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The euro has eliminated exchange risk, lowered inflation, increased trade and more tightly integrated markets. Kai Pfaffenbach / Reuters
The euro has eliminated exchange risk, lowered inflation, increased trade and more tightly integrated markets. Kai Pfaffenbach / Reuters

Reforming Europe's institutions is key to future of the euro

For the European project to succeed monetary union must be accompanied by other kinds of union including a banking union; a fiscal union; a 'competitiveness' union and a political union.

The euro zone will not break up. The price of departure is simply too great for any one country. Indeed, when Mario Draghi announced on September 6 that the European Central Bank (ECB) would undertake unlimited purchases of government bonds, the continent crossed the bridge to its future.

Europe's leaders must see that the drawbridge has been lifted behind them. They cannot back out of this, and thus must steel themselves for the journey ahead. Moreover, they must also realise that for the European project to succeed, monetary union must be accompanied by four other kinds of union: a banking union; a fiscal union; a "competitiveness" union, or convergence; and, to all intents and purposes, a political union.

The euro itself has provided major economic rewards: it eliminated exchange risk, lowered inflation, increased trade across the euro zone, and more tightly integrated financial markets.

The crisis, however, surfaced critical flaws in the euro zone's structure. Europe lacked a strong and common fiscal policy; divergence in competitiveness between the northern and southern economies created a risk of default that had gone unrecognised; and the absence of a banking union created intolerable systemic risks. Adding fuel to the fire, the complexity of European political institutions, and the increasing democratic deficit that it represents in the view of the public, has led to an "executive deficit": an inability to make real decisions.

What is clear is that the euro must survive in more or less its current form, but the deficiencies in the institutions that surround it must be addressed.

The first is a banking union, an absolute prerequisite for a monetary union to succeed. A robust banking union must have shared bank supervision, a shared bank recapitalisation mechanism and a shared bank deposit guarantee. The good news is that the first of these was put in place in September with the proposal of a single supervisory mechanism under the ECB. The two other items are destined to follow.

As the talks of a banking union drag on, they will inevitably lead to discussion of a fiscal union, as the different pieces are intertwined and complement each other - the idea of a banking union without a fiscal backstop makes little sense. There will be three parts to any kind of fiscal union in Europe: a programme of direct bank recapitalisation; an European Union-wide system of deposit insurance that both prevents a run on banks in weaker countries and reduces moral hazard; and some form of debt mutualisation.

Before the anti-federalists recoil in dismay, it is important not to fall prey to binary thinking - it is not "everything or nothing". Between no fiscal union of any kind and a fully-fledged "United States" or Swiss-style confederation, many possible intermediate states exist that would contribute to a much greater sense of fiscal solidarity and discipline.

Reform of European financial governance is a necessary but not sufficient condition for success. It will not be able to gloss over the major issue at the centre of the crisis: the competitiveness gap between Europe's north and its south. Fixing the EU banking system and regaining macroeconomic stability will do a lot to help southern countries increase their productivity but, importantly, these countries will need to engage in a long-term project to increase their labour market flexibility and foster competition and competitiveness.

A crucial consequence of all these reforms must be the injection of entrepreneurial energy into the continent's "lost generation". Youth unemployment is a cancer at the heart of the European economy, stealing its future and sapping its growth potential for decades to come.

The good news is that reforms are under way. Despite slow progress, the "Europe 2020" strategy is designed to kick-start competitiveness in the region. I believe that the path ahead is clear, that Europe's leaders will begin to look forward with hope and optimism and not backward with fear, and that Europe is more likely to confound the pessimists as the year ahead unfolds.

Professor Klaus Schwab is the founder and executive chairman of the World Economic Forum. His ebook, The Re-Emergence of Europe, is published today and available free of charge at http://www.weforum.org/re-emergence-europe

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