"The European Union is and remains a work in progress and is capable of change. The completion of a fourfold union would create a much more robust and resilient framework that could enable decisions to repair investors’ trust and keep centrifugal forces in check."

(Nicolas Véron, Bruegel Policy Contribution – issue 2012/13 – August 2012)

1. Introduction

An “inconsistent quartet”...

Let me start by thanking President Guilherme d’Oliveira Martins for the invitation to speak at the closing conference of the Contact Committee Meeting of the Heads of the European Union Supreme Audit Institutions (SAIs). I am sure that your reflections and discussions yesterday have been very interesting and fruitful. My mandate today is to talk about “Responding to the financial crisis and the role of independent institutions”. Let me start by saying a few words on the fragilities of the EU economic governance model.

We are now in the fifth year since the beginning of the global crisis, the biggest since the Great Depression of the 1930s. Triggered by the collapse of Lehman Brothers, it has rapidly spread from the US to the EU, which, in the last two years, has been at the center of the turmoil and under close scrutiny by its world partners. The crisis has brought to the spotlight inconsistencies and fractures in the euro area economic governance model, dramatically affecting confidence. This weak and inconsistent framework has contributed to unsustainable fiscal positions in some countries, to the accumulation of large macroeconomic imbalances and to tensions in the conduct of the single monetary policy. Important feed-back loops between the financial sector and national sovereigns have also developed, becoming a major source of systemic risk.

In fact, the euro area governance model was built on the basis of an “inconsistent quartet”:

1. “No bail-out” – it is forbidden for one Member State to assume the debts of another;
2. “No-default” – there is no mechanism in place for orderly debt restructuring;
3. “No-exit” – the possibility of leaving the euro is not foreseen;
4. Fiscal sovereignty of the Member States - in contrast with monetary unification, Member States maintain responsibility for fiscal policy, subject to common rules and procedures at the EU level.

With hindsight, it can be said that this framework was insufficiently robust and its implementation was rather weak in the early years of EMU. Indeed, Europe failed to put in place, in an effective way, the rules and the institutions that would ensure compliance with the underlying conceptual framework. This has allowed inadequate fiscal policies, leading to high and unsustainable public debt levels and to the accumulation of tensions, undermining the effectiveness of monetary policy.

Let me add that, besides the four inconsistent pillars that I have mentioned, there was an absent or ignored one: the pillar of banking union, so as to de-link the fate of banks from that of their national sovereigns. Definitely, the governance model needs a banking union, capable of breaking the negative two-way contagion that has been very much at the heart of the current crisis, impairing the transmission of monetary policy across the euro area and leading to the fragmentation of the monetary union.

Before addressing the topic of the banking union, let me briefly touch on the way the EU has responded to the crisis, with special emphasis on the reform of institutions and frameworks.

2. Responding to the crisis

Important progress has already been made….

The initial EU response to the crisis was slow and hesitant, but it has progressively gained momentum, and important steps have already been taken in many areas, including the reform of the financial sector supervisory framework and of economic governance. The approval of the so called “six‐pack” legislative package and of the “Fiscal Compact”(2) have been major steps “to give more teeth” to fiscal surveillance and to prevent unsustainable fiscal policies. A rapid agreement on the “two-pack”, which is currently being negotiated with the European Parliament, would also be very much welcome. From the systemic viewpoint, which is that of safeguarding the stability of EMU by limiting national fiscal sovereignty, a credible implementation of the fiscal compact will represent an important move to address the “inconsistent quartet” that I have referred to and should be seen as a first step on the path that will eventually lead to a fiscal union.

Still on the budgetary front, let me say a few words on the potential role of independent fiscal councils in promoting fiscal discipline. Since the mid-1990s the idea of setting up such institutions has attracted considerable interest among academics and, more recently, has led to proposals from the IMF, the OECD and the EU (the Fiscal Compact also states that compliance with the national budget rule should be monitored by independent institutions). In some countries - the Netherlands, Denmark, the United States and Belgium - this type of institution has existed for quite some time, with forecasting, analysis and evaluation functions. In several Member-States they are now being created as a feature of the new EU fiscal architecture at the national level.

I have long favoured the creation of an institutional framework to ensure an independent and transparent technical assessment of both immediate and long-term financial impacts of political choices. The objective is not to reduce the decision-making power of governments or parliaments but to assess the financial consequences stemming from exercising such power. Such a framework can strengthen the incentives for fiscal discipline, promoting a higher degree of accountability and credibility and potentially increasing the awareness of voters as regards the overall costs of political options.

