Blog Post

Europe needs a broader discussion of its future

When thinking about what will determine the prosperity and well-being of citizens living in the euro area, five issues are central. This column, part of VoxEU's Euro Area Reform debate, argues that the important CEPR Policy Insight by a team of French and German economists makes an important contribution to two of them, but leaves aside some of the most crucial ones: European public goods, a proper fiscal stance and major national reforms. It also argues that its compromise on sovereign debt appears unbalanced.

By: Date: May 4, 2018 Topic: European Macroeconomics & Governance

This opinion piece has been published in VoxEU

This column is a lead commentary in the VoxEU Debate “Euro Area Reform

When thinking about what will determine the prosperity and well-being of citizens living in the euro area, five issues are central. The Franco-German paper (Bénassy-Quéré et al. 2018) makes an important contribution to two of them but I find it overall unbalanced. Let me take the five issues in turn.

1. Providing adequate public goods

The well-being of citizens will depend on whether European institutions, together with national institutions, will provide European public goods. Yet the debate on these issues is often superficial. How to provide border protection, fund immigration, how to divide national and European competences or how to advance the Single Market are topics often lacking thought leadership.

One may argue that such public goods are not directly connected to the euro. Yet, political cohesiveness crucially depends on them. And without political cohesiveness, the foundations of the euro will be more fragile than ever. Moreover, public goods often play a role in macroeconomic stabilisation as Bénassy-Quéré et al. acknowledge but unfortunately don’t pursue. To my mind, the political debate rightly puts a strong focus on these issues at this stage[1].

2. Ensuring that the fiscal stance of the euro zone is appropriate when monetary policy is at the zero lower bound

One of the key reasons for the dissatisfactory macroeconomic performance of the euro area has been its inability to run a sensible fiscal policy for the euro area as a whole. It is well established in standard macroeconomic models that when monetary policy hits the zero lower bound, the role of fiscal policy becomes more important in ensuring a proper macroeconomic stabilisation. Without proper macroeconomic policy, recessions will be deeper than necessary, unemployment will be higher and hysteresis effects in labour markets can lower growth potential for many years to come.

The EU’s institutional set-up ignores this issue and there is no mechanism to ensure that the sum of national fiscal deficits makes sense for the euro area as a whole. International institutions such as the IMF have repeatedly asked stronger countries to contribute more to fiscal stabilisation in the recession years.

Attempts to address this institutional weakness have gone nowhere. Unfortunately, Bénassy-Quéré et al.  put the topic aside and do not confront the significant political resistance on the issue – a missed opportunity to shape the debate. For example, one could propose to amend the expenditure rule and increase expenditure in countries with fiscal space when monetary policy is at the zero lower bound (Claeys et al. 2016).

3. Ensuring that macroeconomic imbalances and structural weaknesses are addressed

One of the key fragilities of the euro area is the fact that prices and wages have diverged so substantially across different countries. The past divergence in the smaller countries of the euro area has been addressed as they have adjusted to the euro area’s core. But the divergences between Germany, France, and Italy remain a major liability.

Adjustment is ongoing, but at a low inflation rate and slowly. The low inflation rate of the euro area has made relative price adjustment more painful, forcing some countries to be close to deflation. As real rates rise as a consequence, the debt burden increases, weighing further on economic performance. Debt-deleveraging in a low-inflation environment is difficult and painful.

Addressing these significant divergences more quickly and with a lesser economic cost requires bold structural and macroeconomic policies at the national level. It requires an acceptance in the national political debates, including in Germany, that national structural and macroeconomic policies matter not only for the domestic economy but also for the euro area as a whole.

It remains a key priority that Germany addresses its low investment, France its overly high and inefficient government expenditure, and Italy its low productivity growth and the weakness of its institutions. Failing to address any of these issues will mean a structurally weak euro area that remains fragile and susceptible to further crises, no matter what is achieved as a compromise on how to deal with sovereign debt. These issues deserve academic debate, which I had hoped my 14 colleagues would bring.

4. Completing banking union and advancing capital markets union

The most convincing section is that on banking union. The idea of sovereign concentration charges(Veron 2017) is well thought through and would reduce the link between banks and sovereigns without creating major financial instability. The introduction of a European deposit insurance scheme – once exposure to sovereign debt is reduced and legacy problems with non-performing loans are addressed – is also sensible. Differentiating the fee structure for the insurance according to country characteristics would sensibly acknowledge that we remain a union in which country policies matter for banks despite being in a banking union.

Yet, one should not claim that introducing such insurance is a major concession by stronger to weaker countries. Introducing insurance after legacy issues are addressed and allowing for differentiated fees depending on risk is just simple, good-sense economics. Unfortunately, it also means that banks in countries with weaker institutions will continue to face higher costs of deposit financing (Wolff 2016). This would cement funding-cost differences for banks across countries, but it would usefully preserve incentives to improve country institutions. It may also be the necessary political condition to get insurance introduced. Overall, it should not be considered a substantial concession to the weaker countries as many strings have been attached.

