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Addressing imbalances in the EMU

László Andor, Corvinus University of Budapest and former EU Commissioner for Employment, Social Affairs and Inclusion

Introduction

The Economic and Monetary Union (EMU) in Europe was designed – in and after the Maastricht Treaty (1992) – with an excessive focus on a few criteria of nominal convergence between the participating member states. This approach never was supported by academic consensus, and the great financial crisis put an end to this infantile phase of monetary integration. Since 2010, a number of new tools have been introduced, in order to tame imbalances and divergence ex ante and ex post. One of the innovations in the post-crisis, i.e. reinforced EMU is the Macroeconomic Imbalances Procedure (MIP) which was introduced in order to detect a variety of financial and economic imbalances inside the euro area. Recognising that the failure to detect and address systemic risk contributed to the extraordinary crisis in the developed capitalist economies, the MIP in the European context is supposed to help monitoring where the next signs of trouble may arise and allow policy makers to take preventative action in time. However, the effort to make the EMU sustainable only began with the MIP. It continued with the launch of the Banking Union and a debate on elements of a Fiscal Union, more frequently framed under the concept of fiscal capacity. This paper explores how the MIP was introduced and implemented at the acute phase of the euro area crisis, and where the strengths and weaknesses of this approach can be found. We will then assess some possible instruments that have been put forward as components of a euro area fiscal capacity, and highlight the importance of partial Europeanisation of unemployment insurance.

The Great Recession and the origin of the MIP

The 2009 great recession and the subsequent sovereign debt crisis inside the euro area called for significant reforms of economic governance in the EU. Financial sector regulation had to be reinforced but it was also understood that the EU needs to detect unsustainable economic trends much earlier in order to prevent fiscal crises and the erosion of national competitiveness. Since in a monetary union, exchange rate misalignments cannot be corrected through devaluation or revaluation, the factors that otherwise would lead to exchange rate movements have to be monitored and tackled in time.

The 2009 great recession and the subsequent sovereign debt crisis inside the euro area called for significant reforms of economic governance in the EU. Financial sector regulation had to be reinforced but it was also understood that the EU needs to detect unsustainable economic trends much earlier in order to prevent fiscal crises and the erosion of national competitiveness. Since in a monetary union, exchange rate misalignments cannot be corrected through devaluation or revaluation, the factors that otherwise would lead to exchange rate movements have to be monitored and tackled in time. Driven by these considerations, the Macroeconomic Imbalances Procedure (MIP) extended EU-level economic governance beyond fiscal policy to broader macroeconomic issues. The MIP consists of a scoreboard of indicators covering all EU members states monitoring external (e.g. current account balance, export market shares, unit labour costs) and internal imbalances (e.g. private credit flows, house prices, unemployment). It was designed under the stewardship of Olli Rehn after the Barroso II Commission was inaugurated, and its legal status was confirmed in the 2011 ‘Six-Pack’ of reforms.

The large current account imbalances experienced in the lead-up to the Eurozone crisis significantly inspired the MIP’s introduction. Whereas the perceived moral hazard of a shared currency meant EMU governance has centred on restricting national fiscal policies, the balance of payments crisis in Europe from 2010 laid bare the inadequacy of available governance tools to deal with macroeconomic imbalances. The MIP was thus intended to cover a perceived blind spot by complementing the Stability and Growth Pact (SGP) with a mechanism to remedy macroeconomic imbalances before they triggered a crisis.

But how exactly the MIP would function? Should an indicator for a country cross particular statistical thresholds, an In-Depth Review (IDR) by the European Commission may be launched, leading to reform recommendations within the European Semester (an annual cycle of policy coordination). If the Commission determines an imbalance is excessive, the ‘Excessive Imbalance Procedure’ may be triggered. If a Eurozone member state fails to cooperate under the EIP, it faces the possibility of sanctions of up to 0.1% of GDP.

However, the introduction of the MIP did not result in a genuine paradigm shift in eurozone macroeconomic policy, and in general the 2010-11 period did not give an impression that the EU would get the crisis response right. Solidarity in the EMU remained limited and lukewarm: emergency loans to EMU countries experiencing private capital outflows were made conditional on strict programmes of fiscal consolidation and internal devaluation, elevating primary fiscal surplus as a new key priority of economic policy.

