The Greek crisis has raised doubts about the sustainability of European Monetary Union. The possibility that a member of the union could default on its sovereign debt has been seen as a threat to the sustainability of other countries debt, in similarly weak positions, but also to the stability of the banking systems of countries exposed to Greek sovereign debt. In short a sovereign debt default could seriously affect EMU.

Greece has taken significant adjustment measures and the other members of Union have offered support. It has been argued, however, that such measures may not be enough to deal with the risk of instability and that other imbalances, most notably the current account imbalances within monetary union, need to be addressed to avoid a deflation spiral that would aggravate sustainability problems in highly indebted countries. More generally it has been argued that the Greek crisis highlights the need to take steps to strengthen the economic governance of the euro area.

Indeed the recent events call for a stronger governance of monetary union. However, it remains unclear what this could mean in practice. If fiscal positions in one or more euro area members deteriorate, their financing will take place at increasing costs, if at all, and a contagion mechanism could spread to the euro area as a whole. In some cases debt could not be sustained and would have to be restructured. The first step towards stronger economic governance therefore is to insure debt sustainability. This task lies foremost with countries, which have to implement the right policies. Incentives to do so, however, may not be always available and this, in turn, requires an effective and credible surveillance mechanism.

What should be the objective of surveillance? An unsustainable debt position may be the result of two quite different mechanism. The first one is a protracted lack of fiscal discipline in an otherwise weak economy, as in the Greek case. The second one is the (Spanish) case where a prolonged period of fiscal discipline turned around as a consequence of the collapse of growth, itself the result of an unsustainable private sector growth mechanism. In both cases the debt/gdp ratio has taken on a rising dynamics although for different reasons. So a first lesson to draw is that a more effective surveillance will have to monitor both the dynamics of debt and the sustainability of gdp growth. The Stability and Growth Pact, as we know it, partly takes the first aspect into consideration and neglects the second. So the SGP should be modified accordingly.

Let us now come to the issue of current account imbalances. Countries with a weak fiscal position tend to run current account deficits, which need to be financed, and as this process becomes unsustainable market confidence deteriorates. Current account deficits however are also the result of deteriorating competitiveness, which is reflected in appreciating real exchange rates. In the euro area relative competitive positions have been diverging in tandem with widening current account imbalances. Again there is scope for a stronger surveillance to insure that deficit countries take measures to improve their competitiveness by addressing the underlying causes of rising inflation and declining productivity, for example through appropriate wage policies and structural reforms. On the other hand I see no rationale, neither any benefit for the euro area, in prescribing surplus countries to slow or even revert their productivity growth. On the contrary, surplus countries should make efforts to increase their productivity growth. This would address the issue of current account imbalances as follows. A current account surplus is the result, other things equal, of excess savings over investment. Such excess savings partly reflect structural, rather than cyclical determinants, hence they should be addressed through structural measures. In some cases, such as China, a very high savings rate signals the need to reform the welfare system and the financial system, so as to decrease savings in households and state owned enterprises. In the euro area the obvious case is Germany, where, however, the main target should be increasing investment. This could be obtained by liberalizing (and thus increasing productivity) the service sector, which remains largely protected from foreign competition and where more competition would spur innovation.

To sum up. A important step towards better economic governance in the euro area would be a stronger surveillance mechanism that should focus on: fiscal sustainability, growth sustainability, competitiveness, structural determinants of current imbalances. Adjustment in such variables clearly requires time and a financing mechanism to smooth the process. But this is what a monetary union is about. A necessary additional factor, however, is effective enforcement of surveillance recommendations. Would a stronger peer review mechanism suffice to complement the disciplining pressure of markets? Hopefully so but enforcement mechanisms require carrots and sticks especially when the economic situation risks getting off track. In a world where imbalances persist over time and market financing is a permanent factor and hence where credibility is essential, the stick is tough conditionality (based on strengthened surveillance) and the carrot is the availability of emergency financing.