EMU economic governance


The institutional setting for Economic and Monetary Union (EMU) is based on a dual structure. The competences for monetary policy and for exchange rate policy have been transferred to the euro area level with the introduction of the euro, while the competences for economic policy have largely remained the responsibility of national policy makers.

The reason for this arrangement, which dates back to the Treaty of Maastricht of 1992, is that economic policies – such as fiscal and structural policies – frequently need to take into account national characteristics and institutional settings and are often the very essence of national public and political debates. This framework was also expected to introduce a certain degree of policy competition among national policy makers, thereby contributing to the emergence of best practices that would be shared among and emulated by governments (see the Monthly Bulletin articles the Institutional setting and workings of the euro area from 2008 and The economic policy framework in EMU from 2001).

At the same time, the EU’s Single Market has made Europe’s economies highly interdependent. In the euro area, economic and financial integration has increased even further as a result of the single currency. To take account of these interdependencies (in particular in the form of spillovers, i.e. when policy decisions in one country affect others), economic policies need to be subject to a European coordination and surveillance framework. Also, uncoordinated national economic policy responses may be less effective in the context of a large common shock which affect most or all European countries in broadly similar ways, such as the economic and financial crisis. Moreover, a European framework is also necessary because national economic policies must be geared towards stability to ensure compatibility with the single monetary policy and its primary objective of price stability, as required by the Treaty.

However, the financial and economic crisis has revealed fundamental weaknesses in the economic governance framework. Economic governance relied on the assumption that countries would have sufficient incentives to “keep their house in order” and thereby, quasi-automatically, contribute to the euro area common good. Economic policy decisions were, in practice, only subject to soft constraints at the European level, even in those areas where hard rules were supposed to apply (essentially fiscal policy – see below). Peer pressure, i.e. pressure exercised by Member States on each other to follow sound economic policies, was largely absent in European policy debates. Moreover, financial markets failed to exercise their disciplinary role properly.

The experience gained since the introduction of the euro suggests that the limits of what soft policy coordination can achieve have been reached, both as regards the formulation and the implementation of European rules and recommendations. The existence of substantial policy spillovers among euro area countries clearly justifies deeper integration in fiscal, structural and financial policies, leading ultimately to a fully fledged economic union to ensure the smooth functioning of EMU. Against this background, the ECB has called for a quantum leap towards strengthening the institutional foundations of EMU, and thus towards a deeper economic union that is commensurate with the degree of economic integration and interdependency already achieved through monetary union (see Reinforcing Economic Governance in the euro area).

Overview of economic policy coordination and surveillance instruments in EMU

Integrated Guidelines

In view of the increased interconnectedness of EU – and in particular euro area – economies, the Treaty requires Member States to regard their economic policies as a matter of common concern and to coordinate them within the EU Council (Art. 121 TFEU). More specifically, the Treaty (Art. 120 TFEU) foresees the adoption of Broad Economic Policy Guidelines (BEPG) which set out recommendations to policy-makers on macroeconomic and structural policies. The BEPG, which have been adopted by the EU Council, upon a recommendation from the Commission, were one of the key policy coordination tools during the first decade of EMU.

Since 2005, the BEPG have been merged with the so-called Employment Guidelines (Art. 148 TFEU) to become the Integrated Guidelines. They are endorsed at the highest political level, EU leaders, at the spring European Council meetings and updated as required.

The Europe 2020 Strategy

Economic reforms in product and labour markets to increase market flexibility and foster competition are crucial for the smooth functioning of EMU. Such reforms enable Member States to raise potential growth and employment. Moreover, such reforms help Member States to improve their productivity and competitiveness while, at the same time, making their economies more resilient to economic shocks. The case for structural reforms is reinforced within the euro area, since Member States can no longer use monetary and exchange rate policies as national policy instruments. Therefore, structural reforms are also crucial to avoid imbalances emerging within the euro area.

Against this background, the EU leaders adopted, at the European Council meeting in June 2010, the “Europe 2020 Strategy” – the Union’s strategy for creating jobs and promoting growth through economic and social reforms, while paying due respect to environmental considerations. Under the three headings of smart, sustainable and inclusive growth, the strategy covers policy actions at both national and EU level aimed at enhancing the welfare of the people of European. The ambitions of the Europe 2020 Strategy are expressed through five EU-level headline targets, covering employment, research & development, climate change, education and poverty.

