Yves Mersch: Europe: a work in progress - political integration and
economic convergence in Monetary Union
Speech by Mr Yves Mersch, Member of the Executive Board of the European Central Bank, at
the Banking and Corporate evening, organised by the Hauptverwaltung in Bayern der Deutschen
Bundesbank, Munich, 22 November 2018.
* * *
Ladies and gentlemen,
Europe has no problem with identifying the issues it faces; it has a problem with implementing
solutions.
Many of the weaknesses and shortcomings of the European framework have long been known.
And the measures required to address these issues have repeatedly been discussed for some
time now. Unfortunately, national interests and complacency have consistently dampened the
momentum that Europe needs to become a true Economic and Monetary Union. Electoral
machinations extending to the regional level and rising populism have recently added to the
problem.
The latest proposal was in June. At a meeting in Meseburg Palace, the leaders of France and
Germany issued a joint declaration in which they stated their objective "to strengthen and deepen
the euro area further, and make it a genuine economic union".
Their statement that sharing the same currency entails specific needs in terms of economic
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coordination and integration is correct - and it is something that has long been known.
As far back as 1970, the committee of experts chaired by the then Luxembourg Prime Minister
Pierre Werner, which drew up the first meaningful plan for a European monetary union, stressed
that insufficient economic convergence and the absence of a common fiscal policy would give
rise to the need for greater economic policy coordination.
Later proposals, including the Maastricht Treaty of 1992, unfortunately failed to sufficiently tackle
the inherent tensions of a currency without a state.
The spirit of Meseberg stems from the original European idea and the pledge of prosperity that
brought the single currency into being: the euro benefits Member States. They profit from having
a credible and stable currency and a larger, competitive market.
But the crisis demonstrated that the euro area is susceptible to negative shocks and that greater
economic and political convergence is needed.
Today, I would like to focus on three areas in which it is vital to make progress.
First, we have to more actively pursue fiscal and structural reforms. Second, we need to further
reduce risks and fragmentation in the financial sector. And third, we must decisively strengthen
the institutional architecture of Economic and Monetary Union (EMU).
Structural reforms and fiscal policy
Unlike countries that have their own currency, euro area members cannot use the exchange rate
to tackle asymmetric shocks.
Instead, they must undertake structural adjustments to ensure that their economies are
competitive and resilient.
If some Member States adjust more slowly than others, economic differences may become
permanent. And to the extent that this endangers the effectiveness of monetary policy and the
cohesion of the Union, it has potentially damaging consequences for all Member States.
It is thus vital that Member States push ahead with structural reforms to make labour and product
markets more flexible, thereby enabling the factors of production to move more quickly between
sectors.
To this end, national reform requirements are determined in the context of the European
semester with a view to strengthening the coordination of economic policies at the EU level.
Country-specific recommendations need to be implemented in the interests of all parties to avoid
persistent imbalances.
But progress in implementing the reforms has been slow. The European Commission concluded
that the overwhelming majority - meaning more than 90% - of country-specific
recommendations had only been implemented to "some" or a "limited" extent in 2017, similar to
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the previous year.
The European Commission suggests supporting countries' reform efforts through the EU
budget. In principle, this could create positive incentives to implement reforms. However, for that
to work in practice, the Commission proposal would need to be significantly strengthened in
three ways.
First, reforms should be selected on the basis of their implications for macroeconomic
prospects. Second, the funding should be distributed on the basis of a quality assessment rather
than in proportion to a country's entitlement to a "slice of the pie". Third, powerful clawback
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mechanisms should be built in so that funds could be recuperated if reforms are reversed.
The implementation of structural reforms is only one of the factors that helps strengthen the
resilience of Member States. Another factor is sound fiscal policy.
Here common fiscal rules are important to ensure that Member States do not take on excessive
levels of debt, because low levels of debt and larger buffers give countries greater fiscal space to
mitigate economic downturns.
Aggregate debt and deficit ratios in the euro area are currently lower than those in any other
major economy, which demonstrates that our common fiscal rules are having a certain effect.
