Europe needs to go back to its political roots, and these roots remain predominantly national. The challenge of improving the robustness of the euro area, in the wake of the crisis, cannot overturn this basic political reality. Forcing the pace on fiscal union, directly or through a mutually-supported banking union, would outrun popular support for the European project. For the foreseeable future, therefore, centralisation and fiscal union do not represent a viable way ahead for strengthening the euro area. As this becomes clear, the present tactic of 'muddling through' will simply become a muddle. These were among the tough messages of Ashoka Mody (Visiting Professor, Princeton; formerly IMF), in his seminar on EMU for the Political Economy of Financial Markets Programme.
As an alternative way of governing EMU, Professor Mody advocated taking lessons from the EU's founding fathers and thinking in terms of a new Compact among countries. The principle should be to make decentralisation more robust, rather than to wish it away. In essence, rather than being subjected to centralised oversight, member states would internalise the policy requirements of living together in a monetary union, and they would enter into an abiding agreement to respect these. He discarded the third possible option - a break-up of the euro area - as extremely costly in economic terms, for reasons that Eichengreen had spelled out.
The key requirement for a decentralised EMU to work was that incentives be changed for both policy-makers and markets. Default risk needed to be reintroduced - moving in the opposite direction of OMT, which had essentially limited the potential losses on sovereign debt. Indeed, in a monetary union without federal transfers, sovereign default was an essential degree of freedom. The expectation of sovereign and banking bail-outs therefore needed to be credibly reversed. One route to this could be to introduce 'sovereign cocos' - bonds on which the terms would be restructured automatically once certain risk thresholds were passed.
In the discussion, a key question was whether the strengthening of default risks would be sufficient to change incentives. There were some views that one should not give up so easily on gradual progress towards a banking union with some fiscal underpinning. Others explored the question whether there were additional means of changing incentives - for example through a strengthening of national institutions to promote fiscal and financial stability.
The concern was expressed that, absent a banking union, links between sovereigns and banks could lead to a self-reinforcing plunge in financial confidence and in output and employment in a troubled member state, which would not be politically sustainable. Without more mutual insurance, the monetary union would simply not prove viable. A softer variant on this theme was that a decentralised EMU might survive for a period, but it would not necessarily resist very severe shocks. In this connection, the experience of the US in the interwar period was debated. In Europe, would a severe future shock be sufficient to trigger support for a fiscal union in the absence of a Roosevelt-like leader - recalling also that Roosevelt had control of both houses of the US Congress?
On the other hand, a more decentralised EMU, it was argued, would probably create conditions in which a possible break-up of EMU, in extreme circumstances, would prove less costly. Cold comfort for EMU enthusiasts - but the speaker's worries about support for a true banking union are undeniably spreading: the concerns of Mody are more and more a la mode!
Professor Kalypso Nicolaidis chaired the discussion. The paper will be found on the PEFM website, and a podcast of the presentation and the comment by Professor David Vines will also be posted there in due course.