In January 2018, a group of 7+7 French and German colleagues presented proposals to reform the euro. They have since become disappointed by the lack of progress (Bénassy-Quéré et al. 2018 and 2019). The debate promoted by their proposals generated hundreds of pages, with many of the contributions collected in a Vox eBook (Pisani-Ferry and Zettelmeyer 2019). In a new paper (Oksanen 2019), I review this ample material and show that, despite its large volume, a surprisingly large number of important elements for fruitful analysis and policy advice were missing.
Most recently, in early October, the proposals for a euro area budget were effectively buried by euro area finance ministers. A tiny instrument will be included in the EU budget, reaching only 0.15% of euro area GDP in seven years. It will not have any macroeconomic meaning, and its declared purpose – namely, contributing to convergence and competitiveness – remains doubtful.
More importantly for the future, the decision in September by the Eurosystem, which consists of the ECB and the national central banks, to cut interest rates to -0.5 % and to restart its quantitative easing programme became the object of fierce criticism. The confusing controversy showed that the interconnections between the fiscal and monetary domains badly need to be clarified.
There are now signs that new orientations are shaping up. With the tenure of Christine Lagarde starting soon, the Financial Times (2019) called in its editorial of 25 October for a broader toolkit for the ECB. This would allow her to finish the job Mario Draghi started, and also reiterates the emerging consensus on the need for fiscal policy to support economic recovery.
The new approach for reforming the euro needs four legs
Useful proposals for reforming the euro need the following four legs.
- The political nature of the euro, like that of any monetary union, should be recognised.
- Mistrust between member states has shaped the euro, as they have not trusted that all countries are willing and capable of conducting sound fiscal policies. The reforms should therefore help in building trust and avoid rules and procedures that create more conflict and disputes.
- Presenting proposals as indispensable even if they are politically unrealistic (for example, when they require changes to the EU Treaty) and economically unfounded is unfruitful and even harmful.
- The potential of the existing institutions, mechanisms, and rules should be carefully recognised. The functions of the Eurosystem are often ignored even if they serve several important purposes.
The basic problem is mistrust
It is now commonly accepted that fiscal policy has been procyclical, with the only significant exception being in 2009 when GDP fell abruptly. Ending short-sightedness and procyclicality requires that their roots are correctly identified. This is not breaches of the fiscal rules, but the rules themselves. In 1997, the Stability and Growth Pact (SGP) rules became short-sighted because it is difficult to convincingly commit all members to conduct sound policies in the long term. The strict rules to be imposed at every instant became a poor proxy. Hence, even the functioning of the automatic stabilisers was hampered.
Former European Commission President Romano Prodi famously said in 2002 that the SGP rules were “stupid”. Yet, the SGP crisis in 2003 was generated by the short-sighted and ultimately legally unfounded interpretation of the rules. This mistake then led to their first revision, which allowed flexibility under unforeseen adverse developments.
There have been attempts to alleviate short-sightedness by giving weight to the medium-term objectives for budget balances. However, these suffered from several deficiencies, not least because they were not based on identifying a relevant range of policy options. The list of other deficiencies is so long that their use is seriously undermined. In all this work mistrust prevailed, and trying to prepare for situations that are never fully foreseeable led to fuzzy complications.
The Global Crisis of 2008-09, and especially the Greek crisis, led to further complications such that that no finance minister would even try to explain the rules in front their parliaments. Even worse, the view emerged that the reason for the euro crisis was that the fiscal rules were not adhered to firmly enough. This led to tight fiscal policies in the euro area as a whole and contributed to a further fall in GDP in 2012-13.
The proposals to replace the use of government structural balances in short- and medium-term fiscal policy with a simple expenditure rule would barely go halfway towards solving the problems of procyclicality. Implementing the proposed sanctions for non-compliance would require additional provisions and exceptions, which could easily lead to conflict and further mistrust.
