Euro's building blocks: Banking and fiscal unions

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Belief in the viability of the euro as a de jure and de facto legal tender and key transactions currency for an entire continent is at the core of all long-term euro area investments.

As is the case with any other currency, occasional spells of weakness – as is currently the case –just reflect the euro's economic fundamentals rather than validating the extreme views that the euro is an unworkable political fix doomed to failure.

The simple truth is that the euro and the European monetary union are irreversible achievements of a unique political quest called the "European project."

Even some of the most vocal Europhobes, such as the Front National (FN) in France, know that their votes are not coming from "ditch-the-euro" ideas. The FN – France's third-largest political party which more than doubled its membership to 83,000 in the last two years – understands that they get votes on issues of immigration, insecurity and protests against an unpopular Socialist government. But the FN leadership also understands that it cannot win by calling to leave the E.U. and NATO for a strategic partnership with Russia.

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Can there be an E.U. without the euro?

The answer is "no," if you want the E.U. as a genuine customs union of 28 nation states, originally founded by six countries that signed the Treaty of Rome in March 1957.

The reason is simple: A customs union cannot have import tariffs and export subsidies. That cardinal rule is instantly violated when a member country devalues its currency, because devaluation is equivalent to an import tariff and export subsidy. Conversely, a country whose currency revalues puts up an export tariff and an import subsidy that penalizes domestic import-competing industries.

Over the 42 years (a period from 1958 to 2000) of a customs union without common currency, Europe has witnessed hijacked Spanish and Italian trucks carrying fruit and vegetables being emptied on French highways for "unfair competition" whenever the peseta and the lira devalued against the French franc. That was followed by stormy sessions at various E.U. forums, threatening the cancellation of the union's free trade agreements.

Eventually, the customs union survived and the E.U. moved to build a single market for goods and services. But that single market now genuinely exists – or is substantially approximated -- only within the euro area.

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The genuine customs union and the single market are only the two most important examples of what the euro actually means for the E.U. "hard core" – the euro area – which is supposed to lead the process of economic and political integration of the entire continent.

This also explains the earlier claim that the monetary union is irreversible as long as the E.U. exists as an integration project focusing on peace and prosperity.

Banking and fiscal unions

How much that project still means becomes clear when one looks at desperate efforts and huge sacrifices some countries are ready to make in order to join their "European dream." And these are not just the highly publicized cases of Ukraine, Moldova and Georgia. A vast swath of West Balkans seeking the E.U. membership is not looking for protection from real or imagined military threats; the countries of that region – considered, along with Greece, as cradles of the European civilization – genuinely want to modernize and, as they say, to bring themselves up to "European standards."

That look from outside is the best testimony of what the "European project" stands for. And that may also give investors fresh insights into the viability of a union currently struggling with one of its most serious political crises.

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Luckily, important institutional building blocks continue to be put in place. The banking union is perhaps the most significant such event since the creation of the euro area. The regulatory and supervisory authority it confers upon the European Central Bank (ECB) will (a) strengthen the stability of the area's financial markets, (b) raise the effectiveness of the ECB's monetary policy and (c) improve the quality of economic management.

This big picture was lost in the recent coverage of the ECB's asset quality review (AQR) of the euro area's banking sector. That was unfortunate because the AQR was the first major step in the ECB's new functions. Tighter screws on the euro area banking system are on the way. For now, however, the structural changes of the area's financial system triggered by the AQR (recapitalizations, mergers and liquidations of unviable financial firms) are a major achievement. Equally important are the limits the banking union will put on national governments' ability to meddle in banks' management.

The fiscal union will be a much harder project because that would entail a huge loss of sovereignty for nation states. But, almost by stealth, that very sensitive transition process is already under way. Budget and public debt rules have been set. They are understood and accepted as binding constraints, subject to an intrusive supervision by the E.U. Commission.

France and Italy just had the taste of things to come during a contentious review of their 2015 budgets – before their respective parliaments had a chance to debate the program of national priorities. That is an entirely novel development.

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Formally, however, the full fiscal union will have to wait for further steps of political integration. As before, these steps will come as time and practice show that the budget process already in place has established a de facto transfer of fiscal sovereignty.

Investment thoughts

I believe it would be unwise to speculate against the euro's survival and viability as a rapidly expanding transactions currency and a reliable store of value.

The euro area economy has been grossly mismanaged during the last financial crisis, mainly as a result of election games in France (2011-12) and Germany (2010-13). The healing process is far from over.

There is a glimmer of hope, however, that less restrictive fiscal policies in France, Italy and Spain, and the possibility of the recovering bank lending to the private sector (now that the ECB's AQR is over), could set the stage for some improvement of economic activity later this year.

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Fixed-income assets are crossed out in my book, but bottom fishing in euro area's oversold equity markets looks quite appealing.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.