Reforms to ensure the stability of the Euro–Member States, the EU and the ECB need to act

In the last two decades, the euro area was hit by multiple crises. Fiscal and monetary emergency actions broke important constraints and expectations set by the euro’s founding principles. Several euro countries broke fiscal rules. As politicians expect European Central Bank (ECB) support for public debt in any crisis, they have weak incentives to build fiscal buffers, or to undertake needed fiscal reforms. Consequently, fiscal spaces for additional borrowing are dangerously narrow. Banks also expect ECB support, and bank regulators still treat sovereign debt as risk free. Consequently, banks hold large quantities of sovereign debt. Sovereign restructuring then imperils the financial system. Reforms are necessary to strengthen the euro, and with it the benefits the euro provides to euro area citizens. Euro countries must face market discipline to give incentives for responsible fiscal policy and economic efficiency. In the end, euro countries must be able to default, i.e. restructure their debt, in an orderly manner without this creating a major financial disaster. This possibility requires a banking regulation reform that avoids the current incentives for banks to accumulate large exposures to public debt, in particular of their own domestic sovereign. The euro area needs a well-constructed European Fiscal Institution (EFI) for the management of fiscal troubles and balance of payment problems of euro countries. The EFI needs all necessary powers, tools, the ability to make swift decisions, and sufficient capital financed by member states, to fully unburden the ECB. The ECB should reduce its footprint to protect its independence, its balance sheet, and thereby its ability to fight inflation even in times of fiscal trouble. The ECB must stop quashing true market signals that give incentives for sound fiscal policies and prudent risk management of banks. The ECB should stay away from quasi-fiscal interventions, such as balance sheet policies that favor fiscally fragile countries and their bondholders and create fiscal transfers between countries and from taxpayers to banks.