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The case for policy change: Democratic legitimacy of EMU cannot be an afterthought in solving the crisis

David Cameron’s promise of a referendum on British participation in the EU has re-ignited the debate about the EU’s democratic legitimacy, just as the struggle to overcome the crisis continues. This column argues that in order to both successfully resolve the crisis and maintain states’ ability to sustain liberal finance, a substantial shift in policy is required. Enhancing the democratic legitimacy of crisis resolution measures and wider financial reforms is essential. Without diffuse support for reforms, crisis resolution is likely to collapse under centrifugal populist pressures.

The fallout of the original market crash has generated continuing public and private debt problems, while global and intra-regional payments imbalances remain unresolved. Serious and persistent policy mistakes dressed up as reform have compounded the difficulties while economic growth remains subdued in the major western economies. It is time for policy change drawing on a better historical understanding of the lessons to be drawn from previous episodes of financial instability. Meanwhile, the bottom line of the ongoing euro crisis should be seen not as an economic problem but in terms of political legitimacy. What kind of economy do we want? What kind of financial system and macroeconomic governance?

These broader questions have not been addressed sufficiently in the dramatic attempts of the Eurozone to overcome the crisis. They have however been placed in the spotlight by David Cameron’s speech on the UK’s future in the EU. The omission of the question of political legitimacy may prove highly significant as political support for the current pattern of adjustment in both creditor and debtor countries is becoming increasingly fragile. The required degree of cross-border cooperation in the Eurozone may prove untenable without citizens’ support, leading to disorderly financial closure and/or euro exit at great cost.

The potential and more obvious flaws of the pre-crisis system of financial and monetary governance were, to a large extent, a function of the characteristics of the policymaking process dealing with financial regulation and supervision. Case studies ranging from the Basel Committee on Banking Supervision to the debt workout regime of the IMF reveal a common pattern: the policymaking processes dealing with financial governance are exclusionary and closely associated with the interests of internationally active financial corporations. The core ideas underpinning monetary and financial governance in the Eurozone and globally are characterised by a mistaken conviction that open financial markets are characterised by a self-correcting equilibrium – the logical consequence of which is self-regulation and a deference to market-based forms of governance (e.g. the reliance on banks’ internal models enshrined in Basel II or the no-bailout clause of the Maastricht Treaty). Perhaps unsurprisingly, it was private financial institutions that had the most to gain from the policy mix and the market opportunities offered by European financial integration.

Despite the achievable benefits of both EMU and financial openness, the underlying legitimacy of the crisis resolution process – or of post-crisis global financial integration in general, for that matter – has improved little over time. Reform that is more likely to provide stability in the future requires a departure from the idea-set underpinning the contemporary market-based financial order. Reform also requires considerable institutional innovation and institutionalised attention to the political legitimacy and long-run sustainability of (financial) openness in the EU. To achieve this, the policy process should be reformed to include a wider range of stakeholders, to reduce financial-sector influence, and to deepen the argument pool. The deliberative process and level of accountability for outcomes must be improved as well. Without policy ‘ownership’ by the countries undergoing adjustment and diffuse support among the population, crisis resolution and reform measures will prove politically unsustainable. Crucially, these democratic reforms should occur simultaneously with a shift towards more effective financial governance.

The state of EMU crisis resolution

Currently, the EU seems determined to hold fast to a discredited policy of ‘structural-adjustment-on-steroids’. Yet as even the IMF now acknowledges, debtor-state austerity alone is self-defeating (see Blanchard and Leigh 2013). The austerity produced by a dogmatic interpretation and implementation of an enhanced Stability and Growth Pact is now successfully stifling growth, even in ‘locomotive’ economies such as Germany. As the IMF has already learned from its experience with structural reforms (IMF 2007), successful implementation of the troika’s policies remains doubtful if deficit economies cannot draw on deep-seated domestic support and in turn perceive debtor and creditor obligations as balanced and fair. To this end, Eurozone governments need to recognise the importance of providing the required ‘policy space’ to respond to domestic social and political imperatives by enhancing the ‘room to move’ for debtor-state governments. Success also involves rebalancing the obligations of debtors and creditors: both the positive and the more negative results of capital mobility are collectively produced through market interaction, so outcomes must be collectively owned and burdens must be shared by public and private debtors and creditors alike. This harks back to the principles of Keynes’ ‘Clearing Union’ proposal: imbalances are a joint problem to be resolved through simultaneous and required adjustment by both surplus and deficit countries.

Successful crisis resolution also requires thinking about whose interests are protected by the current crisis-workout process, who pays the costs of adjustment, and whose interests should be primary to the functioning of integrated financial markets in the Eurozone. This reflection opens the door to effective consensus building for the reform of Eurozone governance. It cannot be that Eurozone citizens in surplus and deficit economies alike are called upon to provide taxpayer guarantees for the indiscretions of private lenders (in whose lending decisions ordinary people played little part) while those in deficit economies bear a disproportionate share of the adjustment burden. In practice the Eurozone has turned out to be rather efficient at saving banks, but the mandate of the ECB excludes saving the citizen guarantors of the system should their own state’s resources become exhausted. The burden of adjustment falls on the weaker, developing and deficit economies that already benefit less from the system of capital mobility and exchange-rate stability than the more advanced economies. This context potentially undermines the ability of states to cooperate in order to sustain liberal finance at all.

