A group of 14 prominent economists, seven each from France and from Germany, has issued a detailed and rather comprehensive proposal for reform of the Euro Area (CEPR 2018).* This is a welcome initiative. There is a window of opportunity for reform in the Euro Area. Economically it has been created by the strengthening and increasingly broad economic upturn: policymakers can leave firefighting mode and focus on structural governance reforms. Politically it has been opened up by the 2015 report by the five presidents of the EU institutions, the initiatives by the new French President Macron, the proposals by the European Commission of December 2017, and, most recently, the declarations of intent on Europe emerging from the grand-coalition talks in Germany.
Together Germany and France account for half of Euro Area GDP. The authors of the report are all well-known in policy-oriented circles, while coming from different traditions. For all these reasons the report is set to be very influential. This appraisal follows the structure of the report itself, examining the underlying philosophy and problem analysis (1), the proposals relating to the financial sector (2), to fiscal governance (3) and finally institutional questions (4). An overall assessment with recommendations for extensions and alternatives concludes (5).
Underlying philosophy and problem analysis
The basic philosophy underlying the report is to strike a balance between risk-sharing or collective insurance (identified as the French view) and rules and market discipline that ensure “sound” domestic policies that make crises impossible (identified as the German view). These are generally seen as alternatives and even entirely mutually exclusive: the stronger the collective insurance at central level, the weaker the incentives for member states to implement prudent policies, and the more attractive are policies whose costs will be borne partly by other countries (moral hazard). The report argues, however, that these approaches should be married. Partly this is for political reasons: the two big national players (and their respective allies) each need to see their views reflected in the reform process. But also in economic terms, the authors argue that, provided they are carefully designed, risk-sharing measures can minimise moral hazard. More fundamentally, risk-sharing mechanisms may actually be necessary to enable the imposition of rules because they reduce contagion from one country to others and thus prevent a country from holding its partners to ransom.
The report identifies as the main weaknesses of the Euro Area: a fundamental instability resulting primarily from the so-called doom loop between national banking systems and sovereigns; a lack of stabilization capacity, primarily at the national level resulting from inadequate fiscal rules and the ineffectiveness of the compliance mechanisms; finally, the resulting political frustration that has led to populism and a breakdown of solidarity between countries.
The basic philosophy has the notable advantage of opening up a space to craft a policy package that is both once coherent and amenable to political compromise. The weaknesses identified are all valid. However, they do not get to the heart of the two fundamental problems facing the Euro Area. At the Euro Area level, first, there is an insufficient capacity in times of crisis to keep aggregate demand in line with potential. The mechanisms to set and enforce an appropriate aggregate fiscal stance are, at best, weak. And, as the crisis showed, the ECB, facing a multitude of fiscal actors, has more difficulty than other central banks in taking the required measures. The report has very little to say on aggregate demand at the level of the currency union on the role of the ECB.
Second, the mechanisms to avoid and correct competitive and macroeconomic (current account) imbalances between the member states are too weak given the powerful mechanism of procyclical differences in real interest rates resulting from differences in inflation rates. These push countries with different cyclical conditions apart, causing rotating booms and busts. This is largely missing from the report’s analysis which merely refers to asymmetric shocks.
In short, a lack of effective cooperation between central monetary and the multiple actors responsible for fiscal and other national policies make it very difficult to stabilise national economies and rapidly and effectively combat crises.
The financial proposals
In line with the importance given to the doom loop between banks and sovereigns, financial-sector reforms occupy a prominent position in the reform proposals. Three sets of measures are proposed:
- Steps to make it more credible to bail in bank share- and bondholders (rather than relying on taxpayer-funded bank rescues) by restricting the use of precautionary recapitalisation and resolution under national insolvency procedures, and measures to reduce non-performing loans (NPL) exposure;
- disincentivising banks from holding “excessive” concentrations of domestic sovereign bonds through higher capital requirements (and by offering a European safe asset – considered below);
- establishing a common deposit insurance scheme offering equal and unconditional protection in all member states and backed by the European Stability Mechanism (but with risky countries paying higher insurance premiums and countries accepting a first loss).
