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Eurozone governance: What went wrong and how to repair it

The crisis has revealed deep flaws in the Eurozone’s governance regime. This essay argues that EU leaders should address fundamental questions about the operational principles upon which the euro is based. Key choices for Eurozone leaders are the nature of the economic policy framework, the optimal degree of decentralisation, and the identification of reforms that will ensure the policy regime can deal with all eventualities.

The EU faces two challenges: managing the crisis while coordinating Eurozone adjustment, and reforming its governance to avoid future crises. The first is vital in the eyes of the markets but creation of the Van Rompuy task force has focused attention on the second.

Recent events have indeed shown that the Eurozone economic governance framework is incomplete (see for example Bofinger and Ried 2010). But to know how to repair the framework, we must first answer the question: “What went wrong?”1

What went wrong in the Eurozone?

The simplistic answer blames bad implementation of good rules. Poor implementation was surely part of the problem, so enforcement must be an important part of the solution. However lessons from recent events indicate that there are deeper problems (European Commission 2010a,b). Before turning to the remedies, however, consider the lessons learned.

The most basic lesson is:

  • Top-down government by statistics does not work (especially, but not only, when they are wrong)

From 2000 to 2008 the Greek budget deficit reported to the EU averaged 2.9% of GDP. We now know the real number was 5.1% (Marzinotto et al. 2010). There are political and practical reasons behind this failure, but the problem runs deeper. The EU budget monitoring system is based on national-accounts data, not central government budget data, and it makes cyclical corrections. These two well-meaning practices imply that the EU budgetary surveillance system need not reflect fiscal facts on the ground.

  • Deterministic governance does not work in a stochastic world

Since 2008, some countries moved from apparently sound fiscal positions to alarmingly weak situations in an astonishingly short period. Given uncertainties, a “value at risk” – or what might be called a “policy at risk” – approach is called for.

  • Not all problems are fiscal

The existing framework implicitly assumes that all stability threats arise from budgetary indiscipline. While this was the key to the Greek case, the Spanish and Irish cases are quite different. Recent history makes a strong case for a broader surveillance framework (Commission 2010a). Fiscal risks need to be prevented more effectively, and non-fiscal risks arising from credit booms, asset-price developments, or a sustained appreciation of the real exchange rate also need to be addressed.

  • A commitment to no assistance is not credible

Although the "no-assistance principle" is nowhere to be found in the Treaty, there was, until Greece, a widespread belief that a member country would be allowed to default rather than be provided with assistance (as is the case for US states). Events show that Eurozone members are entitled to assistance as part of an IMF-led programme with strict conditions. But this does not entirely clarify the endgame. What happens if the bailout programme needs to be bailed out? What if a member benefiting from assistance remains unable to regain access to the market? The ECB’s government bond purchase programme raises related problems. As long as such ambiguity persists, there will be room for speculation about the nature of the solution to insolvency cases.

  • Policy coherence is lacking while ownership of the euro rules is shallow

The euro’s success ultimately depends on its members’ commitment to run policies that are consistent with participation in a monetary union. Such “ownership” has been lacking from the start of the euro. Any reform will therefore require greater ownership by members.

How to repair it: Three dimensions of Eurozone governance reform


Problems clearly run deeper than enforcement, so limiting reform ambitions to tinkering with the Stability and Growth Pact would be widely regarded as indicative of a worrying inability to reform. The Van Rompuy Task Force should therefore look beyond strengthening existing provisions.

The political situation, however, is not auspicious. Fundamental reforms will be difficult – few of the founding EU members show any appetite for further integration. The Monnet philosophy according to which “l’Europe se fera dans les crises et elle sera la somme des solutions apportées à ces crises” applies partially at best.

A realistic reform agenda must ditch long-held federalist dreams – such as a significant increase of the EU budget, significant horizontal transfers, or a much tighter coordination of national economic policies – and attempt at reconciling the need for serious reforms and the lack of political momentum. Three dimensions of such reforms are worth highlighting.

Dimension 1: What policy framework?

