At a time when the EU most needs to stand together in its response to the crisis, member states have taken to bickering and quarrelling in public. This does not inspire hope for the deeper, fundamental changes to economic governance mechanisms that are urgently required. Without these, the future of both the euro zone and the EU does not look bright.

The EU’s collective response to the crisis exposed serious problems not just with the crisis management apparatus in the Union but also the deficiencies of economic governance during ‘peacetime’. These in turn are the result of not just an absence of technical and legal co-ordination mechanisms but also a lack of political will and leadership.

The EU’s response to the crisis, in form of 1) bank rescues, 2) increase of deposit guarantee protections 3) provision of bond guarantees 4) recapitalizations 5) handling of cross-border banks 6) fiscal stimuli and now austerity measures has been remarkably un-coordinated for an area that claims to be a ‘single market’.

Other disagreements have been exposed more recently in the response of the EU in general, and the euro zone in particular, to the problems surrounding the sovereign debt of Greece and other EU some countries. The public quarrelling and ad hoc approach that preceded both the rescue package for Greece and the bigger stability mechanism unveiled in the past few months seriously undermined the credibility and effectiveness of these packages.

This ad hoc uncoordinated approach to policy making in the EU is self defeating and unsustainable.  What should the EU do instead?

The decision to go for a single market, and in the case of several EU states – a currency union, without having in place sufficiently deep policy coordination mechanisms was always a risky one. As a result, the EU has landed itself in a fundamentally untenable situation. The current combination of an integrated economic reality and an insufficiently co-ordinated economic policy is a highly unstable one. The EU - the euro zone in particular need to make a choice between less union-less integration or more union-more integration.

The absence of sufficient political will for ‘ever closer union’ means that we need to work towards medium term second best solutions. These will fall far short of provisions for higher ‘fiscal transfers’ and ‘co-ordinated policy making’ that characterize other well-functioning single currency areas and well-integrated economic areas. What would they look like?

Better contingency management

The EU came into this crisis with few contingency tools. There was a near total absence, both at the level of the member states as well as the level of the EU, of tools to manage bank failures. This led to the near total chaos in policy making that characterized the EU’s initial response to the crisis. This point forward the EU needs to urgently put in place financial institution failure management tools both at the level of member states for national institutions as well as at the level of the EU for cross border institutions.

Similarly, the Greek debt crisis and the big disruptions in the sovereign debt markets, has underlined the absence of a systematic mechanism to tackle sovereign debt problems. The EU urgently needs to put in place a liquidity support facility for countries facing temporary disruptions in their capacity to borrow and a fair and predictable debt restructuring mechanism for countries suffering from unsustainable debt burdens.

Increased fiscal policy space and better co-ordination

While a more co-ordinated fiscal policy and a greater possibility of fiscal transfers between member states would ideally be part of a better EU wide governance mechanism, the current political appetite for this is low. Instead Member States have gone back to the Stability and Growth pact that underpinned the policy landscape in the run up to the crisis. The SGP was breached almost as many times as it was honoured. Even more important, many countries such as Spain and Ireland which were most faithful in meeting the demands of the SGP are actually the ones in trouble with their public finances now.

Some of the SGP’s fundamental flaws were that 1) it was based on numbers and outcomes without any root in policy co-ordination 2) it failed to distinguish between different causes of debt and deficit problems 3) in some cases, it could be procyclical imposing sanctions on countries in a weak fiscal position. Many of these flaws are also inbuilt into the ongoing discussions on revising the SGP which is again likely to fail.

Fiscal policy co-ordination this point forward needs to be based much more strongly on a better co-ordination of tax policy. A consolidated corporate tax base, collective stricter action against tax evasion and tax flight as well as an agreement on minimum rates for capital gains and income taxes on corporations and individuals would be steps in the right direction.

This move will be ably supported by an agreement to impose pan EU green and financial transaction taxes with a revenue sharing arrangement between Member States and the Commission. The revenues flowing to the Commission can be used for better pan EU infrastructure development as well as for building up a contingency ‘rainy day’ fund that can also be used for counter-cyclical fiscal policy. These revenues can also be used to finance the repayment of Eurobonds that can in turn be used to frontload infrastructure spending or in order to assist member states in trouble.

There needs to be a greater room for manoeuvre with respect to temporary deviations from debt and deficit restrictions in order to bring in counter cyclical elements into fiscal policy making.

More space for exercise of monetary policy within the euro zone

The economic structures of economies such as Germany and the Netherlands are very different from those such as Spain and Portugal. They came into the euro zone at different stages of economic development and with different national economic characteristics and the ‘convergence’ upon which the logic for a currency union was premised never really happened.

This meant that the ‘one size fits all’ interest rate that the ECB imposed on euro zone economies was too high for low inflation – low growth economies such as Germany and the Netherlands and too low for high inflation-high growth economies such as Spain and Portugal.

In the absence of closer political union and more co-ordinated economic policy-making, such asymmetries continue and will result in an increased build-up of intra EU imbalances and divergence in competitiveness of the kind that has helped precipitate the ongoing euro zone sovereign debt problems.

One way of mitigating such asymmetries would be to have a widespread introduction of credit reserve ratios, statutory ratios and sector specific variable prudential norms such as loan to value ratios for the real estate market that national central banks within the euro zone can implement. By mandating the holding of variable amounts of reserves and liquidity against the provision of credit, national central banks can in effect change the real interest rates in a country so as to make them more suitable for different economic structures and different stages of the economic cycle.

In the absence of political will for ‘ever closer union’, the EU needs to adopt a half way set of solutions that combine better policy co-ordination in areas such as tax base and contingency management with more policy space for member states in areas such as monetary policy and the exercise of fiscal policy through the economic cycle.