Recognising the fact that the budgetary problems which some Member States are confronted with are to a large extent rooted in the erosion of international competitiveness and the resulting build-up of macroeconomic imbalances, the EU has also introduced a procedure which aims at preventing and, if necessary, timely correcting macroeconomic imbalances in the Member States. This MIP was set up in December 2011 as part of the Six Pack legislation. An alert system was established based on a scoreboard consisting of a set of currently eleven indicators covering the major sources of macroeconomic imbalances: current account balance, net international investment position, export market shares, nominal unit labour cost, real effective exchange rate, private sector debt, private sector credit flow, changes in house prices, general government sector debt, unemployment rate, changes in total financial sector liabilities. For each indicator, alert thresholds have been defined to detect potential imbalances. The MIP has also a corrective arm, the Excessive Imbalance Procedure (EIP)3 .

2 These information have been taken from the homepage of the European Commission: <http://ec.europa.eu/economy\_finance/articles/governance/2012-03-14\_six\_pack\_ en.htm>.

3 See <http://ec.europa.eu/economy\_finance/economic\_governance/macroeconomic\_ imbalance\_procedure/index\_en.htm>.

It is quite hard to assess how appropriate the design of the new institutions is with respect to handling the current crisis and in particular regarding their potential to make the euro area more resilient to future crises (Honkapohja 2013). However, while at the beginning of the crisis European policy makers were reacting rather than acting, in the course of time policy-making has become more pro-active so that the euro area should now be better suited to withstand future negative shocks.

#### 5. Banking union

With the introduction of the euro and the deepening of the common capital market, cross-border banking activities increased substantially, but since 2008 a new disintegration can be observed. This development can be exemplified with respect to the share of foreign assets in Austrian Bank assets. As an example, the share of assets of Austrian banks invested abroad – mainly in other European countries – rose from 28% in 2000 to 39% in 2007. However, in the second Quarter of 2013 only 32% of the assets of Austrian banks were invested abroad (thereof 32% in the euro area, 72% in the EU and 56% in Eastern Europe: BIS 2013, OeNB 2013). Sovereign bonds of a country are held by banks and investors in all countries of the euro area. In 2013, foreign investors held around 70% of Austrian, 57% of German and 35% of Italian sovereign debt (IMF 2013a).

For overcoming the euro crisis and establishing a growth-promoting capital market, it is crucial to break the vicious circle between banks and sovereigns4 . This hinges on three conditions: (i) States reduce their debt; (ii) on the capital markets investment decisions are grounded on economically realistic risk assessments rather than on fear driven speculation; and (iii) profitable banks build up more equity and are more resilient, while unprofitable banks can default in a controlled manner. The banking union aims at (ii) and (iii) in order to make the financial system safer5 .

Capital will promote growth only if it flows to those investment projects which yield the highest risk-adjusted profit. Interest rate differentials should reflect an economically justifiable risk and should not be driven by speculation and self-fulfilling prophecies. Speculative capital flight from the crisis countries and a withdrawal of unsettled investors into the safe havens of the north are harmful. Capital flight threatens the existence of banks since it disturbs the re-financing of loans with deposits; in this respect, capital flight

4 An imminent sovereign default devaluates government bonds and endangers banks which are holding these assets. The other way round, a necessary bank rescue puts sovereigns into difficulties, since capital injections into the banking system increase public debt.

5 An introduction to this discussion with many contributions can be found in e.g. Allen *et al.* (2013), Beck (2012), CESifo (2012) and IMF (2013b).

could aggravate an otherwise manageable crisis. A retreat into the safe havens leads there to artificially low interest rates and over-investment which are no longer profitable at normal interest rates, and could thereby sow the seeds of a new crisis.

Under Basel III, banks must build up more capital and higher liquidity buffers. Profitable banks can get equity from the capital market or through retained earnings. None of these options is available for unprofitable banks. Without a fundamental restructuring, a sustainable recovery of the European banking sector will be very difficult to achieve and take excessively long. The imminent possibility of a controlled bankruptcy of banks is a powerful incentive to pursue less risky strategies, and it is a prerequisite for stricter market discipline.

On 15 October 2013, the Ecofin Council adopted the Regulation on the Single Supervisory Mechanism (SSM) with the transfer of supervisory tasks to the ECB. The SSM has the following cornerstones:

After the Council agreed on general principles of the Single Resolution Mechanism (SRM) on 18 December 2013, the following cornerstones of the banking union became known:

6 In November 2013, guaranteed deposits in the euro area amounted to about 5,910 bill. euro, of which Austria accounts for about 180 bill. euro. In the long run, the resolution fund shall accumulate 59 bill. euro, of which Austria accounts for 1.8 bill; calculated on the basis of IMF Technical Background Notes (2013b: 43), European Commission (2010), and updated with ECB MFI statistics.

The exact rules of the SRM still have to be clarified in the legislative process, particularly regarding the complex voting procedures, the composition of the Board meetings in different cases and the backstop in case of an overburdening of the fund. However, the finalisation of the rules may not delay the decision-taking process. In the event of a crisis, the SRM must be able to act quickly, within a day. The costs for the security of the taxpayers are higher bank fees, which the banks have to earn first. In addition to higher bank service fees, either the lending rates will rise, or interest rates on deposits and other borrowings of the banks will decline, or the return on equity will decrease. Higher lending rates inhibit real growth. If banks reduce interest rates for savings deposits and other debt, then they get in trouble to refinance themselves, which would force them to reduce their credit supply. A lower return on equity would be justified if the banks became safer, and if risk-bearing equity investors would be content with a lower risk premium. However, in Europe the banks' profitability and return on equity are already very low, and the banks must also increase their higher equity ratios. In case the build-up of equity is difficult due to low yields, then a higher equity ratio can only be achieved with a reduction in loans, which in turn inhibits growth. In any case, the costs of financial stability must be priced in and can be reflected in higher lending rates and a lower loan volume.

It may be doubted that a resolution fund in the amount of 1% of guaranteed deposits is sufficiently large. If the capacity of the SRF turns out to be not sufficient, contributions must be increased. That depends on whether the higher security of banks sufficiently reduces the number of bankruptcies or resolutions, and how often the participation of the private sector in losses is sufficient. In the long run, the capacity may be sufficient. Much larger problems might arise in the process of establishing the fund, since during this phase the banking sector has to be restructured and the legacies of past failures have to be adjusted. During 2014, the ECB had to pursue a stress test and check the quality of the bank assets. This might reveal equity gaps and a number of de facto insolvency. Since in the initial phase the common fund is not yet available and the national funds still have to be endowed with capital, it will again be the governments who have to step in and go into debt, and eventually they may be forced to ask for ESM assistance again.

If the contributions are not actuarially fair, insurance will lead to crosssubsidisation and to excessively risky activities of the subsidised banks. Therefore, banks with riskier activities and less equity must pay higher insurance premiums. The banking union rules correctly claim that the contributions are based on the risk profile of the banks. Contributions should vary not only between banks within a country but also between countries. In countries with higher loan and deposit risks, banks should pay higher premiums. However, this is not adequate if a country is in crisis. In this case, the insurance principle without any redistribution can only work if the credit risks differ little between countries. This is possible only after the bank sector has been restructured with banks being either recapitalised or closed down, and after winding down excessive debt of borrowers. This justifies the gradual pooling of the insolvency fund. Costs of bank liquidations which are incurred already in the first year after the loss participation of private investors will be financed by the respective country. Afterwards national participation decreases, while the costs are increasingly financed by the common insolvency fund. If a solidarity and redistribution in the euro area is desired, then this should not be achieved by non-transparent cross-subsidisations of the banking sector, with distortions of competition and of the risk-taking behaviour of banks, but from taxpayers to taxpayers.

The deposit insurance remains national, but should be harmonised and guarantee 100,000 euro per customer and bank in all Member States. The payments are to be made faster. It is intended to set up deposit protection funds in each Member State, to the extent they are not already in place, and to build up reserves from contributions of the banks. As things stand, a mutual borrowing of the national deposit insurance funds should be possible on a voluntary basis. However, this is not systematic re-insurance of the national funds at the European level. A re-insurance would allow additional welfare-enhancing risk diversion between Member States and reduce the risk of capital flight by uncertain depositors. A re-insurance needs rules for borrowing of national funds at a central unit (own central deposit insurance fund, or as part of the central resolution fund SRF or of the ESM), together with an automatic increase of national contributions so that the debt is again repaid ex post. Otherwise, the national funds must ultimately be guaranteed by the Member States themselves, which in the worst case would have again to apply for emergency bridge financing from the ESM.

Special taxes for the financial sector are often justified by the claim that the banking sector is in large part responsible for the financial crisis and should thus pay for the costs. One problem with this is that just the most prudent banks would in the end have to pay for the insolvencies of their most aggressive competitors with particularly risky business models. Special levies on the financial sector should not be charged ex post to finance losses that have already occurred. They make sense only if they serve to prevent future crises. They should ex ante limit excessive risk-taking and correct misdirected incentives. The rationale for corrective taxes disappears if the external costs are already internalised with regulatory measures and risk-based insurance premiums. Since implicit government guarantees for banks will no longer exist, prices for such guarantees in the form of special bank taxes are not justified. They should be eliminated step by step with the building-up of the insolvency fund. Banks should pay no more and no less taxes than other companies.

The banking union should break the vicious circle between banks and sovereigns. This is partly inhibited by the rules that for the calculation of required equity under Basel III rules, government bonds get a risk weight of 0%, while corporate loans are weighted with 100%. Contrary to the experience of the euro crisis, government bonds are classified as absolutely safe, Greek as well as German. The preferred treatment of sovereign debt could be responsible for the credit crunch in the crisis countries. Especially in the crisis countries, banks have major problems with the compliance to the equity standards. They therefore invest in domestic government bonds as these yield high returns because of the high risk premium, but are considered to be absolutely safe and therefore do not require extra equity capital. It would therefore be worthwhile to take account of the actual risk of public debt when calculating required equity.

#### 6. Macroeconomic and fiscal adjustments in the Member States

In this section, the macroeconomic adjustment progress which the crisisstruck countries have made so far is evaluated7 . The global financial and economic crisis hit the euro area Member States via different channels and to different extents. While some countries, particularly Austria and Germany, experienced only a temporary drop in economic activity, followed by a quick recovery, countries with structural problems were thrown into a deep crisis. In Ireland a real estate bubble burst; at the same time the banking sector which had established itself as an international financial centre thanks to attractive taxation regulations, came into severe difficulties. Greece slipped into a severe crisis once investors realised the risks associated with the high public debt. The government had to concede that the true level of public debt was higher than officially published so far. In turn, risk premiums rose substantially, making it impossible for the Greek government to finance its public debt via capital markets. Furthermore, the erosion of international competitiveness of the Greek economy became increasingly visible, and the growth prospects deteriorated, giving rise to increasing concerns regarding the sustainability of public finances. The coincidence of high public debt and declining international competitiveness was also the main cause of the economic crises in Portugal and Italy, while Spain was confronted with different problems. There, public debt belonged to the lowest levels in the euro area prior to the outbreak of the global financial crisis. The recession of the Spanish economy was caused by the bursting of a real estate bubble which led to liquidity and solvency problems in the banking sector as an increasing part of loans became non-performing. In conjunction with the declining international competitiveness of Spanish companies and fast increasing unemployment, this resulted in rapidly rising public debt. In Cyprus the problems were caused by trouble in the banking sector which was also too large in relation to GDP. In addition, the Cyprus banking sector had been hit particularly hard by the haircut on Greek public debt.

