A three-pillar plan to underpin a new fiscal union

The crisis unfolding in the eurozone is a chance for radical and profound action. There is a growing consensus that the stability, indeed the viability, of the monetary union demands change to European Union treaties. Europe’s leaders should seize this opportunity to put in place a permanent structure for eurozone governance.

Any new structure must win the confidence of voters and investors alike. It should also acknowledge the real monetary risks of the European Central Bank being coerced into acting as a sovereign lender of last resort for the entire region. Such a structure should therefore be based on clearly delineated responsibilities for monetary, fiscal and funding policy. These three policy pillars would underpin the eurozone’s fiscal union, allowing member states to maintain national sovereignty over taxation and expenditure (provided their debt positions and related annual deficits remained sustainable), while benefiting from the efficiencies of common bond issuance.

The ECB would fulfill the first of these roles, with independent responsibility for safeguarding monetary, financial and price stability within the eurozone. As such it would act as the lender of last resort only to the eurozone banking system, not to sovereigns.

A newly created European monetary fund would form the second pillar. It would be responsible for safeguarding medium term debt sustainabillty and would oversee the fiscal union, by assessing member states’ economic and fiscal performance; providing support programmes; and policing reform and adjustment programmes.

The third pillar would be a European debt agency, which would be the sole issuer of eurozone sovereign debt, with responsibility for financing all the eurozone’s member states. The credit standing of the EDA would reflect the eurozone’s overall strength, through joint and several guarantees provided by all its members. This would naturally be reliant on the stronger AAA-rated countries, but in practice would merely formalise the responsibility these have already assumed. The quid pro quo would be that debt could only be mutualised up to a level consistent with medium term debt sustainability, and that reform and adjustment would be overseen by the EMF. This should not be formulaic, but depend on a member state’s future debt profile.

To further mitigate the risk that stronger member states could face potential losses as a result of a future debt restructuring by a weaker member state, the EMF would have to be empowered, in the medium term, to impose losses on legacy sovereign bonds.

These debt reductions would be required in the event that reforms and adjustments alone proved insufficient to deliver sustainable debt levels over the medium term.

Bonds issued by the EDA would provide the market with a single, liquid and transparent eurozone benchmark bond market, rivaling the US Treasury market. The current fragmented, illiquid and distorted eurozone bond market would be replaced by a single benchmark yield curve representing the cost of capital for all eurozone member states.

Clearly the EU Treaty changes needed to establish the EMF and EDA will take time to ratify and implement. In the interim, there are several ways by which sovereign funding could be ensured. The ECB could fund the enhanced European Financial Stability Facility (EFSF) to purchase sovereign bonds; or the ECB could act directly through the Securities Market Programme (SMP). In either case, the stipulation would be that any sovereign bonds acquired in the process would be passed onto the EDA once established.

This three pillar structure would produce three tangible benefits. It would give member states more time to implement fiscal and economic reform and adjustment programmes, without the distraction of short-term volatility in sovereign bond markets. It would provide the EU banking system with stable collateral and more time to prepare for a potential restructuring of legacy debt. Finally, it would provide eurozone member states with a uniform, low and stable cost of capital – crucial to support economic growth during this period of fiscal adjustment and austerity.

Simplicity is the key to the acceptance of the three pillar plan. The three independent institutions, each with its own clearly defined role, would provide reassurance that fiscal union need not imply an open-ended commitment by some to fund the past fiscal excesses of others.

Once enshrined in the EU Treaty, these changes would lay the foundations for future prosperity and peace in Europe.

The writer is vice president and chief financial officer of the European Bank for Reconstruction and Development. The views expressed here are personal