This column is a lead commentary in the VoxEU Debate "Euro Area Reform"
Originally, I was part of this endeavour. I was the eighth German member of what has become the 7 + 7 Franco-German group. In December 2017, before the Policy Insight by Bénassy-Quéré et al. (2018) was finished, I quit the group although I still had been a co-author of an op-ed in newspapers in September 2017 in which the basic goal – i.e. to balance risk sharing and market discipline – was outlined. It has been one part of the Policy Insight which does not convince me and finally triggered my resignation: the proposal for a fiscal capacity in European Monetary Union (EMU).
This was not the first time that I engaged in a cooperation which targeted policy trade-offs regarding EMU by proposing a package deal, a grand bargain, a balanced approach. As a member of the German Council of Economic Experts (GCEE), I am an author of the Council’s debt redemption pact (GCEE 2011, 2012). This pact balanced the need for stabilisation of the euro area by mutualising public debt of EMU member states to some extent with provisions to keep moral hazard at bay, i.e. provisions for collateral, the endorsement of an adjustment programme by participating countries, and so on. With the requirement of an adjustment programme, member countries should ensure that they reduce their public debt-to-GDP ratios to below 60%.
The GCEE was fully aware that without such a fiscal solution to the crisis of 2011 and 2012, the ECB would act – with heavily restricted possibilities to reduce member states’ moral hazard leading to a possible over-burdening of monetary policy in EMU. In particular, the ECB could not ensure that member countries reduced their over-indebtedness. The announcement of the Outright Monetary Transactions (OMT) provided such a ‘monetary solution’ (making the debt redemption pact obsolete), but debt-to-GDP ratios in the euro area have remained high. In efforts to warn against over-burdening monetary policy, the two reports by Corsetti et al. (2015, 2016) aimed at striking other balances between market discipline, i.e. a sovereign debt restructuring mechanism, and macroeconomic and financial market stability. Coping with legacy debt problems was central to these approaches. Any proposal for a reformed architecture of EMU must address this issue and ask what the best design would be if they were to be solved.
The balanced approach
The proposal by Bénassy-Quéré et al. (2018) is focused on a compromise between market discipline and risk sharing, but it fails to address the legacy problems convincingly. These high legacy problems in national banking systems and in national public finances currently prevent more market discipline from being introduced in EMU. In the approach of the Franco-German group, legacy debt will be only slowly reduced given the incentives provided by market discipline and the reformed fiscal rules, while a fiscal capacity helps countries to deal with shocks. It might be possible to prevent financial markets from reacting excessively if mechanisms to enhance market discipline were accompanied by risk-sharing mechanisms completing Banking Union or by introducing a fiscal capacity. But it is far from certain that this particular proposal avoids financial market turmoil.
More precisely – and some of the criticisms of the Franco-German proposal in this VoxEU debate show this – the risk-sharing mechanisms of this proposal do not directly deal with the legacy problems. Rather, the authors insist that they must be solved as a precondition for an introduction of risk sharing, for example in the case of the European Deposit Insurance Scheme (EDIS), or they remain vague regarding the introduction of the new lending policy (Bénassy-Quéré et al. 2018: 14). It is unclear to me, for example, how the transition problem to this new architecture of EMU will be solved without forcing Italy into financial market turmoil. Recent financial market concerns after the new Italian government came to power question the perception that Italian debt is expected to be sustainable. In contrast, Andritzky et al. (2018) explicitly show how a transition period could look like that finally leads to a sovereign debt restructuring mechanism. The Franco-German group, however, does not fully endorse that proposal either. Instead, they present their ideas for a fiscal capacity.
The need for additional fiscal capacity
In a situation in which EMU member states do not have much fiscal space to cope with idiosyncratic shocks, additional fiscal space could be created by a European fiscal capacity. The precondition formulated in this sentence is crucial, however, because it underlines the moral hazard problem of a fiscal capacity for the euro area. Originally, EMU counted on member states’ individual fiscal space to cope with economic shocks by expansionary fiscal policy. Arguing that in the status quo, some countries have accumulated excessive debt such that they are unable to provide fiscal impulses from national budgets reveals that the problem is insufficient consolidation of public finances in those states in the first place. It also indicates that the creation of a euro area fiscal capacity now would serve as a premium for countries with profligate fiscal policies in the past.
The moral hazard problem is more or less severe depending on the individual proposal, but it cannot be eliminated. If a euro area fiscal capacity sets in after an above-average economic shock measured by output gaps, the problem of measuring output gaps in real time is insurmountable. The fiscal capacity then provides incentives for biased estimates of output gaps and it will lead to systematic transfers (Feld and Osterloh 2013). If the fiscal capacity is connected with above average unemployment rates, in the sense of an unemployment reinsurance scheme, biases emerge because unemployment increases are higher the less flexible the labour and product markets in a member state are. Incentives to conduct liberalising structural reforms will diminish. Even a fiscal capacity based on trade is prone to some moral hazard (Beetsma et al. 2018). The experience with Germany’s fiscal equalisation system shows that such moral hazard problems are strong (e.g. Baskaran et al. 2017).
