The launch of European monetary union (EMU) communitised the EU member states’ monetary policy. The primary objective of the independent Eurosystem was defined as safeguarding price stability. Fiscal and economic policy coordination was strengthened at the European level. A system of fiscal rules was agreed at European level in order to shield both the single monetary policy and the member states from the effects of potential unsound fiscal policies pursued by individual states. In addition, governments’ propensity to incur debt was expected to be curbed by the markets’ imposition of interest rate premiums for higher risk. The consequences of pursuing an unsound fiscal policy were thus to be borne by the offending state itself and not shared among the other members of monetary union. The Treaties exclude a comprehensive fiscal, transfer or liability union and contain a “no-bail-out” clause. In EMU, ultimate responsibility for financial and economic policy rests largely at national level, and thus with national parliaments. Monetary financing of governments by central banks was expressly prohibited. Responsibility for supervising banks and for ensuring the stability of national banking systems likewise remained rooted at the national level. This coexistence of a single monetary policy and a plurality of national economic and fiscal policies fundamentally sets EMU apart from other currency areas.

This initial institutional framework proved incapable of preventing the sovereign debt crisis. There are several reasons for this, which affected the countries concerned to varying extents. The agreed fiscal rules were not implemented consistently. Ten years after the launch of monetary union, government debt and deficit levels were still very high in some countries in the run-up to the crisis. When the financial crisis erupted, expansionary fiscal policies were then applied across the board. In the case of Greece, the problems were aggravated by the extremely poor quality of the official statistics and the fact that, for many years, the public finance situation was reported in a far better light than was actually the case. Another contributory factor was the build-up of, in some cases, large imbalances in both the real economy and the financial sector. In some countries, this included the funding of real estate bubbles. Excessive debt-financed private and public consumption led to persistent large current account deficits in some countries because domestic demand far outpaced domestic supply. This caused considerable losses in competitiveness in some instances. The attendant risks in the public and private sector were long underestimated by financial investors and not penalised by commensurate interest rate premiums, thus preventing misguided policies from being corrected earlier. Fundamental reassessments of the financial outlook for sovereigns, corporates in both the real and financial sectors and also households eventually triggered a crisis of confidence in a number of countries.

The vulnerability of financial systems was clearly underestimated prior to the crisis. This was compounded by the fact that the desired and welcome integration of financial markets, which was given a perceptible boost by monetary union, made national financial systems increasingly interdependent. Dislocations in one member state spilled over to the financial systems of other member states faster and harder than before. In hindsight it can be seen that these risks to systemic stability in the euro area as a whole were underestimated, and the relevant legal framework, oriented as it was to national self-responsibility, did not afford enough protection.

Extensive aid packages were adopted for individual countries in order to contain the crisis and facilitate orderly adjustment in the countries affected. Central banks provided ample liquidity. In addition, preventive safeguards were extended (inter alia the fiscal compact, the Stability and Growth Pact, procedures to address macroeconomic imbalances, financial market regulation and control) and the crisis resolution mechanisms were considerably expanded (inter alia EFSF, EFSM, ESM).

The crisis will be lastingly overcome only after confidence in stable underlying conditions has been restored. This must entail reversing the trend towards inexorably rising government debt, rectifying misguided macroeconomic and fiscal policies through fundamental reforms and consolidation measures in the countries concerned, and cementing financial stability by putting in place an appropriate regulatory framework.

The task of giving EMU a sound institutional foundation crucially requires maintaining an equilibrium between liability and control and setting incentives for all concerned that are conducive to sustainable economic development. It is also important to maintain confidence that existing treaties and rules will be honoured. The measures taken to contain the crisis, however, have concurrently led to a much greater communitisation of risks. At the same time, the economic and fiscal policy framework, which is fundamentally based on individual national responsibility, was retained, and no material powers of intervention were transferred to the European level.

