGE-UE). Her main research areas are econophysics, econometrics and applied statistics to economics and management.

Annette Bongardt is Visiting Senior Fellow in European Political Economy at the London School of Economics. Previously she visited the R. Schuman Centre for Advanced Studies, European University Institute (EUI), and the European Studies Centre at St Antony’s College, Oxford University. She heads International and European Studies at the National Institute for Public Administration and is Associate Professor at Universidade Fernando Pessoa (Porto). She holds a PhD in Economics (1990) from the EUI, Florence.

António Caleiro has been an Assistant Professor in the Economics Department of the University of Évora (Portugal) since 2001, after having earned a PhD in Economics from

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the European University Institute (Florence, Italy). A simple query on his curriculum vitae shows that his research interests are of multidisciplinary nature.

António Covas holds a PhD by the Brussels University, is Full Professor of European Studies at the University of Algarve and is full member of the CIEO (Center for Research of Territories and Organizations). Its main areas of research are European Union Polity, policy and politics.

António Mendonça is Full Professor at Lisbon School of Economics and ManagementUniversity of Lisbon, is President of the School Council and President of CESA (Centre for African, Asian and Latin American Studies), is Scientific Coordinator of the Master on Cooperation and Development. He was Minister of Public Works, Transport and Communications at the Portuguese Government and research and teach on Macroeconomics and International Economics and Finance.

Carlos Vieira is currently Assistant Professor at the University of Évora, Portugal, and full member of the Center for Advanced Studies in Management and Economics (CEFAGE-UE). He holds a PhD in Economics from Loughborough University, United Kingdom His main research interests are monetary and financial economics, economic integration and higher education policies.

Elsa Vaz is Assistant Professor at the University of Évora, is collaborator of the Center for Advanced Studies in Management and Economics of the University of Évora (CEFAGE-UE) and the Planning and Evaluation Unit for Public Policies (UMPP). She holds a PhD in Economics. Among its research areas of interest are: International Economics; Economic and European Integration; Studies of Impact of Economic and Social Policies with the use of diverse methodologies as models of General Equilibrium.

Francisco Torres is Visiting Senior Fellow in European Political Economy at the London School of Economics, Visiting Professor at Católica Lisbon School of Business and Economics and PEFM Associate at St. Antony’s, Oxford University. He holds a PhD in European Political Economy (Católica Lisbon), a MSc in Economics (Nova), a MA in International Affairs (Johns Hopkins) and a BA in Economics (Católica Lisbon).

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Isabel Camisão holds a PhD in Political Science and International Relations. She is Assistant Professor at the University of Évora, Portugal and full member of the Center for Research in Political Science (CICP). Her main area of research is European Union governance and institutions.

Isabel Vieira studied at the Universty of Évora (Portugal), ISEG - Lisbon School of Economics and Management, University of Lisbon (Portugal) and Loughborough University (United Kingdom. She is a professor of economics at the University of Évora and a researcher at CEFAGE-UE - Center for Advanced Studies in Management and Economics. Her areas of interest are economic and financial integration, education policies and regional development.

Luís Brites Pereira holds a PhD in International Economics from Universidade Nova de Lisboa (Portugal) and the degrees of M. Comm. (Econ.) and B. Econ. Sc. (Hons) from the University of the Witwatersrand (South Africa). He is currently Assistant Professor (Adjunct) and NOVAFRICA Resident Researcher, both at the Nova School of Business and Economics. His recent research focuses on globalisation and governance interactions, and has been published in peer-reviewed academic journals such as Governance and the Open Economies Review.

Manuel Porto holds a PhD in Legal Economic Sciences from the Law School of the University of Coimbra and M.Phil in Economics from the University of Oxford. Was President of the Central Region Commission, President of the National Planning Council, Member of the European Parliament and World President of the European Community Studies Association. Participated in research projects of the Council of Europe, of the European Commission and of the World Bank. Is currently President of AREP (Portuguese Association for European Studies), SRS Consultant, Vice Secretary General of the Academy of Sciences of Lisbon and Professor of the Universities of Coimbra and Lusíada.

Nuno Rico holds a BA in Economics, and currently he works as Economist, with expertise in banking products, in the Portuguese Association of Consumers Defence (DECO). He has former experience working with the EU Institutions in Brussels and in the Office of the Secretary of State for European Affairs in the Portuguese Government. Is author of several research papers about EMU social impacts, trade and enlargement of the EU.

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Paulo Ferreira is Adjunct Professor in Polytechnic Institute of Portalegre, Portugal. He holds a PhD in Management in University of Évora, Portugal. He is also researcher in Center for Advanced Studies in Management and Economics of the University of Évora (CEFAGE-UE) and has published several books and papers in different refereed journals.

Paulo Vila Maior, holds a PhD in Contemporary European Studies (University of Sussex, Brighton, United Kingdom), is Associate Professor at University Fernando Pessoa (Porto, Portugal). His main area of research is the political economy of Economic and Monetary Union, with an emphasis on the Eurozone crisis.

Vítor Bento holds a BA in Economics by ISEG-Lisbon School of Economics and Management and an MSc in Philosophy by Portuguese Catholic University. Is Certified by INSEAD in Corporate Governance. Has experience as CEO in private and public sectors, in Banco de Portugal (monetary and exchange-rate policy) and was Head of Treasury and Debt Management Office. He Taught Economics and Finance in several Portuguese Universities and is author of several books on the Portuguese economy.

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INDEX

A

B

accountability, 113, 157, 165, 168, 170, 171, 172, 209, 214 accounting, 136 actuality, xxxii, 146 adjustment, xv, xxiv, xxv, xxviii, xxix, xxxii, 3, 6, 8, 9, 12, 19, 21, 30, 32, 33, 36, 37, 51, 52, 53, 55, 56, 62, 73, 98, 100, 101, 102, 125, 126, 131, 168, 169, 173, 176, 177, 185, 188, 189, 191, 195, 196, 197, 226 adjustment mechanisms, xxix, 8, 19, 21 adjustment programme, 168, 173 agenda-setting, 112 aggregate demand, xvii, 8, 10 agricultural producers, 152 agricultural sector, 158 algorithmic governance, 204, 207 allocation role, 146 anchoring, 239 anti-cyclical policy, 145, 159 assessment, 29, 31, 33, 76, 82, 87, 90, 110, 125, 131, 143, 153, 196 assets, 63, 67, 68, 72, 73, 86 asymmetric economic shocks, 37, 185 asymmetric shocks, xxix, 21, 32, 35, 36, 37, 50, 51, 53, 54, 55, 56, 62, 64, 66, 68, 75, 82, 98, 99, 100, 122, 125, 126, 128, 129, 130, 139, 185, 186 autonomy, xxv, 36, 64, 102, 111, 155, 213, 237

bail, xxv, 33, 83, 84, 87, 88, 89, 90, 94, 105, 108, 135 bail-in, 84, 87, 88, 89, 94 bail-out, xxv, 83, 84, 94, 108, 135 balance of payments, 3, 5, 7, 14, 187 balance sheet, 72, 74, 91, 125, 188 bank crisis, 83 bank debt, xxvi, xxviii, 52, 53, 72, 187 bank failure, 88, 90 bank recovery and resolution directive, 87, 94 banking, xvi, xxii, xxvi, xxvii, 11, 25, 52, 53, 56, 62, 65, 66, 69, 71, 73, 75, 78, 79, 81, 82, 83, 84, 85, 86, 87, 88, 89, 90, 91, 92, 93, 94, 95, 96, 124, 140, 165, 167, 168, 169, 170, 171, 172, 173, 185, 187, 192, 211, 215, 219, 225, 226, 247 banking sector, xxvi, 53, 73, 75, 81, 82, 83, 85, 90, 93, 124, 167, 226 banking union, viii, xxii, xxvii, xxviii, xxx, 55, 56, 73, 75, 76, 81, 82, 83, 84, 86, 87, 88, 91, 92, 93, 94, 95, 96, 122, 124, 134, 140, 165, 167, 168, 169, 170, 171, 172, 173, 179, 180, 192, 197, 215, 235 bankruptcy, 76, 84, 89, 189 banks, xxii, xxvi, xxvii, xxviii, 32, 33, 52, 56, 59, 66, 72, 73, 74, 75, 76, 82, 83, 84, 85, 86, 87, 88, 89, 90, 91, 94, 104, 105, 124, 127, 130, 167, 169, 176, 188, 235 bank-sovereign linkages, 81 barriers, xxiii, 21, 64, 66, 70, 184, 195 basic services, 190