In terms of political economy, the spreading of sovereign debt across euro area countries may make debt restructuring more difficult though. The financial system may be more easily able to cope with the restructuring when the debt is widely spread in the system, but influential owners of debt in many countries would be affected and will make their political influence heart.

Still, completing banking union with such deposit insurance and fiscal backstop to the resolution fund would increase the financial stability of the euro area and should therefore be pursued. Banking union should be complemented with strong steps that would make capital markets union a reality (Sapir et al. 2018).

5. Dealing with sovereign debt

The core of the paper is about how to reconcile risk sharing with market discipline and here the paper makes an important contribution. It takes up a strand of work that was perhaps first advanced by the Glienecke Gruppe. My main concern is that the paper is not sufficiently courageous in arguing the case for significant integration steps needed to manage the consequences of major debt restructuring. In particular, banking union would not be sufficient to ensure that the economic and political fall-out of a major debt restructuring would be manageable and the other parts of the proposals appear too half-hearted and weak to manage such fall-out.

I have two main worries in this section.

The first is that the paper is explicit about debt restructuring with clear criteria that would remove current constructive ambiguity on when such restructuring would happen. This would mean that market participants can more easily calculate when and how to speculate against a country. Earlier market panic is a likely result. It is notable that the Outright Monetary Transactions (OMT) programme is not explicitly mentioned. Willingly or not, this creates an imbalance where debt restructuring is explicit while OMT is at best implicit. Yet, a euro area without OMT or a true safe asset would be susceptible to bad equilibria problems. (A small rainy-day fund is hardly worth mentioning in this context). Removing constructive ambiguity and not mentioning OMT and the conditions under which it is used could render the euro area more fragile.

Second, I missed a more comprehensive discussion of the implications of debt restructuring in a major country. The authors somehow lightly discuss debt restructuring but do not seem to reflect much on its major consequences.  Cruces and Trebesch (2013) find that restructurings involving higher haircuts are associated with significantly higher yield spreads and longer periods of capital market exclusion. Trebesch and Zabel (2016) find that hard defaults are associated with steep output costs.

The authors suggest that the ESM could ensure the funding for the basic provisioning of public services and the support needed to reduce the impact on the economy. Yet, the ability of the ESM to fund a major country for several years after a restructuring may be more limited than the authors assume, at least in the absence of the ECB’s OMT and in the absence of the IMF. Contagion effects to other countries may further erode the capacity of the ESM. The proposals to experiment with a synthetic safe asset would also not help in providing funding to a country in difficulties. The ESRB report on ESBies(ESRB 2018) even acknowledges that countries losing market access would be excluded from ESBies

All of this does not mean that debt restructuring cannot and should not be a measure of last resort. In fact, the ESM treaty does foresee it and bond spreads currently do price risk. But it is a measure of very last resort and constructive ambiguity currently prevents unwarranted market speculation. If it had to happen in a major country, major political decisions would be needed to preserve stability.

Europe needs to discuss the broader horizons of its future. The starting point needs to be an understanding that a shared currency comes with many spill-overs and therefore shared responsibilities. It is about keeping one’s own house in order but also about taking into account effects on neighbours of one’s own policies.

References

Bénassy-Quéré, A, M Brunnermeier, H Enderlein, E Farhi, M Fratzscher, C Fuest, P-O Gourinchas, P Martin, J Pisani- Ferry, H Rey, I Schnabel, N Véron, B Weder di Mauro, and J Zettelmeyer (2018), “Reconciling risk sharing with market discipline: A constructive approach to euro area reform”, CEPR Policy Insight No. 91.

Claeys, G, Z Darvas and A Leandro (2016), “A proposal to revive the European fiscal framework”, Bruegel Policy Contribution.

Cruces, J and C Trebesch (2013), “Sovereign defaults: the price of haircuts”, American Economic Journal: Macroeconomics 5(3): 85–117.

ESRB (2018), “Sovereign bond-backed securities: a feasibility study”, January.

Glienicke Group (2013), “Towards a Euro Union”, Die Zeit, October.

Leclercq, A (2018), “(How) could European safe assets be constructed?”, presentation at Bruegel event, March.

Macron, E (2017), “Initiative for Europe”, speech by the President of the French Republic at Sorbonne, Septembe.r

Rutte, M (2018), “Underpromise and overdeliver: fulfilling the promise of Europe”, speech by the Prime Minister of the Netherlands at the Bertelsmann Stiftung, Berlin, March.

Sapir, A, N Véron, G B Wolff (2018), “Making a reality of Europe’s capital markets union”, Bruegel policy contribution.

Trebesch, C and M Zabel (2016), “The output cost of hard and soft sovereign default”, European Economic Review.

Veron, N (2017), “Sovereign Concentration Charges: A New Regime for Banks’ Sovereign Exposures”, Study provided to the European Parliament in the context of Economic Dialogues with the President of the Eurogroup in ECON, November.

