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Related publication: 'Memo to Merkel: Post-election Germany and Europe'

When the new German government takes over after Sunday’s election in Berlin, it should not wait for long until it makes the euro area a central topic on its agenda.

Although the architecture of the euro area has been improved since the crisis hit, not all elements are in place to make monetary union work efficiently. Major risks remain: economic recovery is shallow, relative price levels adjust too slowly and hence public debt sustainability is far from being achieved. Unemployment numbers are high, the banking system is weak and decision making is complicated so that accidents such as the one of Cyprus can reproduce. All of those risks can undermine the stability of monetary union and would hence have serious repercussions on Germany. There is thus no time for complacency and more reforms are needed. We see three central elements that the German government should pursue, which include a change in the philosophy of crisis management.

First, while an overall inflation rate of 2% should be maintained for the euro area, it is in Germany’s interest to allow market forces to drive German inflation rates above 2% If this does not happen, the necessary relative price adjustment will drive inflation rates in the South of Europe to zero or even below zero. As a consequence, the ECB would miss its inflation target of close to but below 2%. More worryingly, simple simulations show that these developments may make it very difficult to guarantee debt sustainability in the South. Also, the balance sheets of banks, corporations and households would be further stressed. More financial aid to crisis countries would be the consequence unless governments decide to let a country default. The market-driven adjustment process in Germany would be greatly supported by a significant increase in public investment, both in infrastructure and education. On both counts Germany significantly underperforms the rest of the EU which risks undermining its competitiveness in the medium-term. The new German government should also carefully review which parts of the services sector could be liberalized to unleash the growth potential in this sector.

The second important task is to complete banking union. This is of central importance to end financial fragmentation in the euro area which currently makes a meaningful recovery in Southern Europe illusionary as investment will remain subdued. To complete banking union, the most important element is to agree on a centralized resolution authority with bail-in and fiscal back-stop. To achieve quick resolution that leads to less fragmentation along national borders, it is of central importance to create a mechanism that does not operate on a unanimity basis. There is still a fair chance that a decisive step in this direction before the European election would allow to overcome the banking crisis in the summer of 2014 finally ending fragmentation and restoring the foundations of growth, namely functioning financial intermediation.

To further support this process, the capital of the European Investment Bank should be increased and the activities of the EIB should be more targeted to meaningfully finance SME investment in Southern Europe. Moreover, the desperation of the Southern European member states to overcome unemployment should be taken seriously. A European Youth Unemployment Fund should provide support for training, incentive for corporates to hire and train youths and enable cross-border mobility. These measures should help prepare the grounds for deeper-running governance reform.

The overall strategy to reform the euro area governance structures should be changed. At the height of the crisis, it was crucially important to quickly create new and powerful instruments. Those included a stepping up of fiscal governance and economic policy coordination as well as the creation of the European Stability Mechanism. However, the ESM, which could turn out to become the center piece of economic governance in the euro area, has been created in an intergovernmental logic, in which every member state has a strong veto power. Germany, as the most important economy and the most powerful country, has become the central veto player in this set-up. This increase in power has gone hand in hand with a decreasing relevance of community institutions and in particular the European Commission. This development is neither in Germany’s nor in Europe’s long term interest as it undermines legitimacy and increase antipathy between countries. The more integrated Europe becomes, the more decision making will have to be done and legitimized at the European level. Well functioning community institutions can best define the common interest and can derive legitimacy from the European level. A meaningful transfer of competences in those areas needed together with the repatriation of competences in other areas should be combined with a transfer of parliamentary legitimacy. This will require a Treaty change and Germany should promote this among its partners.

Related publication: 'Memo to Merkel: Post-election Germany and Europe'