Opinion

A resilient Euro needs Franco-German compromise

In a piece signed by 15 leading French and German economists, Nicolas Véron lays out a path to a more sustainable Euro. Germany will need to accept some form of risk sharing. France will need to allow more market discipline. But the two countries can find a common vision for reforms

By: , , , , , , , , , , , , , and Date: September 27, 2017 Topic: European Macroeconomics & Governance

This op-ed was published – in French and German, respectively, and in slightly shortened form – in Le Monde and Frankfurter Allgemeine Zeitung on 9/27/2017

 

 

The euro area has recently seen some good news. A broad-based economic recovery is under way. Significant institutional reforms have been achieved, particularly in the area of banking union. Significant economic reforms are under way in several countries, including in France.

As French and German economists committed to Europe and to the friendship between our countries, we are nonetheless concerned that the Euro area continues to face significant fragilities.  Addressing these requires a comprehensive, collaborative push for reforms. If this effort fails, the chances that a major fiscal and financial crisis will reoccur in the Euro area in the foreseeable future remain high. And if there is a crisis, attempts to address it will be economically painful and likely re-open the political divisions that appeared during the crisis. At a time when global prosperity and security are under threat by economic and political nationalism, Europe cannot afford such divisions.

The euro area recovery is fragile for three reasons.

First, Euro area stabilization has relied too much on the European Central Bank (ECB). Subdued inflation induced highly expansionary monetary policy.  This has helped Euro area countries that were shaken by the crisis recover (even if it may give rise to undesirable side effects, such as financial bubbles). But as price stability is gradually restored, the ECB will remove stimulus, and interest rates will rise. This could put countries under pressure that have not gone far enough in reforming their economies and reducing debt levels.

Second, the financial stability of the Euro area remains threatened by the legacies of the global and Euro area crises. While sovereign debt and non-performing loan ratios have begun to decline, their stock remains high in several countries.  A particular concern is the continuing high exposure of banking systems of several countries to the debts of their own governments. This means that any difficulties in the sovereign debt market will promptly translate into difficulties for the financial system, and hence the real economy. This “doom loop” poses a major threat not only to individual member states, but to all of the Euro area. Despite good progress on banking union, too little has been done to reduce financial fragmentation and strengthen the financial system.

Third, the Euro area’s instruments for promoting sound policies at the level of each member countries remain blunt and are often ineffective (in particular in averting public debt accumulation). They are also a source of political tension, and expose the European Commission – which is supposed to enforce these rules – to criticism of being too tough in some countries and not tough enough in others.

Fortunately, the French and German governments have recognized the imperative for reform. Informal discussions started before the German elections, and will hopefully gain momentum in the coming months. The leaders of both countries have expressed support for a Eurozone budget, a European finance minister, and a European Monetary Fund.

Unfortunately, however, both sides have rather different views on what these terms mean. During his tenure as French Economy Minister, Mr. Macron argued for a Euro area budget, based on a dedicated revenue stream, that would “provide automatic stabilization and allow the European level to expand or tighten fiscal policy in line with the economic cycle”. He has during and after the presidential campaign repeated his support for such a budget although with less precision on the economic rationale. Mrs. Merkel, in contrast, is thinking of a small fund that would support structural reform in Euro area countries. On the European Monetary Fund, ideas are similarly divergent. The German government wants to strengthen the current European Stability Mechanism (ESM) so it can engage in tough surveillance of member states’ policies. France wants to give it more financial firepower.

These differences are mirrored by deep divisions between the two countries. German officials usually take the view that the problems of the Euro area stem mostly from inadequate domestic policies. They have long rejected calls for additional Euro area stabilization and risk sharing instruments, and instead want tougher enforcement of fiscal rules and more market discipline. French officials, on the other hand, have called for additional stabilization and risk sharing via a Euro area investment budget, a Euro-area wide common unemployment insurance scheme, a European deposit insurance, and a permanent common backstop for the single resolution fund (SRF). They concede that this requires strengthening fiscal discipline at the national level, but reject more market discipline, proposing instead to tighten national fiscal rules.

If both sides stick to their current positions, the outcome of the incipient Franco-German push for Euro Area reform is predictable – and depressing in that it would not solve any of the key challenges. It might result in a symbolic, very small Eurozone budget with a “Minister of Finance”, but without a borrowing capacity.  The quid pro quo will not be greater market discipline, as the Germans are hoping, but tougher Euro-area level intervention powers, possibly accompanied by a symbolic strengthening of national fiscal rules.

Apart from allowing both the French and German governments to claim victory at home, such a “small bargain” would accomplish very little. It would not make the Euro area more stable. It would not address the fundamental causes of why fiscal rules have not worked well. And while the idea to strengthen Euro area-level decision making is sound in principle, it will set up Euro members for more fights with “Brussels” if it does not go along with better incentives for adopting national policies consistent with European rules. Worse still, a bargain of this sort may induce a false sense of security, hindering needed reforms both at the national and European levels.

To move Europe forward, France and Germany will need to aim beyond this small bargain. This does not imply the need for full fiscal union let alone a fully-fledged United States of Europe, which is neither necessary nor feasible at this point in time. But it needs more far-reaching reforms, in three respects.

First, they will need to expand their discussion beyond fiscal policy. While a Eurozone budget could be helpful for risk-sharing purposes, it may remain too small, is difficult to design appropriately, and there may be legitimate reasons to expand common fiscal resources at the European Union rather than Euro area level (this may be the better place to provide essential public goods such as infrastructure investment, security and defense). But if this is the case, it will become even more important to facilitate euro-area risk-sharing through non-fiscal and non-monetary instruments. This will require a discussion on how to resolve the continuing deadlock on European deposit insurance, and how to promote capital market integration, which is underdeveloped in the euro area, particularly compared to the United States.

