The monetary union was always a grand gamble. It established the ECB for an immense region that itself was not a state -- a trans-European institution with governmental duties that does not represent any government in particular.
The founding fathers of the euro did not anticipate all the ramifications flowing from this peculiarity. In fact, every expansion of the Eurozone has led to an automatic enlargement of the ECB council, without taking account of increased complexity of governance and monetary policymaking, including funding conditions for governments or refinancing of private commercial banks. To overcome these deep-seated governance problems, a fundamental overhaul of the Eurosystem is required. A central element of this reform must be a redrawing of the boundaries of the central banks that constitute the ECB.
In a monetary union, national interests can diverge over time as regional interests do. Economists have warned from the beginning of the euro project that a single monetary policy is a source of risk, especially when adjustment is necessary and devaluation is no longer possible. Adjustment in a monetary union is painful – as developments in the European periphery make very clear – so it is paramount to prevent such misalignments from arising in the first place. Despite these warnings, European politicians insisted on a system with fundamental flaws.
A common monetary policy must be formulated above and beyond individual national concerns. Yet because the national central banks of the Eurozone have much to say about ECB monetary policy – in fact, they own the ECB – they also pose a source of significant risk.
- One example is their well-recognised reluctance to impose “haircuts” on the value of collateral used by member country private banks for funding their lending activities.
This is one of the few natural brakes on government borrowing, especially when it is driven by reckless fiscal policy. In this sense, the ECB should have applied that brake much earlier, as it became clear in the mid 2000s that southern European countries were losing competitiveness and governments were not acting to restrict national spending.
By any normal reckoning, Greek banks, to take one example, should have faced this constraint in 2003-4, as their government and private sectors were already overextended. A restriction in credit flows to Greek banks and other lenders at the time would have slowed aggregate demand and the deterioration of competitiveness already emerging. The one-interest rate policy praised by then-President Trichet sent exactly the wrong signal to the markets.
Once markets got wise to what was going on, governments that had previously been able to borrow on the same terms as Germany had seen a drastic deterioration in their competitiveness. By then, it was too late. After the adjustment, the ECB was so preoccupied with shoring up the financial health of the system as a whole that it was unable to apply serious haircuts to any single country, even though government ratings, bond yields and credit availability by then had diverged significantly.
In short, the re-politicisation of monetary policy via the national central banks poses a significant risk for further economic integration as well as a neutral (country-blind) money and credit policy in the Eurozone.
How to fix the system
The logical remedy is a redesign of the ECB in a fashion familiar from the Federal Reserve System of the US (Figure 1). The regional Federal Reserve Banks represent large stretches of territory that reach beyond the borders of US states and sometimes even divide them.
- Balance of payments problems and competitiveness misalignments between Federal Reserve Districts do occur, but they are apolitical and immune from the pressures of state legislatures.
- They have little or nothing to do with the finances of the individual states, and a state bailout by a regional Reserve Bank is not an option.
Figure 1. The twelve districts of the Federal Reserve System
That 49 US states have enacted constitutional strictures on deficit funding of current expenditures implies that this no-bailout policy is credible.
Figure 2 presents one example of a repartitioning of the monetary authority of the Eurozone along the lines of already existing EU administrative (NUTS-2) regions. This redrawing of the ECB, which intentionally cuts across national frontiers of the larger countries, would help re-establish a neutral and politically independent allocation of money and credit.
- The number of board members representing the districts could be based on population or GDP.
- The governing bodies of the new ECB could receive democratic legitimation from the European Parliament upon nomination by national authorities.
Figure 2. One proposal for repartitioning the Eurozone
Rather than being penalised, smaller countries would benefit from a reduction in the natural hegemony of the larger member states. The legacy of the defective status quo – the Target-2-accounts on national central bank balance sheets – could be reapportioned to the new ECB districts on a pro rata basis according to NUTS-2 population or GDP shares, and would instantly lose their political relevance.
The elimination of national influences from monetary policy would increase the efficiency and functionality of the monetary union. A neutral, market-based framework for the allocation of central-bank credit to member banks is essential to a functioning banking union. Rigorous haircut rules for ECB bank refinancing on the basis of creditworthiness would force member countries to apply more discipline to national finances, enabling a credible return to the no-bailout principle of the European Treaty. The explosion of the Target-2 imbalances over the last five years would have been prevented by an even-handed application of collateral and leverage restrictions from the beginning, aligning local interest rates with funding imbalances as well as thwarting incipient bubbles in Ireland and Spain. Nationally oriented bailouts like the Long Term Refinancing Operations and Outright Monetary Transactions programs would become a thing of the past. So would be overt national central bank lobbying – as we have seen in the case of the Bundesbank – against putatively independent ECB monetary policy measures.
This next step will be the most difficult along the path of European integration will also be an even greater commitment to the single money project – a veritable crossing of the Rubicon. Yet to secure the sustainable future of a truly independent and neutral monetary policy – and in the interests of the ECB’s long run mandate of price stability – it is indispensable. Without credible steps towards the de-politicisation of monetary policy, it is unlikely that the euro in its current form will be able to withstand macroeconomic shocks in years to come.