Financial Markets Matter More than Fiscal Institutions for the Success of the Euro

Abstract

Many argue that the euro is handicapped as a currency because European governments are unwilling to pool responsibility for fiscal policy in common institutions. This argument is derived from the theory of optimum currency areas and fuelled by analogy with US experience. It is mistaken. A monetary union does not need a fiscal union to work. Worse, efforts to build European fiscal institutions are likely to distract European policymakers from a more important agenda. Europe needs a fully functioning banking union with a common risk-free asset if Europeans want to stabilise the euro as a common currency. Moreover, it would need these things even if the euro did not exist and all it had was the common market. Financial stability – and not fiscal federalism – is the key to Europe's future. European policymakers should focus their efforts on building the necessary institutions.