Carlos da Silva Costa: The importance of strengthening European
integration to ensure the success of the Portuguese adjustment
Article by Mr Carlos da Silva Costa, Governor of the Bank of Portugal, published in Diário
Económico Newspaper, 31 December 2012.
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The flaws in the architecture of the European Economic and Monetary Union
Today it is clear that the architecture of the Economic and Monetary Union was flawed and
incomplete from the start, which made it unable to ensure economic and financial stability
when exposed to abrupt changes in market uncertainty and risk perception. In some cases,
these flaws have heightened the difficulties faced by Member States, which in turn explains
why the contagion effects among euro area economies have surpassed expectations.
The flaws in the architecture and institutional framework supporting the establishment of the
Economic and Monetary Union necessitate an urgent rethink of this model to ensure that the
euro area is stable and resilient both to common and specific exogenous shocks and to risks
of inconsistency among the policies of the various economies. This is to ensure that the
construction of the euro area is supported by all pillars determining its stability and resilience
and that it relies on rules and institutions controlling the mutual interdependence between the
stability of the whole and each of its parts.
The construction of a new future for Europe
The flaws in the architecture of the euro area and the lack of appropriate rules and
institutions to promote the stability of the whole and its parts explain why the sovereign debt
crisis was deeper and more protracted than initially expected. These flaws also explain why
resolving this crisis and restoring sustainable and job-creating growth in Europe requires
measures both at national and European level. In the euro area, these two dimensions
complement and determine each other: the stability of the whole does not tolerate a lasting
divergence/instability in one of its parts. Likewise, the stabilisation of one of its parts depends
on the nature of the impulses it receives from the whole.
National policies to restore debt sustainability
First, the countries that have accumulated significant macroeconomic imbalances in the past
and that were faced with market-based funding constraints in the context of the current crisis
need to adopt policies to restore public debt sustainability, financial stability and
competitiveness, thereby recovering their credibility and confidence. This is the case of
Portugal. The strategy established in the Economic Adjustment Programme for Portugal -
which relies on fiscal consolidation, financial stability and structural reforms - is crucial to
eliminate the macroeconomic imbalances and structural blockages that have led us to this
crisis. In spite of the considerable challenges facing the Portuguese economy and society,
the progress achieved with the implementation of this strategy is already clearly visible today,
particularly in the correction of the external imbalance.
Need for measures at European level to enhance the growth potential of the economy
Compliance by a euro area country with the adjustment programme is a necessary though
insufficient condition to ensure the success of the adjustment process. In fact, the ongoing
adjustment effort at national level needs to be complemented by initiatives at European level
that enhance its effectiveness.
This means that the credibility of the ongoing adjustment programmes must be validated and
sustained by the European context: first, through the adequacy and quality of the rules and
institutions which frame and govern the euro area and each of its parts, thereby annulling the
perception of a risk of fragmentation and of moral hazard; second, through mechanisms to
ensure liquidity (which mitigate the risk arising from asymmetric shocks), mechanisms to
monitor/encourage structural reforms (which, by nature, yield medium term results), and
mechanisms to safeguard the stability of the financial system; last but not least, through an
effective and ex ante practice of cooperation and coordination of the macroeconomic policies
of euro area countries to ensure the stability and growth of both the whole and each Member
State.
In the short term, the euro area needs to have instruments to respond quickly and
effectively to financial stability problems. Important steps were taken in this regard with
the creation of the European Financial Stability Facility and then the European Stability
Mechanism.
In addition, the process of coordination of economic policies at European level must be
strengthened and improved. The main concern should be to ensure that national policies
complement each other. In particular, it is important that the fiscal consolidation path of each
Member State takes into account its room for manoeuvre in order to make the process more
stable as a whole.
It is also desirable to implement investment projects at European level with a proven impact
on potential output, for example in energy and telecommunications. These projects are
expected to contribute to a more integrated, efficient and competitive economy taking full
advantage of the benefits of the European Single Market.
The new European institutional architecture
Building a new European institutional architecture rests on four pillars: banking union, fiscal
union, economic union and the strengthening of democratic legitimacy and accountability.
We must ensure that the construction of each one of these pillars is progressing well and in
an articulate manner. We must also ensure that the materials used in this construction are of
high quality, so that the new building is structurally solid and able to withstand future shocks.
To ensure this high quality we must immediately promote, on the one hand, the shared
notion of common interest and willingness to minimise moral hazard; and, on the other hand,
policies aligned with the stability and economic growth objectives. These materials must take
the form of institutions assuring group control over the integrating parties, in order to
minimise moral hazard undermining group efficiency and cohesion; it shall also ensure the
scrutiny of each member on the manner in which the objectives pursued by the group are
established and put into practice, which is a condition for accepting the constraints defined
by the group. These institutions will make it possible to recover, under shared sovereignty,
the loss of individual autonomy arising from the need to comply with the group's regulations.
The importance of mitigating moral hazard cannot be underestimated, given that it may
obstruct mutual aid and solidarity among Member States. Minimising moral hazard is a
necessary condition of confidence and mutual aid among group members, implying
participation rules and compliance-monitoring mechanisms and institutions.