Wolff, G (2016), “The European Deposit Insurance Scheme”, statement prepared for the European Parliament’s ECON Committee Public Hearing of 23 May.

Endnotes

[1] See for example Emmanuel Macron’s speech at the Sorbonne or Mark Rutte’s speech in Berlin.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Opinion

Fiscal rules and the role of the Commission

The proposals on fiscal frameworks and rules in the recent CEPR Policy Insight on euro-area reform showcase the multiple dimensions of the fundamental dilemmas we are confronted with in the governance of the euro area. This column, part of the VoxEU debate on Euro Area Reform, looks at the challenges to the central role of the Commission that have arisen as the rules-based fiscal framework has been severely compromised.

By: Thomas Wieser Topic: European Macroeconomics & Governance Date: May 22, 2018
Read article More on this topic More by this author

Blog Post

Argentina’s troubles

Argentina has abruptly called on the International Monetary Fund for financial help, amid currency pressures. We review recent economists’ position on this.

By: Silvia Merler Topic: Global Economics & Governance Date: May 22, 2018
Read article More on this topic

Blog Post

Completing Europe’s banking union means breaking the bank-sovereign vicious circle

Several euro area leaders, including the German chancellor, her finance minister, and the French president, have recently referred to the need to “complete the banking union.”. These public calls echo those made in more formal settings, and inevitably raise the question of what criteria should be used to assess the banking union’s completeness.

By: Isabel Schnabel and Nicolas Véron Topic: Finance & Financial Regulation Date: May 17, 2018
Read article More on this topic More by this author

Podcast

Podcast

Director’s Cut: EU policy priorities towards Capital Markets Union

In this Director’s Cut of ‘The Sound of Economics’ podcast, Bruegel director Guntram Wolff hosts a conversation with the European Commission’s Vice-President Valdis Dombrovskis regarding the policy measures required to make tangible progress with the Capital Markets Union project.

By: The Sound of Economics Topic: Finance & Financial Regulation Date: May 8, 2018
Read article More on this topic

Blog Post

Structural Reforms 0.0 – The case for strengthening institutions

Improvement in institutional quality, particularly concerning the rule of law, is the most essential and urgent structural reform the EU can make. Without it, the obtrusive lack of trust in the EU – which has thus far hampered expansionary and reformist efforts – will persist.

By: Maria Demertzis and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: May 3, 2018
Read article More on this topic More by this author

Blog Post

European income inequality begins to fall once again

Following almost a decade of relative stability, income inequality within the EU recorded a sizeable decline in 2016, reaching its lowest value since 1989. The fall of both within- and between-country inequality contributed to the 2016 reduction in overall EU inequality.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: April 30, 2018
Read article Download PDF More on this topic

Policy Contribution

Making a reality of Europe’s Capital Markets Union

It is high time to make the CMU project real.The authors of this publication suggest that capital markets will only transform with concrete action and that ESMA reform should be a priority but cannot be the only one. Policymakers need to set priorities that will move the project forward.

By: André Sapir, Nicolas Véron and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: April 27, 2018
Read article Download PDF More on this topic

Working Paper

State contingent debt as insurance for euro-area sovereigns

Since the financial crisis, EU countries' economies have recovered to the point that they are exiting their adjustment programmes. Institutional stability mechanisms have been improved at the European level, with the promotion of the banking union and the establishment of a European Monetary Fund, for instance. However, the authors argue that such crisis contingencies should include markets in their risk-sharing, which would require better coordination with institutions.

By: Maria Demertzis and Stavros Zenios Topic: Finance & Financial Regulation Date: April 26, 2018
Read article More on this topic More by this author

Blog Post

Building a stable european deposit insurance scheme

Deposit insurance, like any insurance scheme, raises moral hazard concerns. Such concerns arising from European deposit insurance can be alleviated through a country-specific component in the risk-based premium for deposit insurance and limits on sovereign bond exposures on bank balance sheets. This column argues, however, that proposals to maintain national compartments in a new European Deposit Insurance Scheme are self-defeating, as such compartments can be destabilising in times of crisis.

By: Dirk Schoenmaker Topic: Finance & Financial Regulation Date: April 19, 2018
Read article More on this topic More by this author

Blog Post

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: Silvia Merler Topic: Finance & Financial Regulation Date: April 16, 2018
Read article More on this topic More by this author

Opinion

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: Jean Pisani-Ferry Topic: Finance & Financial Regulation Date: April 4, 2018
Read article More by this author

Podcast

Podcast

Director's Cut: Developing deposit insurance in Europe

In this week’s Director’s Cut of ‘The Sound of Economics’ podcast, Bruegel director Guntram Wolff talks with Nicolas Véron, senior fellow at Bruegel, about the implementation of a European Deposit Insurance Scheme (EDIS), one of the three pillars needed for the completion of banking union.

By: The Sound of Economics Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: April 3, 2018
Load more posts