One avenue towards creating a consistent framework for economic policy could lie in the creation of a bona fide fiscal union in which member states transfer part of their fiscal sovereignty from the national parliament to the European level. For instance, a breach of agreed rules could be penalised by shifting fiscal policy competences to a supranational body – which of course would need to have the appropriate democratic legitimacy. The political implications of such an innovation, however, would go far beyond the issues being discussed here. Fundamental amendments to treaties, constitutions and other legislation would be necessary, both in the EU and in the individual member states. This would represent a paradigm shift for national sovereignty. At the moment the individual member countries do not seem prepared to accept such a loss of sovereignty.

However, if there is no fundamental change of regime and, instead, the existing framework is amended and extended, the reform of parts of the framework must not be allowed to jeopardise the consistency of the whole. With this in mind, let us now briefly consider selected aspects of the current economic debate.

The Eurosystem‘s core task was and is to safeguard price stability. The Eurosystem is not permitted to bankroll governments through central bank funding, nor does it have a mandate to extensively redistribute sovereign solvency risks among the member countries. Although it is not always clear where to draw the line in this respect, safeguarding sovereign solvency by, for instance, assuming a lender-of-last-resort function or purchasing an unlimited volume of government bonds would certainly exceed the scope of the current framework. The Eurosystem’s duty is to provide solvent banks with liquidity; it can thereby combat liquidity problems. Its task is not to restore the lost solvency of sovereigns or banks. For an independent central bank within a currency union, segregating monetary and fiscal policy tasks and adhering to its own mandate are crucial to maintaining confidence in the single currency. Going forward, this includes limiting the Eurosystem’s balance sheet risks and bearing in mind the goal of exiting from the non-standard monetary policy measures. The underlying causes of the sovereign debt crisis cannot be resolved by monetary policy.

In introducing the fiscal compact[1], policymakers opted to bolster the existing fiscal framework. This by no means implies a fiscal union, however, as even in the event of the ongoing violation of the fiscal rules, there is no provision for the surrender of national budget sovereignty. The aim is merely to tighten parts of the European agreements and to strengthen them by anchoring them in national legislation. However, ultimate responsibility for fiscal policy and for implementing the rules of the fiscal compact remains at national level. It would be helpful if the requirements for the national rules could be specified as concretely as possible. This should include a stipulation, for instance, that – as is the case with the German debt brake – any slippages from the budget targets must be officially recorded with a binding obligation to subsequently repay the amount in question so as to prevent the debt from building up. There are currently no signs of strict provisions being concretely specified, however. Ultimately, the decisive point is how the rules are actually applied. A problem repeatedly experienced in the past was that the rules that were in place were not implemented stringently enough, and that insufficient measures were taken to counter the propensity to incur debt.

Comprehensive joint liability (for example through the introduction of eurobonds) is incompatible with the lack of intervention powers at European level. In an institutional framework which, ultimately, continues to be based on the member states’ individual responsibility, aid should be given only as a last resort and be tied to strict fiscal and economic policy conditionality. The incentives for the countries in question to undertake their own efforts ought to be impaired as little as possible. Within the ESM framework, therefore, instruments which are tied to conditionality seem more suitable. Where they are tied to preferential creditor protection for the ESM, moreover, the countries providing assistance would enjoy greater protection. Given the lack of intervention powers at European level, the interest rate conditions imposed by the market and for the support programmes continue to provide a crucial incentive to maintain or restore a healthy fiscal position. In this light, the idea of granting assistance loans that carry no interest rate premium, which appears to be envisaged as the rule within the ESM framework, is to be viewed extremely critically.

The problems in the countries affected by the crisis of confidence primarily have to be resolved at national level. European-level fiscal and monetary-policy measures have played a major role in stabilising the situation. They have bought time in which to resolve the structural problems; however, they cannot on their own bring about a permanent solution. This requires swift consolidation of public finances in the countries concerned, structural reforms to enhance competitiveness as well as, if necessary, a restructuring of the financial sector.