Prioritising measures serving fiscal consolidation and cost competitiveness by definition meant that growth, employment and other Treaty objectives became de facto secondary. In the 2012-13 period, as public expenditure and imports were cut, current accounts of the deficit countries improved, but aggregate demand in Europe fell. At the same time, countries with current account surpluses faced almost no pressure to adjust. Their wage growth remained modest, and high savings rates continued to exceed domestic investment.

This constellation of macroeconomic parameters meant that the surplus countries continued to export their capital outside Europe through the financial sector (with mixed results), while overall demand remained deficient. The stability bias of the Maastricht model was working against a fast recovery. The orthodoxy ignored that higher growth could be achieved – in Europe and globally – with a different allocation of income, involving higher wages, lower inequalities, higher investment in Europe's economy and lower current account surplus. Such a model would also be more conducive to geographically more balanced growth and to fulfilling citizens' expectations "beyond the GDP".

Adding another procedure to the already fairly complicated mechanism of EU economic governance did not work out as expected at once. While the need for a new framework was clear, the innovative steps mixed up with those that still represented the conservative approach. Thus the overall policy mix in the first period of Eurozone crisis response simply tried to push Europe’s deficit countries towards an export-led development model building on an interpretation of the Eurozone crisis as a problem of competitiveness1.

Until the Summer of 2012, the EU’s general response to the Eurozone crisis rested on fiscal consolidation, austerity and structural reforms, leading the region back into recession, driving the euro area to record high unemployment but also a sustained external trade surplus. This original crisis management strategy reflected not only the MIP’s close attention to current account deficits and unit labour costs, but also the asymmetric power relations in Europe that was aggravated by the sovereign debt problem of the time. Consequently, the crisis response excessively relied on lowering wages, together with pensions as well as public investment.

This narrative found expression in the MIP’s detailed surveillance of unit labour costs and its asymmetric monitoring of current account surpluses vis-à-vis deficits (deficits larger than 4% of GDP trigger an IDR, compared to surpluses above 6%). As a result, surplus countries, such as Germany, whose 2010 surplus of 5.6% conveniently fell under the threshold, were given considerably more leeway than deficit countries. The fallacy in the underlying assumption that through structural reforms and internal devaluation the euro area periphery can repeat the German export success was rarely exposed. This asymmetric focus on current account balances, combined with the emphasis on adjusting deficits through labour cost reductions, has had severe social consequences for southern Europe.

Critiques and corrections of macroeconomic surveillance

With the increasing risk of eurozone disintegration, the public discourse as well as policy started to change in 2012, arriving slowly to a more balanced approach. This required a more serious assessment of not only deficits but also surpluses2 in the context of a monetary union. Restoring confidence in the EMU and the single currency was primarily an achievement of the European Central Bank (ECB) and its bold moves as from 2012. However, the MIP also played its part by shifting towards a more systemic view of the Eurozone.

Importantly, it became understood that if the objective of the MIP is to create real convergence between the core and periphery of the Eurozone, and to erase external imbalances between them, raising wages can be as effective as lowering them. If Germany, the Netherlands and other core member states raise their wages, they also become less cost and price competitive, which causes lower trade surpluses (at least in the short run). This would not necessarily be a big economic problem for the core because it would raise the Euro area’s effective demand and could stimulate production. This line of reasoning helped the European Commission reach the conclusion in 2013 that German and Dutch surpluses were damaging the stability of the Eurozone, urging the German government to increase investment and wages.

However, this approach of eliminating macroeconomic imbalances by raising wages and investment in core member states run counter to the perceived national interest and deep-rooted beliefs in Germany on the virtues of competition and competitiveness. Resistance did not only come from the conservative and neoliberal camps, i.e. those more closely connected with the ordoliberal tradition. As Martin Schulz stated amidst his failed bid to become Chancellor, because German “exports are the result of good work”, Germany should not be “ashamed” by their large trade surplus. Despite pressure from some countries, in the absence of support from progressive forces in the core surplus countries, this project has had little transformative impact. MIP-skeptics also argued that stronger domestic demand in Germany (and the Netherlands) would only marginally benefit the rest of the euro area mired in high unemployment.

