It also requires that they “tie their hands” in a credible manner through stronger and more automatic economic governance. The monetary financing prohibition, in this way, is a spur towards better policies and better governance – in other words, a closer economic union. Similarly, the monetary financing prohibition changes the relationship between sovereigns and their national banking systems. As sovereigns cannot monetise debt, they can only backstop large banking sectors at a cost to their own creditworthiness. Insofar as this may undermine the balance sheets of the banks they are trying to save, it could end up triggering a self-defeating vicious circle. This implies that the only viable route to support the euro area’s integrated financial sector is through a more integrated system of supervision and resolution. The monetary financing prohibition, by constraining the resources of individual sovereigns, pushes the euro area in the direction of collective solutions. BIS central bankers’ speeches  7  Conclusion Let me now draw to a close. The key theme that has run through my remarks today is that, from every perspective, much closer economic and financial union is essential for the euro area. We have had this demonstrated in the clearest possible terms by the financial and sovereign debt crises. We have already taken important steps in this direction. Europe is ahead of others in addressing its imbalances. The challenge looking forward is to complete the process towards closer union and not settle for the “quick fix”. The people of Europe want closer cooperation in economic and financial matters.

This allowed a certain country to run deficits over 3% of GDP every year it was in EMU and never face corrective action. Moreover, the euro area surveillance framework was “blind in one eye”, with no formal framework for monitoring macroeconomic and financial imbalances. The Lisbon Strategy focused on the structural level, but on policy implementation rather than imbalances. Eurogroup discussions on imbalances had no enforcement mechanism. The Lamfalussy framework for financial supervision did not use the concept of systemic risk. Thus a situation prevailed where countries could be congratulated for strong headline fiscal numbers when these data in fact reflected substantial imbalances that were building up in the private sector. To a certain extent, the weakness of these governance procedures was linked to a misplaced faith in market discipline. The institutional design of EMU gave market discipline a central role in economic governance. The absence of a transfer mechanism between Member States was supposed to encourage markets to actively discriminate between euro area issuers. This was based on the assumption that financial markets would always have perfect incentives to enforce the “rules of the game”. This assumption, in retrospect, looks somewhat naïve. It is well established in the academic literature that markets have complex incentives and dynamics. Market psychology tends towards pro-cyclicality. Perceptions converge around certain information sources, such as ratings, or certain benchmarks, such as indices, which creates herd behaviour.