The Post-Crisis EMU: A True OCA?

Alexandros Kyriakidis

It is no secret that the Eurozone is not a complete Optimum Currency Area (OCA). Chief among its shortcomings is the uneven level of integration between its monetary and economic aspects. When the Eurozone was created, capital restrictions were eliminated but inflation was slow to converge between the core/Northern low-inflation and the periphery/Southern high-inflation Member States (Walters critique).

Economic booms in the periphery/South, financed by excessive and cheap capital inflows from core/North, led to a loss of competitiveness that could not be restored through monetary policy. This resulted in severe trade imbalances, further weakening the import-led, deficit-expanding economies of the periphery vis-à-vis the export-led, highly competitive economies of the core Eurozone Member States. Meanwhile, the absence of a banking union and of a proper Eurozone-wide framework for resolution of problematic banking and finance institutions created moral hazard issues related to predatory lending and unsustainable borrowing, (bailouts became the only alternative for problematic banks).

A rain-check is not an option anymore for the Eurozone’s set-up. In order for EMU to function properly, avoiding crises or at least addressing them effectively, additional steps have to be taken towards a full OCA. The relevant theory, developed by Robert Mundell in the 1960s, identifies three primary characteristics: factor (mainly labor) mobility (in the event of a potential asymmetric shock, workers could move easily to low unemployment areas), convergence (similarity in economic structures of members), and fiscal integration (system of budgetary transfers that enable temporary assistance to members affected by recessions). Developments in finance after the 1960s have also raised the need for a single Central Bank that is also the lender of last resort, a backstop function for bank resolution, and for a banking union.

Have these been achieved within the Eurozone? First, labor mobility. Improving its rather disappointing outcome has been a permanent aim for the EU. It has been calculated that US labor mobility is approximately ten times higher. The EU has accordingly proposed, inter alia, reforming the European Employment Services Network, boosting rights of posted workers through better enforcement of EU rules, etc.

Second, economic convergence. The most advanced of the Eurozone’s post-crisis proposals here is creating the post of European Minister of Economy and Finance, who would also assume represent the Eurozone as a whole externally. A Vice-President of the European Commission would be chosen and the same individual would also serve as the Eurogroup President. The other principal proposals here include:

• the introduction of the Capital Markets Union, which was first advanced in an EC Green Paper and which is suggested as a way of strengthening EMU by “supporting economic and social convergence … in the euro area”;
• the establishment of a financial instrument for structural reform support, monitored through the European Semester process and focusing “on those reforms that can contribute most to the resilience of domestic economies…” (e.g. product or labor market reforms, tax reforms, etc.);
• the introduction of National Competitiveness Authorities coordinated by the Commission;
• the creation of a European Fiscal Board to assist national fiscal councils;
• and the utilization of the Macroeconomic Imbalance Procedure to formalize the convergence process. There is also the proposal for a form of Eurobonds called European Safe Bonds (ESBies); this, however, remains at a very early stage.

Third, fiscal integration. There are two key EU policy initiatives here. The first is the creation of an EU-wide Stabilization function to be activated in the event of asymmetric shocks and to complement any relevant corresponding measures within national budgets. To be effective, this function should “allow for overall net payments of at least 1%” of GDP for the Eurozone alone, to be channeled through some type of borrowing capacity (e.g. increasing EU co-financing, ESIF pre-financing, etc.), without leading, however, to permanent transfers between Member States. The second is the upgrade of the European Stability Mechanism (ESM) to a European Monetary Fund (EMF) and its incorporation within the EU legal framework, with greater involvement in the financial assistance process (the ‘Troika’ have so far dominated the negotiation and monitoring of bail-outs with little ESM involvement).

Fourth, the banking union and a backstop for bank resolution. The banking union has already been set up during 2013-14, consisting of the Single Supervisory Mechanism, the Single Resolution Mechanism and the Single Rulebook (primarily CRD IV, CRR and BRRD). However, it remains incomplete in two main aspects: a full-proof backstop for bank resolution and an EU-wide Deposit Guarantee Scheme (EDGS; other minor elements including proposals on business insolvency, reduction of non-performing loans, etc., also need to be addressed). Regarding the first, an international agreement between EU Member States was signed in 2014 establishing the Single Resolution Fund and, to complement this, the proposal that the EMF be activated when this Fund is insufficient has been suggested. Regarding the second, an EDGS has been proposed from November 2015 to develop from “a reinsurance scheme into a fully mutualized coinsurance scheme” and then into a full insurance scheme covering national schemes.

Final element of an OCA is a unified Central Bank that can also serve as the lender of last resort. The ECB is indeed a common Central Bank, except for its inability to be a lender of last resort. However, this has been indirectly addressed by several ECB initiatives such as the Securities Markets Program, the (Very) Long-Term Refinancing Operations, the Outright Monetary Transaction program and Quantitative Easing. In addition, the proposed EMF could step in as a lender of last resort within the Eurozone in a more direct manner.

Overall, it seems that the Eurozone is now moving towards a true OCA. But caution needs to be exercised as to the pace of this process as well as its detailed institutional set-up. The crisis was not only caused by structural inefficiencies, but also by a malfunctioning or overcomplicated institutional structure (e.g. when France and Germany pushed for more relaxed SGP criteria in 2005). However, caution is necessary when implementing these new measures, especially in relation to democratic procedures that have, so far, proved rather ineffective in ensuring true legitimacy and oversight. These elements are important if the public is to believe and participate in the integration process moving forward.