While some, especially in surplus countries, considered the MIP to be an unjustified departure from the original EMU model, others considered the MIP only to be the start of moving to an alternative paradigm, an EMU 2.0. Such tendencies resulted in attempts to mainstream alternative conceptions of economic development into the MIP. While not eventually included, the initial legislative negotiations over the MIP saw the European Parliament propose indicators that went beyond conventional macroeconomics, such as inequality or environmental sustainability. These ideas were recycled in the policy process at a later stage.

At the end of 2012, the work began on the social dimension of the EMU, culminating in the 2013 October communication of the Commission which introduced a scoreboard of employment and social indicators. These did not become part of the MIP but were added to the Joint Employment Report and thus played a role in the 2014 Annual Growth Survey and the rest of the European Semester.

The transition to a new European Parliament and Commission in 2014 interrupted this process, and the recovery strategy focused on the launch of the Juncker Plan by the Commission and QE by the ECB, together with further relaxation of the fiscal rules. However, in 2015, the progress for more balanced governance continued and a range of social indicators (e.g. the activity rate, long-term unemployment, youth unemployment) were adopted, driven by the Juncker Commission’s push for strengthening a social component of EU, also in the context of establishing a European Pillar of Social Rights.

Just like in earlier debates, no consensus was immediately found regarding the social indicators, and finance ministers remained in the conservative corner. The ECOFIN Council expressed concern at this inclusion ‘given the need to preserve the effectiveness of the scoreboard’. Some critical forces, such as the independent Annual Growth Survey (iAGS), similarly questioned the association of social indicators with macroeconomic imbalances, looking for an alternative way to achieve progressive policy.

These tensions revealed the hegemony of conventional macroeconomics in the governance of Europe, relegating ecological and social concerns to less prominent regulatory mechanisms. Nevertheless, all this has exposed how the MIP is more than a technical exercise, but rather a political battleground signalling the strategic direction and orientation of European governance. While social indicators were eventually included in the MIP’s scoreboard, they are of peripheral interest in IDR analysis and reform recommendations to countries. A key question for progressive forces remains how to mobilise social indicators to push for a transformative development project for Europe.

The idea that the governance of imbalances can be reduced to a technical process of surveillance is not self-explanatory. The MIP does not do much to resolve the structural deficiency that the EMU has made international capital highly mobile, but removed key adjustment tools for member states to deal with balance of payments issues (e.g. currency devaluation or sovereign default). Instead, the MIP places high expectations on European institutions to prevent future crises through the manipulation of macroeconomic indicators largely beyond government control via a regime of monitoring and sanctions. Nevertheless, as the only tool with any capacity to coordinate macroeconomic policies within Europe, the MIP has opened a new terrain of political contestation over the orientation of European economic governance.

According to Hansen and Lovering (2017) the MIP, even with a more balanced implementation approach, remains a rather technocratic exercise, and it is not known for any democratic inclinations3. It forms part of a longstanding trend to de-politicise conflicting economic priorities into a regime of surveillance that treats not only product and service markets but also labour and social welfare systems as economic variables in need of constant adjustment. Just like the SGP, the MIP is not a tool for growth or real convergence capable of ameliorating the tendency of the EMU to produce economic divergence, especially in times of crises. By various observers, it has been seen as just another mechanism for disciplining member states in line with particular economic strategies (see Torres, 2019).

Eurozone fiscal capacity proposal within the EU budget

Having understood the importance of the MIP for analysis but also its limitations in practice, the EMU reform process has had to focus on the need for a fiscal capacity4 for the euro area with a stabilisation function. Commission President Jean-Claude Juncker took the view that such a capacity should be embedded in the long-term budget of the European Union. In its proposal for a new Multiannual Financial Framework (MFF 2021—2027) the European Commission included two new tools connected with the Eurozone. These are: a Reform Support Programme (RSP) with a budget of EUR 25 bn for seven years, and a European Investment Stabilisation Function (EISF) with EUR 30 bn for the same period. The RSP, apart from offering a Reform Delivery Tool and technical assistance, also introduces a Convergence Facility to provide dedicated support to Member States seeking to adopt the euro. But, leaving aside budget constraints, what exactly these new instruments are about determines whether they can be called at least “steps in the right direction”.

