Europe's bold vision hits trouble

Reuters

By Luke Baker and Paul Carrel

BRUSSELS/FRANKFURT, Oct 18 (Reuters) - Barely a year afterEuropean leaders set out an ambitious vision for the euro zone'sfuture, progress has all but stalled and pressure is buildingfor what may amount to a 'make or break' moment for the union.

The idea of a roadmap setting out steps towards the deeperintegration of the euro zone came about in early 2012, when thedebt crisis was at its peak and there were legitimate fears thatGreece could be forced out of the currency union, or that thewhole European project could disintegrate.

With the global economic debate dominated by the UnitedStates and, increasingly, China, the European Union risks losingits influence unless it can speak with one voice.

Herman Van Rompuy, the president of the European Council,which brings together the EU's member states, was asked byleaders to draft a report detailing what was required tostrengthen the single currency and overhaul the monetary union.

The plan involved working with three other topcrisis-fighting figures - European Central Bank President MarioDraghi, European Commission President Jose Manuel Barroso andthen president of euro zone finance ministers, Jean-ClaudeJuncker - on a document to be presented to leaders in June 2012.

The focus was on four 'building blocks' that would completemonetary union: a "banking union" to strengthen the bankingsector, a "fiscal union" to improve coordination ofbudget-related policy, an "economic union" to furtherintegration and finally a "political union" to make the projectmore democratic.

Van Rompuy presented a preliminary report, grandly titled"Towards a Genuine Economic and Monetary Union", to Europeanleaders in June and they gave him the go-ahead to develop theideas further, which took up much of the rest of 2012.

EU leaders' largely unequivocal backing for the plan gaveDraghi the cover he felt he needed to deliver his pivotal pledgejust a month later that the ECB was ready to do "whatever ittakes" to save the euro.

A couple of months after that he reiterated that it was upto EU leaders to define where they wanted to get to and that theECB would only act as a temporary bridge to help get there.

Fast-forward to the present day and the ECB is still holdingthe fort. Its as-yet unused OMT bond-buying plan has deterredspeculative attacks on the currency bloc, but the vision of amore integrated euro zone is almost entirely unfulfilled.

"That vision has hit the natural barriers of the existinggovernance structure," said Andrew Bosomworth, a seniorportfolio manager at Pimco, the world's largest bond fund.

"We're in a holding pattern, where it's really the ECBthat's doing the holding."

MEETING OF MINDS

While the relative recent calm in markets - with euro zonebond yields lower and the euro stable - has removed a lot of thepressure on governments to push ahead, the long-term goals havenot been forgotten by Draghi.

In a speech to students at Harvard last week, he talkedabout Europe's pursuit of "a more perfect union", and emphasisedhow the political will of Europe's leaders had helped hold theeuro zone together, against the expectations of some U.S. hedgefunds, which bet the region would shatter and lost money.

"They had underestimated the depth of Europeans' commitmentto the euro," Draghi said, adding that a "pragmatic focus onpolicy efficacy" should be the driving force for furtherintegration.

In that respect, Draghi's views marry closely with VanRompuy's. The relationship between the two, forged in the monthsafter Draghi took over the ECB in November 2011, is deep. Bothhave an iron grasp of economics and understood instinctivelywhat was needed to reassure financial markets about the euro'sfuture.

"You have to remember, they are both Jesuits by education,"an adviser to Van Rompuy said.

Among the principles Jesuits advocate is a pragmaticapproach to problem-solving and a willingness to learn fromexperience. One of Van Rompuy's favourite phrases is JohnMaynard Keynes's dictum: "When the facts change, I change mymind. What do you do?"

That mental flexibility and willingness to adapt to changingcircumstances may have helped weather the worst moments of thedebt crisis, when sticking rigidly to a single pre-set path mayhave proved disastrous.

Yet now the worst of the debt crisis appears to be over, itis exactly the issue of getting EU leaders to stick to the paththat has been laid out that is proving the problem.

Banking union was the first priority in the four presidents'"roadmap". While that step has been endorsed by heads of state -and slow but steady progress is being made towards it - there isvirtually no mention any longer of the steps that were supposedto come after: fiscal, economic and political union.

Even the timetable envisaged for banking union has slippedand its scope is being gradually scaled back. The complacencythat Barroso, Van Rompuy and others have repeatedly warned ofappears to have taken root.

Some see that as unsurprising given that the pressure is nolonger on in the same way that it was during 2011 and 2012.

"It was extremely important that they laid out their visionbecause it created a sense that they were ready to makeprogress," said Janis Emmanouilidis, a senior analyst at theEuropean Policy Centre, a Brussels think tank.

"But many people would say banking union is enough to handlethe situation for now. As for the steps that come after, I don'tsee the momentum towards that right now."

GAME CHANGER

That foot-dragging means the ECB is effectively alone inholding the euro together.

That is a cause of frustration among ECB policymakers, whoare concerned about uncompetitiveness and indebtedness in bigeuro zone countries like France and Italy. They are particularlyworried that France is trading on the credibility of Germany, asthe tight Paris-Berlin axis binds the two economies together.

Only a determined commitment to structural reforms - and thekind of deep fiscal and economic coordination once envisioned inthe "roadmap" - will help close the book on the crisis andprevent similar problems emerging in the future.

But what to do? The ECB's protection of euro member states has eased the impulse to put their own houses in order. If thecentral bank removed that umbrella to focus minds ingovernments, market pressure could return in a flash and plungethe bloc back into crisis.

The ECB shows no sign of taking such drastic action. Butofficials see a moment arriving soon when the ECB will putpressure on member states.

That moment is the review of bank assets that the ECB willundertake next year as the new single supervisor of the eurozone banking system.

The Asset Quality Review is expected to be a rigorousexercise in contrast to previous stress tests. To an extent, theECB's reputation is on the line. A tough review will show itmeans business.

If the review lays bare big holes in certain banks, thepressure will be on the home countries to press ahead not onlywith banking union, but with fiscal steps that will allow themto coordinate budget policy more effectively.

"Draghi and Merkel are in a staring match," said an EUofficial, describing a situation in which the ECB presidentwants member states to act while German Chancellor AngelaMerkel, as the most powerful leader, proceeds withcharacteristic caution.

"If the ECB decides to be really tough in the asset qualityreview, it's going to be a wake-up call delivered by the ECB tothe member states."

For Draghi, an independent central banker, it is a challengesince he cannot be seen to veer too readily into territoryreserved for political leaders. Monetary policy is his game.

And for Van Rompuy it is complicated by the fact that hismandate as European Council president ends in a year's time. Theoriginal roadmap was expected to take up to 10 years tocomplete, but if Van Rompuy's successor does not buy into it, itcould meet a very immediate roadblock.

The report the four presidents' drafted is close to Draghi'sheart, aides say. A stable monetary policy requires a stablefiscal policy and broader economic unity, they argue.

Ultimately, countries must decide if they are ready tosacrifice some sovereignty on the altar of the European projectfor the long-term vision to move steadily into focus.

Crunch time may be approaching in the form of a EuropeanConvention, which could allow euro zone leaders to make the leapforward to a more integrated bloc - or to acknowledge they havegone as far as they want to.

European elections next May will set the tone for the nextphase of the debate on Europe's future. The European Convention,possibly in the spring of 2015, could allow for changes to theEU treaty to open the way for more profound integration.

"The question then will be: are they just going to tinkeraround with the Treaty, or are we going to get a trulymeaningful change to it that will allow for the realization ofthe four presidents' report?" asked Pimco's Bosomworth.

"History shows no other monetary union of that genreendured, they either fell apart of evolved into a political andfiscal union," he said.

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