We don't need no federation: What a devolved eurozone should look like
At the heart of the eurozone's troubles lies a fundamental contradiction. On the one hand, the economics of a monetary union requires considerable integration of policies at eurozone level, and a high degree of economic discipline at national level. On the other hand, most people in the eurozone do not want to be ruled by some kind of 'eurozone government'. They prefer national democracies – of the sort that struggle to impose sufficient discipline. This contradiction is both intellectually and politically hard to resolve.
Three key principles for an economically and politically sustainable eurozone emerge from this contradiction. First, the countries of the single currency should integrate deeply where integration is economically essential. Second, the eurozone should leave as much as possible to its member-states. Third, there are areas in which democracies may not be able to implement policies that are in the long-term interests of both the individual countries and the eurozone. In these areas, the eurozone should delegate policies to independent national bodies rather than try to enforce European rules.
These three principles suggest that banking and financial markets should be fully integrated. Financial flows across borders are a natural (and in part welcome) outcome of monetary integration. Useful financial integration, such as equity investments across borders, can help cushion the impact of economic shocks on individual member-states, as they spread the pain of such shocks across the currency union as a whole. But capital flows can be destabilising if inflows of short-term debt fuel unsustainable booms. Moreover, some banks are closely connected to their sovereigns: they may hold large stocks of their government’s bonds, and the government may be called upon to bail out the banks in a severe crisis. Banks and governments are also linked to their national economies, via lending and taxes respectively. This can create a ‘doom loop’ of banks, governments and their regional economies, whereby the weakness of one weakens the others, in a self-reinforcing cycle. The regulation and resolution of banks, as well as the protection of depositors should be a European, not a national task, to enhance the stability of the whole monetary union. National financial regulators should be dismantled to open the way for a truly integrated banking system.
A stable level of demand is crucially important in a monetary union, as excessively low demand can lead to regional depressions and soaring debt, destabilising the whole union in the process. The European Central Bank (ECB) has failed to maintain the necessary level of demand and inflation during the course of the eurozone crisis, and needs a stronger mandate to prevent this from happening in the future. Such a mandate should include a higher and symmetrical inflation target, as well as the explicit responsibility for maintaining an adequate level of demand. National central banks should no longer be involved in eurozone monetary policy, since they tend to politicise decisions along national lines.
Countries in the eurozone can be subject to runs on their government bonds, similar to a bank run. For banks, the solution has long been to establish a lender of last resort that prevents a crisis of bank liquidity from spiralling into one of insolvency. Eurozone governments need a comparable lender of last resort, and the ECB rightly took on that role by announcing its unlimited bond-buying programme ('OMT') in the summer of 2012.
When countries give up independent monetary policies, they need to use alternative macroeconomic stabilisation tools such as fiscal and regulatory policies, lest cyclical swings become destabilising. In democracies, fiscal and regulatory policies do not always act in a strongly counter-cyclical fashion. Fiscal rules are one way to tie governments’ hands and enforce counter-cyclical policies but have major shortcomings. They tend to be inflexible and therefore cannot deal with the complexity of fiscal policy-making in a monetary union. Furthermore, fiscal rules – particularly if imposed from the outside – are an inadequate replacement for national institutions, whose decisions citizens and politicians are generally willing to accept.
The responsibility for ensuring that fiscal policy is robustly counter-cyclical and debt sustainable should be given to independent national bodies. Ideally, these institutions should have a macroeconomic mind-set, high credibility in the eyes of the public, and a strong political and constitutional mandate to guard both macroeconomic stability and debt sustainability. National central banks – without a real function since the introduction of the euro – are ideally placed to take on such a role. What is more, the implicit mandate of national central banks – to ensure macroeconomic stability – would not need changing, just the tools.
Macroprudential regulation is the part of financial regulation that looks beyond individual banks to the system as a whole, and it serves three purposes: it guards the stability of the entire financial system; it helps to stem destabilising capital flows across borders; and it acts counter-cyclically to even out swings in national business cycles. Therefore, macroprudential policy should be the joint responsibility of national central banks in their new role, suggested above, and the ECB.
Structural reforms should remain in the hands of national democracies. While it is true that the eurozone as a whole has an interest in good structural policies in each member-state, the economic case for centralisation is weaker than the political need for such policies to remain under national democratic control. If there is a role for the European Union, it is within its usual remit: providing an outside assessment of policies, and using the single market, consumer protection and competition tools to break up vested interests.