The euro area has done a lot since the start of the crisis to strengthen fiscal rules. In particular, Member States have sought to move away from the unstable middle ground of the first SGP by anchoring fiscal rules more firmly in national law. The Fiscal Compact – which requires countries to run balanced budgets over the cycle and reduce their debt levels progressively towards 60% of GDP – has to be written into national constitutions or equivalent, and is overseen by national fiscal councils. This comes closer to the model of having decentralised implementation of rules, but with very little discretion. But will this be enough? I see two possible outcomes. The first is a stable equilibrium between centralised banking governance and decentralised fiscal governance. That is, banking union better insulates national budgets from financial shocks, meaning budget deficits are generally milder. And in this context, the Fiscal Compact provides sufficient medium-term credibility to allow fiscal policy to operate counter-cyclically without threatening market access. The second possibility is some form of deeper fiscal union at the euro area level. Economic union Clearly, the political economy of deeper fiscal integration is difficult, especially given the preferences expressed at the recent European Parliament elections in some reform-resistant countries. Thus, we should focus our efforts for now on making the new equilibrium work. But here again we need consistency. If the current fiscal rules are to be credible, we need higher growth, and that means looking deeply at how we coordinate structural policies across Europe.

Governance of the euro area can be imagined like a set of interlocking cogs wheels: they do not all need to be of similar size – that is, we do not necessarily need the same degree of centralisation in each area – but they need to all move in the same direction. If one cog moves in the other direction, the whole machine grinds to a halt. There were several inconsistencies between policy areas in the euro area that had such a countervailing effect. To begin with, the frameworks for economic and financial policies pulled in different directions. Increasing financial integration encouraged capital to flow from core to periphery, but this was not accompanied by increasing integration of product and services markets to ensure that this capital was allocated efficiently. In fact, as competitive pressures remained weak, in particular in the non-tradable/services sector, certain industries were able to maintain excessive rents and distort price signals. This meant that the low marginal product  4  BIS central bankers’ speeches  of capital in these industries was offset by rising profit margins, leading capital to become misallocated. The fiscal and financial frameworks also interacted negatively with one another. In particular, policy-makers underestimated the extent to which financial integration depended on the false perception of relatively homogenous sovereign credit risk. As euro area banks were heavily exposed to own governments’ debt, when perceptions of sovereign creditworthiness diverged, so did confidence in their respective banking systems.