7 This section draws on Joint Economic Forecast Project Group (2013: ch. 6).

In expectation of euro area membership, these countries experienced a substantial decline in long-term interest rates. This 'euro dividend' seemingly relaxed public and private sector budget constraints. Substantially lower interest costs and easy access to debt financing undermined incentives for cautious public spending and led to overly expansionary private spending, in particular in the construction and real estate sectors. As a consequence, domestic absorption rose significantly faster than domestic production. Rising employment reduced incentives for wage moderation and labour market reforms. The price level increased faster than the euro area average and continuously eroded international price competitiveness. High domestic absorption in conjunction with declining competitiveness resulted in the accumulation of high current account deficits and external debt. These divergence processes were fuelled by the fact that the common monetary policy of the ECB, which by design has to be adapted to the euro area average, was too expansionary for the peripheral countries.

During the boom, in most of the peripheral countries economic structures have emerged which the crisis has unveiled as not being sustainable. In some countries (in particular Spain), the construction sector, in other countries (Ireland, Cyprus) the banking sector became too large in relation to the overall economy. Now these sectors shrink very fast, while the re-allocation of production factors needs time. As a precondition for new growth, the countries must re-gain international competitiveness. Not only wages and prices must be aligned with productivity, but also the production structure needs to adjust to international demand. High-quality goods and services at internationally competitive prices are needed to expand the export sectors and import substituting industries which adds to new domestic investment, employment, and consumption. Sustainable economic growth is also a precondition for the ability to repay public debt in the medium to long run.

Since the outbreak of the financial and economic crises, the peripheral countries have made substantial progress in bringing prices and wages in line with productivity. They managed a real devaluation and a reduction of current account deficits. In addition, significant cuts in public spending and tax hikes, which have been agreed with international lenders in exchange for financial assistance, have reduced public deficits. In the following, we document the adjustment progress in the crisis-struck countries8 . For the assessment of the adjustment progress, the following indicators are taken into account:

• Public finances. One of the main reasons for the crisis was the fact that the sustainability of public finances was increasingly questioned by international investors. Restoring sustainable public finances requires a balanced budget to stabilise the debt ratio. It is unrealistic to expect an

8 Cyprus is not considered due to the short time period elapsed since the outbreak of the crisis.

immediate decline in the public debt ratio in the crisis-struck countries. In most cases the debt ratio is still increasing due to the 'adjustment recession' in the real economy as well as the negative impact of fiscal adjustments on private and public demand. Both factors contribute to low or even negative economic growth, resulting in high unemployment. Furthermore, the debt level is increased by financial assistance to the banking sector. We assess fiscal adjustment with respect to the overall budget balance and the primary budget balance, both in relation to nominal GDP.

The following figures visualise the development of these indicators over the period 1999 to 2012. For most indicators, the forecasts of the European Commission for 2013 and 2014 are also shown (European Commission 2013). This makes both the emergence of the imbalance after the introduction of the euro in 1999 and the achieved adjustments since the outbreak of the crisis in 2008 visible.

Due to the working of automatic stabilisers, fiscal stimulation packages and financial support to the banking sector, public finances markedly deteriorated in nearly all EU countries during the 'Great Recession'. Since 2008, all countries considered here were able to reduce their budget deficits considerably, at least until 2011 (Figure 1). Ireland reduced its budget deficit from 14% in relation to GDP in 2009 and even 31 percent in 2011 to 7.6% in 2012. In Greece, Portugal, and Spain, in 2012 the budget deficit rose again somewhat due to the recession. With a deficit ratio of 3.0%, Italy exactly fulfilled the Maastricht deficit criterion in 2012. Furthermore, among the countries considered here Italy is the only one which has achieved primary budget surpluses in each year since 1999, except for 2009 (Figure 2). On the other hand, improving budget balances have nowhere been sufficient to reduce public debt levels (Figure 3). In Greece, the decline is exclusively attributable to the 'haircut' that became effective in March 2012.

Figure 1 – Public fiscal balance in relation to GDP (%). Sources: Eurostat; 2013 and 2014 forecast EU Commission; own illustration.

Figure 2 – Primary fiscal balance in relation to GDP (%). Sources: Eurostat; 2013 and 2014 forecast EU Commission; HIS.

Figure 3 – Public debt level in relation to GDP (%). Sources: Eurostat; 2013 and 2014 forecast EU Commission; HIS.

Figures 4 to 6 document the adjustment which has been achieved in terms of international competitiveness and the resulting re-balancing of the current accounts. In order to put the adjustment in the crisis countries into perspective, the development of the two most competitive economies in the euro area, Austria and Germany, is also depicted. Between 1999 and 2007, the crisis countries experienced a real appreciation as measured on the basis of the trade-weighted real effective exchange rate with respect to 36 trading partners (Figure 4). Their international price competitiveness deteriorated sharply during this period. The appreciation was particularly pronounced in Ireland and in Spain with 22% and 20%, respectively. The other countries experienced more moderate increases of their real exchange rates by 3% to 7%. The development of the real effective exchange rate is in part determined by the development of the nominal exchange rate of the euro. Since this movement of the nominal euro exchange rate is common to all euro area countries, it does not influence the relative price competitiveness of the euro area countries *vis-à-vis* the other Member States. Excluding the nominal effective appreciation of the euro between 1999 and 2007, Ireland and Spain experienced a real appreciation of 14% and 17%, respectively. Since the beginning of the crisis, all considered countries achieved a real depreciation. With 17%, the correction was most pronounced in Ireland. As Figure 4 shows, the loss of international competitiveness which the countries had incurred after the introduction of the euro until the outbreak of the crisis has already been largely corrected, except for Spain. As can also be seen, the countries could not improve their relative competitiveness compared to Germany, since Germany improved its competitiveness further in the recent past. In contrast, the relative real effective exchange rate of Austria remained more or less constant.

The real appreciation which the considered countries experienced between 1999 and 2007 was largely determined by wage increases in excess of productivity advancements. As Figure 5 shows, this resulted in a sharp rise of unit labour costs. The figure depicts the development of this indicator relative to the euro area average. In Ireland the rise in unit labour costs exceed the respective increase in the euro area average by as much as 20% until 2007. Since the outbreak of the crisis, all considered countries with the exception of Italy made significant progress in correcting this loss of price competitiveness *vis-à-vis* the other euro area Member States. Particularly in Greece, wage cuts have resulted in a remarkable correction of unit labour costs. Due to somewhat higher wage increases in Austria and Germany, reflecting the favourable labour market development in these two economies, unit labour costs increased relative to the crisis countries.

Figure 4 – Real effective exchange rate (on the basis of GDP deflators) (index, 1999 = 100). Sources: ECB; HIS.

Unit labour costs are calculated as compensation of employees divided by labour productivity. Labour productivity is defined as real GDP per employee.

Figure 5 – Unit labour costs, relative to euro area average (index, 2000 = 100). Sources: Eurostat; 2013 and 2014 forecast EU Commission; IHS.

In 2012, all countries except for Ireland had current account deficits (Figure 6). However, the extent of the deficits varied considerably between countries, ranging from just 0.7% in relation to GDP in Italy to 7.7% in Greece. After the introduction of the euro, the current account deteriorated sharply in all considered countries, except for Portugal which entered the euro area already with a sizeable current account deficit of almost 9% of GDP. The largest current account deficit was reached in 2008, i.e. during the financial and economic crisis. Since then, the countries managed a remarkable improvement of their current accounts. The real depreciation brought about by wage and price restraints are bearing first fruits. However, the pace of adjustment varies markedly between countries. While Ireland achieved already surpluses, the current accounts of Greece and Portugal are still deep in negative territory. However, according to the forecast of the European Commission, in 2013 and 2014 all countries except for Greece should achieve current account surpluses or, in the case of Portugal, at least a balanced current account. Germany was able to maintain its current account surpluses in the recent past, indicating its high international competitiveness which goes beyond relative prices, since the German, as well as the Austrian economies are specialised on the production and export of high-quality investment goods which are highly demanded on the world markets.

Figure 6 – Current account balance in relation to GDP (%). Sources: Eurostat; 2013 and 2014 forecast EU Commission; IHS.

Clearly one main reason for this improvement was the collapse of domestic demand and hence of imports due to deleveraging of private households and companies, very high unemployment and the negative impact of the necessary fiscal consolidation measures on demand. But in addition to decreasing imports, rising exports also contributed to the improvement of the current account. As Figure 7 shows, exports declined sharply in the worldwide economic crisis, but meanwhile started to recover. In Ireland, Portugal and Spain real exports of goods and services already exceed their pre-crisis levels.

Figure 7 – Export development since 2007. Sources: Eurostat; IHS.

The financial crisis revealed clearly that many banks in the euro area were too weakly endowed with equity. Due to the recession, more and more loans to the private non-financial sector became non-performing. As Table 1 shows, e.g. in Ireland the share of non-performing loans soared from below 1 percent prior to the crisis to almost 19 percent in 2012.

*Table 1 – Bank non-performing loans in % of total loans.*

Source: World Bank, World Development Indicators.

Due to the systemic relevance of banks and the importance of a stable credit supply to the private sector, governments had to re-capitalise banks, further raising budget deficits and public debt levels. As a consequence, the new regulatory framework initiated at the European level requires that banks have to hold more equity. These new regulations have already resulted in considerable improvements in the capital endowment of European banks, as Figure 8 shows. However, the recapitalisation of European banks is not yet completed. The OECD estimates that the current capital shortage amounts to around 400 billion euro (4¼ percent of euro area GDP) if the euro area's largest banks were to move to a standard of a 5 percent tier 1 capital ratio. According to the OECD, this is not just a problem for banks in the periphery, but there could be large capital needs in the major euro area countries (OECD 2012).

Figure 8 – Tier 1 capital ratios of banks in selected European countries. Source: European Central Bank.

The adjustment of international price competitiveness, but also regarding the banking sector reforms, has strengthened the confidence of international investors into the financial and macroeconomic stability of the peripheral euro area countries. This is visible in a reversal of capital flows. As an example, Figure 9 shows that the withdrawal of bank deposits by non-residents in the banks in the peripheral countries recently started to reverse.

The improvement in the economic and sovereign debt situation of the peripheral countries led also to a reduction of the Target liabilities of these countries (Figure 10). During the crisis, the Eurosystem compensated the interruption and reversal in capital flows by shifting refinancing credit among national central banks. The increase in Target liabilities is a direct measure of net payment orders across borders, i.e. of the portion of the current account deficit that is not counterbalanced by capital imports, or, equivalently, the sum of the current account deficit and net capital exports. Indirectly, they also measure a country's amount of central bank money created and lent out beyond what is needed for domestic circulation. The reduction of these liabilities can therefore be regarded as an indicator for the increase of private capital flows to the respective countries.

Figure 9 – Bank deposits of non-residents in banks in selected countries. Sources: Bank for International Settlements; IHS.

As the previous analyses have shown, all considered countries have made progress in the adjustment towards sustainable public finances and a competitive economy. However, the speed of adjustment as well as the achieved progress varies considerably across countries. Among other factors, the extent of the accomplishment depends on the starting point of the reform progress. At least the real effective exchange rate has in the meantime depreciated in all considered countries, and this improvement in international price competitiveness has resulted in a sizeable decline in the current account imbalances. This was not only due to recession-induced shrinking imports, but also to rising exports. The recapitalisation of banks in the crisis countries has also made progress. The need for strengthening the capital basis of banks is underscored by the evidence that the de-leveraging process of banks in the peripheral countries has contributed to a fall in longer-term loans flows which became negative in the second half of 2012. Supply factors contributed significantly to this development. This has also international repercussions since banks are often the dominant source of funding in emerging and developing economies, and international banks in general and European banks in particular play a key role in their financial systems. Therefore, the impact of European bank deleveraging and tighter credit conditions is directly transmitted to the rest of the world (Feyen, Gonzalez del Mazo 2013).