To start with the RSP, it is being designed so support structural reforms within the member states in line with recommendations outlined in the so-called European Semester. The benefit and functioning of such an instrument is not obvious for several reasons. First of all, a monetary union requires fiscal tools that are more cyclical than structural. Events that trigger fiscal support require urgent treatment, and cannot wait for the next round of the Country Specific Recommendations. On the other hand, the previous round of CSRs may not be relevant for the new situation, should a financial crisis occur in an Autumn period (which is normally the case). Secondly, a practical difficulty is: How to price structural reforms? And how could one design a menu with reform actions and related envelopes that would in an even handed way apply from Finland to Portugal, and from Ireland to Bulgaria? Even more importantly, the content of the support programs also has to be scrutinised. If such programs just serve the purpose of internal devaluation, it can be more controversial and counter-productive than helpful.

Altogether, the RSP seems to revive an old (and failed) idea, which was on the table of the European Council in the 2012-13 period: the Competitiveness and Convergence Instrument (CCI). It was created for very similar concerns as those listed above. The RSP appears to be at best an attempt at political fudge, promoted by those who fear that economically sounder instruments will be impossible to agree politically. A harsher assessment would be that the RSP is a hobbyhorse of people who learned nothing and forgot nothing from the crisis experience. A combination of a robust cohesion policy and new instruments for counter-cyclical stabilisation would be a superior solution.

The second newly proposed tool, the EISF is supposed to maintain the continuity of investment projects in times of crises. However, this is not a source for transfers but loans, in order to compensate for interest rates potentially hiking in a turbulent period. This tool would indeed serve a useful purpose, but at this stage there are still question marks around it. In case of a major crisis, it is not unnatural to reprogram investment projects, and this also takes some time. This may cause delay with the support arriving from the EU level. Besides, the crisis also means that some economic actors may transform or even disappear in the meantime, which causes further complications. Importantly, the support from this facility would arrive to support a particular project, which probably means that the effect would be local, or at least territorially concentrated. The EISF thus could provide asymmetric support in times of asymmetric shocks, and may result in a situation where large parts of a country and its population remain uncovered. One way to mitigate this risk would be to modulate the EISF in a way to include general budget support that can be used also for co-financing country-wide social investments, e.g. teachers’ salaries.

After the Commission unveiled these fiscal tools and integrated them into the new MFF, the small size and the bogus nature of these instruments invited Financial Times columnist Wolfgang Munchau to call the approach homeopathic. This might be a pertinent description, nevertheless, the discussion of these token instruments allows for a new round of discussion about stabilisation in the eurozone.

The small size of the proposed budget makes it necessary to explore whether the revenue side can also help in the stabilisation function by bringing in new incentives with a rebalancing effect. For example, it would be logical to impose a small levy on current account surpluses. The EU has named excessive current account surpluses as destabilising factors since 2010, under the MIP, but sanctions were not attached. In principle, the new MFF provides an opportunity to empower the rule that requires surplus countries (Germany and the Netherlands most of all) to increase investment and wages and thus boost aggregate demand for helping themselves but also the whole community.

Unemployment Insurance: an Historic Overview

Although the Commission has not produced an official initiative in this area, the partial Europeanisation of unemployment insurance has also been subject of research as well as political debate. Some finance ministers of the euro area, like Pier Carlo Padoan (Italy) and Olaf Scholz (Germany) came forward with their favoured models. In the context of imbalances and fiscal stabilisation, this possible tool also requires continued attention.

A Community unemployment fund is not entirely a new idea. It was first outlined by the 1975 Marjolin Report and supported by the 1977 MacDougall Report5 as well. These documents explored the fiscal and financial requirements for a sustainable European economic integration which also stretches to establishing a monetary union. In other words, the question has always been how the Community can help member states tackling cyclical unemployment which is linked to, and aggravated by, the lack of adjustment tools at an advanced stage of monetary integration.

Those early documents of public finance analysis held it as no-brainer that monetary integration requires unemployment insurance as a form of de facto solidarity. Unfortunately, the Delors Report (1989) and the subsequent Maastricht process introduced an incomplete form of the monetary union which only in techniques but not in essence went beyond currency board arrangements. While some young economists like Jean Pisani-Ferry and Alexander Italianer argued for robust automatic stabilisers, political leaders decided to take higher risk with an untested model: a single currency with neither common financial sector regulation nor fiscal stabilisation capacity.