Under the Strategy, Member States present annual National Reform Programmes, consistent with the Integrated Guidelines, which aim to overcome country-specific bottlenecks to growth and employment. Member States’ efforts are supported at EU level by “flagship initiatives” and flanking policies which pertain, for instance to completing the Single Market, financing research and innovation and improving access for EU companies to global markets ec.europa.eu/europe2020/.

The Europe 2020 Strategy is a follow-up to the Lisbon Strategy, which has been only moderately successful, mainly on account of weak governance arrangements, a lack of clear focus and deficiencies in communication. (Monthly Bulletin article July 2005: The Lisbon strategy – five years on). The Europe 2020 Strategy tries to correct these weaknesses, mainly by giving the European Council a strong role in steering the implementation of the reform agenda and by re-enforcing surveillance of Member States’ reform policies.

The reformed framework for economic governance

As a response to the financial and economic crisis, the Council and the European Parliament adopted in 2011 a legislative package to strengthen the EU’s economic governance framework (for an overall ECB assessment see the Monthly Bulletin March 2011 article The reform of economic governance in the euro area – essential elements).

The Stability and Growth Pact

Sound public finances help to achieve other important policy objectives such as strong and sustainable growth, and thereby support employment creation. Fiscal discipline also facilitates the central bank’s task of maintaining price stability (see the Monthly Bulletin article July 2008 One monetary policy and many fiscal policies: ensuring a smooth functioning of EMU).

For these reasons the Treaty requires Member States to avoid excessive deficits (Art. 126 TFEU). The Stability and Growth Pact (SGP), which was adopted in 1997, enhances the Treaty provisions on fiscal discipline by establishing a procedure of multilateral surveillance consisting of a preventive and a corrective arm (see Ten years of the Stability and Growth Pact).

The preventive arm is based on the regular surveillance of national public finances. The Commission and the EU Council assess annually the stability programmes submitted by euro area members and the convergence programmes submitted by non-euro area members. These programmes present an overview of the economic and fiscal developments in each country and set out a medium-term objective for fiscal policy, and an adjustment path towards this objective. The Commission can issue an early warning to a Member State at risk of non-compliance with its commitments under the SGP.

The corrective mechanism of the SGP implies that when a Member State fails to comply with its obligations, an excessive deficit procedure is triggered. The EU Council adopts recommendations for the Member State concerned, establishing in particular a deadline for the correction of its deficits. The EU Council monitors implementation of its recommendations and abrogates the decision of the existence of an excessive deficit when the latter is corrected. If the Member State fails to comply, a series of further steps is foreseen, ranging from enhanced surveillance and disclosure to the imposition of financial sanctions. The Member State concerned is allowed to take part in the discussions on the necessary recommendations in the EU Council but, in line with the Lisbon Treaty, can no longer vote.

Experience since the introduction of the euro reveals that the provisions of the SGP have failed to instil a sufficient degree of fiscal discipline in a number of Member States. Nevertheless, and against the advice of the ECB, Member States agreed, in 2005, on a reform of the SGP which introduced further flexibility into the procedures. Regarding the preventive arm, the reform allowed more discretion in the setting and progress towards the medium term objective for fiscal stability (see below). As for the corrective arm, the new rules widened the use of discretion in determining an excessive deficit and extended procedural deadlines (see the Monthly Bulletin article The Reform of the Stability and Growth Pact).

In 2011, drawing lessons from the financial and economic crisis, the SGP was again reformed as part of an overall reform to improve economic governance. One notable innovation to strengthen the Pact is that decision-making procedures have been made more automatic through the introduction of reverse qualified majority: certain recommendations of the Commission will be deemed adopted unless the Council rejects them by qualified majority within a certain period of time. Moreover, more emphasis has been placed on the public debt criterion and the long-term sustainability of public finances. Moreover, earlier and more graduated financial as well as political sanctions have been introduced to encourage Member States’ compliance.

While these measures are a step in the right direction, the reform should have gone still further. In particular, the ECB regrets that one of the key aspects of such a quantum leap – greater automaticity in decision-making through the use of reverse qualified majority voting to the maximum extent possible – was only partly achieved.

The macroeconomic surveillance framework

As part of the 2011 reform to strengthen economic governance, a new macroeconomic surveillance framework was adopted by the Council and the European Parliament. This new surveillance procedure aims to identify and address macroeconomic imbalances and declining competitiveness. It will therefore complement the existing country surveillance process foreseen under the Europe 2020 Strategy, which focuses on fostering sustainable and socially inclusive growth and employment. The new mechanism, which has a preventive and a corrective arm, will apply to all EU-27 Member States.

