They concluded from the evidence of the crisis that at least five stylized facts should be reflected in macro-financial models: coexistence of bank and bond finance, substitution from bank to bond financing, increasing credit spreads, stickiness of equity prices and endogenous procyclicality of bank leverage. 5 In the pre-EMU economic modelling world, therefore, there was no need to counter financial imbalances and financial instability as the financial sector did not play a crucial role from a macroeconomic perspective. Similarly, under the assumption of self-equilibrating markets, there was no need to monitor macroeconomic imbalances and disequilibria on the labour, product or financial markets. With an assumed stable private sector, apart from exogenous shocks, the only source of instability acknowledged were governments and their fiscal profligacy. This supported the decision to elevate only governance of fiscal policies to the European level. With the benefit of hindsight, it is obvious that this architecture was unstable. Like the neglected build-up of financial imbalances and high indebtness that led to the crisis, the initial design of the European Monetary Union was a victim of the economic thinking then dominant. A few lessons have to be drawn now. Lesson number one: the greater integration of euro area financial markets implied that our economies became more prone to contagion. Financial integration run ahead and European-level financial supervision was non-existing.
The recent reforms to strengthen the euro area fiscal framework – the so-called six-pack and the fiscal compact – are welcome and go in the right direction. But they remain within the logic of the Maastricht Treaty where responsibility for fiscal policies is exclusively in national hands. This creates an inherent credibility problem, as for fiscal frameworks to be fully credible, they have to enforceable. This is impossible without a further and deeper sharing of budgetary sovereignty. This could be achieved by giving European institutions greater competence to effectively compel euro area Member States – in a graduated manner if and when the situation deteriorates – to take the necessary fiscal policy decisions. This would correspond to a further sharing of national sovereignty. But for both weaker and stronger countries, it is in fact an opportunity to regain substantive sovereignty as opposed to formal sovereignty. For the weaker countries, measures that put the soundness of their fiscal policies beyond doubt will allow them to be fully sovereign, in the sense that they can use fiscal policy in its vital economic stabilisation role and take free decisions about taxes or types of expenditure without fear of excessive discipline from financial markets. For the latter, sharing sovereignty at the European level will allow them to effectively protect their domestic economies from spillovers from the rest of the euro area. Moreover, they will no longer be placed into situations where they are de facto forced into taking decisions to avert imminent catastrophe.