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Fixing a sovereignless currency

The euro is unique in that it is a currency without a sovereign. Since the crisis, there have been major developments towards making the Eurozone more resilient, including the banking union and the European Stability Mechanism (ESM). This column, originally published 12 February 2016, explores whether further normalisation is required to make the Eurozone function properly. It argues that the Eurozone, unlike existing federations, lacks the ability to deliver counter-cyclical fiscal policies while complying with fiscal discipline. Macroeconomic coordination will thus require rules, a strong and independent European Fiscal Board, and the strengthening of the ESM.

Editor’s note: Originally published on 12 February 2016, this is a chapter from the eBook How to fix Europe’s monetary union: Views of leading economists.  

Since the inception of the crisis, major progress has been achieved in the Eurozone to make it more resilient. Although still unfinished and not fully tested, the banking union will contribute to reducing systemic risks in the Eurozone, protecting taxpayers from residual risks, and attenuating the sovereign-bank risk loop. In parallel, the introduction of the European Stability Mechanism (ESM) has proved instrumental in dealing with sovereign debt crises through conditional financial assistance. Here again, the agenda is still unfinished since the ESM will hardly address a sovereign debt crisis in a large member state, and because the question of sovereign debt restructuring is still unsolved. Finally, the ECB has provided a powerful backstop to self-fulfilling liquidity crises through its commitment to intervene on secondary markets against adequate conditionality. Although still untested, the Outright Monetary Transactions (OMTs) have been a major stabilisation tool.

These three major advances – banking union, ESM, OMTs – represent significant moves towards more sharing of both sovereignty and risk. In the case of the banking union, the responsibility for bank supervision is now shared at Eurozone level (through the Single Supervision Mechanism), whereas the residual risk is partially shared through the progressive building up of the Single Resolution Fund. For the ESM, risk sharing involved in financial assistance goes hand in hand through a form of ‘federalism by exception’ whereby the centre may impose an adjustment programme in times of crisis. As for OMTs, finally, sovereignty is clearly at the federal level whereas the purchase of troubled debts may involve some form of risk sharing to the extent that liquidity and solvency risks cannot be fully separated.

Such progress has been made possible by the commitment of member states to reduce the amount of risk at the bank level (through higher capitalisation), at the fiscal level (through the reinforced Stability and Growth Pact – SGP) and at the macroeconomic level (through the European semester and Macroeconomic Imbalance Procedure - MIP).

More fundamentally, these three innovations all work in the direction of normalising the Eurozone with respect to existing federations.

In existing federations, such as the US, Canada, Germany, or Switzerland, banking supervision is a federal responsibility; sub-national debt crises are generally solved through some form of conditional financial assistance from the federal level (except for very small entities, which are allowed to go bankrupt, see Corda et al 2015); and the central bank may purchase securities issued or guaranteed by government-sponsored agencies on the secondary market (although the bulk of existing sovereign bonds are federal debts, in sharp contrast with the predominance of national debts in the Eurozone).

The question then is whether these bold evolutions are sufficient, or whether further normalisation is required to make the Eurozone function properly.

The Eurozone remains an outlier

The Eurozone was conceived as a monetary union without a sovereign. It was just an arrangement between several member states to share monetary sovereignty, provided they commit not to abuse the system through fiscal profligacy. This arrangement failed. The response was to transfer an additional block of sovereignty (bank supervision), reinforce the rules of the game and introduce a layer of risk sharing. However, the €500 billion lending capacity of the ESM represents less than 10% of Eurozone members’ combined budgets, whereas in the most decentralised federal country in the OECD – Canada – 24% of general government expenditures are decided at central level. More importantly, the ESM lending capacity is restricted to financial assistance to crisis countries, leaving aside traditional responsibilities of federal governments such as the funding of common public goods (infrastructure, defense, security, etc.), inter-individual transfers, and macroeconomic stabilisation.1

Common public goods

In the current organisation, the funding of common public goods is carried out at the EU level, as part of a budget totalising around 1% of the EU’s GDP. This budget may be criticised in different ways. First, it may not address the priorities of a ‘knowledge economy’ (see Sapir et al 2004, Sapir 2014). Second, it covers a 7-year period (presently from 2014 to 2020), with limited flexibility. Third, although some of its programmes (such as the European Maritime and Fisheries Fund) may target sub-groups of countries, it needs to be approved by all EU countries, at unanimity.