- greater progress with Capital Markets Union to promote integrated capital-market finance, so as to increase the power of private (rather than public) sector stabilisation between countries.
Achieving an adequately backstopped (i.e. through the ESM) common deposit insurance and a harmonised resolution regime would be important steps in stabilising the Euro Area financial system. The bail-in principle has risks, though: if retail investors suffer severe losses the real-economic impact can be very counterproductive for restoring economic growth (which is a condition for stabilising the banking sector).
Reducing NPL exposure is clearly desirable. However, it is well-known that NPL issues are concentrated in a small number of countries. Although all member states have a common interest in their reduction, given the potential for contagion, the proposals appear to leave the countries concerned to resolve the legacy issues in their respective banking systems on their own. More generally, the authors do not sufficiently appear to take account of the fact that, rather than improper regulation or an excessively close bank-sovereign link, the banking-sector problems in some countries are a direct consequence of prolonged contraction or stagnation of the real economy; the source not the symptom of this problem needs to be addressed.
The recommendation to differentiate premiums to the deposit insurance scheme to reflect perceived country risk seeks to address moral hazard (and political obstacles), but it also imposes longer-term costs on already – as a legacy of the crisis – weaker countries. This is counter-productive: at the very least, the weight given to this differentiation factor needs to bear in mind this trade-off. Any lasting solution will require at least some collective efforts to resolve the legacy NPL issues to enable countries to start with a clean slate.
The measures to increase geographical diversification of banking assets and to develop Capital Markets Union reflect a belief that international portfolio diversification and private capital flows have substantial stabilising properties. There is good reason to be skeptical, however. Dullien (2017) shows that studies that purport to show an important role for private-sector compared with public-sector stabilisation are methodologically primed to generate that result; stabilisation across US state borders by the private sector is actually much lower than commonly reported estimates suggest. Theobald/Tober/Lojak (2017) show the destabilisation risks inherent in the securitisation schemes that are supposed to be the cornerstone of a deeper CMU.
The fiscal proposals
The most important reform proposals in the report are to be found in the area of public finances and the governance of fiscal policy. The starting point is the analysis that the fiscal rules are badly designed. The original focus in the SGP on debts and deficit limits was dangerously pro-cyclical. Repeated reforms have reduced the salience of this drawback, but the use of cyclically adjusted variables and other refinements has made the rules complex and subject to myriad measurement and other problems. They are virtually unenforceable, due to the factors already mentioned, but also because the ex post imposition of punitive fines on (sovereign) countries, often when they are already in difficult economic and fiscal situations, is not credible.
In as far as it goes, this analysis can be unambiguously seconded. What is missing, however, is recognition that the whole philosophy of limiting public deficits and reducing debts in the medium-run is inadequate. What is needed is to achieve an appropriate fiscal stance in aggregate, but also in each Member State. For the latter, the output gap and the competitive position (as manifested in indicators such as relative inflation rates, current account developments, the extent of spare capacity etc.) are decisive and these must be analysed in a symmetrical way.
Concretely, the authors propose the following:
- Replace the existing complex fiscal rules with a combined debt and expenditure rule. An independent national fiscal council determines an appropriate amount of debt reduction (as long as debt is above an agreed target such as 60% of GDP) and an expected rate of nominal GDP growth. On this basis it sets a ceiling for nominal government spending (excluding interest and cyclically sensitive items such as unemployment benefit payments, and allowing for any envisaged discretionary measures on the revenue side): the higher the outstanding debt ratio the more spending growth must lag nominal GDP growth. A deviation in exceptional circumstances would have to be permitted by the Eurogroup.
- Adherence to the given ceiling is achieved by obliging governments to issue junior bonds to cover any financing gap; these have no privileges over other securities (in particular no zero risk weighting) and will be the first to be restructured in the event of a government debt crisis. Consequently the interest rate will be higher, with the risk premium depending on market perceptions of the cause and justification of the over-spend and its likely duration. Alongside this market-determined “stick”, compliance with the spending rule is induced by a “carrot”, namely access to loans from the ESM that is restricted to compliant countries.
