Seat of the European Central Bank (ECB) in Frankfurt
Social cohesion

Social cohesion

How to stabilise the euro area

Finally, the economic situation has brightened across the entire euro area. The euro area could use this breathing space to create instruments that offer new room for manoeuvre. KfW's Chief Economist Dr Jörg Zeuner presents three specific measures that can strengthen the euro area.

Dr. Jörg Zeuner

Dr Jörg Zeuner is the Chief Economist of KfW Group and head of the Economics Department. Dr Zeuner regularly contributes to current debates in Germany and Europe with his commentaries on economic policy.

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The tide has turned: the voices that want to strengthen the European Union are becoming louder. The challenges of tomorrow are being addressed with pragmatism again. This is important. A stronger Europe is extremely important for all member states – politically and economically.

Free trade, freedom of movement and legal security are the foundation for the EU’s great economic success. Since World War II, growth in the founding countries has been higher than average and new members have benefited from extremely dynamic catching-up processes. The result? The EU boasts more than half the world’s twenty highest-income countries (not counting oil countries and city-states). Its growth benefits the people. Social balance is one of Europe’s hallmarks.

Despite the great success of the EU, its core, the euro area, is incomplete. The euro states have taken important steps in the right direction. The purchase of government bonds as monetary policy instruments is no longer a taboo. But most of all, the ESM is extending a safety net, backed by the OMT programme of the ECB, that protects the liquidity of the euro countries and gives them time to close financing gaps in case of stress. This is important for the future of the EU. Solidarity is a fundamental principle of European unity and must be visible, particularly in difficult times. The banking union will be implemented in order to prevent stress from occurring as much as possible.

But these changes and experiences from the debt crisis are not yet sufficient. One major deficit is that the euro area has a weak response to forces that are driving the economies of its member states apart. We had to witness this during the debt crisis. Between 2010 and 2012, the ECB and ESM managed the growing differences between interest rates very well, but not the growing differences in growth and employment. That has considerably weakened Europe’s general capacity to act and destroyed mutual trust. Some euro countries took exceptionally long to recover. A major reason for that was the limited effectiveness and power of stabilisation policy in the monetary union.

Dr. Jörg Zeuner
"Solidarity must be visible, particularly in difficult times."

Dr Jörg Zeuner, KfW's Chief Economist

Finally, the economic situation has brightened across the entire euro area. The euro states should make good use of this breathing space. What better way to do so than by working to create tools that provide new scope for action and opportunities for intervention at a higher federal level? What we do not need is a uniform European state in which all economic differences are levelled out by enormous transfer payments. That is neither necessary nor realistic or feasible. What could stand us in good stead, however, are effective instruments that accompany economic adjustment processes in individual member states for the time it takes until all are headed in the same direction. This should be done early, preferably even before a country loses access to the capital market.

In my view, this cannot be done without expanding joint fiscal responsibility. My recommendation is to start by implementing the following three specific measures which by themselves would represent a decisive step forward:

1. Complete the banking union

The banking union serves the important purpose of dampening contagion between the state and the private sector and preventing downward spirals. Therefore, we must not stop halfway. We have created a Single Supervisory Mechanism (SSM) and a common authority for restructuring and resolution (SRB). Following supervision and implementation of further measures to reduce risk in the financial sector, the reinsurance of deposits in a systemically relevant event should also devolve onto the European level.

2. Enlarge the ESM

Europe should be capable of independently developing and accompanying economic adjustment programmes. The ESM should be large enough to offer each individual member state the necessary financial support against certain conditions. It is about temporary financing programmes for when access to the capital market has become difficult or impossible, and about the appropriate design of individual adjustment processes. This would also ease the burden on the ECB and sharpen the separation between monetary and fiscal policy.

3. Create a fiscal instrument for phases of cyclical weakness

We have learned from the debt crisis that the split in the euro area’s economic development between recession on one side and growth on the other blocks decision-making processes, exposing monetary policy to criticism from both sides and weakening it. All countries facing difficulties would benefit from our ability to overcome phases of economic weakness faster, especially the people living there, but also those in other member states. [CS1] The euro area is so closely intertwined that sooner or later a downturn in one economy leaves traces in the partner countries.

Flags in front of EU parliament
Strengthening the community

In response to forces that are driving the economies of the euro states apart in times of crisis, the recommendations of KfW's Chief Economist include enlarging the ESM.

Possible approaches include temporary budgetary aid from a common budget or fund (if a consensus cannot yet be achieved on having a budget with revenues of its own, the authority to incur debt, and spending sovereignty). A more rule-based approach to a balancing mechanism would be an additional, temporary unemployment insurance scheme. Here, however, unemployment benefits could also be replaced by EU-financed training for people who have lost their jobs. What is decisive is that the crisis country should not have to incur any debt of its own. That is where Europeans could really help one another.

But all these instruments can work properly only if they allow regional redistribution within the euro area. This is something we should not shy away from because it is about temporary support of controllable scope for countries whose economies are in a cyclical downturn. And ultimately there would be more public support available to all Europeans than without this tool. It would also leave more scope for expenditure that is crucial to future growth potential, for example in the fields of education, research, transport, energy and security.

I concede that this limited agenda is already controversial and ambitious. And we have not even begun to consider how we would convince member states to adjust their economic policies more quickly to fiscal and structural realities. Still, we should not shy away from the complexity of the task but show determination every step of the way as we mould a robust and successful monetary union for Europe.

Published on KfW Stories: Wednesday, 28 February 2017