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ECB must step up to the plate and end this panic

THE steps necessary to stem the immediate eurozone crisis do not need treaty changes, which is just as well, since treaty changes would take two years or longer. The financial crisis could spiral out of control over the next few months and a disorderly break-up of the euro needs to be averted in the here and now. Adequate instruments to achieve this are available within existing arrangements and indeed have been available all along, but it now appears that they will not be deployed, principally because of German opposition, unless eurozone members agree to ultimate treaty changes.

Next Friday's European summit will be the 15th designed to end the crisis. Previous editions have provided plentiful losses for those who believed the post-summit spin. Those market players who took the view that the spinners were in denial about the scale of the problems and lacked the necessary conviction to deal with them have been proved right every time.

The post-summit market rallies have, however, been getting shorter and risks of a real financial panic have been rising. There will come a point, if decisive action is continually deferred, where one or more of the major bond markets comes seriously unstuck and Europe's single-currency project is imperilled. There is now no short-run option other than a decisive intervention in the Italian and other threatened bond markets.

In a monetary system that is functioning normally, this task would be undertaken by Europe's central bank, the ECB. The inability or unwillingness of this institution to intervene spawned the attempts to expand the EFSF, the stability fund established by eurozone governments to rescue countries which could no longer borrow, a fig-leaf to conceal the impotence of the key eurozone institution, the European Central Bank.

The last 'decisive' summit decided that the stability fund was to be given expanded functions, including support for governments in recapitalising banks, financed by extra borrowing. But it was promptly discovered that the EFSF faced the same market hostility as the threatened governments; it could no longer borrow cheaply and so another wheeze bit the dust.

The embarrassing trip to China by the EFSF chief Klaus Regling, seeking but failing to get a bailout for Europe, will be an enduring reminder of the bungling incompetence that has characterised the European policy response since the crisis began.

Last week, yet another tortuous proposal emerged. It would see the European Central Bank, which is reluctant to buy government bonds, lend money to the IMF, which would in turn lend to the same European governments that the ECB supposedly serves.

Ultimately, if the financial panic is to be stemmed, the central bank will have to act decisively and everyone knows this. The agonising succession of summits is not a search for financial measures to deal with the crisis, since these measures are available and have been known all along; it is a search for political cover.

The entire process has been an illustration of the dangers of closing off options prematurely, as Chancellor Merkel, in particular, has been doing since the crisis broke.

The Irish Government is likely to be faced next week with a proposal that eurozone countries should commit to some form of closer fiscal union in exchange for German agreement to permit the ECB to end the financial panic.

ECB action, preferably direct and not through surrogates, is essential if the single currency is to survive. There is no Irish interest in foot-dragging, so the response will no doubt be positive.

But the Government should ground its response in an appreciation of the need for a meaningful fiscal union, if there is to be one, and for a re-design of the monetary union, whose flaws are now clear to everyone aside from its custodians.

Fiscal union does not mean a reinforcement of the discredited Stability and Growth Pact, the rulebook torn up not by Ireland but by France and Germany.

This supposed cornerstone of the single currency required each member to keep the budget deficit below three per cent of GDP and the ratio of debt to GDP below 60 per cent. Ireland complied with this every year from eurozone entry in 1999 until the European banking crisis emerged in 2008. Both France and Germany had already breached the fiscal rules at that stage.

The pretence that Europe's financial crisis has its origins in fiscal profligacy in a few small peripheral countries and that there is no banking crisis has fuelled the inadequate policy response from the rule-breaking Franco-German political leadership right from the beginning.

A common-currency area constrains its members from exchange-rate alterations in response to economic shocks. If these shocks affect all members equally, nothing is lost and a one-size-fits-all policy is no burden. However, since this is never the case in the real world, automatic compensation for the loss of exchange-rate autonomy comes, in proper monetary unions, from centralised fiscal systems. The suffering region automatically pays less tax in a regional downturn and receives greater budgetary disbursements from the rest.

Wales shares a common currency with England, a sacrifice of exchange-rate autonomy by Wales. But if things go badly in Wales (a failure of the leek harvest, for example) the fiscal transfers are automatic and require no discretionary policy action.

Bavaria is in a fiscal, as well as a monetary, union with the rest of Germany in this sense. Bavaria does not complain about lost exchange-rate freedom when things go badly, because Germany is a fiscal as well as a monetary union.

When Angela Merkel and the German economics profession talk about fiscal union for Europe's common currency, this is most decidedly not the kind of fiscal union they have in mind. They mean a reinforced Stability and Growth Pact, with sanctions against regions (countries) which suffer economic shocks, rather than automatic budgetary transfers.

If Europe had been a proper monetary and fiscal union in the 1990s, the recipient of automatic transfers would have been Germany, labouring under the costs of reunification. Under the form of fiscal union now being hawked about, Germany in the 1990s would have been punished and its burdens intensified. An economic downturn in Bavaria does not induce punishment for Bavaria because Germany is a fiscal, as well as a monetary, union.

If next Friday's summit is presented with a scheme for penalties on countries in budgetary trouble because of local downturns, our Government should, tongue in cheek, suggest a proper fiscal union as an alternative. The pretence that a reinforced Stability and Growth Pact is a fiscal union is preposterous and an abuse of language.

Whether Europe should proceed to fiscal union is rather a large question and it is not clear that such a project enjoys political legitimacy. The immediate concern should be the inadequate monetary union with which 17 EU member states are now burdened.

The common currency project was poorly conceived and has been badly managed. Until this is acknowledged honestly, there is no sensible basis for a new treaty. A common-currency area needs a monetary institution with a comprehensive mandate to deal with financial crises and people of unchallenged competence in charge.

To be more specific, a proper monetary union needs a centralised approach to financial-sector oversight. This means centralised bank supervision. It is ridiculous, in a monetary union with free capital flows and freedom of establishment for banks, to leave bank supervision in the hands of 17 national bank regulators. The United States abandoned this hands-off approach in 1913, after a succession of (you guessed it) banking crises.

It is even more ridiculous to have sacrificed the solvency of European states, Ireland included, in a failed attempt to pretend that the solvency of banks is more important.

Europe needs a centralised system of resolution for failed banks, not a punishment regime for states foolish enough to sacrifice their sovereign solvency in unrequited defence of an ill-designed currency union.

The agenda for Friday's summit should consist of just two items. First, deal swiftly with the immediate crisis. The ECB (not the IMF, China, or the Red Cross) should be instructed to do what central banks do in a financial panic, that is, mobilise the balance sheet decisively to restore confidence.

The second item should roll back the clock to 1999. If we were doing this again, how would we design the monetary union? The Irish Government can credibly claim to be the greatest victim of the failure to create a proper European Monetary Union and should not be shy about the arguments for change.

Sunday Independent