But the rules have repeatedly been called into question in recent months, in particular by
countries with high levels of debt.
To this one can only say that consistently breaching the rules will not only make them less
effective in the long run, it could also worsen financing conditions for some or all Member States.
It is thus imperative that countries, especially those with the highest debt levels, use the ongoing
expansion to build up fiscal buffers and reduce debt.
This is not only crucial to strengthen resilience, it is also a precondition for strengthening the
solidarity between Member States in times of crisis.
As such, the Meseburg declaration represents a turning point, as the German government is now
recognising the need, in principle, for a stabilisation facility at the European level.
The recent proposal for an EU unemployment insurance scheme put forward by the German
finance minister, Olaf Scholz, is also to be welcomed. The fund, which the Member States would
pay into, would grant loans to particularly crisis-stricken social security systems, without any
transfer payments taking place.
In addition, the European Commission is proposing a European investment stabilisation function
to mitigate large asymmetric shocks in the euro area.
And a few days ago, France and Germany agreed on a proposal for a limited euro area budget by
2021.
Two elements are essential for the effectiveness of such instruments. First, a central fiscal
capacity should be designed to increase the euro area's ability to counter severe area-wide
recessions, thereby supporting monetary policy. Second, it should set appropriate incentives for
sound fiscal and economic policymaking.
On both counts, the proposals made so far fall short. They are limited in size and designed to
counter asymmetric shocks. However, asymmetric shocks are extremely rare, and there is a
lack of analytical concepts and normative answers to help distinguish between difficulties
affecting a country through no fault of its own (bad luck) and those that are the result of the wrong
economic policy choices (bad policies). What's more, existing EU Treaty provisions already
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allow for financial assistance to a Member State threatened with severe difficulties.
"Where a Member State is in difficulties or is seriously threatened with severe difficulties caused
by natural disasters or exceptional occurrences beyond its control, the Council, on a proposal
from the Commission, may grant, under certain conditions, Union financial assistance to the
Member State concerned. [...]" Article 122.2, Treaty on the Functioning of the European Union.
In addition, the proposals do not sufficiently counteract moral hazard.
The recent Franco-German proposal takes some of these issues into account, for example by
suggesting that the euro area budget only be made available to countries that fully respect the
European framework, including the fiscal rules. It also explicitly states the aim of fostering
competitiveness and economic convergence. At the same time, any attempt to set up an
intergovernmental decision-making structure to manage a federal sub-budget is likely to be
difficult to implement in practice, and the effectiveness of a financial transaction tax as the central
source of funding is overrated.
However, I don't want to pick too many holes in the idea - indeed, I warmly welcome the fact that
the European debate is picking up speed again.
Reducing risks and fragmentation in the financial sector
Let me now turn to the second set of challenges faced by the euro area: risks in the financial
sector.
The financial crisis demonstrated that an unstable and highly fragmented financial sector
represents an existential threat to Monetary Union.
Europe has translated key lessons of the crisis into a more solid framework by establishing the
banking union. The euro area's largest banks are now supervised at the EU level and their failure
is addressed centrally.
The improved regulatory and supervisory framework has allowed considerable progress to be
made in terms of reducing risks. The Common Equity Tier 1 ratio of large banks has increased
from 9.7% in 2008 to over 14% today. Leverage ratios have risen from 3.7% to 5.8%. And banks
have much more stable liquidity and funding.
At the same time, insufficient progress has been made in creating a European banking market.
Euro area banks largely operate in their home markets, leading to overcapacity and making the
Union more susceptible to fragmentation.
Fragmentation along national lines and overcapacity are also visible at the aggregate European
level if we compare some key figures for the sector with those of other currency areas. From
2013 to 2017, the average return on equity for the euro area banking sector was 4.5%, while it
was 9% in the United States. Over the same period, European banks had a cost/income ratio of
69%, while that of US banks was just 60%. The euro area had 44 bank branches for every
100,000 inhabitants, almost twice as many as in the United States, which had 26. In the euro
area, only 52% of banks' total assets are publicly traded, while the figure is close to 80% in the
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United States.
