The package on economic governance to be discussed by the European Council on 16 December acknowledges the dangers associated with external imbalances as well as fiscal imbalances. It also provides rules for public debt (rather than simply deficit) reduction. Both innovations mark a significant improvement with respect to the defunct fiscal rules for the Eurozone.
However, the proposal of the European Commission overlooks the key lessons from the ongoing Eurozone crisis, which relate to the interactions between private and public debt, rather than to moral hazard in fiscal policies. It is also too shy on the key issue of the enforcement of the Stability and Growth Pact. Without quickly enforceable sanctions and an independent body making sure that they are indeed applied, the new rules will share the same fate of the old Stability and Growth Pact – a set of norms that are followed, only so long as a large country is not involved.
I address below these two critical issues.
Decoupling public and private debt
The old Stability and Growth Pact was aimed at avoiding increases in public deficits in the Eurozone. Under the common currency governments could enjoy lower costs of borrowing without having to worry about the exchange rate. This fuelled the need to define rules forcing governments to reduce the deficit, which was considered to be a sufficient condition for macro stability. The current economic governance package is not much different in that its goal is finding the appropriate instruments to enforce fiscal discipline. No revision of the objectives of the Pact is envisaged, as we had not learned anything from the Great Recession. The issue is that in any major financial crisis the private debt is bound to be fully transformed into public debt unless there are powerful mechanisms preventing this from happening. These mechanisms should be defined at the European level as the pressures to socialise private liabilities are just too strong for a “local” government.
It is quite remarkable, to say the least, that the Commission is concerned about relatively small deviations to the 3% deficit rule when the Irish government decided in a few hours (and without much consultation with the EU) to extend blanket guarantees to banks’ that have been estimated to amount to more than 160% of Irish GDP (see Baglioni and Cherubini 2010). In a financial crisis governments must be selective in bank rescues: not all banks can be saved and none of them should be at all costs. The idea that taxpayers would gain in the long-run by having their government to bail out banks, purchase and then resell toxic assets is simply wrong. As recently shown by Jean Tirole (2010), any serious plan to jumpstart collapsing interbank markets either by purchasing toxic assets from them or by offering state guarantees to bonds, unavoidably involves a cost for taxpayers even when markets are restored and these assets can be resold. This does not mean that these measures should always be avoided, but simply that there cannot be blank cheques as those signed in September 2008 by the Irish government and extended a few weeks ago.
The old Pact was based on the belief that the private sector had all the incentives to avoid excessive risk-taking. Banks would not over-lend to avoid losses; consumers would not over-borrow in order not to go bankrupt; international banks would not give funds to weak domestic banks and to governments continuing to run large deficits, and so on. All this clearly did not happen. In the current crisis we have had numerous examples of the private sector engaged in “reckless behaviour” leading to macroeconomic instability. The fact of the matter is that with the development of financial market and financial integration, the private sector can accumulate (excessive) external debt much more easily than 20 years ago, when only the public sector had the capacity to do so.
The new Pact therefore requires some financial regulation and some rules to monitor the systemic crisis risk associated with the behaviour of single financial institutions. Some consideration should also be given to introducing macro financial regulations imposing to banks higher reserve requirements during economic upturns (and perhaps also when the country has a current-account deficit). Concerning the monitoring of financial institutions, stress tests proved to be a useless exercise: the two Irish banks at the epicentre of the new phase of the crisis had comfortably passed the stress tests implemented just four months ago. The issue is that stress tests are tailored in such a way not to stress markets. The information collected for stress tests should instead be used to evaluate systemic interdependencies. Is it true that a debt restructuring of, say, bank A would drown banks B and C, ultimately endangering the stability of the financial system? According to the bankers involved, this is always the case. But it would be foolish to believe that they are always right. There are objective ways to establish these interdependencies and evaluate the size of spillovers of debt restructuring of financial institutions. These kind of stress-tests should be ideally be based on global credit registers as those advocated at BIS providing information on the bilateral exposures of banks (Cecchetti et al. 2010). At a preliminary stage, the information used to compile standard bank statistics could be used to evaluate the magnitude of systemic interdependence. These analyses should be done systematically by the new European Systemic Risk Board and would also provide teeth to the Commission when banning state aid to banks as well as mergers and acquisitions.
This leads to the second critical issue.
During the crisis, the European Commission authorised state aid to banks amounting to some 25% of EU GDP, of which almost 90% is state guarantees and the rest in bank recapitalisation, purchase of toxic assets, and ad-hoc measures for troubled institutions. One reason for this behaviour is the unprecedented nature of the crisis and a lack of information about interdependencies among financial institutions. Another reason is that the increasing political nature of the Commission makes it highly vulnerable to pressures from member states and also private institutions. The only condition imposed by the Commission in authorising state aid to banks in the midst of the crisis was the presentation of restructuring plans. This condition is just too weak. State aid should be allowed only conditional to measures forcing the too-big-to-fail institutions to break-up, thereby reducing the risks of contagion, and diluting the significant contribution of bank creditors to the costs of restructuring.
The Commission needs a stronger hand to prevent private losses being shifted on to taxpayers. This will free resources for measure-saving jobs and ease the reallocation involved in any recession, which are typically much cheaper than measures to support banks. For example, the German Kurzarbeit scheme which is estimated to have saved up to half a million jobs in 2009 cost “only” €5 billion. A stronger competition policy is also essential for job creation. Empirical evidence on panels of firms and establishments indicates that the bulk of net job creation is in start-ups rather than in the expansion of existing business units.
The enforcement of fiscal rules should also be improved. The only way to make any new Pact credible is to create an independent fiscal authority (as proposed by the ECB) monitoring the enforcement of the fiscal rules. The peer review method turned out to be in most cases a peer protection device. The old Pact died on 25 November 2003, when France and Germany were not sanctioned for their persistent excessive deficits. The new sanctions must be automatic, credible, sizeable, and quickly enforceable. An option worth considering is to define these sanctions mainly in terms of a reduced access to the new European Financial Stability Facility. This would increase the sanction of markets to governments fiscally less responsible. This use of the financial stability facility also implies that a higher endowment of this Fund implies stronger teeth in enforcing fiscal discipline. This is the kind of message that German voters need to receive.
This column is based on testimony to a hearing at the European Parliament on 7 December 2010.
Baglioni, Angelo and Umberto Cherubini (2010), “Bank bailout guarantees and public debt”, VoxEU.org, 1 December.
Cecchetti, Stephen, Ingo Fender, and Patrick MacGuire (2010), “Towards a Global Risk Map”, BIS Working Paper 309.
Tirole, Jean (2010), “Overcoming Adverse Selection:How Public Intervention Can Restore Market Functioning”.