This column is a lead commentary in the VoxEU Debate "Euro Area Reform"
One criticism of our paper on euro area reform (Bénassy-Queré et al. 2018) is its supposed silence on the role of the ECB (Bini Smaghi 2018, De Grauwe and Ji 2018). However, the reforms proposed in the paper actually have significant implications for the ECB’s role, in a way that would make it easier for the ECB to fulfill its mandate.
It is true is that in Bénassy-Queré et al. (2018) we did not recommend significant changes to the way the ECB operates monetary policy or to the way the ECB, since 2012, has reacted to the euro crisis and the risk of disintegration of the euro area. Among the co-authors of the report, we may have different views on the necessity and efficacy of quantitative easing and on the pace at which ECB should normalise its monetary policy. There are standard debates among economists regarding the state of the cycle, the level of output gap, and the risk of inflation. Regardless of how one stands on these issues, however, an important benefit of our recommendations would be to mitigate the risk of overburdening the ECB, by making the euro area more sustainable.
Redenomination risk, self-fulfilling expectations, and multiple equilibria were key destabilising mechanisms during the euro area crisis. At the same time, the explosion of spreads between core and periphery countries also had fundamental underpinnings, including for some countries a lack of fiscal prudence and/or lack effective macroprudential policies (for a quantitative assessment of the respective roles of public debt, private debt, and spread dynamics in different countries, see Martin and Philippon 2017). These fundamental forces were compounded by self-fulfilling dynamics. It took the famous “whatever it takes” declaration of the ECB to stop them and to coordinate investors’ expectations on the ‘good’ equilibrium without redenomination and without exit.
A euro area where the ECB does not take into account the possibility of financial instability through self-fulfilling crises and does not act against it with a mix of strong commitments and actions, such as the Outright Monetary Transactions (OMT) progamme, is not sustainable in the long term (Aguiar et al. 2015). The proposals in Bénassy-Queré et al. (2018) should clarify and facilitate the exercise of this responsibility in terms of financial stability, in three ways.
First, by allowing and facilitating debt restructuring inside the euro area as a last resort action in case of unsustainable sovereign debt, our proposals make it easier to differentiate between a debt crisis due to redenomination risk and a debt crisis due to sustainability. The ECB should only intervene in the first case and not in the second. Our proposals will reduce the financial and economic cost of a debt restructuring and the collateral damage of a sovereign debt restructuring. From this point of view (Gourinchas et al. 2018), this should reduce the pressure on the ECB to intervene and the probability of the actions of the ECB stretching its legal mandate by morphing into partial bailouts for countries with unsustainable fiscal positions.
We fully recognise the difficulty of differentiating between the two risks. Our proposals fit in with an institutional framework where the ESM deals with sovereign liquidity crisis (through lending) and sustainability crisis (through restructuring), while the ECB deals with redenomination risk generated by self-fulfilling expectations. Our proposal to facilitate fast lending by the ESM to pre-qualified countries should reduce the need and pressure for the ECB to step in.
Second, by weakening the ‘doom loop’ between banks and sovereigns through the introduction of concentration charges on sovereign debt, our proposals mitigate one of the key mechanisms that may catalyse self-fulfilling expectations of exit of financially fragile countries (Farhi and Tirole 2018).
Third, our proposals for new fiscal rules, combining more flexibility and more responsibility, and for a fiscal capacity to help countries in case of large negative shocks should also prevent a situation where the ECB is the sole institution with the possibility to provide macroeconomic stimulus. These rules should also contain the ex ante moral hazard incentives (debt reduction targets and junior bonds to finance excessive spending) to prevent countries from running irresponsible fiscal policies and putting themselves at risk of relying on ex post ECB or ESM interventions.
Overall, by clarifying its mission and by reducing the need for intervention, our proposals allow the ECB to pursue its inflation mandate and allow the integrity of the euro area to be better preserved.
Aguiar, M, M Amador, E Farhi, and G Gopinath (2015), “Coordination and Crisis in Monetary Unions”, Quarterly Journal of Economics 130(4): 1727-1779.
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.
Bini Smaghi, L (2018), “A stronger euro area through stronger institutions”, VoxEU.org, 9 April.
Gourinchas, P-O, P Martin and T Messer (2018), “The Economics of Sovereign Debt, Bailouts and the Eurozone”, mimeo.
De Grauwe, P and Y Ji (2018), “Financial engineering will not stabilise an unstable euro area”, VoxEU.org, 19 March.
Farhi, E and J Tirole (forthcoming), “Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops”, Review of Economic Studies.
Martin, P and T Philippon (2017), "Inspecting the Mechanism: Leverage and the Great Recession in the Eurozone", American Economic Review 107(7): 1904–1937.