- Above and beyond the junior bonds, the no bail-out principle is to be rendered credible by insisting that governments with problematic debt dynamics must first restructure their debts. This is to be achieved by more flexible collective action clauses in new bond issuances to prevent bondholders (holdouts) blocking debt restructuring. Also measures to prevent the ESM lending to countries whose debts are not sustainable are to be tightened.
- A European fiscal capacity is envisaged to cushion large shocks. The proposal takes the form of a rainy day fund, i.e. Member States regularly pay in, the fund pays out if shocks (to employment or unemployment) exceed a certain magnitude. Payouts are related to the size of the negative shock. Access is restricted to countries complying with the fiscal rule. Contributions are staggered according to the estimated (based on past volatility) likelihood of payout. Even spending is subject to conditionality. There is no scope for borrowing if the fund runs out of money. Separately, however, access to non-emergency lending by the ESM is to be created to “well-behaved” countries, which would not require a country to reschedule its debts.
- Finally, a safe asset is to be created at European level on the ESB (European Senior Bond) model: existing sovereign bonds (not the junior bonds mentioned above) are pooled and securitized in several tranches. The most senior tranche is the European safe asset. The report envisages this asset partially replacing national sovereign bonds in bank portfolios; restrictions on such holdings create demand for ESBies. The authors argue that ESBies reduce the impact of fickle shifts in sentiment against vulnerable countries, which can be severely destabilizing, limiting spreads and the threat of a lack of market access.
The key section on fiscal proposals suffers from some ambiguities that render a definitive assessment difficult. Above all, it is not clear how the outstanding stock of government bonds and new bonds issues within the agreed spending ceiling are to be treated. With this important reservation, the following assessment can be made of the fiscal proposals.
The shift from a focus on (cyclically adjusted) deficits to an expenditure rule as set out in the report is welcome. No fiscal rule is perfect. At least non-cyclical expenditure can be readily measured, is under government control. However, the focus on convergence to an arbitrary debt-GDP target should be downplayed in favour of nationally specific targets that emphasise counter-cyclicality and the need to achieve consistent policy fiscal stance by all Member States. The country-specific recommendations must be symmetrical, meaning specifically that current-account-surplus, low-inflation countries must be constrained to expand aggregate demand and allow upward adjustment of nominal wages and prices.
And care must be taken with using nominal GDP as a guideline to avoid procyclicality. A higher inflation rate implies higher nominal GDP growth, implying more space for government spending. Yet an important lesson of the crisis is that higher inflation countries need to be more tightly constrained. The opposite applies in low inflation countries. It should also be considered to enrich the expenditure rule by differentiating spending categories so as to privilege productive investment, i.e. combining it with some version of a golden rule (Truger 2016).
The ex post punishment regime has failed. Far-reaching policy federalisation or at least rules providing for a progressive takeover of national policymaking competences in the case of repeated flouting of agreements (as in federal states), while they would be effective, are almost certainly a political non-starter at the current juncture. Seen in this light, the differentiated stick and carrot approach set out in the report has, in principle, much to recommend it. Imposing “market discipline” on government bonds without a backstop has potentially massively destabilising impacts, however (most recently Lindner 2018, and Watt 2017). If it is applied only to new government spending that is in contravention of agreed (and broadly sensible) principles – as with the junior bonds proposed in the report – it could serve as an effective control mechanism. Given risk sharing, there certainly has to be some reliable way to constrain national fiscal policy. Consequently any drawbacks of the partial introduction of market discipline need to be weighed against those of possible alternatives.
However, such an approach should only be considered if the existing stock of sovereign debt, and also new bonds issued within the agreed limits, are not subject to restructuring; they should continue to have zero weighting and the ECB able to purchase them on secondary markets so as to keep spreads within tight limits. As noted, the report is ambiguous on this point. The section on financial markets implies increased use of collective action clauses and thus greater possibilities for restructuring.
