More Fiscal Integration to Boost Euro Area Resilience

Crisis exposed important gaps in architecture of the euro area

Strengthened fiscal governance and cross-country insurance mechanisms would reduce likelihood and severity of future crises

Providing a common fiscal backstop for the banking union is most pressing need

A new paper from International Monetary Fund staff argues that advancing fiscal integration would help address a number of gaps in the euro area’s architecture. Alongside the banking union, a fiscal union would reduce the incidence and severity of future crises by strengthening fiscal discipline and providing a minimum amount of insurance against deep recessions. While putting in place a fiscal union will take time, providing a roadmap for implementation is viewed as essential to anchor confidence in the euro area’s viability, thereby also supporting current crisis management efforts.

European policymakers have taken important steps to strengthen fiscal and economic governance frameworks. However, vigorous implementation and robust enforcement mechanisms are a prerequisite for greater fiscal integration. With these safeguards in place, according to the paper, a clearer ex ante approach to fiscal discipline and cross-country insurance mechanisms—as opposed to a strategy that relies exclusively on support when crises have already occurred—would further strengthen the architecture and ensure stability of the Economic and Monetary Union.

Gaps in euro area architecture

Contrary to expectations, the launch of the common currency did not make euro area economies more similar over time or more resilient to shocks. Real convergence lagged expectations, and country-specific shocks—home-grown or not—remained significant and more frequent than anticipated. For example, falling borrowing costs contributed to localized credit booms in some countries. At the same time, the high degree of trade and, more importantly, financial integration created the potential for problems in one country to be transmitted to others. This was particularly evident at the height of the current crisis when problems arising in banks raised doubts about sovereign creditworthiness, and in turn sovereign stress aggravated the pressure on banks’ balance sheets. Financial stress then travelled between interconnected banks across the euro area.

The paper also notes that weak national policies compounded the effects of adverse economic shocks and that European governance frameworks were too loosely implemented. As a...