This column is a lead commentary in the VoxEU Debate "Euro Area Reform"
The proposal for how to complete the monetary union’s architecture, made by a group of 14 economists from France and Germany (Bénassy-Quéré et al. 2018), constitutes a timely attempt to build a consensus position between economists from the two largest euro area countries and from a broad political spectrum.
Overall, most of the measures advocated in the paper are sensible and form a coherent package in which the various pieces complement each other. Actually, the main proposals of the paper are broadly similar to the ones I made in a paper published last year (Claeys 2017). Basically, to make the monetary union more resilient, it is necessary to complete the Banking Union, develop a Capital Markets Union to increase private risk sharing, reform the European fiscal framework, build a euro area stabilisation tool to deal with large asymmetric shocks, and reform the European Stability Mechanism (ESM).
However, one problematic element of the ‘Franco-German’ package is the implicit view on what should be considered as a safe asset in the euro area. This position is exemplified in the group’s inclination to introduce sovereign bond-backed securities (SBBS) to play the role of safe asset in the euro area.
What is a safe asset?
A safe asset is a liquid asset that credibly stores value at all times, and in particular during adverse systemic crises. There is a high demand for this type of asset: from savers in need of a vehicle to store their wealth for the future, from domestic financial institutions to satisfy regulations and to post collateral in financial operations, as well as from emerging market economies looking for means to invest foreign exchange reserves.
Thanks to their high liquidity and simplicity, sovereign debt securities can play that role as long as two conditions are fulfilled: 1) the country’s fiscal policy is sustainable; and 2) its central bank stands ready to play a backstop role in the sovereign debt market in case of a self-fulfilling crisis, while having an impeccable record in maintaining the value of the currency (i.e. low inflation and stable foreign exchange rate).
However, in the euro area, these two conditions have not always been fulfilled: 1) Greece clearly did not have sound public finances before the crisis; and 2) a strict interpretation of the prohibition of monetary financing, coupled with the difficulty of disentangling liquidity and solvency issues, prevented the ECB from offering a backstop to solvent sovereigns at a crucial moment (from 2010 to 2012). While the prohibition of monetary financing is justified to avoid unsustainable fiscal policies in the monetary union, this left the door open to self-fulfilling sovereign debt crises in some countries – at least until Draghi’s “whatever it takes” promise in the summer of 2012 and its formalisation as the Outright Monetary Transactions (OMT) programme. This put some euro area countries at a disadvantage to issue safe assets and extract the main benefit from doing so, i.e. the possibility to put in place countercyclical fiscal policies at low cost during recessions.
Which asset should play that role in the euro area?
Given the inability of some euro area sovereign bonds to play the role of safe assets during the crisis, ideas on how to create synthetic euro area-wide safe assets emerged. In particular, proponents of SBBS suggested pooling sovereign bonds from all euro area countries and using them to provide cash flows for securities issued in several tranches of different seniorities, in order to supply safe assets (senior SBBS) in large quantities to economic agents needing them.
However, the idea remains untested and politically controversial. Despite the support of the European Systemic Risk Board (ESRB) and the Commission, policymakers and public debt management agencies in many euro area countries are afraid of the unintended consequences that such a drastic change could entail for the sovereign bond markets of the euro area.
But in my view, the main argument against SBBS is that they are unnecessary and represent a distraction in the current debate. Instead, making all euro area sovereign bonds safe again, and for good, is the most desirable way to increase the supply of safe assets and avoid intra-euro area flights to safety during bad times.
What would it take for all euro area bonds to be considered safe again? As mentioned earlier, sovereigns need to fulfil two conditions, they must have 1) sustainable fiscal policies; and 2) a credible (inflation-targeting) central bank ready to play a backstop role in a liquidity crisis.
For public finances in the euro area to be sustainable, respecting fiscal rules is necessary. But current rules need to be drastically improved to play their role – ditching the flawed structural deficit rule and replacing it with a reformed expenditure rule would be a step in the right direction. However, good fiscal rules are not sufficient. To ensure sound public finances in the long run in the Economic and Monetary Union (EMU) it is also essential to have:
- effective macroprudential policies to avoid bubbles that end up weighing heavily on public finances when they burst;
- a completed Banking Union to make European sovereigns immune to domestic banking crises (thanks to the European Deposit Insurance Scheme and a credible Single Resolution Fund);
- and a euro area stabilisation instrument to deal with large asymmetric shocks.
This corresponds to some of the proposals in Bénassy-Quéré et al. (2018).
However, the authors do not offer a convincing solution to fulfil the second condition. Even though it was never activated, the creation of the OMT programme was crucial to end the self-fulfilling crises taking place in several countries in 2012. However, its setup remains fragile and could limit the possibility for some euro area sovereign bonds to qualify as safe assets in a crisis. It is thus essential to reform the ESM/OMT framework to make sovereign debt markets genuinely liquidity-crisis-proof in the EMU.
