Europe’s Plan A

Europe’s politicians nowadays are desperately looking for someone to blame for the euro crisis. Germany blames France, and vice versa. Even lawyers are getting into the act, trying to identify legal responsibility for the monetary union’s design flaws.

Meanwhile, as the crisis has deepened, a new consensus about Europe’s monetary union has emerged. The euro, according to this view, was devised in a fit of giddy and irresponsible optimism or, alternatively, panic at the prospect of German hegemony over Europe in the wake of the fall of the Berlin Wall.

Nothing could be further from the truth. The Report on Economic and Monetary Union in the European Community, which laid out the euro blueprint, was presented in April 1989 - a time when no one (with the possible exception of some Kremlin strategists) was thinking about German reunification. Moreover, the salient issues concerning monetary unions were well understood, and remedies for the most significant obstacles were proposed at the outset.

The committee that drafted the report - now known as the Delors Report, after its chairman, Jacques Delors - was a fundamentally rather conservative group of central bankers, with even the governor of the Bank of England (BoE) signing on.

Its internal debates highlighted two problems of the potential monetary union.

First, the committee explicitly discussed whether the capital market would suffice to impose fiscal discipline on the currency union’s members, and agreed that a system of rules was needed. But those rules were steadily weakened, and by the early 2000s were widely derided (including by Romano Prodi, Delors’ successor as president of the European Commission), as governments found that they could run large deficits without paying higher market interest rates.

The second problem was more serious. In the original plan for the European Central Bank, the proposed institution would have had overall supervisory and regulatory powers. Indeed, the drafters of the ECB statute produced an astonishingly far-sighted approach to banking supervision.

Their 1990 version of the Maastricht Treaty’s Article 25 on Prudential Supervision included the following provisions (placed in square brackets to show that they were not completely consensual): “The ECB may formulate, interpret, and implement policies relating to the prudential supervision of credit and other financial institutions for which it is designated as competent supervisory authority.”

The demand that the ECB should be the central supervisory authority in an integrated capital market met strong resistance, above all from Germany’s Bundesbank, which worried that a role in maintaining financial stability might undermine the bank’s ability to focus on price stability as the primary goal of monetary policy. There was also bureaucratic resistance from existing regulators. Most important, supervision suggested some potential responsibility to recapitalize problematic banks, and thus involved a fiscal cost.

The most energetic actor behind the early thinking on banking supervision was a BoE official, Brian Quinn. But his credibility was sapped in the wake of criticism of the BoE’s handling of the collapse in 1991 of the Bank of Credit and Commerce International - an episode that anticipated later issues in managing the failure of large, cross-border institutions.

A legal vestige of the original plan may offer an easy path to a greater ECB supervisory role today. According to Article 25 of the Maastricht Treaty, the ECB may “offer advice to and be consulted by” the Commission or the Council on the scope and implementation of legislation relating to prudential supervision.

When that phrase was inserted in the Treaty, it appeared as if the hurdles to effective European banking supervision could hardly be set higher. The ECB was not given overall supervisory and regulatory powers. And, until the outbreak of the financial crisis in 2007-8 highlighted the connections between financial and fiscal health, no one considered that a problem. They do now.

Nevertheless, fiscal rules and common banking supervision are still regarded in many quarters as an illegitimate encroachment on member states’ sovereignty.

After all, the European Union has avoided becoming a focus of heated contestation precisely because it never got much of a share of what Europeans produced (its budget, at just over 1 percent of the EU’s GDP, has barely changed in relative terms for the past 40 years). It was the member states that did politics and budgets.

Delors had a different vision. At the time of his report, he concluded that the European budget would amount to some 3 percent of GDP - identical to the peacetime U.S. federal budget’s share of GDP during the country’s first stage of monetary union, in the 19th century.

Moreover, as in Europe today, when Alexander Hamilton proposed a central banking system, the Bank of the United States, alongside consolidation of states’ Revolutionary War debt into federal debt, the implementation of his sensible plan was imperfect. In the American case, the principles of federal finance were not worked out until the Civil War, and the Federal Reserve System was established even later, coming only in 1913.

Europeans can learn from the United States and implement a fundamentally sound plan. But they must also recognize that political backlashes and setbacks are inevitable - and thus that the road from vision to reality may be longer than expected.

Copyright: Project Syndicate, 2012.

*The author is a professor of european studies at Princeton University.
By Harold James