This column is a lead commentary in the VoxEU Debate "Euro Area Reform"
A group of 14 prominent economists, seven each from France and from Germany, has issued a detailed and rather comprehensive proposal for reform of the euro area (Bénassy-Queré et al. 2018). This is a welcome initiative. There is currently both an economic and a political window of opportunity for reform in the euro area. Following the structure of the paper itself, I discuss strengths and weaknesses of the proposals and make recommendations for extensions and alternatives.
Underlying philosophy and problem analysis
The basic philosophy underlying the report is to strike a balance between risk sharing or collective insurance (identified as the ‘French view’) and rules and market discipline that ensure ‘sound’ domestic policies that make crises impossible (identified as the ‘German view’). The authors argue that, provided they are carefully designed, risk-sharing measures can minimise moral hazard issues and may actually be necessary to enable the imposition of rules because they reduce contagion from one country to others, and thus prevent a country from holding its partners to ransom.
The report identifies the so-called doom loop between national banking systems and sovereigns and a lack of stabilisation capacity as the main weaknesses of the euro area.
While valid, this does not get to the heart of the two fundamental problems. At the euro area level, first, there is an insufficient capacity in times of crisis to keep aggregate demand in line with potential. The mechanisms to set and enforce an appropriate aggregate fiscal stance are, at best, weak. And, as the crisis showed, the ECB, facing a multitude of fiscal actors, has more difficulty than other central banks in taking the required measures.
Second, the mechanisms to avoid and correct competitive and macroeconomic (current account) imbalances between the member states are too weak given the powerful mechanism of procyclical differences in real interest rates resulting from differences in inflation rates.
In short, a lack of effective cooperation between central monetary and the multiple actors responsible for fiscal and other national policies, including wage setting, make it very difficult to stabilise national economies and rapidly and effectively combat crises.
The financial proposals
In line with the importance given to the doom loop between banks and sovereigns, financial-sector reforms – including bail-ins of bank bondholders, de-privileging government bonds, and a common deposit insurance scheme with country-specific experience rating – occupy a prominent position in the proposals.
Achieving an adequately backstopped (i.e. through the ESM) common deposit insurance and a harmonised resolution regime would be important steps in stabilising the euro area financial system. The bail-in principle has risks, though: if retail investors suffer severe losses, the real-economic impact can be very counterproductive for restoring economic growth (which is a condition for stabilising the banking sector).The authors do not sufficiently appear to take account of the fact that, rather than improper regulation or an excessively close bank-sovereign link, banking sector problems in some countries are a direct consequence of prolonged contraction or stagnation of the real economy; the source not the symptom of this problem needs to be addressed.
The recommendation to differentiate premiums to the deposit insurance scheme to reflect perceived country risk seeks to address moral hazard (and political obstacles), but it also imposes longer-term costs on already – as a legacy of the crisis – weaker countries. At a minimum, some collective efforts to resolve the legacy non-performing loan issues are required to enable countries to start with a clean slate.
The measures to increase geographical diversification of banking assets and to develop Capital Markets Union reflect a belief that international portfolio diversification and private capital flows have substantial stabilising properties. There is good reason to be sceptical, however (Dullien 2017). Indeed, the securitisation schemes at the heart of the Capital Markets Union (CMU) may pose detabilisation risks (Theobald et al. 2017).
The fiscal proposals
The most important reform proposals are to be found in the area of public finances and the governance of fiscal policy. The starting point is that the fiscal rules are badly designed, complex, and virtually unenforceable.
While this is correct, the authors retain the basic philosophy of limiting public deficits and reducing debts in the medium run. What is needed is to achieve an appropriate fiscal stance in aggregate, but also in each member state. For the latter, the output gap and the competitive position are decisive and these must be analysed in a symmetrical way. Deficits can be too low (or surpluses too high).
The proposed shift from a focus on (cyclically adjusted) deficits to an expenditure rule is welcome. No fiscal rule is perfect. At least non-cyclical expenditure can be readily measured, and is under government control. However, the focus on convergence to an arbitrary debt-to-GDP target should be downplayed in favour of nationally specific targets that emphasise counter-cyclicality and symmetry; current-account-surplus, low-inflation countries must be constrained to expand aggregate demand and allow upward adjustment of nominal wages and prices.
Care must be taken using nominal GDP so as to avoid procyclicality. A higher inflation rate implies higher nominal GDP growth, implying more space for government spending. Yet an important lesson of the crisis is that higher-inflation countries need to run tighter fiscal policy. It should also be considered to enrich the expenditure rule by differentiating spending categories so as to privilege productive investment, i.e. combining it with some version of a golden rule (Truger 2016).
The ex post punishment regime has indeed failed. Far-reaching policy federalisation or at least rules providing for a progressive takeover of national policymaking competences in the case of repeated flouting of agreements (as in federal states), while they would be effective, are almost certainly a political non-starter at the current juncture. As such, the differentiated stick and carrot approach set out in the report has, in principle, much to recommend it. Imposing ‘market discipline’ on government bonds without a backstop has potentially massively destabilising impacts, however (Lindner 2018, Watt 2017). If it is applied only to new government spending that is in contravention of agreed (and broadly sensible) principles – as with the junior bonds proposed in the paper – it could serve as an effective control mechanism. If risk sharing is extended, there certainly has to be some reliable way to constrain national fiscal policy. Any drawbacks of the partial introduction of market discipline need to be weighed against those of possible alternatives.
However, such an approach should only be considered if the existing stock of sovereign debt, and also new bonds issued within the agreed limits, are not subject to restructuring; they should continue to have zero weighting and the ECB should be able to purchase them on secondary markets so as to keep spreads within tight limits. The paper is ambiguous on this point. The section on financial markets implies increased use of collective action clauses and thus greater possibilities for restructuring. That would be highly destabilising.