The focus should be shifted to the long-term sustainability of public finances
The focus should be shifted from short-sighted fiscal discipline to the long-term sustainability of public finances, and this should be done convincingly. This is what “sound public finances”, a guiding principle in the EU Treaty, must mean. There is no easy way to define and measure long-term sustainability with short- and medium-term indicators. However, the euro reform debate suffered from being practically silent on the true long-term issues, obviously because sustainability cannot be easily defined and measured. Yet, independent experts in academia should provide analysis and arguments, and in particular point out aspects that are being, or threaten to be, ignored.
Increasing the retirement age
One example of the deficient analysis of policy options concerns a significant raise in the retirement age. This has not been duly considered for several institutional and political reasons. However, pension reforms can often increase the government deficit and debt in the short and medium term, concealing the positive effects over the long term. Under the current fiscal rules, this has even led to reversals of pension reforms in some countries.
Revamping the role of the Eurosystem
The most striking feature in the debate on the euro has been that the functions of the Eurosystem have not been fully understood. Any monetary union is a politically established institution and requires a pertinent commitment from the high political level to preserve its essential functions. When the euro suffered from the consequences of the Global Crisis, the declaration by Mario Draghi in July 2012 that “the ECB is ready to do whatever it takes to preserve the euro” was a sufficiently convincing commitment and removed doubt.
The crucial roles of the Eurosystem should be recognised:
- Managing the smooth operation of the payment systems at all times. This means that the Eurosystem must accept any transactions irrespective of the internal positive and negative balances possibly accumulating between the euro area central banks under the TARGET2 payment system.
- Functioning as the lender of last resort to solvent governments and financial institutions (its main task). Otherwise, a liquidity crisis emanating from any source could develop into a public finance crisis and cause illiquidity among the financial institutions. This could lead to a general credit crunch, ultimately triggering bankruptcies and a general economic collapse.
Operating as lender of last resort to solvent sovereigns is based on the provisions on outright monetary transactions and the various asset purchase programmes. How solvency can be defined with sufficient clarity is a key issue, and it should be accepted that there is no way to give it a precise meaning that is applicable in all circumstances. The assessment is always political and goes well beyond the technical work of the experts, as it must encompass the capability of governments to adjust their policies in unexpected circumstances. Some room for interpretation must be left to the Eurosystem, working under its commitment to “do whatever it takes” and acting independently in choosing and using its instruments.
Solvency forms the link between sound public finances and a sound monetary system. This means that governments should reorient fiscal policy towards long-term sustainability, and that the Eurosystem must assess their performance when acting as the lender of last resort.
The Eurosystem already executes many functions
The Eurosystem already performs several functions that are called for in numerous reform proposals. It provides a safe asset by accepting deposits, which are as safe as any asset guaranteed jointly by the member governments could ever be. This function of the Eurosystem could be extended by issuing certificates of deposit and making them directly available also to non-banking financial institutions (pension funds, money market funds etc.).
This should be good news, as creating separate bonds issued jointly by the euro area governments would require a change to the EU Treaty, and one which would most probably fail and leave the proposed reform in a limbo. Making Eurosystem certificates of deposit available to the market would have several important implications, including for the international role of the euro and for the conduct of monetary policy.
The proposal to establish a European deposit insurance scheme has little prospect of being adopted until banks in all member states have been cleaned of excessive non-performing loans.
Relief comes from the Eurosystem. Confidence that it will fully perform its function of operating the payment system between euro area central banks under TARGET2 will help in preventing bank runs. This is because actors and markets can assume that the liquidity of solvent banks will be duly guaranteed. This gives time for cleaning non-performing loans in good order.
Secular stagnation, low interest rates, long-term public investment, and climate change also put the monetary stance in a new light
Leading economists have come to ponder fiscal policy and public debt after the Global Crisis of 2008-09, as there is a serious risk of secular stagnation and persistently low long-term interest rates. Here, the relevant time span might be 10 to 30 years.
Responding to this risk requires a reorientation of fiscal policy in the long term. More specifically, low interest rates can facilitate a serious response to combat climate change, a renewal of production and help address the use of energy, as well as other investments in infrastructure. Long-term public investment will help economies to gradually recover from secular stagnation, while achieving long-term sustainability of governments. When secular stagnation is overcome, monetary policy can return to a stance practiced in a more normal environment.