Currently, price stability is assigned to the ECB and budgetary discipline to the Stability and Growth Pact. Other objectives were ill-defined in the Treaty and not operational in practice. There are three economic objectives for Eurozone governance besides price stability:

  • Budgetary discipline,
  • Financial stability, and
  • The avoidance of macroeconomic imbalances.

This poses two key challenges to a new policy framework: task allocation in the reformed policy framework should be clearly defined, and three distinct objectives require at least three instruments. On the first, the much-discussed modifications of the Pact might be sufficient, but national supervisory instruments are also of limited effectiveness in a financially integrated context. This necessarily brings in another array of instruments that can be of a regulatory or a tax nature. On the last, guidelines for wage formation may also be considered part of the required competitiveness monitoring toolkit.

Dimension 2: How much centralisation?

Eurozone budgetary discipline was not a great success. Budgetary discipline might be more successful in a more decentralised system. What might emerge is a system that combines domestic institutional reforms and market forces to keep debts and deficits in check. Germany with its new budget rule could become a benchmark against which market judge a nation’s fiscal creditworthiness. As such, Germany might become the fiscal policy anchor as it became the monetary policy anchor in the European Monetary System.

A strategic choice for the EU is whether governance reforms should encourage decentralisation through providing an umbrella framework for national rules and institutions, through ensuring they are consistent with Eurozone objectives, and through somehow rewarding countries with better institutions. There are strong economic and political-economy arguments in favour of such an approach

Dimension 3: Which reforms to ensure completeness of the policy regime?

The lessons listed above illustrate the importance of completeness of the reformed policy framework – i.e. how the regime behaves in various states of nature and how ex ante incentives relate to ex post rules. Part of this is the meshing of ex-ante surveillance and ex-post crisis resolution. The sort of issue is particularly pressing for the European Financial Stability Facility recently established.

As regards debt crises, a full crisis-resolution regime – call it the European Debt Resolution Mechanism – needs to be defined including the principles and modalities of assistance, debt restructuring, and – possibly – exit. If exit is (sensibly) ruled out because of its potential spillover effects, then this only strengthens the case for defining the debt resolution regime as proposed by Germany (Federal Ministry of Finance 2010). Current reluctance to create expectations of an imminent default should not serve as an excuse for refusing to work out the whole set of principles upon which Eurozone reform needs to be based. Half measures now would only perpetuate the incomplete character of the system.


Europe’s problems run deeper than the lack of enforcement. The Stability and Growth Pact faces more serious difficulties than most European policymakers are willing to admit. Its “preventive arm” is debilitated by the combination of estimation uncertainties in the structural deficit concept, and an overly deterministic approach. Its “corrective arm” is debilitated by the speed at which the budget balance deteriorated in this crisis.

Discussions of Eurozone governance have been going on at least since the first negotiations on the creation of the euro. They have not been settled because of the ambiguities in the positions of the key participating countries, especially Germany and France, and the ambiguities in the compromises they had reached (Pisani-Ferry 2005). But something new has happened.

This crisis is an opportunity for clarification. In order not to waste it, the Van Rompuy Task Force and the European Council should resist the temptation to patch up divergences and limit ambitions to tinkering with the existing policy framework. Rather, they should take the opportunity to address fundamental questions about the operational principles upon which the euro is based.

Keynes once quipped, “When the facts change, I change my mind. What do you do, sir?” Let us hope that Eurozone leaders have the mental flexibility to answer this the right way. The future of the euro depends upon it.


European Commission (2010a), Surveillance of euro area competitiveness and imbalances, May.

European Commission (2010b), ‘Reinforcing Economic Coordination’, Communication COM(2010) 250 final, May

Pisani-Ferry, Jean (2010), “Euro Area Governance: What went wrong? How to repair it?”, Bruegel, 8 June.

Pisani-Ferry, Jean, Andre Sapir and Benedicta Marzinotto(2010), “Two crises, two responses”, Bruegel Policy Brief 2010/01, March.

Ried, Peter and Stefan Ried (2010), “A new framework for fiscal policy consolidation in Europe”, VoxEU.org, 20 May.

1 This essay is an abridged version of the full analysis in Pisani-Ferry (2010).

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