This means that the range of stakeholder inputs into policy design needs to be broadened so as to produce more effective, legitimate, and balanced policy outcomes in the future. Unless the influences on policy decisions are to change, ineffective policy is likely to prevail.

The legitimacy of financial integration and regulation in the context of EMU

In the wider context of financial governance, Walter (2010) has demonstrated that even sound standards and policies may be unsuccessful if they are perceived as imposed by an unfair and exclusionary process. Thus the balanced representation of, and input from, the diversity of interests with a stake in crisis workout must be a goal both globally and at the European level. Historically, the dominant voice in national policy processes related to monetary union and European financial integration, alongside the public agencies legally responsible for regulation and supervision, has been that of private financial institutions. Unless broader stakeholder and country input can be included, skewed and ineffective policy output with a strong whiff of capture will continue. This may apply as much to adjustment policy as to financial regulation and supervision. Already the opposition of banks to ‘ringfencing’ or separation of investment and commercial banking as proposed by the Liikanen report (European Commission 2012) appears to have diluted the recommendations in the implementation phase.

The voice in policymaking of the users of financial services should be increased, from small and medium-sized enterprises to pension funds and their labour-market constituency, to depositors and to savers. These constituencies currently have little say in the making of policy yet are all significantly affected by the decisions taken, especially when crisis hits. An institutionalised system of ‘corporatist’ representation of stakeholders could bring the interests of these constituencies to bear on financial supervision and regulation and the distribution of the burdens of adjustment. Technical forums such as the Basel Committee on Banking Supervision should be actively required to solicit a prescribed range of stakeholder responses leading to real policy inputs. Moreover, the transparency and accountability of the process that translates global regulations into EU directives should be improved.

This involves formalising two elements of an ‘accountability phase’ in the policy process:

  • Accountability for how the input side of the policy process has functioned and whose preferences constituted inputs into policy;
  • Accountability for actual outcomes achieved.

The first involves full transparency on the involvement of lobbyists and social partners, allowing agencies and parliamentarians to judge whether an adequate balance among stakeholder interests was involved in technical forums. The second involves holding public-sector agencies and private financial institutions accountable for outcomes achieved in terms of financial stability and balanced real-economy growth. As the EU develops ever more intrusive fiscal and financial mechanisms the role of the European Parliament should become ever more central too. The more that EU supervisory coordination is strengthened under the new ‘Single Supervisory Mechanism’, the more that home-host responsibilities need to be clearly defined – especially when it comes to the sharing of costs when things go wrong. Until questions in banking supervision/resolution and in macroeconomic adjustment of public-private sector burden sharing and Eurozone distribution have been properly tackled in a way that is supported by EU citizens, the monetary union will not function.


Why do these issues matter? Why is the democratic legitimacy of crisis resolution and financial reform crucial? The answer lies in the long-run sustainability and legitimacy of financial openness and capital mobility. Financial liberalisation is better sustained in economies that mitigate the risks of liberalisation through welfare and other forms of compensation for the vulnerable (Burgoon, Demetriades and Underhill 2012). Nurturing financial openness requires the very policy space that austerity is closing down. Electorates are rebelling against solutions that ‘pool’ sovereignty just as market integration and crisis makes national policy less effective. Failure to think systematically about the emerging legitimacy deficit is generating centrifugal populist political forces. This context potentially undermines the ability of states to cooperate so as to sustain liberal finance at all. In short, we need a Eurozone that demonstrably places citizens above banks to overcome the threat of disorderly disintegration.

This column is based on the extensive research findings elaborated in the January 2013 CEPR eBook Global financial integration, twin crises, and the enduring search for financial stability.


Blanchard, O & D Leigh (2013), ‘Growth forecast errors and fiscal multipliers’, IMF Working Papers no. WP/13/1.

Burgoon, B, P Demetriades and G Underhill (2012), “Sources and Legitimacy of Financial Liberalisation,” European Journal of Political Economy, 28(2), 147-161.

European Commission (2012), High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report (‘Liikanen Report’), Brussels, 2 October.

IMF Independent Evaluation Office (2007), “Structural Conditionality in IMF-Supported Programs”, Washington: IMF Evaluation Report.

Underhill, G and J Blom (2013), Global Financial Integration, Twin Crises, and the Enduring Search for Financial Stability, PEGGED policy report e-book, London, Centre for Economic Policy Research, January.

Walter, A (2010), “Adopting international financial standards in Asia: convergence or divergence in the global political economy” in Underhill, G R D, Blom, J & D Mügge, Global Financial Integration Thirty Years On: from Reform to Crisis, Cambridge, Cambridge University Press.

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