An integrated financial market offers risk-sharing mechanisms that can be used to mitigate
country-specific shocks. Banks that have more geographically diversified loan and deposit
portfolios are more resilient to local shocks and can keep their lending activity more stable.
We must hence continue enhancing the conditions for cross-border banking in the euro area.
The first step is to reduce the legacy non-performing loans on banks' balance sheets which have
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hampered cross-border lending and M&A transactions over the past few years.
That would then pave the way for the completion of the banking union, which we need to
reinforce in order to boost confidence in the resilience of the whole financial sector.
Financial market fragmentation may be exacerbated by perceived or actual differences between
the national safety nets for banks which undermine the banks' capability and willingness to
expand their cross-border activities.
The introduction of a common and credible fund for the Single Resolution Mechanism (SRM)
would inspire confidence that banks can be resolved more efficiently, regardless of their location.
Likewise, the creation of a European deposit insurance scheme (EDIS) would enhance depositor
confidence throughout the euro area and create a level playing field for banks. The main benefit
of EDIS is that it will generate confidence in the financial system as a whole. Provided that the
standards on minimum requirements for own funds and eligible liabilities (MREL), total
lossabsorbing capacity (TLAC) or other risk reduction measures are not eroded, EDIS will probably
never be deployed at all. At the same time, we should not fail to mention that especially smaller
institutions have next to no experience in accessing capital market funding. This makes it more
difficult to rigorously apply the MREL requirements.
Moreover, the introduction of such security mechanisms at European level could give national
governments less incentive to restrict the free flow of capital and liquidity; this would in turn
promote cross-border activity.
But EDIS must be incentive-compatible. Its introduction must not result in any retrospective
sharing of the burden of legacy non-performing loans.
And in order to avoid systematic transfers between banking sectors, the banks' contributions to
the fund should be structured to reflect banks' risk appetites.
Strengthening the institutional architecture of Economic and Monetary Union
These economic and fiscal reforms are essential in order to make the euro area more resilient.
However, they cannot fully prevent the risk of severe economic shocks.
In the future too, effective crisis management will be indispensable to protect the Member States
from serious imbalances.
In this respect, I am very much in favour of strengthening the European Stability Mechanism
(ESM). However, the reorientation of the ESM should be coupled with its integration into EU law.
If the ESM were to remain an intergovernmental institution, any transfer of tasks must be
consistent with the allocation of responsibilities between the EU and its Member States as laid
down in EU law, as a transfer of powers from the European level (European Commission) to the
intergovernmental level (ESM) would amount to a throwback to national models and
selfinterests. By analogy, this also applies to a Euro area budget.
We also need more clarity with regard to the political framework for Monetary Union.
We must identify problems with countries' debt sustainability at an earlier stage. The ESM needs
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to be able to distinguish between liquidity and solvency problems early on. That would allow us
to pick up the can early rather than kicking it down the road.
Similarly, we need to do more to break the bank-sovereign nexus. We need regulatory
instruments to curb the excessive accumulation of sovereign risks on bank balance sheets
without triggering market disruptions.
In that sense, ensuring the adequate regulatory treatment of sovereign risk and facilitating orderly
debt restructuring are two sides of the same coin.
We should be aware that market-imposed discipline often comes suddenly, creates cliff-edge
effects and can have negative consequences for financial stability. The recent Franco-German
proposal to introduce single-limb collective action clauses and moves to align the roles of the
ESM and the International Monetary Fund in debt restructuring negotiations are sensible first
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steps towards creating a more reliable framework for orderly debt restructuring.
This brings me to my final point: democratic control.
Progress in completing Economic and Monetary Union needs to evolve in lock-step with
appropriate democratic control to meet the test of constitutionality.
What matters is that liability and control are aligned. When taxpayers' money is involved at
European level, a European control function is called for.
Any confusion over the assignment of responsibilities and accountability arrangements threatens
the efficiency and legitimacy of European measures.