Figure 10 – Balances in the Target2 system of the ECB. Sources: Ifo institute; IHS.

Differences in the adjustment progress are considerably determined by divergences regarding regulations and institutions. It is striking that among the considered countries, Ireland, the country with the largest progress in the macroeconomic adjustment, is ranked highest regarding competitiveness in the competiveness indicator of the World Economic Forum (WEF). This ranking is also reflected in the ease of doing business indicator of the World Bank. At the other end of the country spectrum, Greece and Italy are ranked at the bottom of all OECD countries, clearly indicating their deficiencies regarding structural change and institutional development (quality of legal system, tax administration, bureaucracy, competition reducing entry barriers and protection of rents, corruption, shadow economy etc.).

It can be concluded that the adjustment process is tough and slow, and the road towards sustainable public finances and macroeconomic balances is long and full of conflict. The extent to which restrictive fiscal policies have contributed to the recession in the crisis countries, i.e. the size of the fiscal multipliers, has recently been hotly debated. Blanchard and Leigh (2013) argue that fiscal tightening is having a surprisingly strong negative impact on growth. On the other hand, the European Commission (2012) notes that fiscal vulnerabilities, leading to sharp increases in borrowing costs and tightening of credit conditions, were the main reasons for the unexpectedly large negative effects on GDP of the current fiscal adjustments. Since interest rates for loans to the private sector are correlated with government bond yields, rising government bond yields in the crisis translate to higher private sector borrowing costs with negative impacts on investment and private consumption. While fiscal consolidation and deleveraging are necessary, the negative macroeconomic and hence social effects might be cushioned somewhat by reducing the speed of adjustment. However, such a slowdown of the reform process bears the risks that financial markets punish the associated additional borrowing needs from the market by demanding again higher interest rates. It is possible that there is some room for flexibility in designing the time path for fiscal adjustment, but these countries would have to proceed very carefully (Honkapohja 2013).

In all countries unemployment has reached very high levels. This not only implies the risk that cyclical unemployment becomes structural with negative effects on the growth potential, but also endangers political support for the painful but necessary adjustment measures. Political turmoil and protests which occurred repeatedly in the crisis-struck countries show very clearly that the continuation and future success of the adjustment progress hinge on a significant improvement of the labour markets. Furthermore, the adjustment progress is until now only visible in flows such as current account balances as well as public and private financial balances. Stocks like public and private sector debt levels will in most cases grow further, since their reduction requires not only lower deficits, but also surpluses.

#### 7. Conclusions

When the euro was introduced, the exchange rate risk was eliminated, resulting in very low interest and in overly expansionary demand, price bubbles and increasing private and public indebtedness in the euro area periphery. In these countries, wages grew much faster than productivity. As these wage gains translated into high price increases, international price competitiveness was eroded. Together with low interest rates and credit financed domestic absorption, current account imbalances built up. Furthermore, governments were confronted with low financing costs of their budget deficits and easy access to credit. Given low credibility of the Maastricht rules, some countries relaxed on fiscal discipline. In the wake of the financial and economic crises, financial markets re-assessed the risk of sovereign default, given high public debt levels or other sources of public sector risk; hence these countries were confronted with increasing risk premiums and ultimately had to accept financial assistance by the international community, subject to strict and painful fiscal and structural reforms.

In the meantime, economic adjustments in the crisis-struck countries have resulted in improved international price competitiveness and lower public deficits. In many countries recapitalisation of the banking sector has made progress, contributing to more financial stability and lower vulnerability. However, the road to full adjustment is tough and slow. Fully re-gaining sustainable public finances and correcting macroeconomic balances will still take considerable time. If the high unemployment in these countries which results from the adjustment-induced recession is not reduced soon, it will endanger the growth potential and negatively affect political support for the painful, but necessary adjustment measures.

Reforms undertaken since the outbreak of the crisis not only involve macroeconomic and fiscal rebalancing at the level of the Member States. Equally importantly, the EU created several new institutions and strengthened the mutual economic surveillance in the Member States. Some of these new institutions involve the transfer of national responsibilities to the European level. Any decision about centralisation or decentralisation in Europe – as currently regarding the banking union – should observe the principle of subsidiarity which is laid down in the European Treaties. According to this principle, decisions should be taken closest to the citizens since needs and preferences are best known at the most decentralised level. On the other hand, some areas with substantial spillovers across countries require regulation at the central level. One important example is the banking union since many banks operate in many different Member States. In such cases where the whole is more than the sum of its parts, central regulation is necessary to internalise cross-country externalities.

It can be concluded that the future of the euro area will be determined by continued national reform towards fiscal balance and increased competitiveness and growth, continued recapitalisation of the banking sector, and the completion of the banking union with central regulation and oversight including bankruptcy rules for large banks. Apart from the design and implementation of the banking union, further reforms should aim at cutting the vicious link between governments and banks. Public debt should be treated with their appropriate risk in calculating equity requirements of banks (Basel III rules). A zero risk weight induces banks to hold too much local public debt, making them overly exposed to sovereign risk of their home country. This problem is made more severe by the lack of a euro area wide safe asset. Creating such an asset along the lines of Brunnermeier *et al.* (2011) would largely eliminate the risk of expectations driven capital flight and distortions in capital allocation in the euro area.

#### References

OECD 2012, *OECD Economic Outlook*, 2012(2), Paris.

### Eurozone Crisis: Possible Future Scenarios

Lubor Lacina

#### 1. Introduction

The Eurozone crisis is not the first crisis in the history of the European integration project. It is clear that there must be strong motives – achievements, benefits – that have always carried the European Union through crisis periods and prevented its disintegration or splitting. So far, as soon as a crisis is over, or even in the course of a crisis, the number of member countries has increased, from the six founding countries to the current 28 Member States, and the integration process has been expanded, from a customs union to today's economic and monetary union.

While some EU and Eurozone countries have managed to successfully withstand the financial and economic crisis after 2008, other States are still up to their ears in problems. Most of the EU countries (including key players like France and Italy) expect painful reforms in the name of fiscal policy recovery and greater competitiveness. Such steps, however, hurt many citizens, and if they arrive sanctified by Brussels it is not difficult to foresee another avalanche of 'Europhobia' or Euroscepticism. This prompts the following question: what motives can the advocates of European integration rely on during the ongoing Eurozone crisis? Are those motives strong enough to protect the EU/Eurozone from growing Europhobia, Euroscepticism and possible disintegration?

#### 2. The Eurozone crisis and its possible consequences

Periods of economic crisis have always been and continue to be associated with the slowdown of the integration process and the increase of 'Euro-centrifugal' or Eurosceptic tendencies in Member States. It is true, however, that the European project has always overcome crisis periods, remaining attractive for other candidate countries and capable of further strengthening of cooperation for integration (fiscal union, banking union, capital market union). Can we expect a shift towards closer cooperation among EU Member States in the near future too? Or in this case will a process of European disintegration begin, either geographical (Member States' withdrawal from the EU) or functional (return to simpler forms of cooperation: internal market, customs union)? The EU, Member States and voters will therefore have to decide whether the sense of privilege stemming from the creation of a large entity with a significant negotiating position in the globalizing world will prevail, or whether a call for greater domestic autonomy and decisionmaking power on significant issues without the influence of a transnational entity will win, as in the UK in/out referendum.

Even in the times of economic growth, low unemployment and stable macroeconomic environment some national politicians attributed their domestic economic problems to EU policies (and later, since 1999, to the common currency or, more precisely, to the European Central Bank's overly restrictive monetary policy). As the length and depth of the current recession increases, the frequency of such Eurosceptic views has also increased. Blame for domestic economic problems is often laid on the common currency or categorically on the EU as a whole. Hence, it is only a matter of time before citizens and politicians (both respectable and populist) start asking questions about the costs of a continued EU or Eurozone membership1 . The position of parties grounding their programmes precisely on criticism of the negative effects of European integration on domestic economies has been strengthening in national election results since 2008. The success of eurosceptic-oriented parties was visible in the results of the European Parliamentary elections of May 2014.

The ongoing crisis of European integration is a test of the newly adjusted EU primary law, regulated by the so-called Lisbon Treaty. Under this treaty, after long discussions among Member States, a provision establishing the right of a Member State to withdraw from the EU appeared for the very first time. Article 50 of the Lisbon Treaty2 clearly states not only Member States' right to secede from the Union, but also outlines the process to be followed to do so. Will this crisis, partly as a result of the legal right to renounce membership, also be the first to lead to the withdrawal of certain Member States, or to splitting the EU into a 'two-speed' union?3

1 These discussions have already begun in the UK (Brexit) and Greece (Grexit).

2 «A Member State which decides to withdraw shall notify the European Council of its intention. In the light of the guidelines provided by the European Council, the Union shall negotiate and conclude an agreement with that State, setting out the arrangements for its withdrawal, taking account of the framework for its future relationship with the Union».

3 We can observe that the Eurocrisis already divided the EU into two parts: the Eurozone countries and the rest of the EU. Some of the decisions were made out-

The length of the current crisis (economic recession) and the ability to restore previous economic growth will be a significant, if unknown, variable. The longer the crisis, the greater the risk of Eurozone disintegration or the withdrawal of some countries from the EU. For example, in 2014 the Greek economy was already only 70% of its pre-crisis level. Beyond this, the decline continues as does the drop in living standards of the Greek population. A number of large economies (Italy, France) have long been shuffling their feet, recording no growth. Unemployment in Greece and Spain exceeds the 25% threshold. On the other hand, however, there are countries (Germany, Estonia) that have managed to rapidly restore their economies to a growth phase, thanks to structural reforms implemented prior to the crisis (Germany-Hartz I-IV), or as in Estonia during the crisis (wage cuts, fiscal restrictions), in this case even at the cost of a temporary, yet significant, drop in living standards. Nonetheless, in general, many fear that the EU economy as a whole will never again return to pre-crisis growth trends.

There are several possible future scenarios of economic development. In the first, there is only a temporary decline of potential output when compared to the pre-crisis trend, but after a certain time the pre-crisis level is reached again. Economic loss is determined by the length and depth of the deviation of potential growth from a long-term trend. In the second scenario, decline in growth remains at this lower level on a long-term basis (for example, due to the inadequate response of economic policy: the unsolved problem of maintaining the stability of the financial system). At the same time, however, the unemployment rate stabilizes at the level reached at the end of the recession. A long period of stagnation is therefore associated with all the negative consequences of high long-term unemployment. In the third scenario, the most pessimistic, economic crisis leads to decline in potential growth, with the growth gap4 increasing even further over time. In connection with this, unemployment may rise.

Nevertheless, reality can be even more complicated. Countries such as Germany, Ireland and Estonia manage to restore the growth of their economies a lot faster because of more flexible labour markets and braver political decisions: past or present structural reforms. In contrast, other economies (such as Greece) are falling into a vicious circle of reforms, savings and further decline in living standards. The heterogeneity of the Eurozone is increasing again. Some shocks are becoming permanent. The dissatisfaction of citizens is growing, not only in Greece, Portugal, Spain or Italy, but even in countries in better economic conditions, such as Germany, Finland or

side the EU legal framework. The Eurozone itself is divided into core and periphery (North and South). The migration crisis divided the EU into old and new member countries (West and East).

4 Growth gap is defined as the difference between potential and actual product. Thus, it shows the volume of product that might have been produced but was not.

Slovakia, that have become the 'sponsors' of problematic countries in the system of stabilization mechanisms.

There are several future scenarios and possible approaches to solving the crisis. These range from a deeper political integration towards fiscal union to the collapse of the entire Eurozone, the return to national currencies and the potential start of disintegration of the entire European project built up over the last 65 years.

