Is it EMU 2.0 or 1.7.3?

By Jean Pisani-Ferry

24 March 2011

For a year European policymakers have been busy fixing bugs in the design of Economic and
Monetary Union. As with defective software, successive new versions of EMU have been introduced
at a frantic pace – only to discover remaining vulnerabilities shortly afterwards. In spite of last-
minute hiccups and disagreements over details, they claim this time to have come up with an
enhanced, bug-free new version – a sort of ‘EMU 2.0’. Can we now trust it?
The starting point for a review is where troubles came from: the crisis prevention regime. Before
2010, it was almost entirely based on the surveillance of budgetary deficits within the framework
of the Stability and Growth Pact (there was also a procedure for economic surveillance, but it had
no traction). The crisis revealed major problems with enforcement of this framework, but also with
its design. No light ever flashed red to indicate that Ireland or Spain were in danger.
The new regime will take into account the debt ratio (so that Italy will not be able to keep it at such
as high level) and implicit liabilities (so that a country with an oversized banking sector will have to
factor in potential rescue costs). Decisions on sanctions will be streamlined by a reverse majority
rule. All this is encouraging.
A second plus is the recognition that not all crises are rooted in a lack of budgetary discipline. It is
now agreed that financial stability and macroeconomic stability also matter. But the new policy
framework looks somewhat unclear. There will be no less than three different, partially overlapping,
European procedures – for budgets, macroeconomic imbalances and macro-financial stability.
Clumsy intergovernmental processes risk blurring priorities, confusing policymakers and
exhausting civil servants.
For this reason it is to be feared that the governance model will soon be in need of reform and that
the EU will have to decide where to rely more on reformed national frameworks and where to
allocate more responsibility to Brussels. The new emphasis on national budgetary rules is a
welcome first step – but only a first step.
For crisis management and resolution there was nothing to reform, because nothing existed. A new
pillar has now been added to the edifice. Agreement to create both a liquidity provision facility and
an insolvency procedure has implied revisiting fundamental principles – not least the no bail-out
clause. EMU will now be equipped with the ability to provide assistance to a country cut off from
market access but also to organise the restructuring of its public debt. This shows an ability to
reform and learn from experience.
The new regime is, however, not without defects. First, it is strange that Europe has agreed to
provide assistance only as a last resort, by unanimity and with harsh conditionality, at a time
when the IMF has created first-resort, near-automatic and low-conditionality facilities to help
countries hit by sudden capital outflows. There is a risk that the European framework will create an
avenue for speculation. Second, the EU has taken the least legally difficult route to debt crisis
resolution, the so-called contractual approach which aims at facilitating agreement with private
creditors. But the most contentious part risks being agreement with the governments of partner
countries. A formal legal procedure would have helped.
When a new version of a piece of software is introduced, users often experience incompatibility

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with files created with the older one. Here also, transition to the new regime may prove difficult.
Even abstracting from Portugal, several problems still await a solution. There is an urgent need to
expedite the resolution of the banking crisis, for which credible and comprehensive stress tests is
an indispensable first step. Foot-dragging – not least by Germany – prevents the return of
confidence. There is an equally important need to sort out state insolvency cases from illiquidity
cases. Greece is likely to find itself insolvent and there are questions about Ireland and Portugal.
Again, confidence will only return after an answer is given. Third, markets need to understand what
will happen if some sort of debt restructuring takes place before the permanent regime is
introduced in 2013. Fourth, the ECB needs to know how it will get rid of the peripheral bonds on its
balance sheet. And last but not least, the EU still has to come up with a strategy to revive growth in
southern Europe.
So the outcome of months of discussion is probably better characterised as EMU 1.7.3 rather than
EMU 2.0. More bugs will have to be fixed, including in the new fixes. This reform process may seem
impossibly long and hesitant by market standards. This should not hide the fact that it has been
exceptionally fast by the standards of international negotiations and European governance.

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