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Index

250 basis points, 11, 12 Basle rules, 83, 86 Belgium, 22, 23, 28, 29, 40, 42, 44, 47, 48, 57, 66, 70, 155, 184 benchmarking, 139 beneficiaries, xxxi, 113 benefits, 19, 21, 51, 64, 79, 113, 128, 129, 130, 139, 148, 150, 152, 174, 197, 211, 218, 225, 226, 234, 239 bias, 10, 66, 68, 69, 70, 79, 82, 83, 88, 92, 109, 125, 127, 130 bilateral relationship, 23 bond market, 68, 69, 76 bondholders, 72, 87 bonds, 68, 69, 72, 73, 83, 86, 89, 106, 124, 125, 130, 168, 171, 236 bottom-up, 168 Bretton Woods conference, 33 Brexit, xxxii, xxxv, 17, 84, 94, 132, 135, 139, 140, 141, 165, 166, 169, 171, 172, 175, 176, 178, 200, 206, 210, 221, 222, 240 budget, ix, xxiv, xxxii, xxxiii, 7, 26, 27, 28, 36, 73, 95, 103, 123, 128, 129, 142, 145, 146, 147, 148, 149, 150, 151, 152, 153, 154, 155, 156, 157, 158, 159, 160, 161, 162, 163, 171, 173, 176, 185, 186, 188, 191, 194, 195, 197, 200, 202, 204, 206, 207, 214, 215, 216, 217, 218, 219, 221, 226, 235, 237 budget deficit, xxiv, 7, 73, 186 budgetary resources, 206 bureaucracy, 204 business cycle, xxix, 21, 35, 36, 37, 38, 39, 40, 41, 43, 45, 46, 48, 49, 50, 51, 52, 53, 54, 55, 56, 58, 59, 126, 186, 190, 197, 226, 230 business cycles synchronization, 35, 37, 40, 46, 48, 59 businesses, 126

C candidates, xxiv, 23, 36, 56, 132, 157, 238, 239 CAP, 146, 154, 155 capital controls, 63 capital flight, 83 capital flows, 51, 52, 71, 78, 122 capital inflow, xxvi, 51, 71 capital markets, xxii, xxviii, 65, 71, 75, 76, 170, 173 capital markets union, xxii, xxx, 122, 143, 170, 235 capital mobility, 63, 73, 188

capitalism, 166, 207, 219 carbon, 157, 175 carbon emissions, 175 casting, 198 catalytic effect, 193 causal relationship, xvii causality, xxix, 19, 50 central bank, xiii, xv, xvi, xxv, 3, 9, 13, 26, 72, 102, 103, 104, 105, 106, 108, 109, 112, 113, 114, 115, 187, 214 central planning, 8, 9 checks and balances, 113, 205, 212 citizens, 54, 56, 127, 132, 151, 153, 155, 156, 157, 168, 172, 177, 184, 191, 192, 193, 231 citizenship, 150, 151, 207, 217, 219 City of London, v, 33, 34, 116, 117, 118, 138, 162, 165, 176, 178, 179, 180, 223, 245, 246 civil society, 206, 219 climate, xxiii, 152 closed economy, 6 cluster(s), x, 40, 41, 43, 45, 46 coal, 154, 175 coherence, 32, 132, 239 collaboration, 161 collateral, 72 collusion, 206 combined effect, xxviii commission, xxiii, xxxi, 7, 49, 58, 74, 83, 86, 87, 88, 90, 91, 94, 95, 98, 101, 102, 103, 109, 110, 111, 112, 113, 115, 116, 118, 122, 123, 124, 125, 126, 127, 128, 130, 131, 132, 133, 134, 139, 141, 146, 147, 148, 149, 150, 151, 152, 153, 155, 156, 158, 159, 161, 162, 168, 170, 171, 172, 179, 180, 181, 185, 186, 188, 190, 192, 193, 194, 195, 196, 197, 198, 200, 201, 208, 209, 212, 214, 215, 220, 229, 232, 241, 245, 247 common agricultural policy, 152 Common Market, 58, 78, 116, 118, 140, 199 common rule, 76, 83, 90 communication, 133 communication strategies, 133 compensation, 33, 100, 189, 218 competitiveness, xvi, xxxii, 33, 54, 86, 128, 150, 151, 158, 165, 166, 167, 174, 175, 188, 189, 190, 191, 196, 197, 229, 230 complement, 82, 128 complexity, xxi, xxxiii, 65, 76, 155, 212, 216 compliance, 20, 31, 83, 110, 111, 128, 186, 207 composition, 66, 161, 173, 175, 230

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Index conceptual model, 9 conciliation, 214 conflict of interest, 157 confrontation, xxi, xxiv congruence, 109 consensus, xiv, xxvii, xxx, 36, 37, 39, 52, 54, 55, 71, 75, 77, 88, 99, 106, 129, 133, 153, 158, 169, 172, 192, 215, 216, 221 consolidation, 12, 91, 125, 170, 173, 189, 193, 198, 219 constitutional amendment, 100, 108 constrained decentralization, 166 construction, xvi, xix, xxxiii, 83, 185, 234 consumers, 67, 152 consumption, xxix, 28, 52, 64, 65, 67, 78, 135, 189 contingency, 205, 222 contractual arrangements, 126 control group, 40 convergence, x, xxiv, xxix, 19, 26, 27, 31, 36, 50, 53, 54, 55, 56, 58, 66, 67, 68, 70, 76, 107, 122, 126, 127, 128, 136, 137, 138, 151, 152, 158, 168, 171, 178, 184, 186, 190, 191, 192, 193, 197, 199, 226, 229, 232, 233, 237, 238, 239 Convergence, 58, 137, 199 convergence criteria, xxiv, 27, 239 conviction, xxiii, 56, 191, 234 cooperation, xxii, 98, 128, 134, 162, 165, 193, 201, 207, 209, 210, 211, 216, 217, 219, 220, 221, 222, 229, 235 coordination, xxii, xxiii, xxiv, xxv, xxxiii, 36, 62, 70, 82, 92, 110, 111, 123, 128, 140, 141, 166, 167, 168, 186, 187, 190, 192, 194, 196, 197, 198, 204, 225, 226, 240 correlation, xix, 27, 28, 29, 30, 39, 40, 43, 50, 51, 56, 60, 65, 66, 67, 71, 78, 240 correlation analysis, 39 correlation coefficient, 27, 28, 29, 30, 40, 43 council, xvii, xxv, 10, 12, 101, 102, 103, 104, 106, 109, 111, 115, 122, 123, 131, 135, 143, 148, 154, 155, 159, 161, 172, 175, 180, 181, 185, 187, 192, 201, 208, 211, 214, 215, 217, 219, 220, 243, 246, 247 Council of Europe, 247 council of ministers, 101, 102, 115, 192, 208, 214, 220 counter-cyclical policies, 126, 128 country of origin, 190 country specific recommendations, 110, 126 creditors, xxix, 7, 17, 29, 72, 84, 230