It seems that the only protection for outstanding and new bonds will be to the extent that they are securitised into ESBies. It is by no means clear that such untested collateralised financial products would really guard against ‘skittish’ market forces destabilising countries. There is no discussion of the size of the ESB market – specifically how to get a senior tranche that is both safe and large, given a small number of mutually correlated securities – nor of a possible stabilising role for the ECB and whether ESBies would be a tool for quantitative easing or other monetary policy measures in the future. At the very least it seems that a disproportionate degree of faith is placed in this measure, the practicalities of which are barely discussed.
The authors accept the need for a euro area fiscal capacity. This is welcome. The version proposed is unnecessarily restrictive, however. Differentiated contribution rates will (here too) penalise the countries who have suffered most in the recent crisis. There is no obvious reason why such a fund should be pre-financed; collectively, the member states are not like households or firms. An ESM credit line with appropriate conditionality would suffice, if the ESM can freely issue bonds (which can be purchased by the ECB to the extent that its inflation mandate allows). Again, the exaggerated concern with moral hazard leads to a serious risk that countries getting into difficulties will at some point transgress against the expenditure rule, will lose access to the various support measures, and will be faced with debt restructuring. Knowledge of this fact will induce anticipative speculation. Such a currency union is fundamentally unstable.
Overall assessment and proposals
The team of French and German economists is to be congratulated for the attempt to put together a package of measures that is effective in stabilising the euro area, internally coherent, and politically feasible. That is a tall order and any critic must recognise the scale of the challenge. To conclude, I focus on suggestions as to where the package needs to be extended or adapted.
Much of the underlying problem analysis is correct, although in some areas it is limited. The downplaying of the inherent tendency to competitive and current account imbalances (‘rotating slumps’) is a serious shortcoming. The proposed policy package attempts to overcome the ‘discipline through punishment’ approach, which has manifestly not worked, without far-reaching federalisation, which seems politically infeasible.
At the same time, it fails to adequately address some important issues and the proposals are skewed – notwithstanding the claim to be a marriage of the risk-sharing and disciplinarian approaches – in favour of the latter. The excessive concern with ‘moral hazard’ issues in a number of areas prevents a clear line being drawn under the crisis. Under the various strictures imposed on them (such as higher interest rates and fund contributions), those countries hit hardest by the crisis will struggle to develop, while those that have emerged from the crisis comparatively unscathed will not be so encumbered. Countries facing higher costs will constantly be confronted with the question of whether they are not better off regaining their own monetary autonomy. Thus the future of the common currency will continually be in doubt (Watt 2017).
If the proposals are to be taken as a point of departure, important changes and extensions would be needed, including notably:
- Solutions need to be found to legacy issues in vulnerable national banking sectors with a collective element.
- The European fiscal capacity should not take the form of a rainy-day fund but a lending capacity by the ESM.
- Any creation of junior bonds must go hand in hand with effective measures to ensure that existing government bonds and new issues under the spending rule are risk-free and thus removed from the threat of destabilising speculation.
- National fiscal stances must be set with much greater regard to safeguarding public investment and to ensuring symmetrical counter-cyclical stances at national level and thus their coherence at the aggregate level.
- To this end it is vital to reform the Macroeconomic Imbalance Procedure to ensure it is symmetrical vis-à-vis deficit and surplus countries and its application to the entire macroeconomic policy mix. Koll and Watt (2017) and Horn and Watt (2017) propose developing the new national productivity boards into a platform for macroeconomic expertise and extending the existing Macroeconomic Dialogue (MED) at the EU level also to the euro area and national levels. Alongside fiscal policy, the MED brings in the social partners and the national central banks. Fiscal, incomes and macroprudential policies can be thus be better aligned towards growth and stability-oriented and mutually consistent stances. Ownership of agreed targets is increased. This approach emphasises the preventive rather than corrective approach, and would reduce the need for disciplinary measures inspired by a fear of moral hazard.
Editors' note: This is an abridged and revised version of a text that appeared in English here and in German here.
References
Bénassy-Quéré, A, M Brunnermeier, H Enderlein, E Farhi, M Fratzscher, C Fuest, P-O Gourinchas, P Martin, J Pisani-Ferry, H Rey, I Schnabel, N Véron, B Weder di Mauro, and J Zettelmeyer (2018), “Reconciling risk sharing with market discipline: A constructive approach to euro area reform”, CEPR Policy Insight No. 91.
Dullien, S (2017), “Risk sharing by financial markets in federal systems. What do we really measure?”, FMM Working Paper No. 2.
Horn, G and A Watt (2017), “Wages and Nominal and Real Unit Labour Cost Differentials in EMU”, DG ECFIN Discussion Paper 059.
Koll, W and A Watt (2017), “A feasible conceptual and institutional reform agenda for macroeconomic coordination and convergence in the Euro Area”, in H Herr, J Priewe and A Watt (eds), Saving the Euro: Redesigning Euro Area economic governance, Social Europe Publishing, pp. 335-352. e
Lindner, F (2018), “Ein Insolvenzverfahren für Staaten wäre schlecht für Europa”, Herdentrieb, 31 January.
Theobald, T, S Tober and B Lojak (2017), IMK Finanzmarktstabilitätsreport 2016. Regulatorischen Fortschritt weiterentwickeln, IMK Report No. 121.
Truger, A (2016), “The golden rule of public investment – a necessary and sufficient reform of the EU fiscal framework?”, IMK Working Paper 168.
Watt, A (2017), “Wolfgang Schäuble’s poisoned parting gift to the Euro Area”, €-Vision, 11 October.