The proposal by Bénassy-Quéré et al. (2018) aims at containing moral hazard incentives. The proposal ensures that first loss is borne at the national level. There is conditionality ex ante and ex post. Member states’ contributions to the fiscal capacity follow a kind of experience rating requiring that they pay back the amounts drawn. Still, and similar to Arnold et al. (2018), it would take a very long time before a member state that withdrew money from the fiscal capacity will finally have filled it up by its contributions. Too much may happen during this decade or more such that transfers finally provide adverse reform incentives. This scheme will not be able to prevent redistribution over the long run. By failing to address the legacy debt problems and instead proposing a fiscal capacity, the Franco-German group rather creates new problems that the Maastricht assignment did not have.
The introduction of a fiscal capacity would finally induce a basic constitutional shift. For the first time, a European institution would get the competence to conduct macroeconomic stabilisation, and thus possibly far-reaching fiscal competencies without the accompanying democratic and legal control. If the fiscal capacity is organised as an unemployment reinsurance scheme, there is also a social union component without further European competencies in labour market or social policies. This is different in the case of credit lines offered by the European Stability Mechanism (ESM) and accompanied by conditionality. The ESM is backed by democratic decisions of the member states whose legislatures are controlled by the rule of law in their countries. This construction actually depends on conditionality such that it cannot be fully eliminated in efforts to make a precautionary credit line more attractive. Put differently: in the first case of a fiscal capacity, liability and control fall apart; in the second case of ESM credit lines with conditionality, liability and control are aligned.
Risk sharing by completing the Banking Union: Isn’t it fiscal?
It is well known from the literature on risk sharing in existing federations that factor markets (through the free movement of capital and labour) as well as credit markets provide for the largest share of inter-regional risk sharing. Poghosyan et al. (2016) provide fresh evidence on risk sharing in the US, Canada, and Australia. They report an offset of 4-11% of idiosyncratic shocks (risk-sharing) and 13-24% of permanent shocks (redistribution) by fiscal transfers. This risk sharing mainly stems from automatic stabilisers from the central budget, i.e. from federal taxes and transfers to individuals, rather than from fiscal transfers from the central to the regional budgets. Similarly, in a study for the Swiss federation (Feld et al. 2018), my co-authors and I find a combined redistributive effect of about 20% while the stabilisation effect of short-term income fluctuations amounts to less than 10%. Again, the stabilisation effect runs largely through the old-age pension system and, to a much lesser extent, via direct transfers in the Swiss fiscal equalisation system. In contrast, Hoffmann et al. (2018) show that risk sharing in EMU via the credit channel collapsed after 2008. The break-down of the inter-banking market in EMU is the main problem.
The completion of Banking and Capital Market Union in EMU follows as a logical conclusion from this evidence. The revitalisation of the inter-banking market is the dominant policy proposal directed at the actual problem at hand. Bénassy-Quéré et al. (2018) consequently propose to complete the Banking Union by introducing a fiscal backstop to the Single Resolution Fund (SRF) using a credit line of the ESM and EDIS (also backed by the ESM). Both proposals come with many strings attached regarding preconditions and regulation in order to cope with moral hazard. Moreover, the Franco-German group wants to reduce the bank-sovereign loop by introducing concentration charges providing incentives to reduce bank exposure to sovereign debt.
Without going into the details, these proposals are well-taken. My disagreement regarding completion of the Banking Union is probably small. I simply do not understand why a credible fiscal backstop of the SRF must be complemented by EDIS. Both may aim at different problems. The SRF is thought to step in if there is a banking crisis in one country that is about to spillover to the whole union. It is activated if the cascade of 8% private liability and (implicit) national fiscal backstops, like in the case of Italian banks in 2017, may have been used. It aims at resolving or restructuring banks, while the ECB acts as lender of last resort to cope with banks’ liquidity problems. EDIS already steps in for a single bank with either liquidity or solvency problems in order to prevent it from inducing a European banking problem. However, if it is not a European problem, national deposit insurance schemes (which are about to be created) should cope with their own banks. If the bank has a liquidity problem with European spillovers, the ECB will serve as lender of last resort anyway. In case of a solvency problem with European spillovers, the SRF and its backstop will serve. Finally, the Single Resolution Board (SRB) has some discretion as to the extent of bail-in demanded from a bank’s creditors. Although this must be criticised, this discretion exists. Thus, if there exists a credibly large fiscal backstop, EDIS might in fact not be necessary.
Bénassy-Quéré et al. (2018) do not consider this interaction between these two elements of their proposal. This is a first shortcoming. EDIS might not be necessary if member countries do what they ought to do. A second shortcoming consists in the transition regime for cutting the bank-sovereign loop. The introduction of concentration charges will do little in the beginning. A considerable risk for a fiscal backstop of the SRF, but also for EDIS, arises from the large amount of government bonds held by banks in several member countries. If a member state has fiscal troubles, it will affect its banks too quickly for the banking union suggestions of the Franco-German group to work – despite its awareness of this problem that is signalled by the introduction of concentration charges.
The introduction of a fiscal capacity would repeat the mistakes made by the introduction of EMU – later steps towards European integration would take place before the first steps have been taken. The experience during the euro area crisis shows how important it would have been to have elements of political union first. This holds even more strongly with regards to fiscal union. The necessary steps to increase the resilience of EMU consist in the completion of Banking Union by a fiscal backstop to the SRF on the one hand, and member states’ reforms and budgetary consolidation on the other. For the time being, this must suffice – and it would be no small achievement.
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