This column is a lead commentary in the VoxEU Debate "Euro Area Reform"
The recent CEPR Policy Insight by Bénassy-Quéré et al. (2018) makes debt restructuring of insolvent sovereigns an essential part of the crisis management structure while also proposing strengthening risk sharing between the member states through a new fiscal capacity and a modification of the precautionary lending facility of the ESM.
The proposals have been criticised for relying too much on debt restructuring and market discipline while paying too little attention to the problems of liquidity of solvent sovereigns in times of financial turbulence (eg. Messori and Micossi 2018). In my view, it makes sense to emphasise market discipline and a credible debt restructuring mechanism as a precondition for it. Yet the liquidity problems of solvent sovereigns could indeed be a problem. However, my suggestion for a remedy, as well as the likely outcome, differs from that which Messori and Micossi seem to prefer.
Market discipline needed but hard to establish
The impotence of the fiscal rules necessitates strengthening market discipline on sovereigns as a complement. This again requires a credible mechanism for the debt restructuring of insolvent member states. Simultaneously, debt restructuring would reduce the need for fiscal consolidation in the affected country. The proposal by Bénassy-Quéré et al. is well-founded.
However, mandating the ESM/EMF to implement debt restructuring is, by itself, unlikely to sufficiently increase the credibility of restructuring and thus market discipline. A key challenge remains: the potential for panic reactions. To avoid such reactions, decision makers are under strong pressure to resort to a bailout even when debt sustainability is clearly questionable.
To alleviate this risk, the decision-making process should be predictable and rapid. Eliminating the unanimity rule of the ESM decisions would help, as would more comprehensive (one-limb) common action clauses in the debt contracts. At least as important is limiting banks’ exposure to sovereign debt, as proposed in the Franco-German paper.
Liquidity support for solvent member states inadequate
Even with these elements in place, one cannot exclude significant contagion effects on other sovereigns. To prevent this, the restructuring decision would have to be accompanied by extensive liquidity support to solvent member states.
Currently, only the ECB has the resources to provide sufficient liquidity to other countries under pressure. The ESM can in principle provide such support in the form of precautionary financial assistance. However, its resources could quickly be exhausted, particularly if a significant part of the €500 billion capacity is tied to supporting the state which is subject to debt restructuring.
This situation is problematic. First, any decision by the ECB, including in particular the OMT asset purchases, is at the discretion of the ECB Governing Council. While the collaboration between the ESM and the ECB could function smoothly, no mechanisms are in place to ensure it is so.
Second, the role of the ECB as a lender of last resort directly to the member states gives it substantial power over sovereigns. This is difficult to reconcile with the independence of the central bank.
Third, a precondition of the activation of the current OMT promise is that the member state applies for ESM assistance and agrees on an adjustment programme. The last requirement may delay the activation of any assistance, thereby allowing market conditions to deteriorate unnecessarily.
ESM/EMF access to ECB funding should be explored as a solution
One should be able provide effective liquidity support to solvent member states while limiting the problematic role of the ECB. This could potentially be achieved by giving the ESM/EMF access to central bank liquidity to finance precautionary financial assistance.
If one wants to avoid expansion of the overall ESM capital commitment by the member states, ECB lending to the ESM could utilise the debt instruments of borrowing states as a form of collateral and be without recourse. This arrangement would not leave the ECB worse off in regard to credit risk when compared to the current OMT, which involves direct purchases of such debt instruments.
To further limit the risk to the ECB, the ex-ante conditionality of the current precautionary assistance could be sharpened. In particular, there should be a strict upper limit for the ratio of government debt to GDP for any country willing to make use of the facility. Given that there is no such constraint in the OMT, this would reduce ECB’s credit risk relative to the current situation. One might also use the member state’s share in the future seigniorage income as collateral for the precautionary assistance. In addition, a fraction of the €700 billion capital commitment could be allocated to credit enhancement on a first-loss basis.
The new arrangement would make a clear distinction between normal financial assistance, conditional on an adjustment programme (and the associated strict monitoring), and precautionary lending subject to ex-ante conditionality. The former would have a definite aggregate upper limit and be financed by the member states. The low-risk precautionary lending facility would be financed by the ECB alone and would be more flexible with regard to the aggregate size. The member states which would not fulfil the ex-ante criteria but remained under market pressure, would be required to resort to ordinary ESM assistance.
An obvious key challenge is whether the ECB financing of member states through the ESM would be consistent with both the no-monetary-financing rule and the independence of the ECB. The fact that the credit risk would be smaller than, or at most the same as, in the current OMT programme should help to ensure that the arrangement is no more in violation of the Treaty than is the OMT.
Still, decision making remains a problem. The OMT is an independent decision of the ECB and has been motivated by maintaining “appropriate monetary policy transmission and the singleness of the monetary policy”. The question is whether one could find a way to separate two decisions: (1) the decision by the ECB about determining when the financial market conditions are deteriorating so as to require a special liquidity facility to be made available; and (2) the ESM/EMF decision on the activation of the facility. While difficult, squaring the circle might not be impossible given how many other legal problems have been solved in the EU.
Fiscal stabilisation function not very useful
Risk sharing in the form of a fiscal stability mechanism would naturally help badly affected member states to bolster aggregate demand. Nevertheless, to be effective, the size of the mechanism would have to be large when compared to the current EU budget of 1% of GDP. In the proposal by Benassy-Gueré et al. the support remains clearly insignificant. With the given parameters, the support would have been on average about 1/10 of the actual deficits of the worst hit countries in 2009 to 2013 (Vihriälä 2018).
On the other hand, there is a risk that the unconditional support from a fiscal stabilisation mechanism could result in unintended transfers, with the associated political consequences. These factors speak against relying on a fiscal stabilisation mechanism as a major help in financial crises, especially when taken together with the observation that fiscal smoothing has played only a minor role in stabilising asymmetric shocks across the US states in comparison to the stabilisation through the capital and credit markets (Alcidi et al. 2017).
The Franco-German paper addresses some of the key shortcomings of the current EMU in a sensible way. Nevertheless, the proposed additional risk sharing is, in part, wasted in an area where it does not provide much benefit (fiscal stabilisation), while risk sharing in an area where it is essential (liquidity provision to solvent member states under financial pressure) is likely to remain inadequate. The willingness to share risks across the member states has limits. Therefore, risk sharing should be employed in fighting the real enemy, financial instability.
Abandoning the fiscal stabilisation instrument and creating a stronger instrument of liquidity provision to solvent member states, based on ESM access to central bank financing, could improve on the efficiency of risk sharing. How to achieve the latter is a tricky issue in many ways. Creative thinking should focus on this problem rather than ever more elaborate schemes of fiscal stabilisation, which is best accomplished by prudent member states themselves.
Alcidi, C, P D’Imperio and G Thirion (2017), “Risk-sharing and consumption smoothing patterns in the US and the Euro Area: A comprehensive comparison”, CEPS Working document 2017/04.
Bénassy-Quéré, A, M K Brunnermeier, H Enderlein, E Farhi, M Fratzscher, C Fuest, P-O Gourinchas, P Martin, F Pisani, H Rey, I Schnabel, N Véron, B Weder di Mauro, J Zettelmeyer (2018), “Reconciling risk sharing with market discipline: A constructive approach to euro area reform”, CEPR Policy Insight No 91.
Messori M and S Micossi (2018), “Counterproductive Proposals on Euro Area Reform by French and German Economists”, CEPS Policy Insight No. 2018/04.
Vihriälä, V (2018), “Market Discipline and liquidity key issues in the EMU reform”, Etla Policy Brief 64.