posted on 17 June 2016
-- this post authored by Jean Pisani-Ferry
Appeared originally at Voxeu.org 10 April 2016
The dramatic episodes in the Eurozone in the past few years called for a number of policy reactions. Yet the response was usually limited to what was deemed indispensable to ensure survival. This column discusses how such half-solutions paved the way for future crises. The author also puts forward a few proposals regarding the Eurozone's policies.
Among them are a European Monetary Fund, an overhaul of surveillance, the completion of banking union, an insolvency procedure for sovereigns, and Eurobonds of some sort. And the sooner such issues are deeply discussed, the faster coherent solutions can be reached.
Jean Monnet's famous statement - that Europe will be forged in crises, and will be the sum of the solutions to those crises - was prescient but inaccurate. The truth, for the Eurozone at least, is that Europe today is the sum of a few solutions and many half-solutions. Each of the dramatic episodes of the 2010-2012 period - the Greek call for assistance, the attacks on sovereign debt markets, the Greek insolvency, the feedback loop between sovereigns and banks, the reversal of capital flows, the break-up speculation - sooner or later triggered a policy reaction. Yet, because the member states did not agree on the diagnosis and the priorities, they limited their response to what was deemed indispensable to ensure survival - as clearly expressed by the ultima ratio doctrine. Time and again, half-solutions brought temporary respite but fell short of the structural remedies that would have cured the fragilities revealed by the EZ Crisis. This paved the way for further crises and further responses.
The Eurozone was therefore long caught in its own sort of Zeno's paradox, until the near-simultaneous announcements of banking union and the ECB's Outright Monetary Transaction (OMT) scheme, later followed by the announcement of a major monetary stimulus, brought the storm to an end. In retrospect it is clear, however, that neither of these responses completely breaks with the Crisis pattern; absent a common fiscal backstop, banking union remains incomplete, and the OMT would not be able to address potential insolvency in a large country. Zeno's paradox is still there.
The case for comprehensive reform
The original paradox did not prevent Achilles from overtaking the Tortoise. But as observed by Guiso et al. (2014), politics may prevent the Eurozone from reaching completeness. Disagreements among governments represented the most significant obstacle in the early phases of the Crisis, but governments are not alone anymore: reservations on the side of public opinion are increasingly hampering ambitions for further integration. For this reason the Five Presidents' report (Juncker et al. 2015) is remarkably elusive about the end-goal. But far from dispelling fears, the absence of a blueprint for the future and the lack of serious discussions about its possible content are in fact fuelling the citizens' concerns. The perspective of another round of crises that will result in another set of half-solutions is probably the most frightening that can be offered to the citizens.
The euro's survival currently hinges more on the fear of the dire consequences of a break-up than on the expectation that it will deliver stability and prosperity. This is not a stable equilibrium. To keep the future fuzzy while kicking the can down the road cannot be a winning strategy. Times may not be auspicious for an ambitious agreement, but at least ambitious discussions should be held on alternative blueprints for the future. As things stand, Europe may not be able to reach consensus on a plan for the future of the euro, but it needs a consensus view on issues that must be solved and the alternative options that can be considered.
Three types of reforms were introduced in response to the euro crisis.
The creation of a crisis management arrangement was an indispensable addition to the policy system. The policy prescriptions of the Troika have been a matter for controversy, but the conditional financial assistance arrangement has proved effective.
There are questions, however, about its future. The Troika is an ad-hoc association of institutions whose statutes, mandates, and accountability differ significantly. Time has come to create on the basis of the ESM a European Monetary Fund (with seconded staff in time of crisis) that would enjoy more policy autonomy and be accountable to parliament. Assistance decisions should be taken by qualified majority rather than unanimity. Furthermore, the Eurozone should rethink the conditions for assistance. It is not by accident that the IMF has created a range of facilities with different degrees of conditionality whereas the ultima ratio principle precluded it in Europe. Earlier intervention, before a country loses market access, contingent credit lines for prequalified countries and lighter conditionality could save jobs and money.
The piling up of fiscal, economic, and financial surveillance procedures has made the system of policy rules undecipherable even for insiders. For this reason there is little ownership of it among national policymakers, and even less among national parliamentarians - not to speak of public opinions. On the economic front, the Macroeconomic Imbalances Procedures (MIP) has failed to address significant current-account imbalances. On the financial front, the creation of the Single Supervisory Mechanism for banks is a major reform but macroprudential supervision has not delivered much. On the fiscal front the superposition of deficit and debt rules, of nominal and structural benchmarks and of Stability and Growth Pact and TSCG procedures has resulted in extreme complexity. Furthermore, the interpretation clauses recently added by the Commission with the aim of introducing some flexibility in the implementation of the SGP (European Commission 2015a) have added to the opacity of the set of rules. The perceived legitimacy of the policy system is low and the credibility of eventual sanctions remains questionable. There is a growing risk that a government will call the bluff and openly defy the Eurozone's fiscal rules.