In this way, the guiding principle of sound public finances and the independence of the Eurosystem in performing its tasks, both anchored in the EU Treaty, are interconnected and can support each other.
When incoming ECB governor Christine Lagarde spoke before the European Parliament on 4 September, she aimed to balance the two policy domains. This was before a row broke out between the majority of the Eurosystem central bank governors and hard-line critics in October. For Lagarde, monetary policy is not the only game in town. She believes that governments should also stimulate their economies according to their capacity, pointing to Germany and the Netherlands. Also, the ECB could direct its corporate asset purchases towards green bonds.
The importance of addressing climate change has also been stated over the past few months by the incoming European Commission President Ursula von der Leyen. This issue gained attention in the various declarations before and after the European Parliament elections in 2019. Mitigating climate change and saving energy are of pivotal importance for the EU, as the need for EU-wide coordination is obvious. It should take a leading role globally.
Pragmatic reforms with a long-term vision
Opening up to these genuine and real long-term issues sets the debate over the reform of the euro in a new light, leaving behind much of the extensive semi-academic debate over the past two years.
It is increasingly accepted that the well-functioning of the euro can be assured provided that the interconnections between the fiscal and monetary domains are duly recognised. The Financial Times editorial on 25 October referred to above offers one example of this view. It added, however, that the ECB must broaden its policy toolkit.
Based on how the Eurosystem has been performing over the past few years, however, the view can also be taken that it already has a broad toolkit ready to be used. While some new features might be useful, the real issue is that some who would seek to give the ECB a narrower role are questioning the efficient use of existing tools. Therefore, the challenge is to establish a sufficiently broad consensus for the use of the tools at hand.
In addition, for the fiscal domain I take the view that pragmatic policies with a long-term vision can well be sufficient without cumbersome institutional reforms that may require changes to the EU Treaty, and therefore risk failure. Focusing on the long-term sustainability of government finances is necessary for several reasons, one of them being that otherwise flexibility in the short and medium term cannot be allowed.
To achieve a broad understanding of this view, it must be emphasised that flexibility should not open the door to irresponsibility. Under the current conditions, it is necessary to remember that, even though governments can now borrow at negative interest rates and should use this opportunity for long-term investments, there is no ‘free lunch’ everywhere else or forever.
Public finances must be sustainable in the long term, and this means, for example, that an increase in the retirement age must seriously be considered. Otherwise, social expenditures will easily get out of hand. Also, to put it briefly, it must be accepted that over the long term a larger share of resources should go towards innovation and investment, since moderating climate change, renewing production and the use of energy requires resources. This means that a smaller share is available for current consumption. Still, seen positively, the investment-led recovery also offers a vision of sustainable growth for consumption.
Communicating the substance and doing it clearly
There is no time to waste. The required investments need innovation and financing, which means that the horizon for tangible effects is two to three decades. This highlights the need to avoid any delays in setting the required actions in motion. Otherwise, the significant threats will become realities.
To serve the public interest, it would be advisable to concentrate on pragmatic reforms that primarily concern the long-term performance of economies, even though politically they may not be high-prestige initiatives.
Politicians must make an effort to communicate the new directions for fiscal and monetary policy to the general public. People must be able to trust that the basic institutions such as public finances and the monetary system are managed with a commitment to “do whatever it takes” to preserve not only the euro, but also our societies at large.
Bénassy-Quéré, A, M K 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, 17 January.
Bénassy-Quéré, A, M K 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 (2019), “Euro area architecture: What reforms are still needed, and why”, VoxEU.org, 2 May.
Financial Times (2019), “Next ECB head must broaden policy toolkit – Christine Lagarde must finish the job Mario Draghi started”, Editorial, 25 October.
Oksanen, H. (2019), “Reforming the Euro pragmatically: Towards sustainable fiscal policy and a revamped Eurosystem”, CESifo WP No 7912, October.
Pisani-Ferry, J and J Zettelmeyer (eds) (2019), Risk sharing plus market discipline: A new paradigm for euro area reform? A Debate, VoxEU.org eBook, June.
 TARGET2 is the leading European payment system for large-value transactions, and is owned and operated by the Eurosystem.