251 creditworthiness, 73 crimes, 206 crisis management, xxvi, 55, 90, 92, 116, 124, 167, 187 crisis response, xxi, 86, 98 critical analysis, 227 criticism, xxiv, 104, 113, 125, 126, 185, 238 culture, xiv, 70, 91, 210, 214, 219 cure, 93 currency, xxi, xxiii, xxiv, xxvi, xxvii, xxix, xxx, 2, 5, 19, 20, 21, 22, 25, 26, 31, 33, 34, 35, 36, 37, 38, 49, 51, 52, 53, 54, 56, 57, 59, 60, 61, 62, 63, 64, 65, 66, 67, 68, 73, 77, 82, 83, 92, 95, 122, 132, 143, 147, 169, 173, 184, 185, 186, 187, 225, 226, 234, 238, 239 current account, x, xxvi, xxix, 3, 14, 17, 28, 29, 31, 32, 33, 34, 49, 53, 59, 71, 73, 146, 195 current account balance, x, 28, 29, 146 current account deficit, xxix, 3, 14, 28, 29, 31, 53, 59 current account imbalances, 28, 32, 33 current account surplus, 17, 28, 29, 33 current balance, xxix customer loyalty, 70 Customs Union, xxii, 184 cyclical component, 39, 40, 43 cyclical components of the GDPs, 40 Cyprus, 40, 42, 43, 44, 46, 47, 48, 57, 83, 85, 99, 106, 124 Czech Republic, 40, 42, 44, 47, 57, 66, 68, 79, 210

D de Gaulle, Charles, 154 debtors, 7, 17, 51 debts, xv, 32, 71, 172, 187 decentralization, 166, 170, 211, 212 decision-making process, 112, 113, 198 defense mechanisms, 193 deficit, 5, 6, 7, 12, 27, 32, 33, 34, 49, 52, 55, 56, 62, 110, 114, 139, 170, 186, 190, 208, 214 deflation, 3, 13 democracy, 11, 133, 207, 211, 216, 217 democratic legitimacy, 113, 118, 124, 131, 168, 198, 206, 215, 218, 219 Denmark, xxii, 22, 23, 40, 42, 44, 47, 48, 57, 66, 155, 168 depreciation, 53, 190 depression, xiv, xvi, 6, 9, 10

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Index

252 desynchronization, 43, 45, 46, 49, 53 devaluation, 53, 188, 196, 230 developed countries, 146, 152, 218, 222 dichotomy, 204 differentiated integration, 175 digital free movement and the creative commons, 219 discrimination, 7, 192 dismantlement, 232 disposable income, 104, 134 distribution, xxxii, 114, 134, 145, 151, 153, 154, 156, 195 distribution function, 151 distribution of income, 145, 195 divergence, xxvi, xxix, 28, 31, 52, 55, 190, 217, 218, 232, 234 diversification, 21, 64, 67, 68, 69, 75, 76, 89, 91

E Ecofin, xv, 109, 111, 192, 208 economic activity, xxv, 64, 70, 71, 189, 237 economic and budgetary policies, 198 economic and fiscal governance, viii, 121, 122, 123, 125, 134 Economic and Monetary Union, viii, xxiii, xxxi, 37, 63, 78, 81, 95, 97, 121, 122, 134, 140, 141, 161, 162, 166, 171, 178, 179, 180, 181, 184, 185, 192, 200, 201, 227, 229, 241, 248 economic change, 132 economic consequences, xxviii, 1, 17, 188 economic crisis, xiv, xv, 23, 24, 36, 177, 189, 197 economic cycle, xxiv, xxvi, 35, 41, 65, 82, 126, 129, 151, 185, 236, 237 economic damage, 88 economic development, 26 economic downturn, xxiii, 82 economic efficiency, 50 economic globalisation, xiii economic governance, xxi, xxviii, 50, 59, 78, 97, 98, 99, 103, 104, 110, 114, 115, 117, 118, 121, 125, 126, 140, 167, 176, 180, 192, 197, 201, 202, 235, 245 economic growth, xviii, xxii, 64, 71, 73, 75, 106, 188, 191, 197, 226, 233 economic growth rate, 233 economic integration, xxii, xxiii, 20, 34, 36, 59, 64, 74, 99, 166, 170, 173, 183, 184, 243, 246

economic performance, v, xviii, 5, 62, 151 economic policy, xi, xiii, xiv, xv, xxv, 10, 36, 62, 64, 107, 114, 115, 141, 166, 167, 168, 169, 204, 206, 214, 226, 229 economic power, 7 economic problem, 6, 9 economic progress, 184 economic reform, xxxii, 173 economic theory, 20, 238 economic union, xxxii, 165, 167, 168, 176, 177 economies of scale, 130 empirical studies, 20, 49, 62, 238 employment, xiii, xiv, xxv, xxviii, 1, 14, 50, 54, 127, 138, 150, 191, 192, 193, 194, 196, 197, 218, 237 employment opportunities, 194 EMU, xxi, xxii, xxiv, xxxii, xxxiii, xxxiv, 3, 4, 5, 19, 20, 21, 22, 27, 31, 32, 33, 34, 35, 37, 48, 49, 50, 51, 54, 55, 58, 59, 63, 65, 74, 76, 77, 78, 81, 82, 83, 87, 92, 93, 94, 98, 99, 100, 101, 102, 103, 104, 105, 106, 108, 109, 110, 111, 112, 113, 114, 115, 116, 118, 119, 121, 122, 123, 125, 126, 127, 128, 129, 132, 133, 134, 135, 136, 137, 140, 141, 142, 152, 165, 166, 167, 168, 169, 170, 171, 173, 174, 176, 177, 178, 179, 180, 183, 184, 185, 186, 187, 190, 191, 192, 193, 195, 196, 197, 198, 200, 201, 229, 235, 236, 247 endogeneity, xv, xvii, xxiv, xxix, 19, 20, 22, 25, 34, 49, 56, 59, 60, 64, 65, 68, 238 equity market, 69, 77 ESDP, 206 EST, 57 Estonia, 40, 42, 43, 44, 46, 47, 48, 57, 243 euro area, 1, 6, 7, 11, 12, 13, 14, 19, 22, 23, 24, 25, 27, 28, 30, 34, 38, 49, 58, 59, 60, 77, 78, 95, 117, 118, 122, 123, 124, 126, 128, 129, 131, 132, 134, 135, 136, 138, 139, 140, 142, 143, 146, 152, 168, 180, 194, 196, 197, 199, 200, 201, 202, 230, 231, 236, 241, 242 euro area finance minister, 131 Eurobonds, 130, 136, 137, 197 Eurogroup, xxxi, 11, 98, 101, 102, 103, 106, 109, 113, 118, 124, 131, 139, 172, 181, 206, 208, 221, 222 Europe, v, viii, xiii, xiv, xix, xxxi, 1, 5, 7, 17, 18, 19, 20, 32, 33, 36, 37, 59, 73, 77, 78, 81, 82, 83, 85, 87, 88, 92, 93, 94, 95, 96, 117, 118, 119, 127, 132, 133, 134, 136, 137, 138, 139, 140, 141, 142, 143, 147, 150, 151, 160, 161, 162, 163, 165, 166, 169, 170, 172, 174, 175, 177, 178, 179, 180, 183,

