Designing a well-functioning euro area is crucial if we want to enable the enterprises, the workers and the consumers of the euro area to live and prosper together. There are three dimensions to reforming the euro area: institutional (what governance and what decision making process?); economic (what economic policy with what level of coordination, what fiscal rules and what adjustment mechanisms?); financial (what financial architecture and what mechanism to allocate capital inside the euro area?).
This Focus concentrates on the financial dimension and the concept of market discipline at the heart of it. Its key message is that asymmetry between debtors and creditors and the fiction of riskless assets can only feed the woes of the euro area.
Two preliminary remarks:
First, the fact that the euro is not a complete currency creates an intrinsic difficulty in building a coherent monetary area. The countries that have adopted the euro have given up the traditional prerogative of sovereign states to create money. Therefore, a debt issued by a euro area country is similar, from a credit risk standpoint, to a debt denominated in a foreign currency. As a consequence the debt of a euro area country can under no circumstance be considered as riskless.
Second, the architecture of a monetary zone can be based, at the two extremes, on market discipline or on the intervention of public authorities. Both ways of operating have their logic as well as their good and bad sides. But beyond this debate, one thing is certain: in order to be effective, the design of a monetary zone must be coherent with its underlying principle. Failing to do so creates a fundamental incoherence in the system.
This is the problem of the euro area today: in theory, market discipline is its governing rule; in practice, it is applied to debtors but much more reluctantly to creditors, which creates an unbalanced and structurally dysfunctional system...