The Eurozone will probably stay a sub-division of the EU for a long time. The question then is whether some Eurozone specific public goods should be financed at Eurozone level, separate from the EU budget. De facto, this is the logic of the ESM, whose mandate is to ‘produce’ a euro-specific public good, namely financial stability. Along these lines, the ESM could be reinforced to provide bridge financing to the Single Resolution Fund and to a future deposit (re)insurance fund. It could also provide precautionary credit lines to countries that comply with the SGP. This would reduce discontinuity triggered by an ESM programme, and it would alleviate the pressure on the ECB to use the OMTs in crisis times, especially when there is a risk of contagion.

Beyond financial stability, it is difficult to delineate a euro-specific public good. Eurozone countries have a specific stake in the free mobility of labour, which could justify targeted spending to safeguard this major achievement of the EU. However, the decision-making on these issues is not at the Eurozone level. Worse, not all Eurozone member states are part of the Schengen area. The EU is paying a high price for its choice of a multi-speed integration process.

Eurozone countries also have a stake in their partners’ growth rates. This is because low growth makes public and private debts unsustainable, raising the risk of a systemic crisis. However, GDP growth depends heavily on local policies, which raises the risk of moral hazard in relation to pro-growth spending. Except for specific projects with large spillovers, such as electricity cross-border connections, there is little scope for funding investment at Eurozone rather than national level.

Inter-individual transfers

In federal countries, social security spending is generally highly centralised, especially for public pensions and unemployment insurance (the degree of centralisation varies across countries for health care, family allowances and social assistance, see Escolano et al 2015).

As with any insurance system, social insurance should be designed behind the ‘veil of ignorance’ – individuals contribute to the system without knowing their personal exposure to the different risks, and the probability of each individual to see the risk materialise is the same across individuals. In federal countries, the distribution of the risks is made more even through harmonised rules for pensions or unemployment benefits across the different states or regions, harmonised labour market structures, and labour mobility. Despite such harmonisation, social ‘insurance’ often involves permanent transfers.

In the Eurozone, since no such harmonisation can be envisaged in the foreseeable future where permanent transfers are not politically possible, the scope for a common social insurance scheme is limited.

Macroeconomic stabilisation

In existing federations, macroeconomic stabilisation is generally the responsibility of the federal government. Fiscal stabilisation goes through federal tax receipts that increase in upturns, whereas federal spending is either neutral or counter-cyclical. The federal budget stabilises both idiosyncratic shocks and symmetric shocks. In the latter case, macroeconomic stabilisation involves fiscal deficits in bad times and surpluses in good times. In contrast, sub-national governments generally apply a budget balance rule whatever the economic situation.

In the Eurozone, macroeconomic stabilisation is devoted to member state budgets for idiosyncratic shocks, and to the ECB for aggregate shocks. As argued by Bénassy-Quéré (2015), this division of labour has largely failed for mainly three reasons:

  1. insufficient market discipline prior to the crisis;
  2. neglect of financial risks with major spillovers on fiscal balances; and,
  3. the inability of the ECB alone to address a massive negative demand shock.

The lack of fiscal stabilisation capacity is not specific to the Eurozone. Indeed, other OECD countries such as Canada, Australia and the UK also tend to run pro-cyclical fiscal policies, which show how difficult it is to design fiscal policies properly. In the Eurozone, the SGP puts limited pressure on governments in good times to reduce their structural deficits, whereas in bad times the rules become binding, and/or the market refuses to lend any more.

Normalising fiscal policy in the Eurozone with respect to existing federations would involve shifting macroeconomic stabilisation from state to federal level, and replacing the complex set of SGP rules by a simple budget-balance rule at state level. Allard et al (2013) suggest that the risk to lose access to the federal budget could raise the level of compliance of member states vis-à-vis both fiscal rules and policy recommendations.