I believe that independent Fiscal Councils have the potential to play a useful role in counteracting the deficit bias, even though, on their own, they are not the solution for such a deep rooted problem. Of course, their mandate has to be well designed, so as to counter the common criticism that it is not democratic to have non-elected experts evaluating elected representatives. This also means that their success hinges on both building up a solid reputation for good and independent analyses and trying not to interfere in the formulation of the economic policy objectives (which has to stay within the political sphere). So, it comes as no surprise that I very much welcomed the setting up, at the beginning of the year, of the Portuguese Fiscal Council (Conselho das Finanças Públicas).

Some other major developments have taken place in recent months to respond to the crisis and to the weakness of the European model:

•  The Treaty establishing the European Stability Mechanism (ESM) has been ratified by all euro area member states and entered into force on 27 September. Decisive action needs to be taken to ensure its full and effective operation;
• The ECB actions to provide liquidity to the banking system have played a crucial role in stabilizing the financial market and safeguarding the financial system. More recently (6 September), the ECB decided on the modalities for undertaking Outright Monetary Transactions (OMT) in secondary markets for sovereign bonds in the euro area, as well on additional measures to preserve collateral availability for counterparties. The implementation of OMT in full respect for the principle of equal treatment should be ensured;
• Following the European Banking Authority (EBA) initiatives aimed at strengthening EU banks’ capital, progress has been made on repairing the banking system (mainly via direct capital impact measures), while ensuring an orderly deleveraging;
• The euro area Summit/European Council on 28-29 June constituted an important milestone in the path towards safeguarding the integrity and stability of the euro area and represented a major shift in the EU policy in terms of breaking the vicious circle between the banks and sovereigns.
• The so-called four Presidents report ("Towards a Genuine Economic and Monetary Union"), presented on June 26, sets out "four essential building blocks" for the future EMU: (i) an integrated financial framework; (ii) an integrated budgetary framework; (iii) an integrated economic policy framework; and (iv) strengthened democratic legitimacy and accountability. The ongoing discussion is vital to shape the future of Europe;
• On 12 September, the European Commission presented two proposals (on the creation of a Single Supervisory Mechanism (SSM) and on introducing targeted amendments to the regulation establishing the EBA), as well as a communication on a roadmap towards a banking union. Although, according to the roadmap, the SSM is planned to move faster and be implemented more rapidly (January 2013) - so as to respond to short-term challenges - it is of the utmost importance to ensure its coherence with the overall framework on the banking union.

3. Building a new future for Europe

Further and multi-layered reforms are needed

We are at a defining moment for the EU and there is no time to “kick the can down the road”. What matters is to ensure that the EU, and in particular the euro area Member States, are able to move towards solving the inconsistencies and failures of the European model. And solving them means that the future of Europe has to be built through greater and deeper integration, according to a four-fold agenda: (i) banking union; (ii) fiscal union; (iii) stronger economic integration; (iv) improved democratic legitimacy and accountability. Let me briefly elaborate on each of these fronts:

(i) banking union

The process leading to a banking union is already underway and it is a necessary step both to overcome the current fragmentation of the monetary union and to sever the link between banks and sovereigns. I see this union as comprising the following key elements: (i) a supranational supervision framework with centralised decision-making and decentralised implementation and extending to all banking institutions; (ii) a single deposit guarantee scheme; (iii) a EU bank resolution and capitalisation fund (a backstop facility). This means that all banks in the euro area should be under the Single Supervisory Mechanism (SSM) and the ultimate responsibility for supervision should lie with the ECB, based on a network of national supervisors. For effectiveness and efficiency reasons, an adequate system of allocation of tasks should be established with the operational conduct of supervisory tasks decentralized to the largest extent to the national supervisors.

Following the fact that all euro area banks will be put under a unified supervision, bank deposits of euro area citizens should also be guaranteed at the European level. This means that the banking union should encompass integrated supervision as well as shared mechanisms for deposit guarantee and for bank resolution, thereby aligning supervisory responsibilities and “safety net” responsibilities. However, to avoid moral hazard – linked to a potential sharing of risks accumulated in the past under national supervision - during a transitional period, the responsibility for reimbursements would stay with the national deposit guarantee systems (with the possibility of borrowing from the ESM, as a backstop, if needed). After the transitional period, there would be full mutualisation of the deposit guarantee and resolution mechanisms, in full alignment with the supervisory responsibilities. Without establishing these common mechanisms the banking union will stay incomplete and the de-linkage between banks and national sovereigns is not ensured.

