The Lesser Evil for the Eurozone

For three decades, the consensus within the European Commission and the European Central Bank on the need for market reforms and sound public finances has been strong enough to overcome opposition in small countries and outlast procrastination in large ones. Today, however, the Eurozone playing field has become a battleground.

By: Date: April 4, 2018 Topic: Finance & Financial Regulation

This opinion piece has been published in Project Syndicate

It was not supposed to happen like this. The formation of a new German government took so long that it was only after the Italian general election on March 4 resulted in a political earthquake that France and Germany started to work on reforming the eurozone. German Chancellor Angela Merkel and French President Emmanuel Macron have now resolved to sort out their differences and deliver a joint reform roadmap by July. But they cannot ignore changes brought by the landslide victory of Italy’s anti-system parties. Until then, populism had seemed contained. It has now become mainstream.

For those who will have to draw the Franco-German blueprint, the message from Italy is that the policy framework that has dominated Europe since the mid-1980s no longer commands broad support. For three decades, the consensus on the need for market reforms and sound public finances has been strong enough to overcome opposition in small countries (Greece) and outlast procrastination in large ones (France). In the coming years, however, the eurozone playing field may well become a battleground.

The first casualty is bound to be the European Stability and Growth Pact, with its plethora of fiscal rules, monitoring procedures, and eventual sanctions for excessive deficits. The 224-page Vade Mecum on implementing fiscal discipline in the EU is hopelessly complex, to such a degree that no finance minister, let alone parliamentarian, fully understands what his or her country must abide by.

For populists, however, indecipherable rules made in Brussels are a simple, straightforward political target. In “Baron Noir” (Black Baron), a popular French TV series, a president engulfed in a financial scandal nearly escapes public indignity by mounting a coalition against EU deficit fines. With populism rising almost everywhere in Europe, reality may soon exceed fiction. For large countries, the threat of sanctions has always been a paper tiger. The difference now is that the EU’s bluff may be called.

Absent sanctions, what will ensure that participants in the eurozone behave? This is what Germany is understandably worried about. Whatever reservations one may have about Germany’s fiscal obsession, rules of the game are required to deal with unsustainable public-debt accumulation in a monetary union. Policy ambiguity cannot be relied on, in a system deprived of a strong power center. If no one knows what will happen if a country does not behave, the expectation may turn out to be that debts will be monetized – at a high inflationary cost.

At a recent conference in Berlin, economists debated what to do if the euro proves unsustainable. Prominent German scholars expressed the view that, absent credible sanctions, only the threat of forced exit could discipline wayward eurozone members. In other words, governments should be facing a clear choice: behave or leave.

Technically, this would not be hard to implement. To force out a delinquent country, the ECB could simply unplug its banking system from euro liquidity. That nearly happened in 2015, when Greece was on the brink of exit, and Wolfgang Schäuble, Germany’s finance minister at the time, considered pushing Greece out. It took a long, dramatic night of talks for eurozone leaders to agree not to do it.

Pushing a country out would, however, have dire consequences. The irreversibility of the euro may be a myth – nothing is irreversible – but it is a useful myth. If businesses and savers were to start speculating about the next exit, trust in the common currency would soon vanish. People would move their savings to protect them from redenomination risk. A German euro would be worth more than a French euro, which in turn would be worth more than an Italian euro. That’s why Mario Draghi, the ECB’s president, said in 2012 that he would do “whatever it takes” to preserve the euro’s integrity.

So, what if sanctions don’t work and the threat of exit is a cluster bomb that would hurt everyone? In a recent paper with French and German colleagues, we advocate making debt restructuring within the eurozone a credible possibility. We do not regard debt restructuring as benign, let alone desirable, and we do not advocate making it automatic or driven by numerical triggers.

But, in a system without sanctions, fiscal responsibility can be enforced only if two conditions are met. First, governments and those who finance them must face the consequences of irresponsibility – that is, ultimately, debt restructuring. Second, the ensuing financial disruption must be limited, so that policymakers do not want to avoid restructuring at all costs. This, in turn, requires a number of reforms that we spell out in our paper.

This idea elicits strong reservations, not only in Italy, where the policy establishment is obsessed with the country’s record indebtedness, but also in France, where debt repayment is regarded as the dividing line between advanced and developing countries. The memories of the Deauville summit – an ill-conceived regime for addressing excessive public debt hashed out by Merkel and then-French President Nicolas Sarkozy – are still vivid. The French view is that debt restructuring should not be contemplated, even as a possible outcome.

But the French must confront the new reality. While the euro survived the financial disruption of 2010-2012, it is now confronted by a potentially more challenging political disruption. This threat must be faced.