The question for the future is one of strategy; should the system of rules be strengthened again? Or would discipline be more effective if decentralised? The creation a few years ago of national fiscal councils and the recent Commission proposal for national competitiveness boards (European Commission 2015b) have been first steps in the latter direction. Domestic institutions that are rooted in, and attuned to the national policy system are more likely than rules coming from above to elicit ownership of the disciplines inherent to participating in a currency union. They can also be much more granular in their recommendations, be it as regards budgetary and fiscal decisions or as regards those affecting wage-setting and price formation. They can balance the need for overall policy consistency at Eurozone level and the need for adaptation to specific national contexts.
The evolution towards decentralisation should be pushed one step further. The remit of the national fiscal councils should first be broadened to encompass issues such as the assessment of tax and expenditures forecasts, the costing of measures submitted to parliament and debt sustainability analysis (some have already been assigned such responsibilities, but not all). Second, governments should be encouraged to rely more on the expertise of these councils, which could be done gradually by granting countries equipped with authoritative institutions more room for manoeuvre within the framework of the Stability and Growth Pact. This would give government an incentive to abide by domestically rooted fiscal discipline principles. Third, these councils should be encouraged to emulate competition authorities and sector-specific regulators, work as a network and develop common methodologies. Although its independence from the Commission and mandate are currently a matter for discussion, the future European Fiscal Board (European Commission 2015c) should function as a hub for this network. The same model would apply to the competitiveness boards.
Radical proposals go much further in the direction of decentralisation. Mody (2013), among others, suggests that governments should be left free to behave as they wish, provided the no bail-out clause is made credible and a sovereign insolvency procedure is put in place. In the view of the proponents of such solutions, the Eurozone should emulate the US and accept the possibility of bankruptcy of a sub-federal entity.
There is logic in such proposals. They are consistent with the landmark 2012 decision to protect sovereigns and banks from mutual contagion by severing the financial link between them and establishing to this end a banking union. Back then the Eurozone was facing the trilemma between national responsibility for banks, strict no-monetary financing and no co-responsibility over public debt (Figure 1). This bind could have been solved by endorsing fiscal union or by giving explicitly to the ECB the role of a lender of last resort for sovereigns. The choice, in principle at least, was rather made to launch banking union.1
Figure 1. The 2012 Trilemma
Source: Pisani-Ferry (2012).
This agenda has not been completed yet. Single supervision and resolution have been major systemic reform steps, but the link between banks and sovereigns has not been fully broken. To start with, banks in vulnerable countries are still more heavily exposed to their sovereigns than they were on the eve of the Crisis (Figure 2). This implies that a government debt restructuring would have lethal consequences for the banking system. Only a diversification of their government bond portfolios triggered by exposure limits or regulatory incentives to holding synthetic securities would ensure that banks are protected from the consequences of such an event. Symmetrically, despite the creation of the resolution mechanism, sovereigns are still exposed to the catastrophic risk of shouldering the cost of a banking system rescue. True, the Crisis has changed the policy philosophy and public money is not anymore the first line of defence against the risk of bank failure. But it remains the last line of defence and for this reason sovereigns will remain exposed as long as this risk has not been mutualised. What matters for markets is who bears the ultimate, catastrophic risk. Recent experience suggests that the political feasibility of bail-ins remains challenging.
The logic of the solution to the trilemma adopted in 2012 - banking union - therefore ultimately calls for two further, mutually reinforcing reforms: exposure limits for banks and a common fiscal backstop.
Figure 2. Shares of domestic banks and non-residents in total holdings of government bonds, 1997-2015
Source: Bruegel, Sovereign bond holdings dataset.
Assuming these reforms are put in place, could the Eurozone function in the same way the US does and let a participant state go bankrupt? There are strong reasons to doubt. The debt of the state of California, the largest in proportion of US GDP, amounts to less than 1% of it, whereas the debt of Italy amounts to 20% of Eurozone GDP. A bankruptcy of the former could be an easily manageable financial event. This would not be true for the latter.
This is not only a matter of legacy. In the US policy system, fiscal stabilisation is assigned to the federal government and state governments are subject to individual deficit and debt limits. In the Eurozone, however, it is assigned to the national level and for this reason alone governments face a permanent trade-off between discipline and stabilisation. Systemically, it is hard to imagine a Eurozone where the national governments' debt would be as negligible as it is in the US. Benign neglect cannot apply.
From these observations does not follow that the Eurozone does not need an insolvency procedure. The combination of extremely low inflation, miserable growth, high national public debt, and the absence of a federal budget that could take on stabilisation and risk management functions implies heightened risk of sovereign insolvency. Furthermore, the absence of an explicit procedure for dealing with situations of insolvency undermines the credibility of fiscal discipline.