The most debated scenario is the disintegration of the EU, meaning that some countries will withdraw from the Eurozone or the EU. This scenario will materialise if several or most current Eurozone members jointly come to the conclusion that it is the euro which prevents recovery from the crisis and it would therefore be advantageous to return to national currencies. In this case, it might perhaps be a joint political decision made by top representatives of EU Member States, which would be kept secret as long as possible to give the Eurozone countries enough time for technical preparation for a return to national currencies. Although it is Greece that gets mentioned most often, there are much greater concerns about the collapse of big economies such as Italy, Spain or France. Nonetheless, it should be noted that the situation calmed down significantly in 2013 owing to measures approved by the European Council, the European Commission and the European Central Bank. These included the creation of the European Stability Mechanism, the building-up of the banking union and the strengthening of supervision over fiscal stability (Two Pack, Six Pack, Fiscal Compact and European Semester), plus the ECB President's statement that the Bank would do 'anything' to save the euro. Many economists have also begun to point out that without the euro there would probably be much greater instability as a result of speculative attacks on individual national currencies (the policy of competitive devaluations: beggar-thy-neighbour policy). Countries with low competitiveness (huge deficits of balance of payment current account), budget deficits and high debt would be particularly hard hit by the major depreciation of newly-established national currencies, major increase of inflation and inability to pay obligations, all of this immediately following exit from the Eurozone. In any case, the withdrawal from the Eurozone would have to be made as a one-shot step without consulting other member countries. In addition, all preparations for the changeover from the euro to national currency would have to be conducted in secrecy in order to minimize economic losses5 . It can be assumed, however, that no government would take

5 The process of replacing the single currency with a national currency would indeed be associated with costs similar to those involved in the introduction of the euro (the costs of printing banknotes, coins, repricing all items, changing accounting systems, etc.). The fact is that while the euro changeover was under preparation for several years, a changeover back to the national currency would have to be done with minimum preparation, undoubtedly bringing with it a host of complications for national

such risky measures without consultation with other Eurozone members, the European Commission and the ECB. The UK can serve as an example of a country where potential withdrawal from the EU has been debated for several years. The British government can rely on detailed studies, updated on a regular basis, about the potential impact of state authority on individual areas and about Britain's position within the EU and in the entire global economy. Before any final political decision, a nationwide referendum – an exceptional instrument in the British political system – is planned. And the UK does not even use the euro; but even so, balancing of benefits and costs of leaving the EU is challenging.

Another possible scenario of the evolution of the economic crisis could be called the 'Japanese way'. The economic downturn stops after a while and remains at this lower level for a long period. The term 'hockey stick effect' is used for a similar economic development. At first the economy records a steep decline in production. After reaching the bottom, the economy does not improve immediately but stays at this lower level for a long time. This condition is usually the result of the ineffectiveness of monetary policy which exhausts all its instruments in the period of decline, at some point becoming ineffective. Interest rates announced by the central bank approach zero. Real interest rates acquire negative values. The ineffectiveness of monetary policy can result in an extremely proactive fiscal policy and the overall growth of government debt. Japan is now one of the most indebted economies of the developed world, with government debt reaching 200% of GDP.

The inability to restore pre-crisis economic growth reduces the standard of living on a long-term basis, and unemployment with all its negative consequences will stay in double digits in some countries. Society will step up pressure on national political leaders and the number of radical proposals to solve the crisis will increase.

In another scenario, the triggering role in the entire collapse of the Eurozone might be played by Germany, should German officials assess their country's continued membership in the group as too costly and risky. Although this variant of Eurozone crisis outcome seems unlikely, it is not entirely impossible. Already when preparations to establish the economic and monetary union began, it was clear that the entire project could take place only if Germany participated. It can therefore be assumed that Germany's decision to return to the mark would lead to the disintegration of the entire Eurozone. From Germany's point of view, the trigger mechanism

economies. On the other hand, it should be noted that even after the introduction of the euro, the dimensions of the national central banks operating in all Member States are much the same as they were before the transfer of decision-making powers on monetary policy to the ECB. Each country thus possesses sufficient professional and technical capacity to restore the national currency and formulate autonomous monetary policy.

might not be so much its own poor economic development but rather the requirement of lagging countries to obtain financial resources from more prosperous EU economies. The truth is that the newly-established German currency would probably appreciate against the rest of the Eurozone or newly-introduced currencies. Yet, this also occurred in the period following the collapse of the Bretton Woods system of fixed exchange rates, and the German economy still managed to maintain its competitiveness by controlling the growth of nominal wages and productivity. The German economy has not lost this ability even in the early twenty-first century, and thus it can be assumed that the impact of currency appreciation on the country's competitiveness would be only temporary. It should be stressed that one of the fundamental values in the European integration process, the principle of solidarity among countries, has reached its limits. The willingness of both the rich Member States and some new ones (for example, Slovakia) to use a portion of their tax revenues to assist other European economies has been gradually diminishing.

At first glance, an elegant solution to the problem of countries suffering from high debt and an increasing risk of being unable to repay would be to decrease the value of the debt via real reduction through faster growth of price levels6 . With a fixed interest rate of the instruments financing public debt, increased inflation would lead to a decline in the real cost of debt service. In this way, the likelihood of periphery countries going bankrupt could be reduced. At present, however, the situation is completely different. Central banks are independent of governments, which in a monetary union do not have the control over the central bank and its monetary policy that they used to have. The Eurozone inflation target is anchored within EU legislation (Statute of the ECB), and any change requires the unanimous approval of all EU Member States. As a first step, they would have to agree upon a relaxation of the inflation target, especially Germany, which identified adherence to a stable price level as one of the basic conditions for entry into the economic and monetary union. This requirement has a very pragmatic explanation. During the second half of the twentieth century Germany achieved one of the highest living standards in the world. It is also home to one of the most rapidly aging populations. German citizens' demands on their own political representation are therefore unambiguous. It is not necessary to increase the standard of living any further, but the *status quo* has to be maintained or, in other words, a stable real value of accumulated wealth must remain a

6 This solution was used in the past to solve the situation of unsustainable debt level. After losing wars, kings would realize that their coffers were empty and debts accumulated in the course of the war exceeded the economy's ability to repay them. The usual solution was to withdraw from circulation gold coins issued by the king (usually with a portrait of the ruling monarch), melt them down and return them back into circulation with smaller gold content, which is none other than inflation.

priority7 . This objective would be threatened by the acceleration of inflation. Thus, considering Germany's position within the Eurozone, the notion of increasing the inflation target of the Eurozone seems unrealistic8 . The problem of countries with high debt service costs will have to be solved by other means. Last but not least, it is also worth noting that solving growing debt by 'discreet' inflation is essentially nothing more than a subtle rip-off of all citizens who have increasingly worthless money left in their wallets while prices all around them keep rising. An alternative to the 'inflation scenario' is faster economic growth which naturally decreases the proportion of debt to GDP ratio. As we have already mentioned, the limitation of this alternative scenario is a low or, in the case of Greece, even a negative growth of the economy in the last few years, combined with an estimated even lower potential growth in the future.

The European Commission, the European Central Bank and the Member States acting jointly in the EU Council and the European Council were startled by the dynamics of the crisis. Debating on resolutions through to the early hours of the morning by top EU and Eurozone representatives has become commonplace since 2008. Especially in the early years of the crisis, a favourite tactic adopted by European Commission representatives was that of an 'ostrich' burying its head in the sand and ignoring the reality of the outside world. The European Central Bank decided to abandon its responsible monetary policy of maintaining low and stable inflation, 'releasing' a huge amount of money into circulation in several steps, entailing the threat of future inflation. Neither the European Commission nor the European Council found the courage to carry out unpopular measures, which is why the International Monetary Fund was invited to help since it had past experience with dealing with both debt and currency crises. The IMF recipe has not changed much over time and is based on a carrot-and-stick principle: «We will help you, but you must first show sufficient self-sacrifice and commitment of your own». In other words, help for States and governments lacking financial resources for pension payments, state employee salaries and the very running of a State is subject to relatively radical savings in government spending.

It is evident that Eurozone Member States cannot restore their competitiveness and economic growth by currency devaluation, as many of them used to do in the past. It is not technically possible to nominally depreciate the Greek euro against the same German euro9 . Reducing nominal wages and prices (so-called internal devaluation) is the only path for at least partial recovery of competitiveness in countries using the common currency. In the long run, however, it is a very dangerous phenomenon. If governments are simultaneously forced to reduce their spending, the aggregate demand of the economy significantly decreases. This will then result in a decline in economic performance: recession. A good example of the limited possibilities of economic policy to cope with a deflationary development is the situation of the Japanese economy over the last 20 years. Japan's Central Bank keeps interest rates near zero in the long term and applies a policy of quantitative easing. Moreover, an expansive fiscal policy has made Japan a country with one of the highest government debts ever. Yet, Japan has been failing to kick-start economic growth. The combination of pressure to reduce nominal wages, efforts to restore public finances and the ineffectiveness of common monetary policy might therefore become one of the factors triggering pessimistic scenarios of potential product development: long-term decline or significantly slower growth of economies than in the pre-crisis period. In this scenario, long-term unemployment would remain high10, heavily burdening state budgets, increasing social tensions and testing member countries' willingness to stay in the Eurozone.

One of the real threats hovering over the Eurozone since 2008 has been a concern that, as a result of the ongoing economic crisis, a country with a high debt may not be able to refinance its debt service and may therefore declare insolvency at some point. This threat was fulfilled in 2010 when the Greek government was forced to ask for financial help due to rising interest rates on financial markets combined with the ongoing recession of the Greek economy. Yet, current EU legislation forbids the European Central Bank and Eurozone countries from participating in any way in the bailout of such economies11. The financial collapse of one economy may, however, undermine the credibility of the entire Eurozone in the eyes of financial markets and thus have a negative effect on all Member States in the form of increasing risk premium. Therefore, despite legal restrictions, the EU and the Eurozone Member

9 In the case of countries of limited openness such as Greece, even the devaluation of currency will have only a marginal effect on competitiveness, growth of exports and consequently on economic growth.

10 For example, unemployment in Greece or Spain has already exceeded 25%, with unemployment among 18-25 year olds amounting to over 50%.

11 However, the ECB has instruments which can be used, and have already been used (LTRO operations) to protect national banking systems from the danger of lack of liquidity.

States have been looking for an option that would make financial assistance to the affected economies possible. The objective of this assistance is to protect the credibility, or stability, of the monetary union. However, even this scenario has a number of limitations, in addition to legislative barriers. The common EU budget has a limited size (about 1% of gross national income of all EU members) and, except for the European Globalization Adjustment Fund (about €500 million per year), does not have mechanisms that might support the financial situation of member countries with rising deficits and debts. Financial resources redistributed through the EU budget are therefore insufficient and additional necessary resources must be found at national level, i.e. in national budgets, outside the existing EU budget. Another important limitation is the amount of resources that would have to be found. It is conceivable that Member States, together with the IMF, would be able to collect sufficient financial resources to help small countries such as Greece, Portugal or Ireland. This, after all, has already happened. However, what if it were necessary to gather resources in the event of public budget collapse in countries such as Italy or Spain? In that case, even financial resources in the order of magnitude of hundreds of billions of euros would not suffice12. Another major constraint is the support of public opinion for such an action. It is, for example, very difficult to explain to the citizens of Slovakia why they should give their money to Greek or Spanish people. Moreover, it is hard enough for national-level politicians to find savings in their budgets to stabilize their own public finances. Finding support among the people – and even among politicians across the political spectrum – for the transfer of financial resources to other countries during the economic crisis thus appears highly unrealistic13. And, as already stated, from the perspective of a German voter the ECB policy of 'printing money' is unacceptable too.

