This column is a lead commentary in the VoxEU Debate "Euro Area Reform"
The policy paper published by 14 French and German economists (Bénassy-Quéré et al. 2018) recognises that the euro area institutional framework needs to be strengthened. The proposals made in the document are a useful basis for discussion, but are nevertheless subject to important shortcomings.
The first shortcoming concerns the proposals to reduce the bank-sovereign doom loop, by setting limits on banks’ government bond holding through binding regulation (Pillar 1). The proposal it is not fully consistent with the current international framework, and risks penalising the European banking system. Furthermore, it may impair the proper functioning of the ECB’s monetary policy. The task of setting limits to banks’ holdings of government bonds and of fostering diversification should thus largely be assigned to the Single Supervisory Mechanism (SSM) (Pillar 2), which is ultimately responsible for the stability of the euro area financial system. This would ensure that the measures are appropriately calibrated in light of the prevailing economic conditions, while promoting the stability of the banking system.
There should in any case be no illusion that rules are sufficient to eliminate the doom loop. Even if banks had limited holdings of government bonds, they would nevertheless suffer disproportionally from a shock affecting their country. Given the lack of a federal budget in the euro area, banks’ ratings, credit risk, and access to financial markets are closely linked to the respective sovereign.
It is thus more important to accelerate the realisation of a fully integrated financial market in the euro area, and to reverse the recent trend towards fragmentation. A much more ambitious plan is required to implement the Capital Market Union within a credible timeframe and more decisive harmonisation, starting with the integration of national regulators into a single one – the European Securities and Market Authority (ESMA).
Furthermore, a true Capital Market Union cannot be created unless the Banking Union is fully implemented. Concerning the SSM, its actions are still impaired by European and national legislation which allows for national authorities to apply discretion and exceptions. Bank capital and liquidity can still not be moved freely within the euro area. The ECB should also be endowed with macroprudential instruments, in particular to prevent credit bubbles, which have represented a major cause of the crisis. The second leg of the Banking Union, in particular the resolution fund (SRF) and the rules for addressing failing banks, remains incomplete. The third leg of Banking Union, the European Deposit Insurance Scheme (EDIS), is a necessary requirement for the development of a truly integrated financial system, and the development of pan-European banks. EDIS is key to mitigate risk, in particular of contagion across the euro area. The Commission proposal is too gradual and not encompassing enough to be fully credible.
The second shortcoming of Bénassy-Quéré et al. (2018) is where it suggests dropping the Stability and Growth pact (SGP) and replacing it with market-based discipline.
The negative assessment of the SGP is not justified. Looking at the current state of public finances in the euro area, it fares relatively well compared to that of other advanced economies, in particular the US, Japan, or the UK. The SGP cannot be accused of having at the same time caused high debt and prevented stabilisation policy. The SGP has certainly evolved and become more complex. However, it is an academic illusion to think that fiscal policy can be run through simple rules, especially at times of crises, or outsourced to Fiscal councils, national or European.
The proposal aimed at strengthening market discipline through the issuance of junior bonds, that are automatically subject to restructuring in case of access to financial assistance from the European Stability Mechanism (ESM), is subject to several problems. First, experience has shown that markets do not discipline governments in good times, while being overly reactive in bad times. Second, an automatic restructuring mechanism, even of junior or subordinated debt, risks triggering self-fulfilling expectations that accelerate the resort to the ESM, and thus to debt restructuring, as shown by the post-Deauville agreement in 2010. In particular, the paper assumes that the restructuring of the junior debt would be without consequences for the ability to issue senior debt, which is contrary to experience (for instance, in the banking sector). Debt restructuring cannot be excluded, when the debt is unsustainable, but it should not be encouraged nor made automatic. It is an illusion that it would be without any consequence on markets and the real economy.
Bénassy-Quéré et al. rightly regret the confusion of roles in the Commission, in particular between the role of watchdog, or prosecutor, and that of judge. The questions, however, should be whose fault it is, and how can it be remedied. The role of the Commission is to monitor and make proposals. It is up to the Council, or the Eurogroup, to take the ultimate decisions. The problem comes from the fact that member states have not had the political courage to vote against the Commission (with the notable exception of 2003) and have often hidden behind the Commission to avoid taking a stance.
For instance, the German government has often complained about the Commission’s leniency towards France’s budgetary policy, but never explicitly voted against the Commission proposals. In fact, with the 2013 reform the Council has made it even more difficult for it to vote against the Commission by accepting the reverse majority voting in the excessive deficit procedure. This lack of courage and transparency by the Eurogroup cannot be addressed just by creating an independent fiscal board or watchdog. The problem is to make the decisions and the procedures explicit and transparent. This will not happen by creating two separate branches within the Commission, as proposed in Bénassy-Quéré et al. (2018).
Concerning crisis management, Bénassy-Quéré et al. are largely silent on the issue of efficiency and democratic accountability of the ESM. In particular, the decisions to grant support to a country should be taken by simple majority, as is the case in the IMF.
The third shortcoming is that the key factor which has been at the root of the European crisis, i.e. the redenomination risk (in other words, the risk of exit from the euro), has not been addressed. The immediate impact of the ECB’s “whatever it takes” stance shows quite clearly that the redenomination risk was a major factor in the euro area crisis. It increased the burden of implementing policy adjustments and fuelled a vicious circle with strong recessionary effects.
The redenomination risk is likely to remain a major problem unless the euro area institutional framework is adjusted. The Treaty does not provide for an exit clause from the euro. For good reasons. Any reference to a euro exit would fuel the doom loop. However, it should be made even clearer that any unilateral exit from the euro would automatically trigger Article 50 of the EU Treaty, leading the country to exit the EU. Such a change would discourage arguments – made by some populist movements – that the exit from the euro would be an easy way out and an alternative to implement the adjustment policies, because the country could still remain member of the EU. Such a clarification would strengthen the credibility of the euro area and reduce the scope for populist parties’ campaigns against the single currency.
Editors' note: A longer version of this column was published as a Policy Brief by the LUISS School of European Political Economy in January 2018.
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.