The preventive arm is based on an alert mechanism that is designed to identify imbalances at an early stage. More specifically, at the start of each European Semester (see below), the Commission will assess Member States performance against a scoreboard of macroeconomic indicators in order to detect the existence, or the risk, of macroeconomic imbalances. The results of the scoreboard and the analysis will be published in a report. If the Commission finds that there are Member States with indications of significant macroeconomic imbalances, it will carry out an in-depth review of economic, financial as well as public finance developments in the Member States concerned. On this basis, the Council can address the necessary recommendations to the Member State concerned.

If during its review the Commission identifies excessive macroeconomic imbalances, it can propose to trigger the so-called “Macroeconomic Imbalances Procedure” (MIP) under the corrective arm of the macroeconomic surveillance procedure. The Council will address policy recommendation to a country subject to an EIP, which in turn needs to submit a corrective action plan (CAP) setting out its national policies in response to the Council recommendation. The implementation of the CAP by the Member State in question will then be subject to close monitoring by the Commission and the Council, a process which will include progress reports and surveillance missions. In case of non-compliance with the recommendations, a sanction mechanism, inspired by the EDP for fiscal surveillance, is foreseen.

The ECB very much welcomes the creation of a new macroeconomic surveillance framework, which closes an important loophole in the EMU governance framework. The effectiveness of the new mechanism must not however be weakened by its broad scope, also in terms of indicators used, so that it can correct imbalances and vulnerabilities at an early stage.

The European Semester

Since 2011, EU surveillance of the economic policies of its Member States has been organised on an annual basis through the European Semester. This process, which takes place during the first half of the year, was set up to better align EU surveillance of fiscal and economic policies, which remain legally separate. It allows fiscal and macroeconomic policies to be assessed simultaneously against the Integrated Guidelines, a step which is expected to ensure greater consistency, in terms of policy direction and reporting, among the different surveillance processes. Moreover, under the European Semester, country-surveillance is complemented by thematic surveillance, which covers progress in the area of broader structural reforms agreed under the Europe 2020 strategy.

The so-called “national semester” takes place in the second half of the year. This is when Member States finalise national budgets and implement policy measures agreed during the European semester.

Although it is too early to fully assess the effectiveness of the European Semester in improving the conduct of fiscal and structural policies in Member States, the framework can contribute to a more integrated and consistent approach to economic policy making.

The Euro Plus Pact

At their summit on 11 March 2011, euro area leaders adopted a Pact for the Euro. The Pact aims to strengthen the economic pillar of EMU by further extending economic policy coordination to areas falling under national competence, in particular with regard to competitiveness, employment and the long-term sustainability of public finances. The Pact is also open to non-euro area Member States and has been joined by Bulgaria, Denmark, Latvia, Lithuania, Poland and Romania, so the Pact was re-named “Euro Plus Pact”.

The Pact builds on existing economic policy coordination instruments, in particular the Europe 2020 Strategy, and is consistent with the Single Market. The participating Member States are committed to making a special effort and to undertaking concrete actions that are more ambitious than those already agreed. The Pact forms part of the European Semester and national commitments are reviewed on a yearly basis by the Heads of State or Government.

The euro area dimension in economic policy coordination

The potentially substantial spill-over effects in a monetary union (see above) require euro area countries to coordinate their economic policies particularly closely. This specific euro area dimension is recognised in the Lisbon Treaty, which contains a new chapter dedicated to “provisions specific to Member States whose currency is the euro”. The Protocol on the Eurogroup, which is annexed to the Treaty, refers explicitly to the need “to develop ever-closer coordination of economic policies within the euro area”, so as to promote conditions for stronger economic growth in the EU as a whole.

In keeping with this specific euro area dimension, the Lisbon Treaty has also revised the voting procedures for decisions to be taken in the field of the BEPG and the SGP. As already mentioned, only euro area countries participate in EU Council votes on decisions concerning euro area countries. The need for euro area countries to be particularly stringent in respecting agreed rules is also reflected in the corrective arms of the SGP and the EIP, with financial sanctions only foreseen for euro area countries.

Another example of the euro area dimension in the field of economic policy coordination exists in the field of fiscal policies, where the euro area countries have agreed to enhance their surveillance in the framework of the Eurogroup. More specifically, the Eurogroup conducts an annual mid-term review on the appropriateness of budgetary policies in euro area countries ahead of the submission of draft national budgets for debate in national parliaments.