The Eurozone crisis proved that European budgetary structures have not been designed to perform a stabilization function. The Eurozone was therefore not prepared to help member countries adjust to asymmetric shocks in the early stage of the crisis. This issue was addressed through Eurozone crisis management actions by creating stabilization mechanisms that did not have the form of a budget (EFSM, EFSF, ESM and redemption fund: one pillar of the banking union). The above-mentioned development reveals a need to re-

12 At present, the European Stability Mechanism has up to €500 billion at its disposal, which experts still consider insufficient should it be necessary to provide financial assistance to Spanish or Italian economies. Estimates refer to up to triple the current sum if help to countries such as Italy and Spain were to suffice.

13 The financial resources granted to Greece, Ireland, and Portugal also provoked quite a negative reaction, on the part of both opposition parties and public opinion. A good example is the fall of the Slovak government headed by Prime Minister Radičová in connection with the Slovak Parliament's voting on the provision of funding for the European Stability Mechanism.

think and redesign fiscal stabilization mechanisms in the Eurozone, since individual Member States fail to implement successful stabilization policies. All federations and monetary unions have substantially bigger federal spending than the EU, where only 2% of public spending is performed at supranational level. Ratios in analysed federations range from 35% of total social security spending in Canada to 67% in Germany. In general, the biggest portion of expenditure is focused on the elimination of asymmetric shocks and takes the form of social transfers. The problem in the EU/Eurozone lies in the reluctance of Member States requesting financial support to submit decision-making on their budgetary policy to a supranational authority: EU institutions. Most countries are not willing to give up autonomy in decisionmaking on fiscal policy priorities (Kadidlo, Lacina 2015). Nevertheless, countries providing these financial terms make establishment of a fiscal (transfer) union conditional on transferring part of the decision-making powers in the area of fiscal policy to a supranational level14, as is the case with monetary policy in a monetary union. The support for such a scenario, which would bring the EU closer to a federal union, is therefore much higher at the level of the main EU representatives (such as the European Commission and European Council Presidents) than at national level.

#### 3. European integration as a long-term project – how to sell it to citizens?

For media strongly affecting not only public opinion (read: voters' attitudes) but also the opinions of politicians themselves, it is not sufficiently 'attractive' to describe the gradual steps and long-term achievements of the European integration process from its beginning. With regard to recent negative economic developments associated with the construction of the latest phase of the integration process, i.e. an economic and monetary union, analyses concerning the future development of the EU thus often present simplified conclusions about the need for the entire disintegration of the EU and a return to nation States. It is, however, actually quite simple to look at the other side: at the unprecedented success of previous phases of the integration process. In other words, the gradual building-up of the customs union and the single market associated with an increase in the living standards of all EU citizens. Benefits associated with the liberalization of trade as well as the possibility of free travel between countries are nowadays taken for granted both by the media and by ordinary citizens. Yet, they are one of the tangible and indisputable results of the European integration process and are not and have never been a matter of course in other regions.

14 See, for example, the reluctance of some EU countries (the United Kingdom and the Czech Republic) to join the so-called Fiscal Pact, or the discussions about the introduction of new EU budget revenue in the form of a financial transaction tax*.*

The promotion of values and processes that we nowadays take for granted has always required complicated consensus-seeking among all member countries, their politicians and citizens. It is also true that the EU took over 60 years to achieve its present condition. A realistic observer of European integration ought to be reconciled to the fact that there has been and always will be a long journey from the original idea to its implementation, which calls for political compromises and the support of public opinion in the real environment of a democratic system.

Let us now make a short detour from discussion of the topic conducted on the basis of historical and economic arguments for a brief consideration of a technical-psychological nature. The late twentieth and early twenty-first centuries have been associated not only with the expansion of computer technology but also with access to a virtually infinite amount of information through Internet. As a natural consequence, people are overloaded with information from almost all over the world on a daily basis, so there is no space left for reflection on events and decisions that have taken place in the past but still affect the *status quo*. It is much easier to discuss details of events taking place on the other side of the globe (childbirth of an American celebrity, one hand in Bill Gates' pocket during a meeting with the South Korean president, etc.) than the historical context of the current state of the world, of Europe, or the position of a nation State or an individual. Again, nothing new under the sun, since philosophising has always been the pastime of only a small minority. This should not surprise EU leaders: they do not offer any substantial philosophy or ideas anyway.

The age of the Internet-connected world is governed by an aspect that strongly influences the perception of ordinary citizens. An individual's perception becomes much more oriented and sensitive towards current events, based on which s/he forms opinions even on such long-term processes as the integration of the European continent. At the same time, people are traditionally impatient when it comes to problems that require long-term solutions. In the early twenty-first century people have become accustomed to immediate responses by politicians to events as they arise. Yet the solution to the financial and economic crisis requires not only a rapid adoption of measures but also a search for comprehensive, systematic solutions, which are often unpopular among citizens – voters – too. It is also sometimes difficult to find support for necessary reforms across the political spectrum. Criticism of ruling parties' measures leads to the instability of political systems, early elections and a weakening impact of the measures implemented. The demand for populist solutions is growing, *inter alia*, because of current EU political leaders' inability to easily and clearly explain why and what they want and how they intend to achieve it.

It turns out that integration built on market and democratic principles is a much more stable model than integration based on 'one-party' rule and central planning of even the most basic activities. Thanks to the success of the

#### Lubor Lacina

European integration process, the current generation can continue to enjoy one of the most stable periods in the long history of European civilization. The controversy surrounding the awarding of the Nobel Peace Prize in 2012 to the EU only illustrates how European and national politicians have failed to convince EU citizens of the stabilizing nature of the European integration process and its long-term contribution to the rise in living standards. Instead of opening up a discussion on the conditions for maintaining peace within the European continent in years to come, the Nobel Prize was exploited as an opportunity to express disagreement with the development of the economic situation in the Eurozone and dissatisfaction with the institutional structure of the EU. Surprising? Only partially, given the fact that EU leaders could not even agree who would personally receive the Prize at the Oslo ceremony. In policy circles, evidently, anything can be turned into a farce.

The Nobel Peace Prize reminded us that integration, which began in the 1950s, has demonstrated a success worth pursuing. Interest in membership was expressed in the past even by countries located partly or fully outside Europe, such as Turkey or Algeria. The European integration process has become an inspiration for emerging integration groupings in Africa, Asia and Latin America. An increase in the living standards of all social strata as well as the construction of social systems due to the co-creation of a peaceful environment and free market represent the resounding success of open cooperation among today's EU member countries, to which the European integration process has contributed significantly. Even countries remaining outside the process (for example, Switzerland and Norway) have gradually built special relationships with the rest of integrated Europe.

Up to the turn of the millennium, with the adoption and implementation of the Maastricht Treaty the European integration project was 'pushed' by politicians who had personal experience of the horrors of the Second World War: the so-called war generation. It is possible to give many examples of French and German leaders overcoming, by personal agreement, seemingly insurmountable obstacles (clearly visible at national level) during the bilateral negotiations that usually precede negotiations of the entire EU. Such politicians included not only Konrad Adenauer and Jean Monnet but later also, for example, François Mitterrand and Helmut Kohl. It was these politicians' personal experience of the consequences of the Second World War and their political courage that led to the reunification of Germany, agreement on the common currency project, and an unprecedented increase in the number of Member States effected by welcoming in 12 countries of Central and Eastern Europe. In addition to national leaders' ability to determine the direction of European integration within the European Council, one can also observe the highly important role played by strong personalities in the role of President of the European Commission (for example, Jacques Delors). Their departure from active political life and replacement by younger politicians who are only indirectly familiar with the conflicts of the first half of the twentieth century could be one of the factors explaining the slowdown of the European integration process and the reluctance to proceed further towards the establishment of a fully-fledged federation: a political union.

By contrast, the euro crisis caused a backlash among voters not only against the common currency project, but also against the whole process of European integration. In some countries seriously affected by the crisis, such as Greece for example, latent hatred towards Germany persisting since the Second World War has intensified again. In other countries the crisis, coupled with the need to implement unpopular reforms that reduce the standard of living, and the decline of economic growth has sparked debates about pros and cons of EU membership, as already indicated in previous chapters. Even more than 60 years after the end of the war, Germany is expected to pay off her debt for having provoked the largest ever global conflict with unprecedented human and economic losses. Germany is thus perceived as a country that has no right to tell other countries and their political representatives what to do to address debt problems, non-competitiveness and other negative effects of the economic recession. However, Germany itself has been implementing this policy for a long time and its economic strength continues to grow.

The Eurozone crisis has clearly shown how prevalent national interests and their favouring by national politicians hinder completion of the European integration process, i.e. the creation of a fully-fledged political union, a new State. The earliest sign came as far back as the 'game' surrounding the approval of the Nice Treaty. Then it was further demonstrated by the preparation and attempted ratification of the Treaty establishing a Constitution for Europe and consequently by the Lisbon Treaty. The EU political trappings and the EU institutions have not managed to 'sell' citizens the idea of continuing integration towards the creation of the United States of Europe, nor have they sufficiently explained the reasons for such a plan.

The Eurozone crisis exacerbated the sensitively-perceived relations between large and small Member States. Small EU Member States have long been concerned about being dragged along by decisions made and prearranged by large Member States. On the other hand, large Member States complain about the rigidity of decision-making in a circle of 28 different national interests and priorities. The reform of EU institutions so that they are able to make effective decisions with a growing number of countries is still only halfway through. Another problem hampering effective decision-making is the current model of two-speed Europe, with only 19 Member States (out of 28) using the euro. The need to solve the Eurozone crisis thus began to create parallel decision-making institutions, one for Eurozone countries and another one for the entire EU.

The economic crisis has reinforced the pragmatic behaviour of national politicians. They approach the evaluation of successes and failures achieved in the EU selectively. If any measures seem successful, they tend to 'sell' the achievements as mainly the result of their own initiative. By contrast, in the case of unpopular measures such as labour market or pension reforms, they tend to refer the need for reform to pressure coming from EU institutions. Thus, from the public's perspective, successes – positive integration – tends to be associated with the initiative of national governments, whereas failures are laid at the door of the EU. This in turn strongly influences the evolution of public support for the entire project of European integration.

It is very interesting to see how something that one tends to conceive as a highly bureaucratized and technocratic model is influenced in direct negotiations by the personal sympathies and antipathies of individual actors, or by their attitudes *vis-à-vis* the issue of the redistribution of power at national and supranational levels. As we have already mentioned, progress in the integration process was long driven by a generation of politicians who personally experienced the effects of two world wars. Their departure from the political scene brought a new dimension into negotiations among member countries. Compromises are no longer sought on the basis of personal relationships but rather on grounds of political orientation and attitude towards the European integration process.

An important role in the change of atmosphere in the negotiations was also played by the long-awaited accession of Central and Eastern European countries to the EU. In most cases, the position of the new Member States is based on a simple economic calculation of the costs and benefits associated with membership in the integration grouping, rather than on a genuine perception of the chance to participate in long-term cooperation in order to maintain peace. The Baltic countries provide an example of Member States' differing positions. In their considerations, the benefits emerging from membership of a democratic and market-oriented grouping always outweigh a simple profitcost calculation. From this perspective, the example of the Baltic republics should serve as a model for all new member countries' political representations, as well as for their citizens. However, we also have to ask whether such reasoning can be emulated in the context of a completely different historical experience. Is not Baltic countries' euphoria apropos the EU an obvious and understandable contrast to previous painful Nazi and Soviet times? In the rest of EU countries such positive thinking does not come so easily.