(ii) fiscal union

The EU needs to develop an integrated budgetary framework, able to ensure sound and sustainable fiscal policies. Some important pieces of the fiscal “puzzle” are already there (e.g. six-pack, fiscal compact). However, it is necessary to build some others and ensure that all the pieces fit together and give us a complete and consistent picture. However, the act of approving budgetary rules (no matter how tough they are) does not, in itself, ensure compliance. This means that we have to ensure effectiveness and credibility, by introducing binding rules and “biting” enforcement mechanisms: we need common fiscal policy rules to preserve the sustainability of public debt over the long term and adequate institutional arrangements to ensure the right enforcement. In fact, the EU needs a qualitative move towards a fiscal union.

In this area SAIs have an important role to play, stemming from their intrinsic responsibility to promote accountability and transparency when public funds are at stake. However, they should not try to formulate themselves economic policy objectives. Policy evaluations and recommendations should only concern the possibilities of reaching those objectives, checking, in particular if the use of resources is the most efficient. In other words, it is not up to SAIs to set the final destination but rather to check whether the route followed to reach that destination was the most efficient, to recommend alternative and less costly routes or penalize infringements.

(iii) stronger economic integration

 Building on the European Semester and the Euro Plus Pact, further steps have to be taken towards stronger economic integration. The EU needs to improve its capacity to adjust to shocks and to be equipped with an integrated economic policy framework, able to monitor, assesses and coordinate essential economic policy measures and reforms (both at the EU and at national level). Particular emphasis should be put on areas with a potentially larger impact on competitiveness, economic growth and employment, while promoting social cohesion.

(iv) Improved democratic legitimacy and accountability

Moving towards more integrated fiscal and economic policies also calls for commensurate steps towards setting up robust mechanisms to ensure democratic legitimacy and accountability of joint decision-making, while enhancing solidarity. If the EU ignores the political dimension it won’t be able to move towards increased budgetary integration and fiscal union, by lack of accountability and legitimacy.

For more than two decades, there has been debate, both at the academic and the political level, on the existence of a “democratic deficit” in the EU. Some authors also refer to an “executive deficit”, stemming from the lack of an appropriate framework to make executive decisions. The crisis has given a new impetus to this debate and is forcing the EU to rethink its institutions and to ponder what “European integration” means from a political standpoint.

In my opinion, this implies that there should be a “center” dealing with the economic policy of the euro area and responsible for the “whole”. From this viewpoint, the Eurosystem is currently the only body that “thinks” the euro area as one entity. Given the accountability/ legitimacy weakness of the existing mechanisms, all other EU institutions tend to look at the euro area piece by piece. In the future, both the European Parliament and the European Commission must become more representative, responsible for - and accountable to - the euro area as a whole. This means, for example, that the responsibility/accountability of a MEP (either Portuguese or German) should not stay inside the national border of the country in which he was elected. Moreover, it is necessary to reconcile two concerns: the need for a response with legitimacy vis-a-vis the whole; and the need to ensure that all parties (however small) are represented and take part in the decision process. Personally, I favor the creation of an upper house (a “senate”) to perform the role of the current Commissioners per Member State, thereby ensuring the right balance between the national dimension and the euro area dimension. The “senators” would also ensure the necessary balance when national political majorities differ from the majorities represented in EU elected institutions.

Of course, in any process of sharing sovereignty, nobody is willing to give up sovereignty unless the opportunity cost of not doing so is so high that it becomes highly punitive. But I am convinced that, from cliff to cliff, with more or less controversy and drama, the EU evolutionary process - although time consuming, because it naturally requires consensus - will eventually lead to increased sovereignty sharing. The EU has a “genetic code” that has made it evolve from the customs union to the internal market, to the exchange rate mechanism and to the economic and monetary union, and that will lead to increased budgetary, economic and political integration.

4. The Multiannual Financial Framework

... an opportunity to improve the rules of the game

Before concluding, allow me to say a few words on the next Multiannual Financial Framework (MFF) for 2014-2020 which was the subject of yesterday’s Seminar and which should support the new EU governance model.

Indeed, the preparation of the next MFF is critical and should not be treated as “business as usual”. It is taking place in the context of a broader assessment of existing arrangements for EU spending and funding. Bearing in mind its leading theme - smart, sustainable and inclusive growth – this is an opportunity “to change and improve the rules of the game”, to align incentives and to induce value for money, thereby ensuring a more efficient use of EU resources. Beyond discussing amounts and ceilings for the next period, this should be an occasion to make fundamental choices and to improve and rationalise programmes, to simplify and modernise mechanisms and procedures and to reallocate resources to the productive fabric, so as to boost growth and employment in a sustainable manner.

