European Economic Governance: Deutsche Bank Research says that following the major storm it’s now time for Europe to seriously address changes in the systems and procedures which were shown to have been inadequate both before the financial crisis and in the response to the recent sovereign debt crisis.

European Council President, Herman Van Rompuy, will present final change proposals to meetings of the Eurogroup of Eurozone finance ministers and the Ecofin council of EU27 finance ministers, early next month and on September 16th, a special EU summit will debate the Van Rompuy report on economic governance. By early October, the European Commission is to table proposals for sanctioning budget offenders under a revised Euro Stability and Growth Pact.

DBR economist, Dr. Nicolaus Heinen, says the Eurozone responded to the major turbulence in financial markets with a gigantic rescue package worth €750 bn. This rescue package is a temporary measure. It is a protective cocoon that gives the Eurozone three years to reinvent itself and inspire new confidence in the economic future of the monetary union among markets and investors by implementing convincing economic governance. Initial proposals have now been published.

He says the EU and EMU  (European Monetary System) need an economic policy management model that delivers more than the hitherto implemented fiscal coordination and the latest ad-hoc responses to the crisis. Many people call it economic governance. What it actually means is the more effective management of national fiscal policies, the monitoring and correction of (negative) macroeconomic developments and a permanent crisis mechanism. First orientations regarding economic governance were agreed by the Council of European Heads of State or Government on June 17, 2010.

• In fiscal policy the effectiveness of the medium-term objectives (MTOs) of the preventive arm of the Stability and Growth Pact (SGP) is to be enhanced - - for example via sanctions, with national budget rules and medium-term budget planning by EU member states. The level of and trend in government debt are to play a bigger role in the SGP than has been the case up until now. Furthermore, from 2011 onwards stability programmes (Eurozone countries) and convergence programmes (non-Eurozone countries) are to be presented in the spring of the year before their adoption (“European semester”). This is intended to enable better coordination and timely action to correct negative developments. The quality of statistical data is to be assured via independent statistical authorities.

• The agreements on stricter macroeconomic surveillance specify the use of a scoreboard for assessing the developments in competitiveness and macroeconomic imbalances and flagging up negative developments in a timely fashion.

Ideas for joint economic governance are currently also being discussed in the task-force convened by President Van Rompuy. The task-force members comprise the finance ministers of the EU’s 27 member states, the Commissioner for Economic and Monetary Affairs, the president of the ECB and the president of the Eurogroup. The first proposals for the future management of economic policy in the EU and EMU are due to be published in early October. The comments of individual countries on the work of the task force are not publicly available. However, position papers have been published by the Commission (May 12th and June 30th), the ECB (June 10th) and the finance ministers of Germany and France (July 21th) with proposals for European economic governance.

Heinen says the DBR synopsis shows that the position papers contain both proposals for effective coordination of fiscal policy and macroeconomic surveillance as well as proposals for future crisis mechanisms for the EU and the Eurozone. They do have similarities, but there are also differences between them. He gives 3 grades: green for commendable; amber for ambivalent/imprecise and red for inadequate.

• The preventive arm of the SGP is to enable more extensive intervention in national budgetary policy in future - - for instance with a stronger focus on the sustainability of government debt and the stipulation that national budgets must be compatible with the SGP. The sanction proposed by the Commission and the German and French finance ministries is the lodging of interest-bearing deposits for member states that fail to comply sufficiently with the MTOs of the preventive arm. The ECB has not issued concrete proposals for sanctions, but has done so for surveillance mechanisms. It proposes the introduction of an independent fiscal agency to conduct permanent surveillance.

• For the corrective arm there is discussion on the one hand about speeding up the excessive deficit procedure (EDP), and on the other hand about quasi-automatic sanctions together with a reversal of voting arrangements: Commission proposals would then have to be rejected by a qualified majority of the Council – at present they have to be approved. This last proposal comes from the ECB and goes further than the provision originally agreed by European Council. The economist says this means there is no prospect of its implementation for the time being, because it would require a treaty amendment.

• The final recommendation made by the Commission and the Franco-German duo is for a European semester - - a phase in the first six months of each year when not only the national budgetary policies but also the economic policies of member states are coordinated for the following year. The ECB has not issued any proposals concerning this issue.

• The common feature of all macroeconomic coordination proposals is that they would like to install an early warning system with intervention measures administered by the Commission. The differences lie in the proposed indicators and the type and prospective severity of the sanctions. The strictest stance is taken by the ECB, which proposes sanctions modelled on the EDP. In this connection there is an interesting Franco-German proposal to enter into a political arrangement when voting is being conducted to achieve a de facto denial of voting rights. This would not require a treaty amendment.

• And finally, a crisis mechanism is proposed for countries in serious difficulties. All the parties involved are agreed that this crisis mechanism can only be activated under strict terms of conditionality in order to minimise the risk of moral hazard. While the Commission’s proposals focus on solutions and compliance with certain conditions, the ECB’s focus is on sanctions. This could hold even greater potential for conflict. Currently, however, this is not a problem as the existing crisis mechanism (EFSF) will not need to be replaced until 2013.

The DBR synopsis complements these comments). Nicolaus Heinen says three items need to be assessed individually.

• With regard to economic policy, the differentiation between proposals for Eurozone and non-Eurozone countries is likely to become an issue. Such a differentiation is made in the documents drawn up by the Commission and the Franco-German duo: potential sanctions and conditionality will play a lesser role with non-Eurozone countries. While this appears plausible at first glance, the question that soon arises is to what extent an economic “core Europe” could leave behind the non-Eurozone countries - - and thereby indirectly prevent them from joining EMU.

• The European semester is set to become the topic of extensive debate in political circles. One critical issue will remain the integration of national parliaments with budgetary prerogatives. They will insist on exercising these rights, and that is why a European peer review of draft budgets prior to the national budget process is currently not yet conceivable. Even integrating the European Parliament might not solve this constitutional problem. Nevertheless, the European semester would even then be a suitable instrument for effective coordination via the exchange of information and information transparency.

• Last but not least, another issue is to what extent quasi-automatic sanctions and a reversal of the burden of proof in the EDP would influence market perceptions. It is conceivable that in this case alone the triggering of the EDP could lead to major reactions by market participants. On the other hand, such a change in processes of this kind - - just like the European semester -- would be a clear sign of a paradigm shift towards more serious budget coordination that could be rewarded by the markets.

All three documents make references to the objectives of the Europe 2020 growth agenda. The economist says this gives reason to hope that this growth agenda may be more successful than its predecessor.

Leaving that aside, Heinen says it is currently still too early to assess whether the work of the task- force will actually make the EU and EMU robust enough to ride out the rough waters that may lie ahead. The outlook is, however, good, if the proposals made by the task-force are based on the recently published orientations. They show that European economic governance must not necessarily contradict principles of market order and incentive-compatible economic policy - - if it is properly designed.