Ireland and the future of the European Union

Tom McDonnell:  Presentation to the Oireachtas Joint Committee on European Union Affairs, Thursday 21st February 2013: “Ireland and the future of the European Union” National Debate 2013

It is important to consider the implications for Ireland of increasing financial, budgetary, and economic policy integration within the European Union. But what will this integration look like? The answer to that question depends on the changing structure of the Economic and Monetary Union (EMU). We know that EMU as constructed was fragile, incomplete, and highly flawed:

• There was no centralised authority responsible for the supervision, regulation and, if necessary, resolution, of financial institutions 
• There was no fiscal transfer mechanism to deal with asymmetric shocks; no ‘automatic stabilisers’ at Euro zone level to replace those lost at the domestic level; and no mechanism for offsetting competitive imbalances or for preventing them in the first place 
• There was no Lender of Last Resort for member states and therefore no ‘circuit breaker’ to protect against negative feedback loops of spiralling borrowing costs. Member states were at the whim of massive and destabilising credit inflows and outflows 

The long-term viability of the European Union’s Economic and Monetary Union depends on correctly diagnosing and resolving the EMU design flaws and ending the three interlocking crises – the sovereign debt crisis; the banking crisis; and the real economy crisis of low growth, high unemployment and high private over-indebtedness.

To understand what EMU will look like in ten years’ time we must understand what the different solutions to these problems look like.

We have already seen a number of official policy responses and changes (or proposed changes) to EMU in recent months. These include:

• European Central Bank (ECB) interventions in the secondary bond markets through their Securities Market Programme (SMP) and through their new Outright Monetary Transactions (OMT) initiative. (In other words, the ECB has been indirectly buying government bonds through the SMP and has agreed to do ‘whatever it takes’ through the OMT); 
• Special purpose vehicles have been created in the form of the EFSF and ESM (European Financial Stability Facility and European Stability Mechanism respectively) to preserve the stability of the Euro by providing emergency funding lines to sovereigns; 
• Numerous initiatives including bank recapitalisations and cheap liquidity have sought to stabilise the European banking system; 
• The parameters of a Single Supervisory Mechanism (SSM) have been agreed and from the start of 2014 the ECB will be legally responsible for supervising 6,000 banks. 

Responses to the sovereign debt crisis have thus far been somewhat insufficient. For example, the structure of the ESM is inherently fragile. Nevertheless, the ESM is an important crisis stopgap.

It is often forgotten that the historical rationale for a central bank was not to stabilise prices by controlling inflation, but to stabilise the entire economic system itself by providing backstop or ‘last resort’ liquidity to banks and to sovereigns. The OMT initiative was therefore a crucial step and reflects the critical need for the Euro zone to have a Lender of Last Resort (LOLR) for sovereigns – for that is precisely what the OMT represents. The announcement and formulation of the OMT in August and September 2012 was when the Euro was saved. The detail of how each measure is implemented will be very important.

But this set of measures remains critically incomplete. Little has been done to ease the growth and employment crisis. Pro-cyclical policies of internal devaluation have taken hold in the periphery. These policies were undertaken to deal with fiscal and competitiveness imbalances but have not been matched by countervailing measures in the core. The overall effect has been ‘deflationary’ (i.e. it has caused economies to contract rather than grow). This has exacerbated and elongated the jobs and growth crisis in Europe.

In the medium term, a permanent mechanism is needed so that the so-called ‘multiple equilibria problem’ of sovereign borrowing costs spiralling out of control is eliminated for any state showing a willingness to pursue a sustainable fiscal path. Different versions of Eurobonds have become fashionable as an idea. But moral hazard concerns mean they are not the solution. A better solution would be to assign a banking licence to a special purpose vehicle, for example the ESM, and then to use this vehicle as a de facto conditional Lender of Last Resort for sovereigns. This would be a key institutional development.

How can we break the link between sovereigns and banks? The next few years will see the gradual construction of a banking union for the Euro zone, and this of course will have major implications for the EU as a whole. A centralised banking union is a necessary component of any viable monetary union. In practice this means independent centralised supervision, regulation and resolution of financial institutions at the Euro zone level. This will have major implications for member states. In addition, protecting taxpayers and depositors in the future, while also dealing with capital flight, will require a centralised deposit insurance scheme modelled along the lines of the FDIC (Federal Deposit Insurance Corporation) in the United States. This would end the differentiation between banks in the periphery and the core and help create a genuine banking union.

So we are looking at further integration in the form of a Euro zone banking union and possibly the creation of a Euro zone lender of last resort.

A more fundamental question is whether Euro zone member states can align monetary and fiscal policies to the goals of employment and growth. The answer to that question is yes. But only at the level of the Euro zone itself. The broad framework required involves intergovernmental coordination of policies to prevent competitiveness and domestic fiscal imbalances from growing too large. An example of this is the new European semester. In order to help offset regional recessions and asymmetric shocks, such a framework will require a centralised fiscal fund. This is because member states have lost much of their power to use their own budgets as a countercyclical ‘automatic stabiliser’, while also losing control over other macroeconomic policy levers such as exchange rate policy and monetary policy. These lost policy tools need to be replaced in some form.

Safeguarding democratic legitimacy and accountability within a full fiscal union would require a fundamental overhaul of the treaties and far greater power for the European Parliament and its committees.

However, what I have described is very far from a complete fiscal union. While greater integration and coordination between EU member states is inevitable under EMU, full fiscal union is unnecessary.

It is important to note that in parallel to the formal development of the EMU, other more ad hoc forms of integration will occur. A good example is the Financial Transaction Tax (FTT) – also called the Tobin Tax or Robin Hood tax – which has been signed up to by 11 Euro zone member states, but not Ireland. The European Commission tabled its proposals on 14th February of this year, confirming a levy of 0.1% for shares and bonds, and 0.01% for derivatives. The FTT is an example of the enhanced co-operation procedure permitted under the existing EU treaties. These types of procedure may become more common in the future as it becomes increasingly difficult to reach agreement between the soon-to-be 28 EU member states. However, they also represent the risk of a fragmentation of economic policy across the EU, with multi-lateral agreements replacing common EU-wide policies.

The attitude and position of the United Kingdom within the EU is of great economic significance for Ireland. It seems unlikely that the UK will actually leave the EU but that is a political question perhaps better answered by my colleague. I am limiting my response to the likely consequences of particular outcomes rather than speculate on the future of the UK’s relationship with the rest of Europe.

In sum, this is a critical decade for the European project. Catastrophic errors were made in the design of the EMU. Economic history and economic theory were both ignored. I have sketched a brief outline of the type of policies needed to create a durable EMU.