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Index 184, 185, 191, 192, 198, 199, 200, 201, 202, 204, 205, 206, 207, 209, 210, 211, 222, 225, 226, 227, 229, 231, 232, 240, 241, 243, 247 Europe 2020 Strategy, 166, 174, 175 European Banking Authority (EBA), 86, 214, 215, 217 European Banking Union (EBU), xxx, 81, 82, 84, 85, 86, 87, 88, 89, 90, 91, 93, 94, 95, 176 European Central Bank (ECB), x, xiii, xiv, xv, xvi, xvii, xviii, xxv, xxvii, xxviii, xxxi, 11, 12, 33, 34, 62, 63, 68, 69, 70, 72, 73, 77, 78, 82, 83, 86, 89, 94, 95, 97, 98, 99, 100, 101, 103, 104, 105, 106, 107, 108, 109, 112, 113, 114, 115, 116, 117, 118, 119, 124, 131, 135, 137,138, 167, 168, 170, 172, 173, 174, 176, 179, 180, 181, 187, 199, 202, 205, 206, 214, 217, 218, 231, 233, 240, 241, 245 European Commission, xxiii, xxxi, 7, 49, 58, 74, 83, 86, 87, 88, 90, 91, 94, 95, 98, 110, 111, 115, 118, 122, 123, 125, 126, 127, 128, 130, 131, 132, 133, 134, 139, 141, 146, 147, 148, 149, 150, 151, 152, 153, 155, 156, 161, 162, 168, 170, 171, 179, 180, 181, 185, 186, 188, 190, 194, 196, 200, 201, 209, 212, 215, 220, 229, 232, 241, 245, 247 European Community, 118, 150, 162, 247 European Council, 10, 103, 106, 109, 111, 115, 122, 131, 143, 172, 180, 181, 185, 187, 192, 201, 208, 215, 220 European Court of Justice, 109 European Deposit Insurance Scheme (EDIS), xxx, 81, 86, 91, 93, 170 European Economic Area (EEA), 165, 168, 175, 177 European extra-territoriality, 206, 221 European Financial Stability Facility (EFSF), 100, 124, 176 European Fiscal Board, 131 European integration, xv, xix, xxii, xxiii, xxviii, xxxii, xxxiv, 5, 17, 21, 31, 32, 103, 108, 111, 141, 147, 165, 168, 175, 176, 177, 183, 184, 203, 238, 239, 240 European macroeconomic algorithmic, 204 European market, xxii European Monetary Fund (EMF), xxx, 81, 86, 131, 171, 172, 180, 214, 220 European Monetary System, xxiii, 38 European Monetary Union, xxi, xxii, xxiii, xxvi, xxviii, xxxiii, 1, 3, 33, 34, 36, 49, 59, 79, 98, 160, 178, 179, 180, 186, 235, 238, 239 European Network of Territorial Cooperation (ENTC), 221

253 European Parliament, xxxi, 98, 112, 116, 118, 122, 123, 131, 139, 140, 148, 154, 155, 156, 161, 172, 200, 202, 208, 209, 214, 219, 220, 247 European policy, 204, 206, 211, 220, 221 European Public Prosecutor, 206 European safe asset, 90, 171 European semester, xxxiii, 103, 110, 123, 140, 198, 206, 212, 237 European Single Act, xxiii, 215 European Social Fund, 191 European social model, 190, 192, 193, 198, 199, 218 European Stability Mechanism (ESM), xxiii, xxvii, xxx, 56, 81, 86, 90, 98, 100, 101, 111, 124, 131, 167, 171, 172, 176, 204, 214, 235 European Treasury, 172, 217 European Union, x, xxiii, xxiv, xxvi, xxviii, xxxii, xxxiii, 2, 3, 11, 19, 20, 36, 40, 41, 43, 56, 57, 61, 62, 65, 77, 78, 84, 97, 98, 103, 105, 115, 116, 117, 118, 119, 123, 132, 134, 140, 141, 145, 146, 147, 148, 155, 157, 159, 160, 161, 162, 163, 178, 183, 184, 199, 205, 206, 207, 208, 210, 212, 214, 215, 217, 218, 219, 220, 221, 222, 225, 226, 227, 228, 229, 230, 231, 232, 233, 234, 237, 239, 240, 241, 246, 247 Euro-regions, 208, 212 Eurosystem of Fiscal Policy (EFP), 128, 172 Eurozone, i, iii, v, viii, x, xiii, xix, xxi, xxii, xxiv, xxv, xxvi, xxvii, xxviii, xxix, xxx, xxxi, xxxii, xxxiii, xxxiv, xxxv, 11, 12, 17, 32, 33, 35, 36, 38, 40, 41, 43, 45, 46, 48, 49, 50, 51, 52, 53, 54, 55, 56, 57, 58, 59, 61, 62, 63, 65, 66, 67, 68, 69, 70,71, 72, 73, 74, 75, 76, 77, 78, 81, 82, 83, 84, 85, 86, 87, 88, 89, 90, 91, 92, 93, 95, 97, 98, 99, 100, 101, 102, 103, 104, 105, 106, 107, 108, 109, 110, 111, 112, 113, 114, 115, 116, 118, 137, 138, 140, 142, 143, 145, 146, 147, 152, 158, 163, 165, 166, 167, 168, 169, 170, 171, 172, 173, 174, 175, 176, 177, 178, 179, 180, 185, 186, 187, 188, 189, 190, 191, 192, 194, 195, 196, 197, 199, 201, 202, 203, 204, 206, 207, 208, 210, 217, 221, 222, 225, 226, 227, 229, 230, 231, 232, 233, 234, 235, 236, 237, 238, 239, 240, 241, 242, 243, 248 Eurozone crisis, v, xxi, 65, 69, 77, 81, 85, 87, 88, 90, 92, 93, 98, 99, 100, 102, 103, 104, 105, 106, 108, 109, 116, 118, 165, 167, 168, 179, 241, 248 Eurozone institutions, 102, 165, 170 ever closer union, 92, 175, 177 ex post synchronization, 38

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Index

254 exchange rate, xxv, 4, 6, 10, 13, 21, 22, 27, 34, 36, 55, 62, 64, 67, 122, 188, 190, 195, 226, 230 exchange rate policy, 62, 230 exchange rate regime, 6, 10, 13 expenditures, 149, 150, 151, 153, 155 exports, 13, 14, 22, 190 external financing, 236 external shocks, 54, 229, 235

F factor market, xxiii, xxiv, 82 federal governance third way, 215 Federal Reserve, 104 federalism, xi, xxxiii, 21, 100, 124, 128, 203, 204, 205, 208, 209, 210, 211, 212, 213, 214, 215, 216, 217, 218, 219, 220, 221, 222, 223 financial backstops, 167 financial crisis, xiii, xviii, xxi, xxvi, xxxi, 7, 17, 18, 22, 23, 24, 25, 28, 30, 31, 32, 34, 37, 41, 49, 50, 52, 53, 79, 82, 98, 113, 116, 117, 131, 167, 176, 183, 184, 186, 226, 234 financial development, xxxiv, 227 financial fragmentation, 61, 63, 70, 74, 78 financial instability, xxxiv, 36, 75, 76, 82, 170, 196, 236 financial institutions, 67, 89, 92, 187 financial integration, vii, xxx, 21, 32, 50, 51, 60, 61, 62, 63, 64, 65, 66, 67, 68, 69, 70, 73, 74, 77, 78, 79, 92, 122, 168, 187, 217, 247 financial markets, xxi, xxvii, xxx, 32, 33, 50, 52, 56, 61, 66, 67, 69, 70, 72, 73, 74, 75, 83, 91, 166, 168, 170, 186, 187, 196, 231, 235, 236, 239, 240 financial mechanisms, 186, 194 financial regulation, 32, 167, 176 financial resources, 17, 148, 149, 193, 196 financial sector, xv, 62, 70, 73, 76, 83, 98, 136, 176, 225 financial shocks, 92 financial stability, 11, 62, 74, 75, 92, 100, 116, 124, 127, 176, 187, 235 financial system, xvi, xxiii, xxvii, xxx, 3, 74, 134 financial union, 125, 170 financial policies, 92 fine tuning, 98, 100 Finland, 22, 23, 25, 28, 29, 30, 31, 40, 41, 42, 44, 47, 48, 57, 96, 243 fiscal compact, 111, 123, 171, 204, 206, 212