The situation is interesting in the group of original member countries too. Despite remaining the driving force behind the European integration process, we can observe that Germany has over time lost some of the allies with which it used to create a strongly pro-integration camp in the past. The Netherlands and Austria were traditionally significant supporters of the European integration project, and Germany's allies. Their positions have been almost identical to those of Germany. But the same cannot be said about the rest of Germany's traditional allies. France, the second engine of the European integration process over the last 50 years, is increasingly assuming the role of an observer of changes rather than an initiator, mainly due to instability on the domestic political scene and recurrent problems with the dynamics of economic growth. The long-term alliance between the two countries sustained by personal relationships between leaders (see Mitterrand-Kohl) has not yet been restored and, given the different political and economic orientation of the two countries since Hollande was elected President, one cannot expect it to strengthen significantly in the near future either. Since the unsuccessful referendums on the Treaty establishing a Constitution for Europe, France has been 'shuffling her feet'. However, this is not to say that it is gradually moving into the Eurosceptic camp, but rather that it is relinquishing its former role as a country determining the direction of Europe's further unification. Another long-term ally of Germany used to be the Netherlands. As in the case of France, however, negative economic trends, instability in the political arena and the unsuccessful referendum on the Treaty establishing a Constitution for Europe weakened the country's unique position as Germany's special ally. We have already spoken about the relationship with Germany of peripheral countries (such as Greece, Italy, Spain, Portugal and Ireland), and no substantial shift can be expected in this area any time soon. A whole new chapter is the position of the United Kingdom, which in recent years has even been toying with the idea of abandoning the EU altogether.

When it comes to support for the integration process, an interesting situation can be found in countries with internal disintegration tendencies. It is useful to note that at a time when the potential withdrawal of some countries from the Eurozone (Greece, Cyprus) or the EU (UK) is increasingly under debate, a completely different development can be observed within the Member States themselves. Good examples could be Spain or the United Kingdom. Both in the case of efforts to separate the Basque country (Catalonia) from the rest of Spain and in the case of Scotland's desire to become independent from the UK, we can discern a clear ambition of these potentially new territorial units to join the EU.

Thus, although the recent crisis generally tends to lead to a decline in the support of politicians and citizens for the European integration project, an entirely opposite trend can be observed at regional level. On the notional balance pan, the number of countries that have joined the process of European unification in the past clearly outweighs those countries that jumped off the running train, or gave the leap serious consideration. Over more than 60 years, the number of Member States has grown from the original six to the current 28, with many other countries (for example, Macedonia, Serbia, Montenegro, Iceland, Turkey, Ukraine, etc.) seeking to obtain full EU membership. So far, Greenland15 remains the only example of a country leaving

15 In 1985, Greenland withdrew from the EC, which it used to be part of as a result of its status as an autonomous territory within the Kingdom of Denmark. Nevertheless, Greenland has continued its cooperation with the European Union on the basis of a customs union.

the European integration project, and the only country that has seriously considered termination of membership is the United Kingdom. The process of European integration thus still appears to be rather centripetal than centrifugal, with the gravitational force naturally changing throughout time.

#### 4. Future motives and challenges of European integration

Since the outbreak of the financial and economic crisis in 2008, the decisions of EU institutions and the representatives of member countries have been driven by external circumstances rather than a clear strategy. Threats such as the collapse of the Eurozone or the withdrawal of some countries from the EU have been successfully averted so far, also due to the active role of the European Central Bank. Yet, they have been averted at what is (for the time being) an unknown price to be paid by all EU citizens in the future. Candidate countries are nonetheless still interested in access to the EU and the Eurozone. In July 2013, Croatia became the 28th Member State and other countries of former Yugoslavia (Macedonia, Serbia, Bosnia and Herzegovina, and Montenegro) are also interested in gaining EU membership.

During the Eurozone crisis, Estonia decided to replace its national currency with the euro. Latvia joined the Eurozone on 1 January 2014 and Lithuania on 1 January 2015. At the end of 2013, Ukraine too expressed interest in signing the Association Agreement with the European Union. However, the combination of Russia's political pressure, the EU's conditions for signing the Agreement and an overall lack of unity in the Ukrainian political scene caused a setback in the efforts to draw Ukraine closer to the EU. Politically, linguistically and culturally divided, Ukraine then underwent a series of bloody clashes between demonstrators and police forces, leading in the end to the fall of President Yanukovych's regime. The subsequent separation of the Crimea and conflict in the eastern parts of the country bolstered Ukraine's desire to take shelter under the wing of the EU, built on democratic principles.

The second group of non-EU countries is also worth mentioning: i.e. the countries that could join the EU but do not want to. Norway has not found the motivation; the wealth of raw materials and their exportation provide the country with above-average affluence, with the integration into the European Economic Area enabling it to make use of the single market principles as we know them in the EU. Also traditionally 'cautious' Switzerland is satisfied with a similar level of cooperation with EU countries, since it too is wealthy and does not wish to allow Brussels to influence it through primary and secondary EU legislation.

The globalized world makes ever-increasing demands on the 'sleepy' EU, daily testing its competitiveness and reminding it that the bizarre dimension of EU social systems is unparalleled in the world. A huge tax burden, gigantic contributions to social and health systems, combined with the effective impossibility of letting surplus employees go, at least in in some EU countries: all these factors undermine the willingness of European and world companies to offer new (expensive) jobs. It often seems that the more absurd and rigid the labour market and the higher (artificially higher) the salaries not based on skills and efficiency on the employees' side, the higher unemployment is in the EU. Indolent citizens are, however, accustomed to the social safety net and fail to see that it will turn against them one day. Those who realised this got out of the crisis surprisingly quickly: the Germans, for example. An agreement between the government and the trade unions in the middle of the last decade froze salary increases for practically ten years. It managed to keep production costs and the prices of German products (the overwhelming majority of which were exported) relatively low, thus keeping them competitive in both the internal EU and the global markets. Currently Germany's exports are growing and the government in Berlin has already started talking about the preparation of surplus budgets. This is sheer utopia for countries such as Greece, Spain, Portugal and Italy, where employee salaries increased by approximately 30% from the introduction of the euro up to the beginning of the crisis in 2008. In parallel, of course, the price of their products rose too, leading customers all around the world to increasingly opt for German goods. Hence, it is true again that the gap between the rich North and the poor South continues to widen, with the crisis even intensifying this trend.

Globalization too has been showing the EU its dark side: it is increasingly necessary to 'compete' with those who are younger, more agile, competitive and not indolent (emerging markets). In this case, however, we are our own worst enemy, and so is the way in which the rampant social system has got out of hand and damaged our competitiveness and promptitude. It does not just protect us against poverty and misery, which was what we originally wanted from it, but also fails to motivate us to economic activity and often even discourages us from it.

It is paradoxical that it is the European Union that has been putting spokes into its own wheel. Whatever the scale and speed of global warming, EU countries will certainly not reverse the trend by themselves. The total greenhouse gas emissions of China and the whole developing world are likely to grow over the next few decades, because these countries do not possess the latest expensive technologies (which are 'cleaner'), or do not want to possess them, thus maintaining low production costs. Only absolutely exceptionally has economic growth been achieved while simultaneously reducing energy consumption (perhaps only in the case of Denmark, and even there only in the short term). Growing wealth almost always goes hand in hand with growing demands for barrels of oil and cubic meters of gas and is associated with this increasing discharge of so-called greenhouse gases.

Against the background of the growing competitiveness of the US (also thanks to new modes of hydraulic fracturing) and other world regions, EU countries are committing ritual suicide right in the world media spotlight. The struggle for 'greener' energetics has already cost the EU hundreds of billions of euros in direct and indirect costs and has increased the prices of electricity and other production inputs, including artificially-created emission allowances traded on an artificial market stacked with interventions by the European Commission. Certain economic sectors thus found themselves in a completely uncompetitive situation. The notion that instead of producing and exporting advanced products (turbines, locomotives, transport infrastructure, generally demanding products with high added value, know-how and technological innovation) the EU will get rich thanks to an army of trained sports masseurs or diet advisors, is illusory. Moreover, not only did the EU invest billions of euros in the fight against global warming, it also tied a large part of its political prestige to it. If it turns out that this was – for various reasons – a wrong decision, its political image will suffer worldwide.

As is evident from the preceding text, looking for an answer to the question at the beginning of this chapter is not clear-cut. In its history, the EU has overcome a whole series of crises that most contemporaries have no idea about. The European integration project has demonstrated several times a huge inner potential enabling it to survive beyond periods of trends towards disintegration. A realistic view of the current situation tells us that through joint efforts the Eurozone crisis too has very probably been overcome. The question remains, however, whether the EU has emerged from this crisis weakened or strengthened. It will be interesting to see whether internal contradictions among Member States will predominate in future or whether Member States will realise that the only chance in an increasingly globalizing world is to keep the EU united and act as a politically and economically strong region with ambitions to world hegemony.

The basic building block for future direction is the assumption that what the EU needs most in this chaotic and tightly-interconnected world is risk management. In other words, the Union – and its institutions – must in the first place cope with external and internal shocks, or at least learn to moderate their impact. This is closely related to the Union's ability to reinforce its power position on the global stage, be it through agreements and treaties (for example, rules on trade and capital flows) or through *ad hoc* actions enabling it to prevent future shocks or eliminate them before they destabilize the whole of Europe (this applies, for example, to armed conflicts).

The by-product of the transition from a unipolar to a multipolar system has been the erosion of the competencies and importance of global institutions. This will diminish the efficiency of global agreements and treaties in future, that is, if it is possible to conclude them at all. This will lead to the growing significance of *ad hoc* actions aimed at the most pressing problems concerning the whole planet. As was indicated by the Copenhagen Climate Change Conference in 2009, in such situations it will be the most powerful actors, i.e. the US and China, who will try to find a compromise based on their own needs and the limitations of their counterparties. If the EU does not wish to be left on the doorstep again, and wants to transform the G2 into the G3, it must find a common voice. You are either at the table or on the menu.

#### References

The European Parliament and the European Council: Functions and Roles in the Eurozone Crisis Management. A Political Agenda Analysis Elisa Cencig, Laura Sabani

1. Introduction

The economic and financial crisis has had profound consequences not only for the economies of EU Member States, some of which are still far from complete recovery, but also for the architecture of the Economic and Monetary Union. This work aims to analyse the action of the European Council and the European Parliament in response to the economic and financial crisis, and it purports to do so by looking at the agendas of these two institutions.

The theoretical approach underpinning this analysis is the policy agendas project, which dates back to Baumgartner and Jones' (1993) seminal work on the US political system and was later applied in comparative politics to analyse other countries (Baumgartner *et al.* 2009). In particular, the codebook developed by these scholars allows studying the actions of different institutions by applying a standardized content-coding procedure; it hence enables comparison over time and across policy fields. The agenda setting approach was therefore chosen as it provides an objective way to evaluate the policy areas the European Council (EUCO) and the European Parliament (EP) dedicated most of their attention to, as well as the specific issues in the area of economic and financial affairs.

The policy agendas project is a very flexible tool to quantitatively illustrate where the main priorities of an institution lie and how they evolve over time. In this perspective, we study the content of the EP plenary meetings agendas, which are an objective record of what the EP is up to at the macrolevel, in comparison with the European Council Conclusions. Our quantitative analysis is based on the European Council Conclusions database, directly derived from the pre-existent dataset compiled by the EU Policy Agendas team, with the addition of 2013 and 2014 meetings. The European Parliament Plenary Agendas database is entirely original and was compiled following the same content coding procedure used for the European Council Conclusions by the scholars working on EU Policy Agendas.

