A New Monetary Union for Europe—Will It Work?

Another day, and another EU official talks up the future of the euro zone and its besieged currency. On Monday EU Monetary Affairs Commissioner Olli Rehn used a speech to lawmakers to outline his vision for a monetary union 2.0. Outlining plans to put the supervision of the European banking system in the hands of the European Central Bank, Rehn said even Europe’s smaller banks needed to be monitored by officials in Frankfurt.

A one Euro coin stands on a map of Brussels.
Sean Gallup
A one Euro coin stands on a map of Brussels.

"As we have seen in recent years, even small banks can be systemic and cause financial turmoil,” said Rehn, pointing to the examples of Northern Rock, Anglo Irish and Bankia.

Once the banks are properly supervised, Rehn said euro zone nations needed to cement their interdependence by moving towards fiscal union and enshrining sound budgetary policies that helped nations avoid unsustainable fiscal developments.

"This could in turn involve coordinated or even common — but limited — debt issuance, as long as the risk sharing is accompanied with commensurate steps towards common decision-making on budgets that safeguard against moral hazard and free-riding," said the Finnish Monetary Affairs Commissioner.

If this could be delivered with budgets brought into balance or surplus coming alongside some form of common issuance of debt, then we would certainly be moving towards the euro 2.0 that Rehn referred to in his speech. However, the problem remains getting there as investors across the world turn their attention to Europe for two weeks of crucial meetings.

Market sentiment is this week likely to be driven by Thursday’s ECB meeting at which some investors hope for more information on how Mario Draghi will deploy his so-called big bazooka. On Monday he told lawmakers that the ECB buying short-term national debt would not mean the central bank had breached its own rules.

"If we are in the short term part of the market where bonds have a length of time maturity of up to one year, two years, or even three years, these bonds will easily expire."

"So there is very little monetary financing effect at all in what we are doing,” said Draghi.

European stocks and the euro moved higher on these comments but investors hoping for more on Thursday are likely to be disappointed. Draghi has made it clear the ECB will only intervene in the market once nations have asked for assistance from the European Financial Stability Facility, something both Spain and Italy are highly reluctant to do. This could of course change, but the chances of it changing before Thursday are pretty low.

The tone though has definitely softened from the rich northern countries which would have to sign off on any bond purchase. The finance minister of Luxembourg told CNBC it is in the interests of the richer north to help periphery.

“I think it is in our interest to help others, to help ourselves. That's true for Luxemburg, that's true for Germany. We are not just doing this out of solidarity as important as that is, but we're also doing this to stabilize our financial institutions and thereby our economies,” said Luc Frieden in an interview with CNBC on Tuesday.

“Therefore in the short term, taxpayers might be tired, may not understand everything, because they don't see the food in the short term, but if they think well in the long term I think it's worthwhile fighting for having a common currency area even if that might be an area that changes a little bit,” said Frieden.

Even the German Chancellor is talking up European solidarity, claiming she may be able to succeed where others have failed during the debt crisis, namely in being re-elected.

"We have to say, you must make changes — we know from Germany that that's the only way things get better. It is not enough to continue like this. But I also say that, in such a difficult phase, these countries deserve our solidarity, that we want them to overcome these difficulties," said Amgela Merkel while drinking a beer in Bavaria on Monday.

Talking up European solidarity and signing off on the ECB buying up huge amounts of Spanish and Italian debt are not the same thing though.

Some money managers are betting that over the next two to three months the euro crisis will ease and are predicting that by the end of the year things will look far more positive.

“My fund is up 10 percent this year and my clients are asking if I will just give up and protect that gain,” Michael Browne, a fund manager at Martin Currie told CNBC.com. Browne believes too many investors are betting on a negative outcome but he is trying to decide whether to bet big on a positive outcome.

“If the policy makers get their act together the upside for non-defensive cyclical stocks could be huge,” said Browne.

Getting to the promised land may not prove very easy, as anyone who has followed the euro zone debt crisis over the last two and half years will know only too well.

“We are not dissuaded from our outlook for a prolonged economic downturn in Euroland, an event more akin to a Great Depression of the 1930s than to any business cycle we have seen in our lifetimes,” said Carl Weinberg from High Frequency Economics in a research note.

Weinberg has been consistently bearish on the euro zone debt crisis and its impact on the economy. With much of Europe stuck in recession it is difficult to argue with the man who thinks euro zone policy makers have only managed to delay the inevitable despite meeting after meeting on how to save the euro.

“Our only error has been to underestimate the time frame in which the episode will play itself out,” said Weinberg.