fiscal deficit, 85, 99, 205 fiscal federalism, 21, 100, 128, 162 fiscal governance, 121, 125, 138, 172, 199 fiscal imbalances, 27, 28 fiscal integration, xxviii, xxx, xxxiii, xxxiv, 55, 56, 75, 168, 170, 171, 173, 186, 194, 198, 230, 233, 235, 239 fiscal pact, 102, 106, 237 fiscal policy, xvi, xvii, xxii, xxv, xxxiv, 36, 82, 91, 98, 99, 102, 110, 114, 115, 123, 128, 135, 143, 169, 170, 171, 172, 173, 174, 195, 206, 214, 218, 230, 235, 237, 239, 240 fiscal rules, xxxiv, 99, 102, 106, 109, 114, 123, 125, 128, 221, 237 fiscal stability treaty, 27 fiscal union, 50, 90, 117, 128, 135, 136, 140, 143, 170, 171, 197, 231, 232, 236, 240, 241, 242 flaws, xix, 1, 53, 82, 99, 125, 126, 168, 183, 185, 225, 226 flexibility, xxv, 21, 36, 51, 54, 55, 56, 65, 116, 125, 168, 185, 186, 190, 194, 196, 226, 237, 239 fluctuations, xxv, 50, 59, 237 food products, 151 foreign exchange, 21 France, 2, 7, 22, 23, 28, 40, 42, 43, 44, 47, 48, 57, 59, 66, 70, 78, 139, 141, 142, 154, 155, 168, 171, 172, 184, 186, 198, 200 free trade area, 150 full employment, 9, 152 funding, 70, 83, 85, 126, 149, 152, 153, 157, 187, 196 funds, xxxv, 64, 69, 89, 90, 101, 124, 128, 129, 130, 149, 151, 152, 173, 196, 226

G GDP, ix, xi, xxxii, 4, 11, 12, 13, 14, 15, 16, 22, 29, 38, 40, 49, 59, 60, 114, 130, 148, 154, 155, 159, 189 GDP per capita, xi, 40, 155 general theory of macroeconomic conditionality, 204 genuine EMU (GEMU), 168, 169 geographical origin, 69 geography, 34, 206 geometry, 23, 132, 193, 227, 230, 234 German Constitutional Court, 108 Germany, v, xv, 2, 6, 9, 10, 11, 13, 21, 22, 23, 24, 25, 26, 29, 40, 41, 42, 43, 44, 47, 48, 57, 66, 88,

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Index 89, 91, 95, 118, 139, 141, 154, 155, 156, 171, 172, 184, 186, 200, 231, 233, 241, 243 global economy, xviii global scale, 83 globalization, 159, 166, 177 gold standard, 6, 10, 13, 18 goods and services, xxii, xxiii, 51, 65, 185, 195 government budget, ix, 5, 27, 28 government budget deficit, 27 government debt, ix, 4, 14, 55, 89 government expenditure, 175 Great Depression, 9, 10, 11, 13, 18 Greece, x, xxii, xxvi, 6, 11, 12, 22, 25, 26, 28, 29, 40, 41, 42, 43, 44, 46, 47, 48, 57, 62, 69, 71, 73, 83, 84, 85, 99, 100, 107, 118, 124, 155, 173, 176, 187, 201 growth, xiii, xviii, xxviii, xxix, 1, 6, 13, 20, 22, 33, 34, 38, 49, 54, 95, 105, 110, 128, 138, 139, 150, 151, 173, 174, 177, 189, 200, 204, 206, 207, 208, 221, 229, 230, 231 growth rate, 38, 231 guidelines, xix, xxv, 55, 102, 126, 194, 236, 238, 239 guiding principles, 184, 197

H harmonization, 83, 193 hegemony, 209 hermeneutics, 108 heterogeneity, xxv, 169, 204, 228 higher education, 246 Hodrick & Prescott, 39 homogeneity, 20 HP filter, 39 human capital, 194, 196 Hungary, 40, 42, 43, 44, 45, 47, 48, 57, 68, 79, 210 hybrid, 205, 209 hyperinflation, 10 hypothesis, xv, xvi, xxiii, xxix, 19, 20, 22, 25, 26, 48, 156, 231, 238

I Iceland, 40, 42, 43, 44, 45, 47, 48, 53, 57 IDA, 139 idiosyncratic, xxiv, 19, 36, 45, 51, 99, 100, 105 illusion, xv, 2, 5

255 imbalances, xvi, xxvi, xxvii, xxix, 2, 5, 6, 8, 10, 19, 20, 27, 28, 29, 30, 31, 32, 33, 34, 49, 50, 51, 52, 53, 54, 55, 56, 59, 64, 71, 75, 76, 99, 100, 123, 126, 137, 166, 167, 173, 188, 195, 197, 205 improvements, 22, 73, 122, 123, 124, 131, 134, 152 indirect effect, 49 individual action, 8, 122 industrial revolution, 223 industrialized countries, 104 inequality, 138 inflation, xiii, xiv, xxiv, 10, 11, 12, 21, 55, 105, 179, 195, 205, 233 infrastructure, 128, 196, 220 institution building, 176 institutional adjustment, 98, 99, 100, 101, 102 institutional architecture, 7, 8, 112 institutional balance, viii, xxxi, 97, 98, 101, 102, 106, 108, 109, 113, 115 institutional change, xxviii, xxx, 100, 101, 131, 173 institutional framework, xxi, xxiv, xxv, 98, 131 institutional innovations, 208 institutional reforms, xxviii, 132, 176, 235 institutionalisation, 220, 221 integrated economic policy framework, 168, 169 integration, xiv, xix, xxii, xxiii, xxiv, xxvii, xxviii, xxix, xxx, xxxii, xxxiii, xxxiv, 17, 19, 20, 21, 23, 25, 31, 32, 33, 35, 36, 38, 50, 51, 53, 54, 55, 56, 59, 60, 61, 62, 63, 64, 65, 66, 67, 68, 69, 70, 73, 74, 75, 77, 78, 79, 87, 92, 98, 122, 132, 147, 150, 154, 160, 165, 166, 168, 169, 170, 171, 172, 173, 174, 175, 176, 177, 185, 186, 187, 190, 191, 193, 194, 195, 197, 198, 204, 214, 223, 226, 227, 230, 231, 232, 233, 234, 235, 239, 241, 247 integrity, xxii, xxvii, xxxiv, 5, 17, 185, 236 interbank deposits, 66 interbank market, 68, 70 interdependence, 52, 56, 64, 71, 73, 167, 188 interest groups, 174 interest parity, 66, 67, 78 interest rates, xiv, xvi, xxiv, xxvi, xxvii, 9, 11, 12, 13, 28, 32, 52, 55, 62, 63, 64, 70, 72, 73, 103, 104, 105, 106, 114 international investment, x, 29, 30 International Monetary Fund (IMF), xiii, xviii, 16, 22, 78, 83, 86, 127, 135, 136, 137, 141, 174, 179, 188, 199, 201 international trade, xiii intervention, xv, xvii, xxxi, xxxii, 9, 62, 66, 73, 108, 114, 115, 146, 147, 189, 191, 196, 222, 240

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Index

256 investment, xiii, xviii, xxiii, xxx, 32, 63, 74, 76, 83, 125, 126, 128, 134, 151, 159, 194, 195, 197 investors, 52, 68, 71, 73, 75, 76 Ireland, x, xxii, 6, 12, 22, 25, 26, 28, 29, 40, 41, 42, 43, 44, 46, 47, 48, 57, 62, 69, 71, 83, 85, 99, 100, 107, 124, 155, 176, 187, 201 Italy, 22, 25, 28, 40, 41, 42, 43, 44, 47, 48, 57, 62, 66, 69, 71, 73, 88, 89, 95, 117, 155, 184, 200, 243, 246

J job insecurity, 190 joint debt issuance, 130, 131 Joint Economic Committee, 163