Absent a shared consensus on the sanctity of rules, there are not many possibilities. One is a euro without an anchor, something Northern Europe would not want to remain part of for long. Another is a euro with a wide-open exit door, something that would quickly lead to another financial crisis. And still another is a euro with defined and predictable internal debt-resolution mechanisms. The latter option is, admittedly, not without risks, but it is certainly safer than the exit threat. France, and Europe, should choose the lesser evil.

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 article

Parliamentary Testimony

European Parliament

The role of independent expertise in legislative process

Testimony before the European Parliament Committee on the Internal Market and Consumer Protection (IMCO).

By: Zsolt Darvas and J. Scott Marcus Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: July 18, 2018
Read article More on this topic More by this author


Ubu ou Machiavel?

L'administration Trump veut imposer une approche transactionnelle des relations économiques gouvernée par le rapport de force bilatéral en lieu et place du contrat multilatéral. Un défi d'une ampleur inédite pour l'Europe.

By: Jean Pisani-Ferry Topic: Global Economics & Governance Date: July 6, 2018
Read article More on this topic More by this author

Blog Post

EU income inequality decline: Views from an income shares perspective

Over the past decade, the income share of low earners has increased in the EU while that of top earners has slightly declined. Although the upward convergence of the impoverished central European population is impressive, the southern European poor have faced a major setback while the southern European rich have hardly suffered.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: July 5, 2018
Read article More on this topic More by this author


Griechenland braucht einen Neuanfang

This was first published by Die Zeit. Acht Jahre nach Beginn des ersten Hilfsprogramms für Griechenland ist es soweit – Griechenland soll wieder auf eigenen Füßen stehen. Die Eurogruppe soll heute das Ende des dritten Hilfsprogramms beschließen und die Modalitäten für die Zeit danach definieren. Ziel sollte es jetzt sein, einen tragfähigen Ausstieg aus dieser für alle Seiten […]

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: July 3, 2018
Read about event More on this topic

Past Event

Past Event

Euro tragedy: a drama in nine acts

This event featured a presentation by Ashoka Mody of his new book, which argues that the Euro is at the root of the problems the European Union faces today.

Speakers: Maria Demertzis, Ashoka Mody and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 27, 2018
Read article More on this topic More by this author

Blog Post

The Meseberg declaration and euro-zone reform

The recent Franco-German Meseberg declaration will set the scene for next week’s summit. We review opinions on this important agreement.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: June 25, 2018
Read article Download PDF More on this topic More by this author

Working Paper

EU financial services policy since 2007: crisis, responses and prospects

This paper presents a holistic overview and assessment of the European Union (EU)’s financial services policy since the start of its financial crisis in mid-2007. Its emphasis is on public policy initiatives and developments at the European level, including those specific to the euro area.

By: Nicolas Véron Topic: Finance & Financial Regulation Date: June 21, 2018
Read about event More on this topic

Past Event

Past Event

For a stronger and more integrated Europe

This event will feature the presentation of the Economic Survey of the European Union 2018 and Economic Survey of the Euro Area 2018.

Speakers: Angel Gurría, Zsolt Darvas, Pierre Beynet and Aida Caldera-Sanchez Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 19, 2018
Read article Download PDF More on this topic

Policy Contribution

Is the European Semester effective and useful?

The authors study whether and to what extent EU countries implement recommendations on macroeconomic imbalances given by the EU in the so-called European Semester. Overall implementation of recommendations by EU countries has worsened in the last few years, in particular when it comes to recommendations addressed to countries with excessive macroeconomic imbalances.

By: Konstantinos Efstathiou and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: June 13, 2018
Read article More on this topic More by this author


« Mieux vaudrait laisser les gouvernements libres de tenter les politiques de leur choix »

Les peuples ont le droit de faire des erreurs: Selon l’économiste Jean Pisani-Ferry, l’Union européenne doit accepter les aspirations légitimes à des politiques disparates, tout se prémunissant contre la contagion de leur corollaire : la possibilité d’une faillite souveraine.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: June 12, 2018
Read article More on this topic

Blog Post

Is the ECB collateral framework compromising the safe-asset status of euro-area sovereign bonds?

Central banks’ collateral frameworks play an important role in defining what is considered as a safe asset. However, the ECB’s framework is unsatisfactory because it is overly reliant on pro-cyclical ratings from credit rating agencies, and because the differences in haircuts between the different ECB credit quality steps are not sufficiently gradual. In this note, the authors propose how the ECB could solve these problems and improve its collateral framework to protect its balance sheet without putting at risk the safe status of sovereign bonds of the euro area.

By: Grégory Claeys and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: June 8, 2018
Read about event More on this topic

Past Event

Past Event

What next for banking union?

This event will discuss the future of Banking Union.

Speakers: Maria Demertzis, Philipp Hildebrand and Guntram B. Wolff Topic: Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 8, 2018
Load more posts