Our main expectation is that the European Council, as a key deal-breaker taking highly strategic decisions, devoted a large share of its attention to the crisis, yet with a more unstable coverage pattern and a disrupted distribution of attention shares. On the contrary, we expect the European Parliament to have dedicated a limited part of its agenda space to economic and financial affairs, essentially because of the necessity to continue with 'business as usual' policies and the lower degree of mediatization of its meetings. Therefore, we expect its agenda to be remarkably more stable, with the attention devoted to economic and financial issues holding more or less a constant share.

The quantitative analysis confirms the expectations and shows that EU-CO exercised a key agenda-setting function in leading the reform of the Economic and Monetary Union architecture, by devoting a consistent part of its meetings to the crisis. On the other hand, the European Parliament has been a pivotal actor in ensuring the adoption of all 'crisis-related' legislation, but it would be probably far-fetched to say that it acted as an agenda-setter, given the limited agenda share dedicated to these issues. Briefly, it might well be possible to conclude that the economic and financial crisis reinforced the role of the European Council and contributed to its image as a powerful engine of European integration. However, the implicit assumption that directly relates attention shares to the agenda-setting power of an institution is open to criticism.

The chapter is organized as follows. Section 2 briefly summarizes the main institutional features of the European Parliament and European Council and discusses the role played respectively during the Eurozone crisis. Section 3 reviews the literature on the Policy Agenda Project. Section 4 analyses and compares the policy agendas of the European Council and the European Parliament from 2009 to spring 2014. Section 5 compares the response of the two institutions to the economic and financial crisis. Section 6 concludes.

2. The European Parliament and the European Council: institutional features

#### 2.1 The European Parliament

Directly elected since 1979 by universal suffrage, the European Parliament represents the citizens of the European Union and has traditionally acted as one of the most 'integrationist' institutions of the EU, constantly supporting the reinforcement of its supranational features, as opposed to intergovernmental dynamics which dominate the work of the Council of the EU (Hix, Høyland 2011).

Unlike most national parliaments at Member State level, the EP does not enjoy the power of legislative initiative, which in the EU is a prerogative of the Commission. It is however a co-legislator together with the Council (comprising all Member States' ministers, with a composition varying according to the policy debated) and is responsible for approving all EU secondary law, taking the forms of directives and regulations. Under the ordinary legislative procedure (OLP), known before the Lisbon Treaty as the 'codecision' procedure, it stands on an equal basis with the Council and submits all legislation proposals to a single reading; a conciliation committee is convened should any disagreement between the two legislators arise. Special legislative procedures apply in particular domains, notably the consultation procedure and the consent procedure, but the OLP has become the standard one, directly signalling the reinforcement of the EP within the EU governance structure. Analogously to legislation, the EP also has equal powers to the Council on the adoption of the EU annual budget.

In addition to its legislative and budgetary powers, the European Parliament exercises supervisory functions, namely it oversights the work of the Commission, which is requested to submit regular reports on its executive powers and on the implementation of the EU budget, as well as to reply to the oral and written questions addressed by Members of the European Parliament (MEPs). Over time, the EP has gained a strong voice in the appointment process of the European Commission, which it now has the right to approve and dismiss. Although the European Council is still responsible for choosing a candidate for the post of Commission President, under the Lisbon Treaty it is requested to take into account the results of the European elections before the candidate is finally elected by the EP. The Parliament can censure and ultimately dismiss the Commission, and enjoys a range of oversight powers over the other EU institutions.

#### 2.2 The European Council

The European Council has completely different features, starting from its much shorter history, as it was formally created at the 1974 Fontainebleau summit. It is composed by the Heads of State and Government of all EU Member States, plus the President of the European Commission and its own President. The latter is a permanent position (elected for two and a half years) since the adoption of the Lisbon Treaty, which marked the formal recognition of the European Council as an EU institution.

Meeting at least four times a year, the main role of the European Council is to provide the Union with impetus for its development and delineate its main future priorities (Schoutheete 2006). Initially meant primarily as an arbiter trying to solve by consensus complex, sensitive political issues, its function is nowadays that of an agenda-setting body (Alexandrova *et al.* 2014a): formally deprived of any legislative powers, it can deal with any policy area and sometimes reform it quite substantially as a result of one of its summits. It addresses deadlocks in the legislative procedures, redefines the Union's priorities and gives impetus to determined issues, hence engaging in dramatic, highly mediatized issue portrayal rather than dealing with low-key, everyday matters (Werts 2008; Puetter 2014). Although the total number of meetings per year can exceed the minimum of four and is set by the European Council itself, the scope of the debate is much more limited than that of the Parliament, and each meeting inevitably has to prioritize some issues over others.

#### 2.3 The role of the two institutions in the Eurozone crisis management and reform

As for the role played by the two institutions in the Eurozone crisis management, the action of the European Council as a major decision-maker is what first comes to mind to scholars and common citizens alike. Decisions somehow related to the economic and financial crisis were devoted ample space in newspaper headlines and appear to have been one of the most visible outputs of the European Council's action over the last years (Puetter 2012).

Major changes to the governance structure of the EU in the economic domain, as well as leaps forward in the area of financial regulation, have directly followed from intergovernmental decisions. In spite of the power of legislative initiative firmly resting in the hands of the Commission, a key agenda-setting function has been exercised by EU Heads of State and Government in order to guide the EU's action in these fields. The launch of the European Semester, the new (stricter) fiscal rules enshrined in the Fiscal Compact, the establishment of the Single Supervisory Mechanism and the European System of Financial Supervision: none of the above would have been agreed upon without ex-ante consensus within this highly politicized forum, let alone all decisions related to emergency financial assistance packages via the European Financial Stability Facility (EFSF), European Financial Stability Mechanism (EFSM) and later European Stability Mechanism (ESM) funds.

On the other hand, the European Parliament has been a pivotal actor in ensuring the adoption of all 'crisis-related' legislation, notably a wide range of regulations and directives concretizing the enacted measures, but it would be probably bold to say that it acted as an agenda-setter in this field. Although it did apply some modifications to the European Commission's original proposals, the EP appears to have stood in the half-light compared to the European Council, which has been widely acknowledged as *the* crisis-solver. Furthermore, the EP certainly has limited powers to enhance the share of its agenda dedicated to economic and financial affairs: even if MEPs can discuss own initiative reports or motions for resolution, most of the assembly's work – at least in the legislative domain – consists in taking forward the various committees' activities, in turn influenced by the Commission's proposals.

This perceived inequality in the relations between the two institutions, whereby the European Council acts as a veritable deal-breaker, while the European Parliament tends to ratify already settled decisions, may reflect a change in the institutional balance of the Union. It might be possible that the economic and financial crisis reinforced the prerogatives of the European Council and contributed to its image as a powerful engine of European integration, while the EP has not been granted a substantial increase in power, nor has it gained a major role in the newly reformed system of economic policy coordination. On the other hand, this perception might only be due to the different degree of mediatization of the two institutions. The European Council, although relying upon a considerable influence, does not exert any legislative power whatsoever and is compelled to rely on the Commission and the co-legislator to implement its strategies and transform its *desiderata* into outcomes, hence making the EP a key decision-maker whose voice simply cannot be ignored.

#### 3. The Policy Agendas Project: review of the literature

The Policy Agendas Project was launched in the United States by Frank R. Baumgartner and Bryan D. Jones, who focused in their research on the allocation of political attention at the beginning of the policy cycle (Baumgartner, Jones 1993; 2005). The theory is evoked here only in its essential features, as the literature comprised in the policy agendas project, both on the US system and compared, is vast and would require an entire chapter for an adequate presentation. Baumgartner and Jones's analysis, aiming at complementing established studies of the public policy process with a more nuanced view of its initial phases, largely drew inspiration from the psychological concept of bounded human rationality. Human beings do not always make the best decisions in complex environments and do not always attend to the most pressing problems, as dynamics of attention shifting prevent individuals to devote their consideration to the full range of issues at stake. The central assumption of the theory is that these attention dynamics characterize individuals and institutions alike, hence government officials and governmental institutions present similar cognitive boundaries. Government decision makers often have huge amounts of information thrown at them, especially when they are surrounded by actors pushing for policy change: they are faced with fiercely competing issues and it is very difficult to assess what bits of information are relevant or accurate, which ones deserve more attention than others. The political system is accordingly seen as an attention allocating instrument, with a huge amount of information on the input side and public policies as an output. The process according to which information is prioritized, and attention is allocated to some problems rather than others, is called agenda setting, and enables the reduction of redundant incoming information streams. The scholars assume that information is not used efficiently in politics, as some bits are totally ignored while others are given disproportionate attention and credibility, giving rise to a punctuated pattern; this process is inevitable and inherently linked to the aforementioned shortcomings of human cognition (Baumgartner, Jones 2005).

Baumgartner and Jones's research analyses the process whereby the US political system processes information by detecting signals and prioritizes them basing on urgency and other criteria. The preliminary stage of decision making, where attention is allocated to one issue over another, is a very sensitive stage when thresholds of importance based on perceived urgency determine priority setting decisions. Their theory of governmental attention allows them to put forward a generalized model of punctuated equilibrium in public policy (Baumgartner *et al.* 2007). The bounded rationality in information-processing results in the neglect of information until it can no longer be ignored: at the tipping point, it becomes disproportionate and a major shift in attention follows. For this reason, political change is not incremental but rather characterized by an alternation between under-reaction (reflecting stability) and over-reaction (the punctuations). Empirical studies have confirmed the punctuated equilibrium model, which predicts the distribution of attention change to display a high level of skewness, with a majority of very small attention shifts coupled with a considerably high number of large ones, while medium-sized changes are relatively less frequent (Baumgartner *et al.* 1998).

Regarding its methodology, the policy agendas project produced a dataset tracking policy change in the US since the Second World War, with the help of specific policy content categories. The key assumption behind the use of this database is that attention to an issue can be meaningfully measured by its relative occurrence in policy documents, with the number of references interpreted as an indicator of the issue's status on the political agenda (Alexandrova *et al.* 2014b). The analyzed resources include among others congressional hearings, public laws, executive orders, Gallup surveys, US budget authority data, with each item content-coded according to a comprehensive list of 19 topics and 225 subtopics.

All observations are coded in accordance with the single predominant policy area and are assigned a numerical value, with the resulting relative frequency of one issue signalling its rank on the overall agenda. The resulting database is a powerful tool for quantitative and objective comparison across years and issue areas, in contrast with the qualitative, case-study approach that is predominant in the public policy literature. This approach has remarkable advantages over alternative strategies of data collection such as interviews and surveys, primarily in view of the fact that its standardized nature allows for comparison not only over time, but also between different institutions within a political system or across political systems altogether.

The Policy Agendas Project has been successfully exported from the United States with the creation of the Comparative Agendas Project (CAP) and the EU Agendas Project, resulting in a wealth of non-US based studies enriching the literature (see e.g. Baumgartner *et al.* 2006; Green-Pedersen, Walgrave 2014). Over the past decade, there has been an increased scholarly attention to agenda setting processes in the European Union (Princen 2009, 2011). Alongside being an essential stage of the policy process in any political system, the relevance of studying agenda setting in the EU has distinctive features. Studying the EU agenda may in fact highlight some patterns of its institutional and political set-up, which are all the more interesting because of the flexibility and continuous adaptation of the EU's structure over time. In addition, the boundaries of agenda span with its expansion and contraction dynamics might represent a promising source of information on the process of EU integration, notably by analyzing which (and how) issues are dealt with at the European in relation to the national level (Alexandrova *et al.* 2014b). Nevertheless, a majority of existing studies tends to adopt a case-study approach, hence failing to reap the benefits of the large quantitative datasets that are central to the policy agendas perspective (Princen 2013).

