Aside from a single currency and a fiscal brake, EMU’s institutional architecture was minimalist: governance of economic and financial policies remained firmly a national competence. What lay behind these expectations? Of course, political considerations were a dominant factor, insofar as governments had incentives to limit the centralisation of fiscal, economic  BIS central bankers’ speeches  1  and financial policies. But to an extent, it also reflected the economic thinking that prevailed at that time. The rational expectations, perfect foresight paradigm was – and to a large extent still is – dominant. Many of its followers are, of course, aware of its limitations but hope to successfully expand the theory to encompass new aspects of reality. Standard models feature unboundedly rational agents and complete knowledge of all variables’ probability distributions in all possible future states of the world. They do not foresee significant credit cycles or irrational asset price bubbles. Moreover, information is fully symmetric and complete state-contingent contracts can be written and enforced. Default – a situation in which debtors cannot repay due debt in some states of the world – was also ruled out. The optimal lending contracts in such an environment do not even resemble a debt contract. Agents use so-called “Arrow-Debreu” securities. The set-up allows a different payback for every future eventuality so that borrowers are always able to meet due repayments.
The ECB is taking measures to ensure the proper transmission of its monetary policy and maintain price stability, which buys time for this adjustment to continue. Completing the euro area’s institutional architecture To stabilise EMU over the long-term, however, requires a more fundamental reform of the institutional architecture. The minimalist approach pursued at Maastricht was found to be inadequate in the context of highly integrated financial markets. In recognition of this, the Presidents of the European Council, Commission, Eurogroup and ECB have been asked to lay out a roadmap to complete EMU over the next decade. They presented their interim report to the European Council in July and will present a final version in December This Report does not aim to identify what features we would ideally like for the euro area, but rather what features it cannot do without. Having been thoroughly stress-tested over the last three years, we now have a much clearer idea of what rules and institutions are essential for monetary union to function effectively. In the view of the Four Presidents, a stable EMU needs to be built on four pillars: financial union, fiscal union, economic union and political union. Let me explain each in turn. Financial union The first and most urgent pillar is financial union or, as it is more commonly known, banking union.