However, launching a fully-fledged Eurozone budget would entail far-reaching institutional changes, with a federal government (at least a finance minister), a federal parliament, a federal tax, and the ability to issue federal debt; with no guarantee that the discretionary part of the federal budget would really be counter-cyclical.

Additionally, there is a size question. According to Sørensen and Yosha (1998), the US federal budget smooths around 15% of idiosyncratic shocks to US state incomes.2 The smoothing effect rises to 25% in Canada, but is only about 10% in Germany (see Allard et al 2013). These results are obtained with two-digit federal budgets (e.g., 20% of GDP in the US). The question then is whether a small Eurozone budget of say 2–3% of GDP would provide any significant macroeconomic stabilisation.

At first sight the answer is in the negative – if the federal budget is ten times smaller than in federal countries, the amount of smoothing should be about one tenth, hence 1–2.5%. It is surely not worth designing a complicated system, with political opposition and moral hazard problems, to obtain such a small smoothing effect.

However, federal budgets, which are the result of history, are generally not devoted to macroeconomic stabilisation. They cover the running of federal services, military spending, or permanent transfers that may not react to the macroeconomic cycle. In the Eurozone, a macroeconomic stabilisation scheme may be designed from scratch with the single objective of producing significant stabilisation.

Early proposals in this direction include Italianer and Vanheukelen (1992) who suggested that a member state whose unemployment rate increases by, say, 1 percentage point more than the Eurozone average (or falls by 1% less) would receive a transfer as high as 1% of GDP, an amount capped at 2% of GDP for a 2% unemployment gap. Inversely, member states enjoying an increase in the unemployment rate that is less than the average (or a fall that is greater) would pay a contribution (the amount being calculated so as to balance the system). As shown by Hebous and Weichenrieder (2015), Spain would have received transfers of 2% of GDP each year from 2008 to 2012, after having paid contributions of 1% in 2003-2004 and 2% in 2005.  Symmetrically, Germany would have received transfers over 2003-2005 and paid a contribution of around 1% of GDP during the crisis.

One drawback of such system is that countries in bad times have to pay for countries in very bad times. This constraint is waived if the system must be balanced only over the cycle (not on a yearly basis). According to Hebous and Weichenrieder, applying a simple rule would have allowed the system to borrow around 0.8% of Eurozone’s GDP in 2009, which could have significantly raised the amount of macroeconomic stabilisation.

Alternatively, temporary transfers may be based on output gaps (see Enderlein et al 2013). However, given the frequent revisions of the latter and the distance between output gaps and the real life of the people, this idea has received less attention than schemes organised around the unemployment rate. Indeed, recent proposals mostly focus on European Unemployment Insurance (EUI), with two main avenues – an ‘all-time’ system (e.g., Dullien 2013, Lellouch and Sode 2013) or a ‘catastrophic’ one (Gros 2014), the latter providing more stabilisation than the former but only for countries suffering ‘big’ shocks.

In order to contain moral hazard, however, most proposals include a system of clawback so that each member state would balance contributions and transfers received over the medium run. Hebous and Weichenrider note that clawbacks tend to move an insurance scheme into a borrowing one. The usefulness of such a scheme is doubtful for those countries not liquidity constrained. If member states are not prepared to pool some resources to really insure at least large shocks (‘catastrophic’ scheme), then it may be better not to pretend to set up an EUI.

Back to basics

The above discussion suggests that what is still missing in the Eurozone is the ability to deliver counter-cyclical fiscal policies while complying with fiscal discipline. The problem then is twofold:

  1. There is no Eurozone budget, and suggestions to introduce one tend to degenerate de facto into a borrowing scheme once the constraint of moral hazard is introduced.
  2. There are 19 national budgets, but they tend to be pro-cyclical or neutral, and at the same time to often violate fiscal rules.

One way forward would be to raise the incentives for national fiscal policies to be counter-cyclical, both in good times and in bad times.

In good times, a country complying with the SGP could nevertheless see its fiscal policy constrained by the MIP, in case there is a risk of overheating like in Ireland or Spain before the crisis. This would involve streamlining the MIP and making it more symmetric with respect to the SGP (see Bénassy-Quéré 2015).