It seems that the only protection for outstanding and new bonds will be to the extent that they are securitised into ESBies. It is by no means clear such innovative (i.e. untested) collateralised financial products would really guard against “skittish” market forces destabilizing countries. There is no discussion of the size of the ESB market – specifically how to get a senior tranche that is both safe and large, given a small number of mutually correlated securities – nor of a possible stabilizing role of the ECB and whether ESBies would in future be a tool for quantitative easing or other monetary policy measures in the future. At the very least it seems that a disproportionate degree of faith is placed in this measure, the practicalities of which are barely discussed.
The authors accept the need for a Euro Area fiscal capacity. This is welcome. The version proposed is unnecessarily restrictive, however. Differentiated contribution rates will (once more) penalize the countries who have suffered most in the recent crisis. There is no obvious reason why such a fund should be pre-financed; collectively the member states are not like households or firms. An ESM credit line with appropriate conditionality would suffice, if the ESM can freely issue bonds (which can be purchased by the ECB to the extent that its inflation mandate allows). Here, too, the concern with moral hazard is exaggerated and counter-productive: there is a serious risk that countries getting into difficulties will at some point transgress against the expenditure rule, will lose access to the various support measures and will be faced with debt restructuring. Knowledge of this fact will induce anticipative speculation. Such a currency union is fundamentally unstable.
The institutional proposals
In terms of governance the report identifies a number of serious shortcomings, particularly in the fiscal area. These range from legal complexity (a lack of a unified legal basis, a plethora of decision-making rules), to a blurring of the functions (prosecutor, judge) of individual institutions (Eurogroup, Commission) and a lack of clarity regarding democratic control and inter-institutional rivalries and lack of trust (e.g. between ESM and Commission, or European Parliament and Eurogroup).
Against the background of recent Commission proposals for a euro area finance minister who is simultaneously Commission Vice-President and Eurogroup chair, the authors put forward three models, each with strengths and weaknesses.
- Strengthening the Commission’s role in supervision while appointing a full-time Eurogroup chair who is not tied to any national government.
- Delegating supervision to an independent technocratic body while having a Commissioner preside over the Eurogroup.
- Constructing a Chinese wall within the Commission between the supervision and enforcement functions.
Irrespective of the model adopted here the report recommends that all conditional financial assistance should be the responsibility of the ESM; the Commission and ECB would withdraw. As no role is foreseen for the IMF the Troika would be no more. The ESM would be held politically accountable by the European parliament but financially by its shareholders.
The second option would appear most in line with the other body of recommendations; however it would require Treaty change. It is not really clear whether this is worth the political capital that would be needed; arguably the Commission proposal is to be preferred.
The team of French and German economists is to be congratulated for the attempt to put together a package of measures that aims to be effective in stabilising the Euro Area, internally coherent and stands at least some chance of gaining political support. That is a tall order and any critic must recognise the scale of the challenge. The proposals are a starting point for debate. This concluding section sums up the appraisal and makes some suggestions as to where the package needs to be extended or adapted.
Much of the underlying problem analysis is correct, although in some areas it is limited. The downplaying of the tendency to competitive and current account imbalances is a serious shortcoming. The proposed policy package is broadly positive and contains some useful and innovative suggestions. A strength of these proposals lies in attempts to overcome the “discipline through punishment” approach, which has manifestly not worked, without far-reaching federalisation (which seems politically infeasible).
At the same time it fails to adequately address some important issues and the proposals are skewed – notwithstanding the claim to be a marriage of the risk-sharing and disciplinarian approaches – in favour of the latter. The excessive concern with “moral hazard” issues in a number of areas prevents a clear line being drawn under the crisis. Moral hazard is certainly an issue. But the common currency is a positive sum game: if not it will, and indeed ought to, fail. There is too little recognition that under the various conditionalities imposed on them (such as higher interest rates and fund contributions), those countries hit hardest by the crisis will struggle to develop, while those that have emerged from the crisis comparatively unscathed will not be so encumbered. This will prevent the needed long-run convergence between the Euro Area member states. Countries facing higher costs will constantly be confronted with the question whether they are not in fact better off, given such drawbacks, regaining their own monetary autonomy. Thus the future of the common currency will continually be in doubt (Watt 2017).
