ABSTRACT
Euro-sceptics have long pointed to the disruptive potential — both political and economic — of country-specific shocks in a monetary union that was not an optimal currency area. The euro crisis has confirmed the risks associated with a ‘one-size fits all’ monetary policy, decentralized financial supervision, and inadequate fiscal backstops. When the euro was designed, significant concerns were expressed about its implications for fiscal discipline in individual members and the possible spillover to other members. Some designers feared that expectations of a ‘bailout’ would give rise to moral hazard (and insufficient market discipline), triggering larger public deficits, and government debt levels. This preoccupation affected the
constraints placed on fiscal policy, which were addressed by treaty provisions — no monetary financing of government deficits and no required ‘bail-outs’ — and by the stability and growth pact (SGP). The issue of private sector (corporate and household) deficits and debts
and the risks that those imbalances can pose were, in contrast, largely ignored in part because the ‘Lawson Doctrine’ held sway. According to this view, current account deficits were only bad if they stemmed from government deficits because in the absence of distortions, private sector imbalances were rationally determined and welfare improving — the ‘efficient market hypothesis’. Possible pressures on macro-imbalances and supervision flowing from larger funding, in particular from banks, to private borrowers (from a bigger euro-area financial market), were not a central part of the euro-design debate. The institutional framework for banking supervision under the euro
relied consequently upon two principles: (1) national competence enshrined in ‘home country control’; and (2) cooperation among the competent national authorities. The ECB’s role in banking supervision was to contribute ‘to the smooth conduct of policies pursued by the competent authorities’ by promoting cooperation. This setup was considered to have two main advantages at the time. One, it minimized any potential conflict between the conduct of policies by the ECB to achieve price stability and to financial stability (e.g., lender of last resort function). Two, national responsibility for national banking systems would preserve continuity, would benefit from their greater knowledge and expertise, and would properly align incentives, avoiding mutualization (e.g., national deposit insurance schemes). The cost of any bank/supervisory failure would be borne by the rele-
vant national fiscal authority, which thanks to the SGP would be able to absorb these costs without endangering fiscal solvency. However, this national approach also risked having different national supervisory practices creating an uneven playing field that could help maintain ‘national champions’ in the banking sector by limiting competition, allow national banks to support domestic industrial policies, and help assure government access to bank credit. In effect, home country bias would be reinforced. Some critics focused on the possibility that asymmetric economic shocks
could lead to strong country-specific booms/downswings against the background of the common monetary policy. As a booming economy expanded, its inflation rate would rise, and real interest rates at the national level would fall, intensifying ‘perversely’ the national boom. Higher national inflation would also result in loss of competitiveness vis-a-vis the currency union. Both factors would contribute to deterioration in the current account balance driven. These dynamics were central to the ‘Walters Critique’ developed in the late 1980s. Economic modeling work in the 2000s — notably in Brussels and Oxford — explored whether these national booms/downswings could reach destabilizing levels, and whether ‘active’ national fiscal policies had a role to play in dampening such country-specific cycles.