Second, they will need to do some serious thinking on how to address the legacy problems from the crisis – particularly the large continued exposure of banks to their national sovereigns – which trigger the diabolic loop between banks and sovereigns and destabilize cross-border capital flows. This calls for regulatory curbs on such exposure, which are a natural complement to European deposit insurance. It also requires a discussion on whether, and if so how a European safe asset could be implemented to switch off the diabolic loop.

Finally, and most importantly, French and German officials will need to take a leap of faith away from their traditional positions – while insisting that the legitimate concerns that motivate these positions are addressed.

Germany needs to accept the idea of more risk sharing in the Euro area – but should insist that this is done in a way that maintains sound incentives, does not become a vehicle of permanent redistribution and increases the credibility of the no-bailout rule for sovereigns and of the bail-in framework for banks. Eliminating the vicious circle between sovereigns and domestic banks supports these objectives by enhancing the feasibility of a sovereign debt restructuring without a banking panic, and of large-scale banking sector restructuring without massive public cost.

France needs to accept the idea of more market discipline – but should insist that this is introduced in a way that does not lead to financial instability. A possible approach could be an obligation to finance excessive new deficits through bonds which would be restructured if the country loses market access. More generally, sovereign debt restructuring should be recognized as a tool of last resort to restore solvency inside the Eurozone. But this must only happen after exposures of banks to their home sovereigns have been sharply reduced from current levels, and must go along with better risk sharing instruments, so that any debt restructuring becomes very unlikely.

And both sides should throw their weight behind a simplification of the devilishly complex fiscal rules of the Euro area, in order to reduce the need for micromanagement from Brussels, which has become a recipe for populism.

As economists who speak a common intellectual language – but are also aware of our own national biases – we believe that meaningful Euro area reforms that meet these aims are difficult, but possible. There are solutions, although never simple ones. In the coming months, we hope to contribute some of our own thinking toward finding them. The French and the new German governments will need to lead and work closely with its European partners and Europe’s institutions on reforming Europe and the euro.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to communication@bruegel.org.

View comments
Read about event More on this topic

Upcoming Event

Mar
26
12:30

Spitzenkandidaten series: Yanis Varoufakis

The first event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Maria Demertzis, Martin Sandbu and Yanis Varoufakis Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More by this author

Opinion

New EU industrial policy can only succeed with focus on completion of single market and public procurement

France and Germany recently unveiled a manifesto for a European industrial policy fit for the 21st century, sparking a lively debate across the continent. The fundamental idea underpinning the manifesto is a good one: Europe does need an industrial policy to ensure that EU companies remain highly competitive globally, notwithstanding strong competition from China and other big players. However, the Franco-German priorities are unsuitable for the pursuit of this goal.

By: Simone Tagliapietra Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: March 18, 2019
Read about event More on this topic

Upcoming Event

Apr
3
12:30

Spitzenkandidaten series: ALDE

The third event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
4
08:30

Spitzenkandidaten series: Jan Zaradhil

The fourth event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Jim Brunsden, Maria Demertzis and Jan Zahradil Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
9
12:30

Spitzenkandidaten series: Manfred Weber

The fifth event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Manfred Weber and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
11
12:00

Spitzenkandidaten series: Frans Timmermans

The sixth event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Frans Timmermans and André Sapir Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: The case for a legislative remedy for recessions

Bruegel's Maria Demertzis welcomes Yale Law School professor Yair Listokin to this Director's Cut of 'The Sound of Economics', to discuss how law might be deployed as a macroeconomic tool to counter financial crisis.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: March 12, 2019
Read article More on this topic

Blog Post

The European Union must change its supervisory architecture to fight money laundering

Money laundering scandals at EU banks have become pervasive. The authors here detail the weaknesses the current AML architecture's fundamental weaknesses and propose a new framework.

By: Joshua Kirschenbaum and Nicolas Véron Topic: European Macroeconomics & Governance Date: February 26, 2019
Read article More on this topic More by this author

Blog Post

Greening monetary policy: An alternative to the ECB’s market-neutral approach

The ECB’s market-neutral approach to monetary policy undermines the general aim of the EU to achieve a low-carbon economy. An alternative tilting approach would foster low-carbon production, accelerating the transition of the EU to a low-carbon economy, and could be implemented without undue interference with the chief aim of price stability.

By: Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: February 21, 2019
Read article More on this topic More by this author

Podcast

Podcast

Deep Focus: A greener monetary policy approach for the ECB

Bruegel fellow Dirk Schoenmaker walks Sean Gibson and 'The Sound of Economics' listeners through his latest working paper, focusing on how to make monetary policy in Europe more climate-friendly

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: February 21, 2019
Read article More on this topic More by this author

Opinion

France’s institutional system favours rebellion against its leader

The 'yellow vest' movement proves that France's political and budgetary centralism, as the source of citizens' feelings of abandonment and revolt, must be reformed.

By: André Sapir Topic: European Macroeconomics & Governance Date: February 19, 2019
Read article

Opinion

What can the EU do to keep its firms globally relevant?

There is a fear that EU companies will find it increasingly difficult to be on top of global value chains. Many argue that EU-based firms simply lack the critical scale to compete and, in order to address this problem, that Europe’s merger control should become less strict. But the real question is where the EU can strengthen itself beyond the realm of competition policy.

By: Georgios Petropoulos and Guntram B. Wolff Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: February 15, 2019
Load more posts