In the context of the common provisions for the five Common Strategic Framework (CSF) Funds, the use of financial instruments should be expanded and strengthened as an alternative to traditional grant-based financing. In particular, in cases where investment projects are capable of generating sufficient revenues to build up financing reimbursement capacity, they should be financed through appropriate financial instruments (loans, including subordinated debt, quasi-equity, equity participations and guarantees) and not by grant-based financing. Significant leveraging and multiplier effects (by intensifying the revolving nature of the funds) can only be achieved by making use of those instruments.

This move is even more urgent in the current context of slow or negative economic growth and stringent credit conditions – in particular in countries like Portugal – where the search for alternative sources of financing is of the essence. One idea worth exploring would be the creation of a national financial institution – a Public Investment Bank – aimed at fostering and managing the Funds in the context of the new Multiannual Framework. Such an institution would allow enhancing the mix between grant-based financing and the use of financial instruments, in order to maximize the productive use of resources and to promote EU regional development goals. Indeed, EU resources and funds have to be seen as “development mechanisms” (to support regional and social development) instead of “assistance mechanisms”. And structural funds have to be a positive-sum game, because reducing disparities ultimately benefits all the countries in EMU.

The new MFF calls for institutions within the EU to deliver their services more efficiently, with greater emphasis on prioritisation. It will bring new challenges both to the European Court of Auditors (ECA) and to national SAIs and will require increased efficiency and value added. They all have to operate in an environment that changes increasingly fast and to cope with new developments as they unfold, while fostering sound management of EU and national resources. To be effective, SAIs should not limit their activity to pointing out errors when they occur, but also help preventing them, by analysing and checking the design and the robustness of the processes and procedures and identifying flaws or potential sources of error. In the case of the ECA, it has a crucial role in promoting public accountability and transparency, in assisting the European Parliament and the Council in overseeing the implementation of the EU budget and in protecting the financial interests of EU citizens. Therefore, within this mandate, it is important that the Court checks whether the frameworks are well designed and whether incentives are appropriately aligned so that the mechanisms, themselves, have the potential to generate a “virtuous” use of the EU resources.

5. Concluding remarks

Let me conclude by stressing, once again, that the crisis has taught us a number of important lessons about the construction and operation of the European Union and, more acutely of the euro area. The EU has been built on unbalanced pillars, which ended up making the whole structure unstable and vulnerable. This structural instability came to light more clearly with the international financial crisis, which found Europe in a situation of fragile public finances and high indebtedness of the public and private sectors. The response to the crisis by the EU authorities was initially hesitant and with a low degree of coordination. However, steps have gradually become stronger and more determined, more articulated and anchored in a long-term vision, a vision for a new future for Europe.

The European project is still work in progress. By analogy with the construction sector, we can say that currently there are several construction sites in Europe. It is necessary that, in all those sites, the works continue at a good pace, in a coordinated manner and, above all, with high quality materials, so that the new foundations are solid to support structurally stronger buildings, able to endure future storms. In addition, the various buildings should form a harmonious neighborhood, so that it becomes a good place to live, both for the current and future generations.

It is essential that citizens in each Member State realize that the new rules and frameworks that are being developed are not an external dictat, they are vital to the survival of the group and of each of its members. And we have to keep in mind that EMU has two important dimensions which are correlated and cannot be dissociated: an integration dimension, where group solidarity is crucial; and a national dimension of individual responsibility.
 
I am confident that Europe will not only overcome the current crisis but also emerge stronger and more cohesive than before. As a matter of fact, fundamental reforms and most needed adjustments often occur precisely because at a certain point in time things went terribly wrong. After all, if we look back to the steps of the European construction, we realize that periods of tension and crisis have typically been followed by further strengthening of the EU framework and further integration.

The euro will prevail and it will stay as the common currency of a group of countries which share a single monetary policy; which will engage in a banking union; and which will operate in a framework of binding budgetary rules and mechanisms and institutions that will ensure their enforcement. The euro area will also be an area where Member States share more sovereignty, with increased legitimacy, accountability and solidarity; and where all European institutions become increasingly responsible for the “whole” and not just for the sum of the parts.

Allow me to end by quoting Henry Ford: “Coming together is a beginning; keeping together is progress; working together is success”.

Thank you.

Estoril, 19 October 2012(1) As prepared for delivery.
(2) On 2 March 2012, the "Treaty on Stability, Coordination and Governance in the Economic and Monetary Union" (which includes the so‐called “Fiscal Compact”), was signed by twenty‐five Member States (all but the UK and Czech Republic).