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Europe, Stop Kidding the Markets!

Back to the euro zone, then. EU leaders speak at length about both the need to restore the credibility of the euro and to convince the markets of its longevity. But it takes more than words to do this, and actions speak louder than words.

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Many people have now bought into Professor Milton Friedman’s view, published back in 1999, that a monetary union without fiscal union is not viable in the long term. He meant genuine fiscal union, or at least some sort of central budgetary authority.

A “stability pact” is not such an authority, and will not convince the markets, if only because in its earlier form it was ignored by euro zone members when it suited them to run budget deficits larger than the Maastricht treaty allowed.

Looking at the proposed solution for the current crisis, and some new form of stability and growth pact, it is not clear to me how fining a country that is already in debt, and struggling to borrow from capital markets, is supposed to help. By then it will be too late as it implies the country has over-borrowed, again making it difficult then to pay the fine.

So how will further borrowing from the capital markets help the situation? We have already gone down this route with version 1.0 of the stability and growth pact and that didn’t work.

What is needed is an agreement, and then an undertaking, to make the euro work. This needs a centralized budgetary authority, which has control over the debt issuance process as well, to ensure that governments do not run up unsustainable public deficits. Tie that into a genuine lender of last resort role for the European Central Bank and we are almost there.

But the former must be announced first, otherwise the latter will not be enough. And it’s worth emphasizing this last point – some City commentators think that all that is required is for the ECB to be allowed to buy sovereign debtto any size it wants, and that solves the problem. No, it doesn’t, it just buys a few months of reduced tension.

The euro needs genuine fiscal union in parallel with an enlarged ECBrole to remain viable. The former will take some time to set up, which is why we need the latter as a short-term solution. But over the long term, both are needed, otherwise it is bye-bye to the euro in its current form.

It’s way past time that the EU stopped trying to kid the markets with words alone and no action. Time to make it work…

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The author is Professor Moorad Choudhry, Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland. The views in this article represent those of Moorad Choudhry as a private individual, and do not represent the views of Royal Bank of Scotland or of Moorad Choudhry as an employee of Royal Bank of Scotland.