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The debate on euro-area reform

A paper jointly written by 14 French and German economists set off a debate about the reform of euro-area macroeconomic governance. We review economists’ opinions about it.

By: Date: April 16, 2018 Topic: Finance & Financial Regulation

A group of 14 French and German economists proposes six reforms which, if delivered as a package, would improve the euro area’s financial stability, political cohesion, and potential for delivering prosperity to its citizens – all while addressing the priorities and concerns of participating countries.

First, these economists would break the vicious circle between banks and sovereigns through the coordinated introduction of sovereign concentration charges for banks and a common deposit insurance Second, they would replace the current system of fiscal rules focused on the ‘structural deficit’ by a simple expenditure rule guided by a long-term debt reduction target. The third measure would be the creation of the economic, legal and institutional underpinnings for orderly sovereign-debt restructuring of countries whose solvency cannot be restored through conditional crisis lending. Fourth, the economists recommend creating a euro-area fund, financed by national contributions, that helps participating member countries absorb large economic disruptions. Fifth would be an initiative to create a synthetic euro-area safe asset that would offer investors an alternative to national sovereign bonds. Sixth, they advise reforming the euro-area institutional architecture, by creating an independent fiscal watchdog, assigning the Eurogroup presidency role to the Commission, and the policy responsibility for conditional crisis lending to a reformed European Stability Mechanism (ESM), with an appropriate accountability structure.

Another (different) group of 14 economists argues on Politico that the Franco-German proposal neglects the fact that if the monetary union doesn’t rapidly succeed economically it will become politically unsustainable. This group thinks that institutional and political issues should be at the heart of the reform debate. A new political approach would include a European executive, democratically accountable before a parliament of the euro zone that could remove him or her from office in a no-confidence vote, and endowed with a larger degree of political autonomy.

This would be only possible with a real and sizeable euro-zone budget, which would perform five critical functions: (i) credibly backstop the financial system; (ii) enable stronger macroeconomic stabilisation in the event of shocks; (iii) provide the ability to raise taxes, decide on expenditures and issue debt – unlike the current EU budget, ; (iv) help create a new form of cohesion and convergence policy for members that have structural competitiveness and institutional challenges.

These solutions would also have far-reaching political consequences that would require a significant leap in the governance of the euro zone, with a European commissioner in charge of monetary and fiscal affairs of the euro zone, chairing the Eurogroup and taking executive decisions on its behalf, and being democratically accountable to a euro-zone parliament.

Guntram Wolff says that despite claims to the contrary, Germany and France do not yet agree. He thinks that in trying and build consensus, the 14’s Franco-German approach would put far too much emphasis on debt restructuring and far too little emphasis on what can be done to strengthen the sources of growth and cohesion in Europe. Such a minimalist governance structure would make it difficult for Europe to prosper and may put its financial, economic and political stability at risk.

Wolff thinks this approach is unrealistic, and that the job of academics should be to point out what is missing and wrong. At the same time, he thinks the answer published in Politico may be politically difficult to implement and progress will require continued tough work

After a previous strong disagreement with the Franco-German paper, Stefano Micossi writes that there is room to strengthen those recommendations in view of the need to make the euro area more resilient to idiosyncratic liquidity shocks.

Micossi is doubtful of the introduction of sovereign concentration charges, which he thinks may be counterproductive since it would have the distinct effect of reducing liquidity in some sovereign debt markets, especially as long as financial fragmentation and adverse risk spreads on high-debt sovereigns persist. The  provision of a safe asset to accompany the diversification of banks’ portfolios (ESBies) would not change his conclusion, unless asset substitution between ESBies and national sovereigns were to be undertaken on a truly massive scale.

On the proposal to tighten the rules governing resolution, state aid to banks, and precautionary recapitalisations to strengthen the change in policy regime from bailout to bail-in, Micossi thinks care is needed to avoid these changes going beyond their purpose and ultimately limiting the financial stability exception provided for by EU legislation. On the Franco-German proposal for deposit insurance, Micossi thinks that the economists’ approach is a concession to German concerns on sharing national banking losses but likely to perpetuate an adverse risk premium on banks from certain countries, and therefore maintain an element of financial fragmentation even in steady state, as long as certain weaknesses in national banking systems were not eliminated.

Micossi thinks that in seeking to assess the net effect of the these proposals on investors’ confidence, the critical measures to consider  are the specificities of the Soveriegn Debt Restructuring Mechanism (SDRM), on one hand, and the liquidity impact of the new ESM credit line for ‘pre-qualified’ countries – respecting country-specific recommendations and not at risk of losing market access – on the other.

Lorenzo Bini-Smaghi argues that the proposals made in the Franco-German 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). Bini-Smaghi argues that the task of setting limits to banks’ holdings of government bonds and of fostering diversification should instead largely be assigned to the Single Supervisory Mechanism (Pillar 2).

The second shortcoming is the suggestion to drop the Stability and Growth Pact (SGP) and replace it with market-based discipline. Bini-Smaghi thinks that the negative assessment of the SGP is not justified and that the proposal aimed at strengthening market discipline through the issuance of junior bonds automatically subject to restructuring in case of access to financial assistance from the European Stability Mechanism (ESM) is subject to problems, including the risk of triggering self-fulfilling expectations that accelerate the resort to the ESM, and thus to debt restructuring.

A third shortcoming in Bini-Smaghi’s view is that the key factor at the root of the European crisis – i.e. the redenomination risk – has not been addressed. This is likely to remain a major problem unless the euro area’s institutional framework is adjusted. 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 clarification would strengthen the credibility of the euro area and reduce the scope for populist parties’ campaigns against the single currency.

Sebastian Dullien thinks that, as a whole, the package is not convincing, for three reasons. First, it does not address the issue of boom-and-bust cycles in the euro area. The package does not address the argument that Economic and Monetary Union (EMU) might have led to longer and deeper national business cycles. In a monetary union, all participating countries have to live with the same nominal central bank interest rate. The implicit hope seems to be that under better supervision, banks will not fuel real-estate bubbles again and, in the future, European institutions will provide funds so that even severe national banking crises can be solved by resolution and recapitalisation, without pushing national governments to the brink of default. Yet, it is highly questionable whether all this is sufficient to prevent deep boom-and-bust cycles at the national level in the future.

Second, the proposal puts an excessive trust in the ability of financial markets to stabilise national economies and to discipline governments in a sensible and desirable way. Yet, as we have seen prior to the euro crisis, in good times financial markets tend to lend to governments irrespective of imbalances (as they did to Greece), while in bad times they might cut off financing indiscriminately.

And third, Dullien thinks the Franco-German paper proposes fiscal rules and rules for sovereign debt restructuring which run the risk of reducing governments’ policy space. In principle, the public expenditure rule has the advantage over the current rules that fiscal policy most likely would be less pro-cyclical. However, the automatism of maturity extension carries the risk that it actually creates new incentives for speculation.


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