So far, however, Eurozone authorities have rejected calls for a corresponding procedure, claiming instead that Greece was and would remain an exceptional case.
For reasons of effectiveness, completeness, and credibility, time has therefore come to reconsider the approach to sovereign insolvency. First, conditional financial assistance of the sort provided to Greece and other countries would be made more effective and less costly if it implied the automatic maturity extension of maturing private claims. Second, as the introduction of exposure limits for banks will deprive sovereigns from access to 'their' banks and make some of them more fragile financially, predictable solutions that reduce the social cost of state insolvency would help make such an event less damaging economically. Third, only an insolvency procedure can ultimately make the no bail-out clause credible and insulate policy-motivated government bond purchases by the ECB from support to an insolvent sovereign.
An insolvency regime should not be regarded as an automatic, rules-based procedure for determining when debt should be restructured. Sustainability assessment requires both objectivity and judgement and a decision to restructure can only be taken once the interests of all interested parties have been taken into account (Gianviti et al., 2010).
The introduction of an insolvency procedure in a high-debt, low-diversification context is admittedly a delicate venture, to say the least. For it not to result in a shock to the banking system, it should be preceded by a diversification of bank balance sheets. But an insolvency procedure, a common fiscal backstop and exposure limits for banks would be mutual complements. For this reason they should be considered as components of the same reform agenda.
The last question relates to stabilisation. The Maastricht assignment made individual member states responsible for responding (within the limits set by the Stability and Growth Pact) to idiosyncratic shocks, while monetary policy was given the role of responding to common shocks. In exceptional cases, like in 2009, coordinated fiscal responses would supplement monetary policy, but this was supposed to occur rarely. In such a setting, there was no macroeconomic need for a common fiscal capacity.
There is a significant risk that this arrangement will prove insufficient in the years to come. The effectiveness of monetary policy is being hampered by the near-zero inflation and real interest rates environment. To the extent such an environment is likely to persist (and there are reasons to fear that low real rates, at least, are here to stay), any monetary support will have to rely on unconventional measures only. Furthermore, the next Eurozone recession could hit before monetary policy has started to normalise, which means that a proper response would require new unconventional measures over and above those already in place. The chances that monetary support would prove insufficient are not to be neglected.
On the fiscal side, however, there is a risk that governments will prove unable or unwilling to provide fiscal stabilisation. Constraints set by the EU fiscal framework, high debt levels, and the vivid memory of the 2010-2012 attacks on sovereigns may all push governments to err on the side of caution. True, this should not apply to Germany, but Berlin is unlikely to be willing to provide fiscal support for the whole of the Eurozone.
In a near-zero inflation environment, an under-provision of both monetary and fiscal support when confronting a recession would carry significant macroeconomic risks. In addition, it would undermine political support for monetary union in testing times. For these reasons the Eurozone should prepare and reflect on how this gap could be filled.
Several proposals for creating a Eurozone budget have been put forward, for example by French Treasury officials (Lellouch and Sode 2014). Whether or not there is a public finance rationale for a common budget is an issue that should be examined in its own right, independently from its possible stabilisation role. It is doubtful, however, that such a budget could reach a size that would make its stabilisation role a meaningful complement, let alone a substitute to that of national budgets.
One option to overcome excessive risk aversion at national level would be to facilitate access by individual member states to a low-conditionality borrowing facility. It has already been mentioned that a shortcoming of the current crisis management arrangement is the lack of such a facility. Support could come either from an ESM credit line or in the form of a joint borrowing tranche as proposed in Enderlein et al. (2012). Granting prequalified states the unconditional right to issue a pre-determined amount of Eurobonds (to be followed, if needed, by a low-conditionality tranche and then by an ESM programme) would go a long way towards rescuing the Maastricht assignment.
An alternative would be to supplement national fiscal stabilisation with a common borrowing scheme that could be activated when facing especially adverse circumstances. In practical terms the ESM borrowing capacity could be enlarged so that it could be activated for the financing of investment projects. This would also amount to the issuance of some form of joint bonds, but with the aim of financing Eurozone spending rather than of helping individual states. One way or another, additional risk-sharing looks to be a necessary dimension of the response to the shortcomings of stabilisation in the Eurozone.
The proposals put forward in this note are admittedly ambitious: a European Monetary Fund; an overhaul of surveillance; the completion of banking union; an insolvency procedure for sovereigns; and joint bonds, or Eurobonds of some sort.
Clearly, such an agenda is bound to be controversial and is unlikely to be endorsed any time soon. The role of such proposals is not to command instantaneous support, however. It is to highlight issues, to outline coherent solutions and to elicit serious discussions about them. Again, what the Eurozone needs to escape its Zeno's paradox is a genuine discussion about its long-term future.
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