Monday, 10 May 2010

Small but important steps in fixing the monetary union

Most of us harbour bad habits and it often takes a life-threatening event to make us change our ways. It seems to work that way in many other contexts as well. EU or the Euro Zone was badly under pressure last week as the financial markets began to doubt the viability of the Euro project.

In some of my earlier posts, I have expressed my doubts about the long term prospects for the Zone, given the huge structural differences between the countries and the lack of integration. The EU summit in Brussels this weekend addressed none of that, but took clear steps in overcoming some of the most glaring deficiencies.

Right from the start it has been a problem that the Euro was launched without the creation of strong institutions to support it. In order for a currency union to work, one would expect a strong central bank, and a central budget instance with the possibility of financing deficits in the markets if needed.

Instead we got a central bank with a very limited charter (inflation fighting), and no central fiscal authority. Plus an increasingly unwieldy decision process as a steadily increasing number of members have resisted handing over authority to the EU institutions.

The Greek crisis forced some changes to all that. We now have the first steps towards establishing the Commission as a fiscal authority (managing the huge stand-by facility for countries in need of credit while dealing with fiscal problems), ECB announced that they suspend the rating limits for Repos, and will begin to make open market purchases in bonds issued by institutions and companies in Europe. ECB will also become more active in offering overdraft rights to commercial banks, something that the US Federal Reserve and Bank of England did already in 2008.

While market participants may complain that the underlying budget issues have not been resolved, the steps agreed by the EU member states have all the potential to become a game changer. EU just made a significant move in the direction of strengthening the monetary union. It may not dispel all doubts about the debt of the Club Med members immediately. However, I believe that the markets will eventually realise that this is meant very seriously.

So compared with the situation a week ago, we have now seen that the EU has moved to strengthen the community institutions, to give the ECB a good deal more muscle, and to show that fiscal solidarity is available to member states who take determined action to address their fiscal deficits. The only question that lingers is: why did it take so long until something happened?

That is an issue for the history books, but it has to do with Europe being made up of sovereign states which have a very hard time accepting to play together as it is needed in order to have a monetary union.

For now, we should see the panic sentiment seep out of the market. The market panic was based on ignorance about the fiscal and financial effects of the Greek loan package. With the new stand-by package, such worries should be addressed. ECB's new liquidity facility for the banks should remove the fears between European banks. Markets should recover. The long term problems inside the EU will, however, persist and will rear their heads again. But that is for tomorrow's markets, not today's.

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