As one of the main lessons from the first decade of the euro, the ECOFIN Council concluded in October 2008 that competitiveness in the euro area should be monitored more comprehensively. The Eurogroup regularly reviews labour markets, competitiveness developments and macro economic imbalances within the euro area. Moreover, the new Integrated Guidelines adopted under the Europe 2020 strategy include a detailed guideline for euro area members focusing on macro-economic imbalances.

Further progress in strengthening the euro area dimension in economic policy coordination was made at the summit meeting on 26 October 2011, when the euro area leaders agreed to meet at least twice a year in the form of “Euro Summits“ to provide strategic orientations on economic and fiscal policies in the euro area, so that the euro area dimension can be taken better into account in domestic policies. They also committed to number of additional measures, above and beyond existing requirements, such as the adoption of balanced budget rules (in structural terms) translating the SGP into national legislation, preferably at constitutional level or equivalent and the consultation of the Commission and other euro area countries before the adoption of any major fiscal or economic policy reform plans with potential spillover effects. (Euro Summit statement)

Moreover, reflecting the core role of the Eurogroup, the Commission and the ECB in the daily management of the euro area, there will be at least monthly meetings of the President of the Euro Summit, the President of the Commission, and the President of the Eurogroup in which the President of the ECB may participate. The Presidents of the three supervisory agencies (see The ECB´s role in the reformed financial supervisory architecture) and the Head of the EFSF/ESM may participate on an ad hoc basis.

Moreover, in a new provision introduced by the Lisbon Treaty (Art. 136.1 TFEU), euro area countries may adopt measures to strengthen the coordination and surveillance of their budgetary discipline and to set out economic policy guidelines in order to ensure the proper functioning of EMU. Such measures, which would be legally binding on euro area countries, need to be consistent with other policy instruments (such as the Integrated Guidelines and the SGP). The Commission has been invited by the euro area leaders to present proposals on how to implement this Article.

Crisis management and the European Stability Mechanism

The European Council on 28-29 October 2010 agreed to establish a permanent crisis management mechanism to safeguard financial stability in the euro area as a whole. The establishment of the future European Stability Mechanism (ESM) was formally adopted at the meeting of the European Council on 24-25 March 2011 as part of a comprehensive package of measures to respond to the crisis. This adoption followed a limited Treaty change to Article 136 TFEU to allow euro area countries to establish a stability mechanism which is to be activated, if need be, to safeguard the stability of the euro area as a whole, with any financial assistance granted under strict conditionality.

The ESM is expected to enter into force at the latest in July 2012 with a lending capacity of € 500 billion and is expected to replace temporary measures such the European Financial Stability Facility (EFSF) and the European Financial Stabilisation Mechanism (EFSM), which were established following the ECOFIN decisions of 9 May 2010 to provide financial support to Member States in financial difficulties.

The EFSM was established as an EU mechanism with its legal basis in Article 122 TFEU while the EFSF was established as a euro area mechanism on the basis of Article 122 TFEU together with an intergovernmental agreement among the euro area countries. The two mechanisms together have a potential lending capacity of € 500 billion.

At their summit meetings of 11 March 2011and 21 July 2011, the euro area leaders agreed to increase the flexibility of the EFSF and the future ESM by allowing them to act on the basis of a precautionary programme, finance recapitalisation of financial institutions, and interventions in the primary and secondary bond markets.

On 26 October, euro area Heads of State or Government agreed to maximise the available resources of the EFSF, without extending the guarantees underpinning the facilities, by (i) providing credit enhancement to new debt issued by Member States and/or (ii) through a combination of resources from private and public financial institutions and investors, which can be arranged through Special Purpose Vehicles. In addition, further enhancement of the EFSF resources can be achieved by cooperating even more closely with the IMF.

The ECB is involved in parts of the operations of the EFSM, EFSF and the future ESM.

First, it will liaise with the European Commission and the IMF and assess whether there is risk to the financial stability of the euro area as a whole, and ECB staff will undertake a rigorous debt sustainability analysis. EFSF and ESM interventions in the secondary bond market will be on the basis of an ECB report.

ECB staff will also provide technical experts along with the European Commission and the IMF for the negotiation on a macroeconomic adjustment programme with the Member State requesting financial support and for monitoring the programme implementation (see the Monthly Bulletin article July 2011 The European Stability Mechanism).

Moreover, in December 2011 the ECB agreed to act as an agent for the secondary market activities of the EFSF.