The necessary reform of the ESM
The problem of the OMT programme is that it is difficult to distinguish liquidity from solvency issues. If the ECB were using the OMT in all cases in which yields increase significantly, without being confident that they are related to a self-fulfilling issue and not linked to fundamentals, this could lead to moral hazard. A strong presumption ex ante that debt is sustainable is thus necessary to justify an OMT programme. To solve that problem, the ECB decided that the implementation of an OMT programme would be conditional on participation in an ESM programme. This implies that the Commission, in liaison with the ECB, would have to assess first whether the public debt of the country requesting help is sustainable, before the ESM programme can be approved. More importantly, given that the ESM board – composed of the finance ministers of the member states – needs to approve the programme, this means that there must be not only a technical assessment but also a political agreement that debt is sustainable. The ESM thus plays a fundamental role in the current setup, not primarily because of its capacity to lend to countries (which is relatively small) but because it provides the political validation of the debt sustainability necessary for the ECB to act.
However, the current options available at the ESM are not appropriate to solve a liquidity crisis, which would be highly problematic if the OMT ever needs to be used. Thus, the role of the ESM must be clarified and its functions should be differentiated depending on whether countries face liquidity or solvency crises. As I proposed in Claeys (2017), there should be three distinct ESM tracks:
1. A track for ‘pure’ liquidity crises, in which the ESM would just be used as a political validation device for the ECB’s OMT programme, without any conditions attached or any debt restructuring.
Conditionality would not be needed because there would no ESM loans involved and therefore no need to ensure the country’s capacity to repay its European partners. On the contrary, the current situation is problematic because a country might be forced to implement policies to access an OMT programme solely because of a problem of multiple equilibria for which it might bear little responsibility. In principle, today, to be eligible for the OMT, countries could apply to an ESM precautionary credit line instead of a full programme, but credit lines are still conditional on the signature of a Memorandum of Understanding. Moreover, the criteria for accessing credit lines is overly restrictive as it requires “market access on reasonable terms”, which might not be the case in a liquidity crisis. In practice, the criteria could be interpreted loosely and conditionality could be very light. But, for the sake of clarity, it is better to create a new track reserved for pure liquidity crises to ‘authorise’ OMT programmes by the ECB (the central bank would retain its independence as the Governing Council would be the one ultimately activating the asset purchases once debt sustainability is technically and politically validated). In the absence of such a track, countries facing a self-fulfilling crisis and in need of an OMT programme might be reluctant to apply to the ESM for fear of losing economic sovereignty. Adding a liquidity track to the ESM toolkit would increase the credibility of the OMT and reduce the likelihood of it ever being used.
2. A track for situations in which countries could be ‘at risk of insolvency’ in the future.
The ESM would offer a precautionary credit line under relatively light conditions, which would also make the country eligible for OMT once there is no doubt remaining on the sustainability of the country’s new debt trajectory. This track will be particularly useful in the cases in which liquidity and solvency issues are difficult to disentangle. This type of programme could be activated at an earlier stage with light conditionality, and no debt restructuring, to avoid full-blown crises and last-minute decisions.
3. A track for clear solvency crises, in which the ESM would provide funding conditional on a full macroeconomic/fiscal/financial adjustment programme and on the restructuring of the sovereign debt held by private institutions, which would also enhance market discipline ex ante. In that case, the ESM would provide a loan to help the country smooth the shock of losing market access.
Bénassy-Quéré et al. make some suggestions to reform the ESM in a direction that would lead to a set-up with two tracks broadly similar to track 2 with a flexible ESM facility (for countries with good policies ex ante and with light policy conditionality ex post), and to track 3 with a basic ESM programme conditional on sovereign debt restructuring. Unfortunately, they do not go as far as introducing an option similar to track 1, i.e. without ESM loans and without any conditionality, neither ex post nor ex ante. This track is, in my view, essential if financial markets were to call the ECB’s bluff one day and the OMT actually needs to be used to solve a liquidity crisis. The absence of such a track in their proposal to reform the ESM is problematic because it makes debt restructuring and/or policy conditionality compulsory to access the ESM and thus the OMT.
More generally, making debt restructurings the norm in the euro area could have dangerous implications. First, frequent debt restructuring would make it impossible for countries to borrow in bad times to run countercyclical fiscal policies (while ESM loans would not be sizeable enough to compensate for market access loss). Second, it is difficult to believe that public debt restructuring can be painless (even if banks are more protected thanks to concentration charges), given the crucial roles played by member states as a benchmark in domestic financial markets and in the real economy through the provision of safety nets and essential public goods (health, education, defence, etc.).
Overall, an improved euro area architecture – with a completed Banking Union, effective macroprudential policies, improved fiscal rules, a euro area stabilisation instrument, and a reformed ESM/OMT framework – would, in the long run, make all euro area sovereign bonds safer and thus limit drastically the intra-EMU flight for safety observed during the crisis. This would make the provision of safe assets through untested and potentially disruptive SBBS unnecessary.
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.
Claeys, G (2017) “The Missing Pieces of the Euro Architecture”, Bruegel Policy Contribution No 2017/28.