In bad times, to the extent that the country retains market access, incremental investment and/or incremental unemployment spending could be temporarily excluded from the measure of the fiscal deficit. The corresponding expenditures would be put in an adjustment account, and introduced back into the deficit during the recovery.

Public investment is a good candidate to make fiscal policy more counter-cyclical, since it can generally be moved forward or backward with limited damage. As for incremental unemployment expenditures, they normally display a high multiplier. To the extent that the hike in unemployment is temporary, they do not involve any ratchet effect. Expanding unemployment spending during a crisis (and avoiding cutting investment to preserve social transfers) is a major challenge for macroeconomic stabilisation at the country level. There is much less rationale for adjusting other areas of public spending (such as education, health care, or security) over the cycle. On the revenue side, since stable tax rates are generally considered an important confidence factor, going beyond automatic stabilisers may not be appropriate.

At a later stage, a European unemployment fund could be set up at the Eurozone level in a similar way as in the US with the Federal Unemployment Tax Act (FUTA). Employers and employees contributions would be transferred to the national compartments of the fund, and the fund would transfer the benefits to the national insurance agencies. In case a Member state is temporarily in deficit, the Fund could make loans. If a member state is later unable to repay the loan, the contribution rate would be raised to balance the account over the cycle. Once national labour markets have significantly converged and confidence has been recovered, exceptional transfers could be delivered to specific countries suffering exceptional situations, as it is the case in the US.

The terms ‘good times’ and ‘bad times’ can hardly be carved in stone, nor can they be left to the decision of the politicians. The European Fiscal Board could play a key role to promote an independent view of fiscal policy in exceptional good or bad times, at national and euro-wide level. As argued by Calmfors and Wren-Lewis (2011) and Calmfors (2015), fiscal councils are a complement to fiscal rules – they allow operationalising more flexible, ‘intelligent’ rules. The ‘flexibility’ of the SGP with respect to economic activity could then be left to European Fiscal Board guidance rather than relying on ‘rules in the rules’.

Based on the experience of five federal countries, Bordo et al (2011) consider a strict no bail-out clause to be instrumental in fostering fiscal discipline. However, Cordes et al (2015) find that the no-bail out clause is generally not applied to large sub-national jurisdictions, except if the national one is itself in crisis. Rather, sub-national jurisdictions receive federal assistance against adjustment commitments, which is the current approach of the ESM. In order to avoid self-defeating adjustment programmes, and because the ESM is not supposed to lend to insolvent governments, it is necessary to make a sovereign debt restructuring a real possibility by further strengthening the financial sector and its firewalls, and addressing the holdout problem. This is more important than designing debt restructuring rules that will also be difficult to carve in stone. In a sense, the debt restructuring scheme is already there. What is missing is the condition for it to be applied.


Can a currency survive without a sovereign? Probably yes, for some time, if macroeconomic coordination can build up a ‘shadow’ sovereign. Political legitimacy being national, governments will unlikely volunteer for more coordination. Hence the only solution is to rely on rules, complemented with a strong, independent  European Fiscal Board, in order to strike the right balance between fiscal discipline and macroeconomic stabilisation.

Simultaneously, the ESM should be strengthened to back existing stabilisation tools (banking union, national budgets), and provide firewalls. A larger ESM would mean issuing more federal bonds that would also provide stabilising ‘safe’ assets.

In the medium term, the ESM could be turned into a fully-fledged treasury that would manage a crisis fund (the ESM itself) and possibly other funds (unemployment insurance, investment, refugees…). The governance would have to be adjusted around a Finance Minister that would be accountable to the Eurogroup and to a Eurozone chamber of the European Parliament. Before such institutional changes can be made, at least the governance should be simplified through the generalisation of qualified majority voting at the Eurogroup and at the ESM board.


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1 As highlighted by Pisani-Ferry (2011), the ESM is a mutual assistance arrangement, not a common budget with delegated competences.

2 When a state income falls by 10% before federal taxes and transfers, it falls only by 8.5% on average after federal taxes and transfers.

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