That said, when EU leaders looked into the abyss in 2012 and faced the risk of Eurozone disintegration, the moment of truth came and far reaching reforms were announced (Banking Union, Fiscal Union, Political Union). The Four Presidents’ report, the Commission Blueprint for Deep and Genuine EMU and the Thyssen Report of the EP pointed to the same direction. The words of the Blueprint on automatic stabilisers were repeated by the 2013 October Commission Communication about the Social Dimension of the EMU. Subsequently, the European Parliament report by Pervenche Beres (French Socialist) and Reimer Böge (German CDU) confirmed the need for fiscal capacity.

Documents produced by the Juncker Commission, including the 2017 Reflection Paper on the future of the EMU, highlighted the danger of economic and social divergence in the Eurozone but in the absence of a great political momentum (even taking into account the election of Emmanuel Macron as President of the French Republic) only very modest reform proposals were put forward, especially as regards risk sharing. In May 2018, Juncker proposed a new Multiannual Financial Framework (MFF) which would embed facilities serving the EMU stabilisation function into the seven-year EU budget, but with tools that may not be convincing due to either size or profile.

Should there be a consensus about the need for an EMU fiscal capacity and embedding it into the MFF with a stabilisation function, it is important to ensure that such an instrument allows for demand side intervention, step in without major delays, and reach a large number of citizens affected by adverse macroeconomic developments. Unemployment insurance, or reinsurance, satisfies these criteria, and should be considered either linked to the MFF or as a stand-alone mechanism. In this task, decision makers today can rely on a wide pool of research, analysis and simulations.

Indeed, since the Eurozone crisis of 2011-13, a great deal of analysis, including by the Commission itself as well as a host of think tanks and independent experts, has explored the issue and run simulations, all pointing to overwhelming economic and social benefits of automatic fiscal stabilisers. The European Commission, in cooperation with Bertelsmann Foundation, held two public conferences about the possibility of EU level unemployment insurance in 2013-14. Important inputs were provided by Prof. Sebastian Dullien, whose book on the subject was published by Bertelsmann too. Subsequently, a CEPS led consortium of researchers delivered multiple simulations and analysis pointing towards the feasibility of a re-insurance mechanism. On the other hand, some continued to favour fiscal stabilisation unrelated to unemployment. One such study was presented in the European Parliament by Prof. Heikki Oksanen, similarly to the intput to the 2013 Commission—Bertelsmann conference by Prof. Henrik Enderlein. Another model was designed by MEPs Jakob von Weizsacker and Jonás Fernandez and presented in the European Parliament, combining modest transfers with loans, effectively forcing member states to save in good times to be able to secure long enough and generous unemployment coverage in bad times.

A partial pooling of unemployment benefit schemes as proposed by Dullien was understood to represent a more perfect form of integration, a US inspired reinsurance model was seen as one matching better the European way that respects subsidiarity but adds further layers if justified by clear added value. However, the point is that had either of these insurance mechanisms existed in EMU from the start of the single currency, all member states would have been beneficiaries for a shorter or longer period. Countries experiencing a severe recession would have received fiscal transfers, helping them towards a faster recovery and avoiding a perception that for the EU arbitrary fiscal targets are more important than democracy and social cohesion.

Eurozone unemployment insurance or reinsurance can deliver stabilization in three ways. First, it would contribute to economic stabilization by shifting demand and purchasing power to countries and regions which otherwise would need to implement fiscal ‘adjustment’ and internal devaluation. Second, social stabilization would be enacted as well, by directing the flow of funds towards more vulnerable groups, and helping to tame the rise of poverty among the working age population (which has been a major trend in recent years in Europe). The third type is institutional stabilization. The EMU is based on rules but the application of these rules has been the subject of academic as well as political debates. Member states agreed on tightening them but pragmatic considerations often point towards more flexibility, the cases of Spain and Portugal being the most significant controversy before the current one vis a vis Italy.