K Keynes, 6, 9, 11, 18, 33 Keynesian, xvii, 9, 10, 148

L labor market, 32, 128, 142, 158, 170, 193, 194, 196, 226, 237, 239 Latin America, xiii, 243, 246 Latvia, 40, 42, 43, 44, 46, 47, 48, 57 lead candidate, 132 leadership, xv, 104, 208 learning, 194, 211, 219, 220 legacy costs, 174 legacy debt, 93, 127, 169, 170 legislation, 90, 140 legitimacy deficit, 110 lender of last resort, xv, xxvii, 5, 26, 32, 33, 72, 86, 115, 124, 170, 187, 199 lending, 71, 124, 188 liberalization, xxiii, 65, 196 liquidity, xv, xvi, xvii, xviii, xxvi, xxxi, 13, 52, 53, 66, 67, 68, 69, 70, 72, 76, 82, 84, 91, 94, 124, 127, 168, 171, 172, 176, 187, 188, 240 liquidity trap, xvii, xviii Lisbon, 1, 81, 115, 118, 121, 145, 147, 160, 163, 165, 166, 167, 177, 180, 204, 205, 207, 208, 246, 247, 248 Lisbon strategy, 160, 166, 167 Lisbon Strategy, 160, 166, 167 Lithuania, 40, 42, 43, 44, 46, 47, 48, 57

litigation, 86 living conditions, 54 loan guarantees, 176 loans, 52, 66, 67, 72, 73, 74, 77, 125, 147, 170, 176, 187, 219

M Maastricht Treaty, xxi, xxiii, xxv, xxxi, 25, 27, 36, 53, 55, 67, 134, 167, 197, 236, 239 macroeconomic imbalance, vii, xxix, 10, 19, 20, 27, 28, 31, 33, 34, 49, 59, 99, 100, 123, 126, 166, 201, 205 macroeconomic imbalances procedures, 123 macroeconomic policies, xv, xxv, 173, 184 macroeconomic policy, xviii macroeconomic stabilisation, 171 macroeconomics, 58 major decisions, 101 mantle, 113 market access, 76, 92, 124 market discipline, xxx, 74, 84, 123, 127, 171 market economy, 213 market failure, 72 methodology, 37, 228, 229, 233 Middle East, 206, 221 migration, xxxii, 134 mixed economy, 166 MLT, 57 model of integration, 172, 177 model of nominal exchange rate variability, 21 momentum, 74, 93, 123, 132, 221 monetary authority, xxxi, 99, 100, 102, 103, 104, 105, 108, 109, 113, 114, 115, 240 monetary policy, xiv, xv, xvi, xvii, xviii, xxiv, xxv, xxxi, xxxiv, 26, 37, 38, 54, 55, 64, 68, 72, 76, 82, 98, 99, 100, 102, 103, 104, 105, 109, 114, 115, 122, 125, 129, 130, 137, 146, 150, 166, 174, 195, 205, 218, 226, 229, 230, 231, 234, 235, 237 monetary policy instruments, 37 monetary union, xxiv, xxviii, xxix, xxxiv, 1, 2, 3, 4, 6, 7, 8, 12, 17, 19, 20, 28, 32, 34, 36, 37, 38, 49, 50, 51, 52, 53, 54, 56, 63, 64, 75, 76, 99, 112, 137, 138, 139, 143, 166, 167, 168, 171, 173, 176, 177, 185, 191, 197, 206, 215, 218, 222, 225, 226, 227, 231, 237, 239 money markets, 68, 69 money supply, 103, 105

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Index monitoring, xxvii, 56, 71, 77, 94, 98, 101, 102, 109, 110, 137, 139, 158, 178, 192, 197 moral hazard, 55, 88, 93, 114, 128, 129, 130, 133, 170, 171, 198 Multiannual Financial Framework (MFF), xxxii, 146, 148, 150 multi-level governance, 168 multi-speed approach, 204, 222 mutualization, xxx, 82, 89, 91, 100

N nation states, 219 national budgets, 102, 131, 147, 154, 157, 159, 226 national debt, 84, 220 national interests, xxxiii, 101, 103, 131, 133, 205, 209, 232 national ownership, 133 national policy, 129 nationalism, 184 natural evolution, 90 natural resources, 150, 151, 152 negative effects, xvii, 54, 64, 100, 106, 183, 195, 207, 221 neglect, 8 negotiating, xxxiii negotiation, 214, 216 net international investment position, x, 29, 30 Netherlands, 22, 23, 26, 28, 29, 40, 41, 42, 43, 44, 46, 47, 48, 57, 156, 184 networking, 208, 209, 212, 213, 219, 220 neutral, 195 New Deal, 118 no-bail out, 105 no-bail out clause, 105 non-elective executive entities, 204, 215

O OCA criteria, 21, 25 OCA endogeneity hypothesis, 20, 22 OCA indices, 19, 20, 21, 22, 27, 31 OCA theory, 20, 21, 23, 25, 32, 238 OECD, xviii, 22, 40, 57, 59, 127, 134, 136, 137, 142, 173, 180, 245 operational independence, 103 opportunism, 98, 110, 112, 113, 116

257 optimal currency area (OCA), vii, ix, x, xi, xxi, xxiv, xxxiv, 19, 20, 21, 22, 23, 24, 25, 26, 27, 28, 29, 30, 31, 32, 34, 35, 36, 49, 58, 64, 118, 169, 173, 186, 234, 237, 238, 239 optimal currency zone, 35, 57 optimal monetary area, xxxiv, 56, 237 optimal monetary zone, 38, 49, 230, 239 output gap, 129 outright monetary transactions (OMT), xxvii, 98, 104, 106, 108, 109, 114, 116, 119, 124, 135, 168, 171, 172 Outright Monetary Transactions (OMT), xxvii, 98, 104, 124, 168 overproduction, 10 oversight, 131, 236, 237 own resources, xi, 128, 130, 142, 145, 146, 148, 149, 153, 154, 155, 156, 157, 158, 159, 160, 161, 162, 163, 206, 214, 218, 221 ownership, 82, 133, 169

P parallelism, 213 Parliament, 98, 110, 132, 148, 161, 172, 208, 209, 214, 217 participants, 5, 17, 21, 63, 135, 147, 165, 166 penalties, xxix, 2, 62, 186 Poland, 40, 42, 43, 44, 45, 46, 47, 48, 57, 68, 79, 210, 243 policy, xiv, xvii, xviii, xxv, xxx, xxxi, xxxiii, 33, 37, 54, 55, 63, 64, 70, 72, 83, 86, 87, 90, 92, 93, 94, 99, 100, 101, 102, 103, 104, 105, 109, 111, 112, 113, 114, 115, 116, 117, 122, 123, 127, 128, 131, 132, 137, 140, 145, 146, 151, 152, 158, 159, 167, 170, 173, 174, 185, 189, 193, 203, 204, 205, 206, 208, 209, 210, 211, 212, 214, 215, 218, 219, 220, 221, 222, 235, 240, 246, 248 policy choice, 129 policy coordination, xxxiii, 82, 123, 140, 141, 166, 167, 180 policy instruments, 173, 204 policy makers, 170 policy options, xxx policy reform, 206 policy responses, 33 policymakers, v, xiv, xviii, xix political crisis, 19 political leaders, xxi, 93, 111, 118