Of the aforementioned steps to resolve the crisis, the swift consolidation of public finances has particularly drawn criticism of late. However, critics overlook the fact that precisely the agreed implementation of the consolidation measures is key to the credibility of the new fiscal regime, which seeks to ensure sound public finances in the future and to build confidence. It should also be remembered that several of the countries affected by the crisis are experiencing severe balance of payments problems. Private investors have drastically scaled back their investments, and it is only extensive fiscal aid and the provision of a very ample supply of liquidity that is shielding the countries from even more abrupt adjustment processes (among other things, as a result of a sharp rise in interest rates). This is already greatly easing and extending the adjustment path in the countries affected. Although public funding can cover capital requirements for a time and to a certain extent, it cannot and must not be a permanent substitution for private investors. In light of the above, the overriding objective of national policymakers in the crisis-hit countries must be to regain the confidence of the financial markets. Given the, in some cases, very high government debt and the fragility of confidence in the sustainability of public finances, delaying consolidation would be dangerous – all the more so if structural reforms were also postponed as a result. Moreover, it is far from obvious that a protracted adjustment process would meet with greater political acceptance than swift consolidation. A temporary weakening of domestic demand is ultimately an inescapable consequence of the preceding exaggerations.

Consolidating public finances should go hand in hand with fundamental macroeconomic structural reforms. This would improve the economic outlook and, given credible implementation, rapidly build confidence. Eliminating any imbalances that have emerged will also reduce current account differences. Adjustment processes are already under way. The objective has to be to tackle the root causes of the problems; current account deficits and surpluses would then be narrowed more or less automatically. Those countries that have lost much of their competitiveness must restore it – both by implementing productivity-enhancing structural reforms and by improving price competitiveness.

In Germany, there is less need for active intervention, as recent developments were not triggered primarily by misguided domestic policy. It would make little sense, for instance, to actively weaken Germany’s export industry, which is performing especially strongly vis-à-vis non-euro-area countries, or to loosen national fiscal policy in the (rather futile) hope of boosting demand in the peripheral countries. However, initiatives aimed, say, at improving domestic investment conditions and the institutional framework for an expansion of the service sector or measures that create confidence in the sustainability of public finances and the social welfare systems might indeed help to promote growth, which would have a positive knock-on effect on domestic demand. This must not hamper the normal market adjustment processes, however. These will boost the peripheral countries’ competitiveness against Germany. In this scenario, Germany would probably tend to display above-average rates of inflation within the euro area in the future – monetary policymakers must naturally ensure that aggregate euro-area inflation is in line with the stability objective and that inflation expectations remain firmly anchored.

Reforming the financial sector is key to preventing future crises. The current reform of financial system regulation therefore needs to focus on durably raising investors’ risk awareness and bolstering the resilience of the financial system. Measures such as raising capital requirements, with surcharges for systemically important institutions or for an economic boom, additional liquidity standards or improved monitoring and regulation of areas of the financial system that were previously barely supervised will ensure that, in the future, the financial system is much better able to deal with dislocations without outside help, ie without recourse to the taxpayer. It is vital to decouple the interconnection between sovereign solvency risks and financial stability to a greater extent than was hitherto the case. To this end, the privileged status accorded to government bonds, eg with regard to capital requirements or in liquidity regulations, should be critically reviewed. Another key requirement for systemic stability is to formally establish the monitoring and containing of systemic risks as an autonomous area of responsibility with its own instruments at national and European level. The Bundesbank, too, will play an active part in this respect under its planned macroprudential mandate. At the European level, the establishment of the European Systemic Risk Board (ESRB) at the beginning of 2011 created an institution for monitoring cross-border and EU-wide risks and for coordinating associated policies. A further question is whether, and to what extent, risks arising from the banking system should in future be borne at the European level. In this field, too, however, liability and control need to be kept in equilibrium. A communitisation of risks arising from the banking system would necessitate a Europeanisation of banking and financial supervision. But this would be inconsistent with a system of national fiscal responsibility as long as the solvency of the national banking systems is closely tied to fiscal solvency. Consequently, an institutionalised assumption of liability for risks arising from the financial system in the euro area is likely to be sustainable in the long term only if it is part of the transition to a genuine fiscal union.

[1] For more on the fiscal compact and the ESM, see also the statement by the Deutsche Bundesbank at the public hearing of the Budget Committee of the German Bundestag on 7 May 2012.