The EMU institutions need to be reformed. There is, however, a deep disagreement about the right way to proceed. Some see increased risk sharing and centralisation of decision making as being essential, while others emphasise risk reduction and market discipline. A recent paper by a group of French and German economists combines these elements in an interesting way.
The paper is the most promising blueprint for an economically sensible and politically feasible EMU reform to date. Still, it falls short of making market discipline on sovereign nations a credible approach, as it does not deal adequately with the problem of avoiding contagion when resorting to debt restructuring.
A way to address this difficult problem might be to give the crisis management body, the ESM or a future EMF, access to central bank financing with appropriate constraints. This would allow prompt and effective action to be taken in order to protect solvent member states against market pressures when debt needs to be restructured for the insolvent ones. On the other hand, one should ditch the idea of a fiscal capacity for cyclical stabilisation across member states, an idea also presented in the paper. It would be an inefficient means of reducing risk of financial instability, which is the fundamental problem of the EMU. Prudent fiscal policy during good times allows member states to smooth aggregate demand sufficiently well in times of crisis.