The task is complicated by the particular architecture of Economic and Monetary Union. The
distinction between the euro area and the EU means that it is more difficult to fully tailor
accountability to euro area tasks. In particular, the European Parliament does not sit in euro area
composition when discussing euro area matters. And of course it leaves a sour taste when
representatives of countries that neither belong to the euro area, nor will remain in the EU in the
long term, actively fill central positions in the European Parliament or its committees.
At the same time, responsibilities and accountability also need to be proportionate in areas of
shared competence between the EU and Member States. This holds true for the ESM and for
fiscal policies, where the situation is more complex and blurred.
The ESM, for example, was created on the basis of intergovernmental arrangements and for
tasks where the EU only has a coordination role, and where the European Parliament is not yet a
counterpart in terms of accountability.
We need to strike a balance here. On the one hand, accountability should be assigned to national
parliaments for decisions that are fully in the hands of national authorities.
On the other hand, the ESM needs to be equipped with swift and credible decision-making
procedures. This will never be fully possible in an intergovernmental setting that is hampered by
national vetoes and operates outside the constitutional safeguards of the acquis.
Against this backdrop, the ESM should be turned into a body that is governed by EU law and is
accountable to the European Parliament. This would ensure that the ESM is better placed to act
in the sole interest of the euro area.
A similar logic, necessitating Treaty change, must be applied in any further discussions
regarding a euro area fiscal capacity and the possible introduction of an EU investment facility or
a European finance minister.
If a euro area budget is established, it should be part of an ongoing debate on a euro area finance
ministry and a euro area composition of the European Parliament.
We should avoid undermining established Union methods. This also holds true for parallel
financial structures aiming to bring separate funds under the same umbrella, in case they would
hamper the efficiency of established federal institutions.
We should neither succumb to the appeal of relying on secondary legislation in areas where
primary law is unambiguous, nor use semantic tricks to subjugate the letter and spirit of the
Treaty to secondary legislation. The central bank must keep its distance from politics rather than
constantly pushing its way into new fields of action under cover of financial stability.
Conclusions
The euro area is a special construct. 19 countries share a common currency, but responsibility
for their economic and fiscal policies still lies in national hands.
Convergence in these areas is, however, crucial for the success of Monetary Union. So it is
imperative for all Member States to adhere to the common rules.
The resilience of the euro hinges on the implementation of the necessary economic and fiscal
reforms. And further steps must be taken to boost private and public risk-sharing.
At the same time, as we progress towards completing Economic and Monetary Union, we should
keep in mind two principles that are at the heart of effective policy in a democratic society.
First, liability and control must be aligned, with important decisions taken only by those who will
bear their consequences.
Second, the discharge of democratic control must lie at the level at which policy decisions are
taken.
Given the current state of our Economic and Monetary Union, further efforts to deepen it through
political and economic convergence are clearly indispensable.
1
archiv.bundesregierung.de/archiv-de/meta/startseite/meseberg-declaration-1140806
2
www.ecb.europa.eu/pub/economic-bulletin/focus/2018/html/ecb.ebbox201805_06.en.html
3
While the Commission mentions such a mechanism, the identification of reversals is left overly vague.
4
"Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural
disasters or exceptional occurrences beyond its control, the Council, on a proposal from the Commission, may
grant, under certain conditions, Union financial assistance to the Member State concerned. [...]" Article 122.2,
Treaty on the Functioning of the European Union.
5
Restoy, Fernando (2018), "The European banking union: what are the missing pieces?"; Public lecture at the
International Center for Monetary and Banking Studies, Geneva, Switzerland, 16 October 2018.
6
www.ecb.europa.eu/pub/fsr/shared/pdf/ecb.sfbfinancialstabilityreview201711.en.pdf?
bc1a2e57de30c0b2cee99fbd4ae141a5;
7
See Y. Mersch (2016), "Reflections on the feasibility of a sovereign debt restructuring mechanism in the euro
area", ESCB Legal Conference 2016.
8
See Benassy-Quere et al., "Reconciling Risk Sharing with Market Discipline",CEPR Policy Insight, No 91, Centre
for Economic Policy Research.