Conclusions

The Macroeconomic Imbalance Procedure attempts to prevent future economic crises within the Eurozone by tackling emerging imbalances. Precisely how to achieve this, however, has opened a struggle for the very direction of European governance. We have seen that there are competing interpretations of the MIP, not independently from political ideology or specific national interest. While the the MIP represents progress as compared to the original Maastricht design and its escessive focus on nominal convergence criteria, it falls short of effectively tackling either current account imbalances or disparities in living standards among member states. Further possibilities regarding the content and the method of economic government have to be explored.

While there is no consensus about how to measure and achieve convergence in the EMU, there is probably a broad agreement about the dangers of lasting divergence in the euro area. Hence a better mechanism for ex ante and ex post rebalancing remains a crucial political question if the single currency has a chance to achieve its promise of European convergence and collective prosperity. It is, however, very unlikely that any mechanism delivering monitoring and recommendations would be a substitute for a well-designed fiscal capacity aiming at risk-sharing. While some experts simply recommend ignoring the rules and giving up on them entirely, it is more likely that a modus vivendi could be found through the creation of stabilization tools that would allow the reconciliation of uniform fiscal rules with the need to maintain national welfare safety nets and social investment capacities.

References

Andor László (2013) Can we move beyond the Maastricht orthodoxy? VOX CEPR Policy Portal Posted : 16 December 2013 https://voxeu.org/article/can-we-move-beyond-maastricht-orthodoxy

Charlemagne (2013) Fawlty Europe: Will the European Commission dare to utter the unmentionable to the Germans? The Economist, November 2, 2013

Csortos Orsolya and Zoltán Szalai (2013) Assessment of macroeconomic imbalance indicators, MNB Bulletin, October 2013 https://www.mnb.hu/letoltes/csortos-szalai.pdf

Darvas Zsolt and Alvaro Leandro (2015) The limitations of policy coordination in the euro area under the European Semester, Bruegel Policy Contribution, Posted : NOVEMBER 12, 2015 HTTP://BRUEGEL.ORG/2015/11/THE-LIMITATIONS-OF-POLICY-COORDINATION-IN-THE-EURO-AREA-UNDER-THE-EUROPEAN-SEMESTER/

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1Originally, the Eurozone imbalances that had produced a full-blown crisis were driven by low real interest rates in southern Europe unsustainably driving up public and private debt, consumer prices, and labour costs. For many EU policy-makers, the resulting large current account deficits in southern Europe were predominantly seen as a competitiveness crisis, which to some extent was mixing up the cause and the consequence.

2The Economist columnist Charlemagne (2013) was among those appreciating the logic of MIP and the contradictions of the current account surplus. He commented that « a large and persistent surplus in the trade balance (or the current-account balance, which includes foreign income) can be the symptom of a distorted economy. » To use a self-explanatory example, he added : « If big surpluses were a guarantee of vitality, then Japan would never have suffered its lost decades. »

3Hansen and Lovering conclude that the „MIP and the SGP will need a radical reorientation if the European project is to work for all its member states by allowing for the expression of a collective democratic voice on Europe’s future economic strategy. While developing visions for a more democratic Europe, progressives should not, however, lose sight of more immediate remedies for rebalancing the MIP and the EMU more broadly. This includes strategies to raise wages and investment in core member states to solve the crisis of demand in the Eurozone, as well as pushing for governance instruments to recognise the social and environmental components of economic imbalances. While the MIP will not resolve the economic, political, and ecological imbalances of Europe, it will be a crucial site in the battle for the future of Europe.”

4Stabilisation can be linked to various fiscal tools and mechanisms. One can opt for a new stabilisation facility that is in size comparable to the existing EU budget, or a significant relaxation of the fiscal rules. Some proposed the establishment of a Eurozone finance minister. Further innovative action, however intransparent, inside the European Central Bank is also possible. Budgetary solutions have the advantage of being rule-based, targeted, transparent and involving political accountability, as long as they are appropriately designed.

5While distant in time from the actual introduction of the single currency, the MacDougall Report highlighted the important link between monetary union and unemployment insurance with the following argument: „Apart from the political attractions of bringing the individual citizen into direct contact with the Community, it would have significant redistributive effects and help to cushion temporary setbacks in particular member countries, thereby going a small part of the way towards creating a situation in which monetary union could be sustained.“