Eurozone Edging Ever Closer to Political Union

The ECB recently published a paper on its website detailing its preliminary proposals to reinforce economic governance in the euro area. The paper was split into three main sections. (1) Strengthening surveillance and greater prevention/correction of excessive deficits and debts. (2) Improving the surveillance framework and the correction of economic imbalances, and (3) a framework for crisis management in the euro area. It makes for interesting reading, and there are three main points to draw out in more depth.

Firstly,  the most significant proposal is the creation of an independent fiscal surveillance agency. This will effectively be a government watchdog much like the UK’s recently created Office for Budget Responsibility. This body will be tasked with monitoring and assessing euro area countries’ fiscal policies. Once a country is deemed to have breached the ceiling of a debt to GDP ratio of 60% and/or has a deficit in excess of 3% they will be eligible to face an array of sanctions, ranging from purely financial penalties to loss of voting rights. Hopefully these penalties will be more strictly enforced than is currently the case. Remember, under the Maastricht treaty the EC already has powers to fine countries that break the stability pact (those running a deficit of more than 3%). Clearly a desire to create a larger eurozone dominated the perceived need for fiscal probity in the past, allowing countries like Greece to join the EMU that otherwise wouldn’t have met the requirements.

Secondly, the level and depth of monitoring will be directly proportional to the perceived risk of an individual countries fiscal policies. The idea behind this is that it will allow policy makers to focus on the areas that need attention while applying a lighter touch to those countries with sounder fiscal positions. All well and good, but what happens when more than a handful of countries experience difficulties simultaneously?

Finally, the ECB outline a crisis management body with control of a special purpose reserve fund. This will be used to bail out failing states (one already exists) either by offering direct loans or purchasing government bonds in the market (already been done). There is also talk of minimising moral hazard. This appears like a noble but futile exercise to me as the mere existence of central banks creates moral hazard – It’s what they do. Once a lender of last resort is introduced into an economy the behaviour of borrowers and lenders is influenced so as to create more risk in the economy than there otherwise would have been.

These preliminary proposals are wide-ranging and could potentially have a massive impact on European fiscal policy. One can see how the implementation of strict requirements and monitoring of fiscal policy could lead to European governments running extremely similar fiscal policies. There can not be too much of a disparity between taxes, borrowing and spending across countries if they all have the same targets for debt to GDP ratios and fiscal deficits in mind.

The idea that we won’t have an effective European monetary union without a political one is the prevailing view in the market. I agree. Fiscal policy by committee is probably not the ideal way to strengthen the Euro but perhaps it is the least controversial means of getting there.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Matthew Russell

Job Title: Fund Manager

Specialist Subjects: Corporate bonds and ABS

Likes: Travelling, gym, reading & pool parties

Heroes: John Nash, John Stuart Mill, Ari Gold

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