In order to overcome the crisis that has been undermining the European project, the sense of
urgency, diagnosis and the convergence of willingness are not enough. It is essential to
establish and implement a new institutional framework ensuring the move to a new mutual
confidence stage. The future of Europe therefore involves the mandatory deepening of
financial, fiscal, economic and political integration of Member States.
Banking union
The design of the banking union has been drawn up. This is a key pillar to solve the financial
fragmentation in the euro area and to break the link between sovereign risk and banks' risk.
Currently, euro area corporations experiencing similar situations in terms of profitability and
risk are faced with rather differentiated credit conditions merely for geographical reasons.
Portugal must overcome this problem, in order to strengthen the competitiveness of
Portuguese corporations.
In my opinion, a complete banking union should encompass three key elements: (i) a Single
Supervisory Mechanism, applicable to all credit institutions, involving centralised decision
making and decentralised implementation; (ii) a Single Deposit Guarantee System; and
(iii) a Single Resolution Mechanism.
The Single Supervisory Mechanism was recently approved by the Council of the European
Union. Under this new mechanism, the European Central Bank (ECB) shall be responsible
for carrying out supervisory tasks over credit institutions in the euro area Member States.
There will be, however, a coordinated distribution of tasks between the ECB and the national
supervisory authorities, depending on the size of banks and national banking systems.
With all banks in the euro area under unified supervision, responsibility for deposit guarantee
and resolution shall be held at the level where supervisory powers are exercised, i.e. at
European level. Banking union must therefore cover not only integrated supervision, but also
shared deposit guarantee and bank resolution mechanisms.
If a single supervisory mechanism is not accompanied by European deposit guarantee and
bank resolution mechanisms, it represents banking union under construction and therefore
an incomplete separation between sovereign and banking risk.
Fiscal union
Lack of fiscal discipline among Member States during the pre-crisis period revealed the need
to strengthen the European fiscal policy institutional framework.
Important decisions have already been taken in this field, involving a range of regulations to
promote fiscal discipline in Member States (for example the so-called "six pack" and "fiscal
compact"). However, work for the construction of that pillar is still currently under way. These
regulations must be complemented by institutions assuring their effective implementation.
Indeed, Europe needs a qualitative change towards fiscal union.
Economic union
The achievement of a genuine economic union requires the establishment of an institutional
framework able to assess, coordinate and monitor Member States' economic policy
measures and reforms. Special emphasis should be placed on areas with a potentially higher
impact on competitiveness, economic growth and employment, simultaneously promoting
social cohesion. Member States' economic policies and macroeconomic imbalances are an
issue of common interest and therefore require a "win-win" concerted response. The
"European Semester" and the "Euro-Plus Pact" are important improvements in this area.
Strengthening democratic legitimacy and accountability
To move towards more integrated fiscal and economic policies we need to implement
mechanisms ensuring democratic legitimacy and accountability in joint decision-making. If
this political dimension is ignored, we will not be able to evolve towards greater financial,
fiscal and economic integration, for lack of legitimacy and accountability.
This political dimension of the integration process must reconcile two sources of concern: the
need for a legitimate response vis-à-vis "the whole"; and the need to ensure that all parts,
irrespective of their size, are represented and participate in the decision-making process.
In particular, the so-called "community method" must be revitalised, in tandem with restoring
the European Commission's central role, by strengthening its effectiveness and legitimacy.
This subject requires separate attention. I have already tackled it in a number of public
addresses, as for instance on the occasion of the European Courts of Auditors meeting in
Estoril this year.
It must be understood, however, that the political pillar, although going hand in hand with the
pillars of greater financial, fiscal and economic integration, has its own different timeframe.
The construction of the other pillars cannot be delayed for the launch of the work on the
strengthening and reconstruction of the political pillar. The time criticality of the problems
requires prompt responses to the Economic and Monetary Union's flaws. These are likely to
be a catalyst for responses of political organisation and legitimacy that are less grandiose,
but certainly more efficient, as they are based on the resolution of actual problems (as may
be expected from an evolutionary/gradualist model, such as has been the case in Europe, as
opposed to the institutional/constitutional model, which is a federal integration-like model).
By way of conclusion, I would like to stress once again that European development is very
important for the success of Portugal's adjustment. Determined domestic policy action is
essential but not enough. The European context must validate the credibility of the
adjustment in every euro area economy. The level of certainty, quality and vigour of the new
euro area mechanisms and institutions are key to strengthening market confidence and are
therefore an indispensible complement to national adjustment effects. This means that there
is a virtuous relationship between the so-called frontloading of national adjustment processes
and the frontloading of the European integration process. For this reason, the Governing
Council of the ECB has repeatedly advocated that the response to the sovereign debt crisis
should be the responsibility of the European Council and that the costs and depth of the
crisis were inversely related to the celerity and forcefulness of the response. The Portuguese
and the citizens of other Member States must understand this: the regulations and
mechanisms under development in Europe are not the result of some external imposition, but
are rather inherent to the integration stage representing a successful Economic and
Monetary Union and are therefore essential for the prosperity of Europe and each of its
Member States.