The European Council has been the object of particular attention by the EU Policy Agendas team. Researchers collected empirical data by content coding all European Council Conclusions (previously called 'Conclusions of the Presidency') starting from the establishment of this institution in 1975, in order to determine what issues have been addressed at different summits and analyse attention dynamics over the years and phases of European integration. Because of the secretive, closed-door nature of its deliberations, the Conclusions mirror only approximately the debates held at meetings, but they represent the only available source of information. The EU codebook, comprising 21 major topics and some 250 subtopics, has been used to code European Council Conclusions at their smallest unit of analysis, the (quasi) sentence level (Alexandrova *et al.* 2014b). The data allowed scholars to analyse patterns of agenda development within the EU leaders' forum.

Two main findings appear relevant in relation to the European Council's agenda. First of all, some topics related to the 'core functions' of government, i.e. international affairs, economic issues and governance of the EU, take up a large part of the agenda most of the time, a result similarly found by comparative analyses of executive agendas in a number of countries. Taken together, the three topics attracted almost half of the agenda space of the European Council over the entire analysed 1975-2010 period, while the remaining policy fields were devoted each between less than 1 and 7 percent of the total attention (Alexandrova *et al.* 2012a). In spite of the distinctive pattern of competences attribution between the EU and Member State levels, the European Union hence shows a common bias towards general core government issues as addressed by all political systems (Alexandrova *et al.* 2012b). A second key finding of their analysis is the empirical validation of the punctuated equilibrium theory of policy-making, according to which small, incremental changes are punctuated by large shifts in attention to problems (Alexandrova *et al.* 2012a).

4. Policy agendas of the European Parliament and European Council from 2009 to 2014: a comparison

In this section we analyse and compare the policy agendas of the European Council and the European Parliament over the period from autumn 2009 to spring 2014, corresponding to the EP's 7th term. Since our aim is to describe the reaction of the EU institutions to the economic and financial crisis, the study does not go further back in time. This choice prevents the possibility of comparing the pre- and post-crisis scenario, but seemed more suitable to our objectives and constraints. Year 2009 is taken as a good approximation for the start of the crisis, although some of its effects had already begun to appear in 2008, in order to limit our analysis to one parliamentary term and allow for a meaningful assessment of the last legislature.

Given the 'small agenda' of the European Council and the highly mediatized nature of some crisis-related measures (to name some examples, the several decisions to grant financial assistance to Greece or the resolution to establish a banking union), we expect the European Council to give much more space to issues related to economic and monetary affairs, as well as the financial crisis, compared to the Parliament. The latter is expected indeed to devote a relatively limited coverage to economic and financial affairs in its political agenda, yet this attention is expected to be more stable over time. In fact, it is not uncommon that European Council meetings focus solely on a constrained number of issues at time, issues that may receive very indepth handling but might similarly be dropped off the agenda at the following meeting, when a new 'hot topic' emerges or policy priorities shift. The European Parliament instead has to continue with 'business as usual', i.e. legislation and implementation related to all existing policies, which may not be revolutionized but need 'daily care' and cannot be simply overlooked. Therefore the attention devoted to all policy areas (not only economic or financial issues) is expected to follow a more constant pattern over time, with small and medium-size changes in attention but less major disruptions than what is expected for EUCO. When looking at the qualitative content of the agendas, it is also highly likely that the two institutions prioritize different policy areas, not only at the macro-level but also at the micro-level when analysing the most debated items under the economic and financial umbrella.

The European Council Conclusions database is directly derived from the pre-existent EU Policy Agendas dataset, with the addition of 2013 and 2014 meetings (up to the one taking place on 20-21 March 2014). Only the data from the June 2009 summit onwards were retained, and the database was extended using the same content-coding procedure, in accordance with the EU Policy Agendas Codebook. Each item (sentence or quasi-sentence) is assigned two main variables (alongside date and year), which are 'CAPIC' and 'main CAPIC'. CAPIC (Comparative Agendas Project Issue Code) is the main variable and is meant to code for the policy content of each single unit of analysis. Each unit is assigned only one of the topic codes, which are organized in major topics (main CAPIC – e.g. major topic 1 is for Macroeconomics, 2 for Civil Rights, Minority Issues and Civil Liberties, 3 for Health and so on) and subtopics (CAPIC – e.g. within the major topic 'Macroeconomics' 101 refers to Inflation, Prices and Interest Rates, 103 to Unemployment Rate, 105 to Budget and Debt).

In total, the 2009-2014 dataset comprises 31 meetings: 5 of them took place in 2009 (June, September, October, November and December), 6 in 2010 (February, March, June, September, October and December), 7 in 2011 (February, June, December and two each in March and October), 6 in 2012 (January, March, June, October, November and December), 6 in 2013 (February, March, May, June, October and December) and one in 2014 (March). In addition to the March, June, October and December sessions which are the four yearly meetings foreseen by the Lisbon Treaty, some of these were informal (September and November 2009, February 2010, 26 October 2011, January 2012), others were euro area summits (26 March 2010, 11 March, 21 July and October 2011, January 2012) and some were of a special or extraordinary nature (11 March 2011 and November 2012). The database includes 6690 coded sentences or quasi-sentences.

The European Parliament plenary agendas database is entirely original, but similarly compiled following the same content coding procedure. There were 73 plenary sessions of the EP during the 7th term, the first one taking place on 14-17 September 2009 and the last on 14-17 April 2014, with elections taking place for the renewal of the assembly in May 2014. Their distribution over the years is the following: 6 were held in 2009, 17 in 2010 and 2011, 15 in 2012, 12 in 2013 and 6 in 2014. Every item on each plenary agenda is coded, be it a vote on a legislative proposal, an own initiative report discussed by the EP or a debate on any policy area: for example, when the agenda item is *State aid rules on services of general economic interest – Report* it is assigned CAPIC 1541 (competition policy) and main CAPIC 15 (banking, finance and internal trade). The database contains a total of 5127 agenda items, with an average of 70 agenda items per session.

4.1 The agenda of the European Parliament (2009-2014)

#### 4.1.1 Composition and dynamics of the EP plenary agenda

The allocation of attention across policy topics shown in Table 1 underlines a clear pattern of emphasis on certain fields. In conditions of scarce agenda space, issues do have to compete for attention and their relative frequency can be taken as a measure of saliency. Research on domestic policy agendas in a comparative perspective has demonstrated that there is a number of more or less unvaried core topics, namely economic affairs, government structure, defence and international affairs, consistently ranking at the top (Alexandrova *et al.* 2014a). In the case of the European Parliament's plenary agendas, we can indeed observe that government issues and foreign affairs occupy respectively the first and second position in terms of agenda space. Banking and finance, together with internal market issues, are also high on the EP agenda; this result falls in line with the priority constantly given to the creation and functioning of the single market over the different waves of European integration.

*Table 1 – Aggregated attention to policy fields in the EP, 2009-2014.*

The rest of the policy areas are all given less than 5% of the agenda each, with relatively more attention to agriculture and foreign trade, while the lowest ranks are occupied by public land and territorial issues, media/culture and education. The attention to all topics on the agenda (on a semester basis) is displayed in the boxplots of Figure 1, which clearly shows how most salient issues are also those subject to the higher degree of variation in their relative frequency on the agenda.

For example, governance occupies the first place on the EP agenda, but its relative frequency varies widely, ranging from 20% to 36%; a similar pattern can be easily detected for international affairs (with a minimum of ca. 12% and a maximum of 21% of agenda space) as well as banking/financial issues and foreign trade. On the contrary, policy areas consistently receiving a very low degree of attention have a much more stable pattern, with no relevant changes in their relative frequency on a semester basis, as it emerges from the graph. The only possible exception is agriculture, which has a mean of ca. 5% of the agenda space but a maximum value of 10%. The variation for all other low-ranking items instead occurs within a concentrated range, meaning that the EP coverage has a very constant nature. This finding matches well with the nature of this institution, which deals with all policy areas taken up by the EU, mainly exerting a legislative function and hence debating/approving pieces of legislation (be it directives or regulations) across the whole spectrum of policy topics.

Figure 1 – EP attention to all topics on the agenda per semester within the period 2009-2014.

EU governance and government operations cover almost 30% of the whole agenda of the EP plenary sessions, surpassing largely any other agenda item over the whole 5-year period under analysis. Under this main policy area, almost a half of the occurrences are general matters linked to government, the future of the EU or budgetary matters (all operations related to the budget, from its approval to the discharge procedure and sectorial allocations, are indeed coded in this category). Frequent matters of debate are also institutions and inter-institutional relationships (11%), while nominations/appointments and regulation of political life and ethics both take up more than 5% of the agenda space under the governance umbrella. The second largest topic on the European Parliament agenda is international affairs, with almost 17% of the agenda space, reflecting inter alia the ever-growing powers the EP has gained in this policy field over time. Once again, general references are most frequent (35% of the total), but almost 30% of all foreign affairs-related agenda items is represented by human rights, signaling the traditionally intense Parliament's concern for human rights issues and the strong role it plays in this field. Other relevant subtopics are foreign aid and EU enlargement, with each about 10% of the space. Banking, finance and internal trade comes third on the EP agenda, with 9% of the whole agenda space: the European Parliament is hence more concerned with single market and banking/financial issues than with macroeconomics, which occupy the 6th place barely covering 4.45% of the agenda. The variety of issues under this policy area is very wide, with five different topics getting about 10% of the total occurrences: financial markets regulation (hardly surprising, given the high priority given to this policy field during this last term), harmonization of technical requirements, banking system and financial institution regulation, creation of the common market and consumer protection.

Taken together, the three topics of EU governance, international affairs and financial/single market issues attracted more than half of the attention of the European Parliament over the whole 7th term. On a semester basis, their cumulative frequency varies between 45% and 60%, while the remaining 18 policy areas are given a much more limited attention share, as shown in Figure 2. These results therefore confirm the findings of comparative research, showing that 'core functions' of government together account for the lion's share in a political institution's agenda, of course with slight differences in the relative saliency among the exact top areas. However, an interesting pattern can be observed if one adopts a different unit of analysis, notably by breaking down the data and analyzing the distribution of attention by session, instead of taking semesters as units of comparison.

Figure 2 – Relative distribution of EP attention to core topics per semester, 2009- 2014.

Figure 3 presents the same statistic, i.e. the cumulated frequency of the three top issues, but looking at each plenary session held by the European Parliament. Interestingly, a far wider degree of variation emerges; there are in fact single sessions where these three core topics – EU governance, international affairs and banking/finance – together cover less than 40% of the plenary agenda, while in other sessions (e.g. October 2010, May 2012 or April 2013) they easily reach an astonishing 80% of total agenda space.

Figure 3 – Relative distribution of EP attention to core topics per session, 2009- 2014.

#### 4.1.2 Attention to economic issues in the European Parliament

In order to better enlighten how the European Parliament reacted to the economic and financial crisis starting from 2009 (the year of its 7th direct election by European citizens), we will now take a closer look at its specific attention to the policy area related to macroeconomics, as well as the subtopics under this category. As we have already seen, a preliminary observation is that 'economic issues' is not part of the top-ranking three policy areas consistently highest on the EP agenda. As Figure 4 shows, its relative frequency on a semester basis varies between less than 3% and slightly above 6%, hence never enjoying a clear-cut priority on plenary agendas. Nevertheless, a session-on-session analysis again highlights a far wider variation, with occasions when macroeconomic issues alone covered almost 30% of the agenda (Figure 5); in 8 sessions out of 73 macroeconomics exceeded 10% of relative frequency and it is even possible to notice than during 13 of its sessions the EP did not deal with this policy area at all. **./"%0\*%)&\*)1'\$#\*"\$\*%\*23\$45)6778967:;** 5067890%:40;<0-=>%?-%3@0%A<4?B07-%C746D710-3%7E0-.7

Figure 4 – Relative frequency of macroeconomic issues on the EP agenda per semester, 2009-2014.