Capped at US$63.5bil, Europe’s monetary union is still unfinished work

BRUSSELS: Leaders of the European Union meet here this week to discuss the future of the eurozone.

In recent years, governments have strengthened the system a lot, making it less likely that a crisis in one member state would jeopardise the currency area as a whole. Even so, they haven’t done enough.

Today the eurozone is much more robust than it was at the start of the Greek sovereign-debt crisis.

There’s a rescue fund (the European stability mechanism or ESM); a tried-and-tested central bank equipped with new tools; and the beginnings of a so-called banking union.

All this is valuable, but it falls short in two main ways. First, the banking union needs to be completed. Second, lacking the adjustment mechanism provided by individual exchange rates, the eurozone needs better ways to absorb economic shocks.

The good news is that Europe’s efforts to strengthen the system have put much of what’s required in place.

The ESM is there to help countries should they lose access to capital. Governments have to apply for an adjustment programme, which offers financial support in return for fiscal discipline and structural reform.

To be sure, the system bungled the case of Greece: Excessive fiscal restraint and the government’s lassitude on structural reform have prolonged the agony unduly. But Portugal, Ireland, Spain and Cyprus all benefited from the ESM’s intervention and are now expanding at a healthy pace.

In addition, ECB President Mario Draghi has ensured that the central bank has the tools it needs. The most important innovation is “Outright Monetary Transactions” – the power to buy unlimited quantities of shortterm sovereign bonds once a country has applied for an ESM programme.

This scheme is a vital backstop. Investors know the ECB can step in, so they’ll be more reluctant to bet against a country in financial difficulty.

The other big step was the banking union. The ECB has taken over from national central banks as the leading authority in overseeing the eurozone’s largest lenders.

This has resulted in stronger oversight. The Single Resolution Board decides how to wind down a bank deemed “failing or likely to fail,” and can use funds for the purpose from the Single Resolution Fund.

This ought to mean that individual govern- ments don’t have to bail out a bank on their own.

The system faced a test just last month, when political instability in Italy caused a sharp sell-off in the country’s sovereign bonds.

Other countries were also affected – but less than in the past. As Draghi put it, “Contagion was not significant. ... It was a pretty local episode.” The reforms have made the eurozone more resilient.

Nonetheless, the work is not complete. As yet, the banking union isn’t really a true banking union. The resolution fund, capped at 55 billion euros (US$63.5bil), is too small. The ESM should therefore be empowered to support it when necessary, and to act without delay (since resolutions typically take place over a weekend). — Bloomberg