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Index

258 political leadership, xxi, 93, 111, 118 political legitimacy, 204, 206, 214, 216, 218 political parties, 133, 166, 210, 211, 213, 214 political power, 112 political system, xi, 174, 204, 205, 209, 210, 216, 219, 220 political uncertainty, 85 populism, 133, 134, 184 portability, 194 portfolio, 51, 84, 89, 112, 187 Portugal, v, x, xiii, xvii, xxi, xxii, 1, 3, 6, 12, 19, 22, 25, 28, 29, 35, 40, 42, 43, 44, 46, 47, 48, 57, 61, 62, 69, 70, 71, 73, 81, 83, 84, 85, 94, 97, 99, 100, 107, 121, 124, 145, 154, 155, 180, 183, 186, 187, 188, 199, 200, 201, 203, 212, 225, 243, 245, 246,247, 248 potential benefits, 239 potential output, 13 poverty, xxxiii, 189, 190, 191, 192 presidency, xiv, xvi, 13, 206, 208 pressure groups, 210, 212 price stability, xxv, 11, 12, 100, 103, 104, 205 private banks, 71 private sector, xvii, 29, 52, 53 probability, xxix, 19, 21, 228 problem-solving, 208 product market, 67 production costs, 190, 196 productivity growth, xviii, 189 professional careers, 194 professional qualifications, 194 profit margin, 89 profitability, 74, 104 programming, 126, 152 project, xiv, xv, xix, xxiii, xxviii, xxxiii, 20, 24, 32, 33, 34, 36, 39, 76, 123, 132, 133, 134, 135, 136, 137, 141, 142, 143, 147, 151, 172, 174, 175, 177, 184, 185, 190, 191, 192, 193, 197, 198, 205, 226, 234, 237, 239, 240 proliferation, 219 propagation, 83, 184 property rights, 219 proportionality, 6, 149 prosperity, xxii, xxxii, 2, 5, 127, 134 protection, 50, 56, 89, 128, 152, 189, 190, 191, 192, 193, 194, 197, 218 prudential regulation, 86 public administration, 158, 211, 213

public debt(s), xv, xxiv, xxv, xxvi, xxvii, xxx, xxxi, 14, 49, 52, 53, 62, 71, 72, 73, 74, 75, 83, 85, 86, 89, 100, 105, 106, 108, 109, 114, 130, 166, 184, 187, 190, 205, 217, 219, 226, 231, 232, 233, 239, 240 public finance, xxvi, xxix, 2, 5, 12, 14, 87, 106, 147, 148, 173, 186, 189, 192, 195, 214, 226, 236 public financing, 188 public goods, 149, 151, 159, 171, 175 public investment, xviii, 136, 173 public opinion, 138, 157, 211 public policy, 245 public sector, 85, 189, 248 public service, 127 public support, 88, 197 purchasing power, 54, 63, 189 purchasing power parity, 63

Q quantitative easing, xiii, xv, xvi, 97, 98, 105, 205, 214, 219

R rating agencies, 106 real estate, xxvi recession, xiv, xvi, xviii, xxvii, 6, 9, 10, 11, 12, 14, 53, 54, 71, 151, 189 recognition, 99, 109, 194, 229 recommendations, xxv, 63, 110, 142, 149, 162 recovery, xiii, xiv, xv, xvi, xvii, xviii, xxvii, 32, 74, 94, 105, 122, 174, 188, 189, 193 redistribution, xxxii, 100, 106, 129, 146, 153, 195, 218 reform(s), xxiii, xxxi, xxxii, 17, 61, 75, 76, 93, 110, 111, 113, 123, 125, 126, 127, 132, 133, 134, 136, 148, 153, 156, 166, 168, 169, 172, 173, 174, 176, 177, 189, 196, 206, 208, 212, 216, 220, 227, 236, 239 refugees, 206, 210, 221 regional cooperation, 216 regional economies, 212 regression, 23, 28, 29, 30, 31, 155 regulations, 88, 204, 205, 207, 212 regulatory agencies, 147 regulatory changes, 125 regulatory framework, 73

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Index reinforcement, 145, 208 reinsurance, 128 rejection, 133 relative prices, 7 relevance, xxxiv, 18, 21, 37, 63, 71, 76, 101, 103, 130, 228, 230, 235, 239 resilience, xxx, 74, 81, 93, 167, 169, 183, 186, 192, 235 resolution, xxvii, 62, 75, 84, 86, 87, 88, 90, 91, 92, 93, 94, 124, 140, 143, 170, 214, 215, 225, 226 resource allocation, xviii, xxi, xxiii, 195 resources, xi, xxv, xxxii, xxxiv, 90, 123, 128, 130, 145, 146, 147, 149, 150, 151, 152, 153, 154, 155, 156, 157, 158, 159, 161, 194, 195, 196, 206, 214, 217, 218, 221, 237, 240 restrictions, xvii, xviii, xxxiii, 6, 38, 188 revaluation, 13 revenue, 130, 153, 157, 158, 159, 171, 175 rhetoric, 115 risk, xxii, xxiv, xxvii, xxviii, xxx, xxxi, xxxiii, xxxiv, 4, 5, 9, 11, 32, 50, 52, 53, 56, 61, 63, 64, 68, 69, 70, 72, 73, 74, 75, 76, 79, 81, 82, 83, 84, 86, 88, 89, 90, 91, 92, 93, 94, 105, 106, 110, 121, 122, 124, 125, 126, 128, 129, 131, 132, 133, 134, 135, 139, 165, 167, 169, 170, 171, 174, 187, 188, 192, 193, 195, 196, 197, 206, 207, 210, 218, 219, 220, 222, 227, 236, 237, 239, 240 risk perception, 72, 196 risk-reduction, 81, 84, 88, 90, 91, 92, 93, 124, 125 risks, xxvii, xxviii, xxx, 11, 12, 13, 53, 56, 62, 63, 64, 68, 69, 72, 73, 74, 75, 82, 94, 105, 122, 124, 172, 177, 185, 188, 197, 205, 218, 234, 235, 238 risk-sharing, xxxi, 50, 53, 56, 63, 64, 74, 75, 76, 81, 84, 88, 90, 91, 92, 93, 122, 125, 126, 128, 131, 132, 134, 135, 170, 236 risk-taking, 32 rule of law, 204 rules, xxiii, xxv, xxxiv, 2, 7, 8, 32, 51, 52, 62, 63, 71, 83, 85, 86, 87, 99, 101, 102, 106, 108, 109, 110, 112, 114, 123, 124, 125, 126, 128, 131, 134, 142, 166, 175, 186, 189, 191, 204, 206, 218, 221, 227, 236, 237, 239 rural development, 151 Russia, 206, 221

S safe asset, 90, 125, 130, 171

259 sanctions, 109, 111, 186, 236, 237 Sarkozy, French President Nicolas, 7 savings, xxx, 2, 13, 14, 17, 32, 61, 62, 64, 65, 70, 75, 170, 189 savings rate, 2 scale economies, xxii scapegoating, 169 scenario(s), xxxiv, 20, 113, 114, 185, 193, 225, 228, 229, 230, 231, 232, 233, 234, 235, 238, 239, 241 Schengen Agreement, 134 Second World, xiv secondary market, 105, 106, 108, 109, 168 selective memory, 10 Senate, 213 sensitivity, 67, 105, 237 separatism, 147 SGP, xxiv, 62, 110, 111, 125, 126, 166, 167, 171, 186, 204 shareholders, 84 shock amplifiers, 53 shortage, 70, 196 showing, xxiii, xxv, xxvi, 30, 38, 51, 69, 70, 148, 154, 159, 184, 194, 238 signals, 66 single currency, xix, xxi, xxii, xxiii, xxiv, xxvi, xxvii, xxix, xxxi, 6, 19, 20, 21, 22, 23, 24, 25, 26, 28, 31, 32, 33, 36, 45, 50, 51, 53, 54, 56, 61, 62, 64, 68, 75, 76, 99, 132, 134, 177, 184, 188, 191, 195, 218, 226, 229, 238, 239 Single European Act, 216 single market, xxiii, xxxii, 21, 26, 66, 73, 110, 116, 122, 129, 134, 136, 141, 176, 177, 191, 193, 194, 195, 196, 204, 210, 215, 218 single resolution fund (SRF), 75, 90, 91, 93, 124, 170, 171 single resolution mechanism (SRM), 75, 86, 92, 124 Slovakia, 40, 42, 43, 44, 47, 48, 57, 210 smoothing, 39, 64, 67, 78, 123, 135 SMS, 92 social adjustment, xxiv, 196 social consequences, 125, 190, 191 social costs, 9 social dimension, viii, xxxiii, 55, 131, 183, 185, 188, 190, 191, 192, 193, 194, 197, 198, 199, 200, 201 social exclusion, 133, 189, 192 social group, 174 social interests, 214 social issues, 127, 133, 191, 192, 193 social market economy, 152, 213, 218