If the proposals are to be taken as a point of departure, important changes and extensions would needed to overcome the drawbacks identified, including notably:
- Solutions need to be found to legacy issues in vulnerable national banking sectors with a collective element, reflecting a common interest in their swift resolution and as a precondition of future risk-sharing.
- The European fiscal capacity should not take the form of a rainy day fund but a lending capacity by the ESM.
- Any creation of junior bonds must go hand in hand with effective measures to ensure that existing government bonds and new issues under the spending rule are risk-free and thus removed from the threat of destabilising speculation.
- The national fiscal stance should be set with much greater regard to safeguarding public investment and to ensuring symmetrical counter-cyclical stances at national level and thus their coherence at the aggregate level.
- To this end it is vital to reform the Macroeconomic Imbalance Procedure to ensure it is symmetrical vis-à-vis deficit and surplus countries and it can be effectively applied with regard to the entire macroeconomic policy mix. Koll/Watt 2017 and Horn/Watt 2017 propose using the new national productivity boards as a platform for expertise and to extend the existing Macroeconomic Dialogue (MED) at EU level also to the Euro Area and national levels. Alongside fiscal policy, the MED brings in the social partners and the national central banks, to guide national policy-setting and -making towards growth and stability-oriented and mutually consistent stances. Fiscal, incomes and macroprudential policies can be thus aligned while protecting the autonomy of the various actors. This approach is a necessary extension of and corrective to that proposed by the 14 Franco-German economists, while at the same time being compatible with that concept.
* This column was originally written for the journal Wirtschaftsdienst and appears there (98. Jahrgang, 2018, Heft 2 · S. 79-99) in German (subscription needed). https://archiv.wirtschaftsdienst.eu/jahr/2018/2/frankreich-und-deutschland-starke-partner-fuer-ein-stabiles-europa/ I would particularly like to thank Susanne Erbe for the fruitful cooperation.
CEPR (2018) ‘Reconciling risk sharing with market discipline: A constructive approach to euro area reform’, CEPR Policy Insight No 91
Dullien, S. (2017) ‘Risk sharing by financial markets in federal systems. What do we really measure?’, FMM Working Paper, Nr. 2., ISSN: 2512-8655
Horn, G. and A. Watt (2017) Wages and Nominal and Real Unit Labour Cost Differentials in EMU, Discussion paper 059, July 2017, DG ECFIN, https://ec.europa.eu/info/publications/economy-finance/wages-and-nominal-and-real-unit-labour-cost-differentials-emu_en
Koll, W, A. Watt (2017) ‘A feasible conceptual and institutional reform agenda for macroeconomic coordination and convergence in the Euro Area’, in H. Herr, J. Priewe, A. Watt (eds) Saving the Euro: Redesigning Euro Area economic governance, Social Europe Publishing, pp. 335-352 https://www.socialeurope.eu/book/saving-euro-redesigning-euro-area-economic-governance
Lindner, F. (2018) Ein Insolvenzverfahren für Staaten wäre schlecht für Europa, Herdentrieb, 31. January 2018, http://blog.zeit.de/herdentrieb/2018/01/31/ein-insolvenzverfahren-fuer-staaten-waere-schlecht-fuer-europa_10744
Theobald, T., S. Tober, B. Lojak (2017) IMK Finanzmarktstabilitätsreport 2016. Regulatorischen Fortschritt weiterentwickeln, IMK Report, Nr. 121, Düsseldorf February 2017
Truger, A. (2016) The golden rule of public investment – a necessary and sufficient reform of the EU fiscal framework?, IMK Working Paper 168
Watt, A. (2017) Wolfgang Schäuble’s poisoned parting gift to the Euro Area, €-Vision, 11 October 2017, http://andrewwatt.eu/2017/10/11/wolfgang-schaubles-poisoned-parting-gift-euro-area/