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260 social norms, 54, 190, 191 social policy, 191, 194, 196 social problems, xiv, 191, 198 social responsibility, 213 social security, 127, 191, 193, 194 social welfare, 1 solidarity, xiv, xxii, 56, 96, 132, 151, 155, 159, 178, 184, 198 solution, xxx, 39, 75, 76, 91, 100, 110, 125, 171, 196, 198, 217, 218, 235 sovereign bonds, 69, 72, 73, 89, 124, 125, 171 sovereign debt crisis, xiv, xxvi, xxx, xxxii, 23, 37, 49, 50, 52, 53, 55, 56, 61, 62, 63, 70, 71, 76, 100, 105, 138, 140, 165, 166, 167, 173, 174, 176, 185, 187, 225, 236 Sovereign debt crisis, xxx sovereign risk, 72, 91 sovereignty, xxx, xxxi, xxxiv, 52, 74, 76, 93, 128, 129, 130, 131, 134, 157, 168, 177, 184, 187, 198, 211, 215, 235, 236, 237, 239 Spain, xxii, 6, 22, 25, 28, 29, 40, 42, 43, 44, 47, 48, 57, 62, 66, 69, 70, 71, 73, 85, 117, 124, 155, 186, 200 specialisation, 64 specialization, xxii, 38, 50, 59 stabilisation, 123, 124, 126, 128, 129, 130, 131, 170, 171, 204, 218, 220 stabilisation function, 128, 130 stabilisation mechanism, 124, 128, 129, 204, 220 stability, xxiii, xxiv, xxviii, xxx, xxxii, xxxiii, 12, 50, 51, 54, 63, 74, 76, 83, 86, 87, 89, 92, 95, 104, 127, 134, 136, 151, 156, 157, 173, 183, 184, 185, 186, 191, 198, 204, 206, 212, 225, 235, 237 stability and growth pact (SGP), xxiv, 27, 62, 99, 102, 110, 111, 116, 123, 125, 126, 136, 142, 166, 167, 171, 186, 202, 204, 206, 236, 237 stabilization, xxii, xxviii, xxxiii, xxxiv, 20, 33, 37, 55, 106, 137, 151, 171, 183, 185, 192, 195, 197, 226, 237, 240 stabilizers, 26, 55 stakeholders, 113, 207, 211 standard deviation, 22 standard of living, 152 state intervention, 9, 84 state of emergency, 210 stealthy federalism, xxxiii, 204, 205, 209, 211, 214, 215, 217, 219 stimulus, xviii, 119, 174 stock markets, 65, 66, 68, 79

structural changes, xxvii, 76, 189, 194 structural funds, 146, 159 structural policies, 126, 127, 139, 145, 150, 151, 159, 237 structural reforms, xvi, xxii, xxix, 54, 76, 83, 85, 86, 110, 125, 126, 127, 137, 141, 142, 158, 169, 173, 174, 179, 183, 186, 194, 196, 197, 202, 234, 245 structuring, 56 subjectivity, 240 subsidiarity, 145, 147, 149, 157, 159, 162, 211 succession, xxvi, 52, 71 supervision, xxiv, xxvi, xxvii, xxx, xxxiv, 32, 56, 66, 70, 75, 76, 86, 87, 90, 91, 92, 94, 98, 124, 167, 187, 190, 211, 215, 226, 236 supply shock, 17 supranational, 4, 17, 64, 81, 87, 92, 93, 102, 103, 111, 116, 117, 118, 125, 129, 131, 184, 210, 211 surplus, xxix, 5, 6, 13, 14, 56, 64, 126, 146, 170, 206 surveillance, xxvii, 56, 102, 110, 118, 127, 131, 167, 194, 201, 237 survival, 50, 114, 138, 139, 167, 226 sustainability, xxii, xxvii, 12, 13, 17, 36, 52, 55, 62, 71, 72, 73, 75, 114, 122, 124, 128, 130, 131, 133, 151, 152, 159, 166, 184, 186, 191, 192, 193, 226, 236, 239 sustainable currency area, 169 sustainable development, 150, 151, 152 sustainable growth, xvi, xxxii, 151, 174, 178, 192 Sweden, 22, 23, 24, 25, 40, 41, 42, 43, 44, 47, 48, 57, 156 Switzerland, 22, 23, 24, 40, 41, 42, 43, 44, 46, 47, 48, 57 symmetry, 7, 21, 38, 50, 56, 65, 123, 125, 126, 186 symmetry of business cycles, 21, 38 symptoms, xvii, 54, 184 synchronization, xi, xxiv, xxix, 35, 36, 37, 38, 39, 40, 41, 42, 43, 44, 45, 46, 47, 48, 49, 50, 51, 54, 55, 56, 59, 65, 69, 82, 185, 186, 190, 226, 230, 236, 237 synchronization of business cycles, xxix, 35, 36, 37, 38, 39, 41, 43, 45, 49, 50, 51, 54, 55, 56, 190, 226, 230

T tariff, 21, 184 tax base, 123, 157 tax capacity, 130

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Index tax rates, 133 tax system, 193 taxation, 130, 134, 150, 175, 214 taxes, 66, 123, 130, 154, 157, 175 taxpayers, 89, 91, 92, 195 teams, 243 technical support, 20 technological advances, 68 territorial, 151, 206, 207, 212, 213, 216, 217, 221 theoretical approach, 216, 238 time periods, xvi, 22, 39, 40 time pressure, 166 time series, 39 trade, xxii, 6, 20, 21, 22, 32, 38, 49, 50, 51, 60, 64, 122, 189, 190, 243, 247 trade deficit, 189 trade linkages, 21 trade policy, xxii trajectory, xxviii, 46, 174 tranches, 130 transaction costs, xxiii, 26, 63, 157, 226 transactions, 21, 69, 130 transition period, 211, 215, 216 transmission, xv, xvi, xvii, xxvi, 51, 52, 68, 72, 76, 130 transparency, 125, 155, 157, 198 treasury, 131, 172, 217, 218, 221, 248 treaties, 90, 204, 207, 216, 220, 221, 222 treatment, 10, 70, 90, 95, 123, 171 Treaty of Rome, xxxi, 141, 184, 191, 203 Treaty on European Union (TEU), 165, 169, 176 Treaty on the Stability, Coordination and Governance in the Economic and Monetary Union (TSCG), 171, 176 triggers, 125 Troika, v, 83, 85, 86, 117, 187, 188, 196, 202, 212 turbulence, xxviii, 17, 69, 98, 102, 114, 235, 236, 238 Turkey, 206, 221 two pack, 110, 111, 204

261 unemployment insurance, 133, 137, 139, 236, 240 unemployment rate, x, 13, 30, 31, 53, 189, 231, 233 unification, xxviii, xxx, xxxii, 1, 21, 34, 36, 55, 61, 74, 79, 172, 197, 235 unilateralism, 204 unions, 19, 60, 138, 143, 188 United Kingdom (UK), xxii, 22, 23, 24, 25, 40, 42, 44, 47, 48, 53, 57, 58, 66, 84, 95, 132, 135, 148, 154, 155, 156, 162, 165, 168, 169, 172, 175, 176, 223, 246, 247, 248

V variables, xxi, 22, 28, 29, 55, 186, 228, 233 variations, 22, 25 varieties, 166 varieties of capitalism, 166 veto, 131, 176 vocational training, 191 volatility, xxiii, 23, 68, 76 vote, 138, 156, 216 voters, 89, 132, 133, 172

W wages, 8, 9, 13, 53, 54, 133, 188, 189, 190, 196 war, 8, 193, 207, 213, 222, 226 wealth, xxii, xxxii, 145, 146 Western Europe, 184 White Paper, 179, 185, 192, 193, 200 wholesale, 66, 67, 69 withdrawal, xxxiv, 227 workers, 194, 196 World Bank, 247 World War I, 6, 184, 238

Y young people, 53, 189 youth unemployment, 191

U Ukraine, 206, 221

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