Securing the euro’s long-term future: the proposals on the table
The fact that growth in the euro area is currently accelerating and spreading must not cause us to forget about the area’s vulnerabilities, which raise questions as to its resilience in the event of another crisis. While undeniable progress towards greater integration has been made over the past decade, this remains insufficient. With the economic climate favourable and euroscepticism temporarily ebbing the time appears to be ripe for translating a debate of ideas, and proposals to consolidate the euro area that have now been on the table for a number of years, into political decisions. However, assessments of shortcomings in economic governance continue to diverge, and we are far from having a shared view of alternative models for organising economic policy in the euro area. The road to agreement lies in balancing financial solidarity, fiscal discipline and reform conditionality.
A euro area still beset by imbalances
The euro area continues to be ill-prepared for a major shock. Growth is accelerating, but continues to fall short of past performance and that of other regions; and while imbalances are decreasing, private and public debt remain high in a number of countries. With the exception of the ECB, which is openly pursuing its stated objective of price stability and financial stability, no EMU institution has an official mandate to stabilise aggregate euro area growth. Moreover, supervision of domestic policy suffers from pro-cyclical bias, since such policy is constrained by a strict framework that prevents growth from being supported as long as public sector debt remains high. As a result of imperfections in labour and capital mobility within the euro area and significant price rigidity, the various member country markets cannot adjust and share risks in such a way as to absorb a shock. While the banking union and ECB intervention have reduced financial fragmentation within the euro area, the degree of financial fragmentation nonetheless remains high. The ECB’s presence on debt markets and its extraordinary refinancing operations have so far staved off the risk of a liquidity crisis. However, this has been at the cost of strict constraints, dictated by the desire to maintain national separation of risks (with sovereign debt purchased by national central banks); these constraints have contributed to the idea of ‘redenomination risk’ (the risk of a country leaving the euro area) and the creation of a safe haven asset that is asymmetrically available within the euro area (the German Bund) without there being any genuinely European risk-free asset. OMT, the programme under which the ECB can purchase unlimited amounts of sovereign debt of Member States that have requested assistance, put in place in 2012 but never activated, is intended to protect the transmission and unicity of monetary policy within the EMU. However, its implementation is subject to strict conditions in the form of a process for assessing the risk to the stability of the EMU and the sustainability of the requesting country’s debt. The trigger for ECB purchases is a request for a loan as part of an adjustment programme or financial assistance from the European Stability Mechanism (ESM). However, as of now, the ESM is not sufficiently well funded to meet the refinancing needs of a major country and/or recapitalise its banking sector. Furthermore, while the creation of the Banking union is a major step forward, it remains incomplete: there is still no permanent safety net ensuring its credibility in the event of a systemic crisis. Moreover, the unlimited nature of ECB purchases is weakened by strict constraints, imposed via a ruling of the European Court of Justice under pressure from the German constitutional court, which de facto prevent the ECB from truly acting as lender of last resort. Fighting a speculative attack by purchasing unlimited amounts of debt could endanger the central bank’s balance sheet. Indeed, its ability to call for capital from Eurosystem member states depends not only on government decisions but also, in some countries, on a parliamentary vote. The lack of a clear and democratically legitimate political process for Member States to bail out the ECB is the system’s real Achilles heel. All in all, the factors leading to an unstable equilibrium, which are the reason why redenomination risk is still a threat within this monetary union, have yet to be eradicated.
What does the euro need to survive?
To be able to cope with a systemic crisis, the most pressing need is to create a credible permanent safety net. This would mean continuing to share risks by increasing the ESM’s firepower, but also funding the European deposit insurance scheme. Major progress has been made on reducing risks (e.g. bail-in rules, TLAC/MREL, leverage, liquidity, strengthening the Stability and Growth Pact, procedure for excessive imbalances), notably to limit moral hazard, which goes hand-in-hand with greater solidarity – though not enough in the view of some countries, which are fearful of the risk associated with continuing high levels of non-performing loans and public debt.
Some European leaders, as well as the European Commission (EC), propose building a fiscal tool to attenuate macroeconomic shocks and prevent them from morphing into a crisis, notably when central bank actions in favour of cyclical stabilisation are constrained by official market interest rates hitting the zero lower bound . Furthermore, while in the United States the financial channel takes precedence over the fiscal channel when it comes to ensuring that shocks are absorbed, it is much less important in the euro area due to the embryonic state of the capital market. In spite of the ECB’s efforts, the financial channel remains jammed up by the low degree of sharing of private financial risks, but also by barriers imposed by domestic supervisors on inter-country liquidity transfers. The EC is therefore pushing for efforts to be focused on overcoming these barriers through development of the capital markets union, but also on the creation of a shared budget. If this fiscal tool were to be put in place, it should be used to create the necessary macroeconomic conditions (in terms of growth, inflation and interest rates) at the aggregate euro area level to re-float debt (hurt by years of low growth and inflation) and foster convergence between Member States’ economies while ensuring financial stability.
What governance model?
There are a number of possible governance models, depending on how one answers the two foundational questions of risk-sharing (and therefore the degree of control and discipline) and centralisation of the role of macroeconomic stabilisation. A first model (1), which gives negative answers to these two questions, would imply less solidarity and thus less discipline. It would be characterised by greater sovereignty, simplified fiscal rules, a procedure for restructuring sovereign debt, diversification of bank portfolios to prevent systemicity, and clear affirmation of the no bailout principle, supported by risk reduction. This model, defended by liberal parties and governments, now no longer appears possible, given the high level of public debt and the risk-sharing that has already taken place. A second model (2), which centralises responsibility for stabilisation without pooling risks, would be similar to the American model, with a federal budget endowed with the ability to borrow but abiding by the no bailout principle for States. In both cases, the question of what constitutes an excessive level of debt and the debt restructuring process remain to be defined. The complex distinction between a liquidity crisis and a solvency crisis would be a key factor for activating OMT.
A third model (3), combining a centralised stabilisation function with the pooling of debt, would allow for bailouts in the event of an extreme crisis and subject to conditions, but at the price of giving up sovereignty under strictly defined European rules. While a pure federal model with as much fiscal capacity as the United States is not possible, a shared macroeconomic stabilisation function would nevertheless need to have sufficient firepower to support a major country or a group of countries in distress. Such large-scale pooling of resources is difficult to imagine without decision-making and supervisory powers being concentrated. This federalist approach would thus see a centralised supervisory function under the auspices of the Commission or the Eurogroup, answerable to the European Parliament.
A fourth model (4) is also possible, involving greater risk-sharing within the function of financial assistance and lender of last resort in the event of a crisis, but without any centralised macroeconomic stabilisation function. Under this model, fiscal policy and the macroeconomic stabilisation function would remain decentralised, but would benefit from greater room for manoeuvre thanks to the withdrawal of European supervision and national empowerment supported by a network of national agencies independent of executive power and with a European coordination centre. This sovereignty would be suspended if a country requested access to financial assistance, which would be subject to strict conditions and power of veto for the other countries over the debtor country’s budget. The EC’s function of monitoring macroeconomic imbalances would also be scrapped, in favour of national agencies responsible for consistency of wage policy and productivity and competitiveness trends. Countries would regain independence subject to all participants seriously and credibly buying into the constraints of a monetary union.
 Cf. Observatoires: Europe in crisis: acknowledge accountability in order to keep forging ahead, published 14 March 2017; Banks are first to witness the challenges of European integration, published 4 April 2017; A European Monetary Fund: tomorrow, after the crisis, or never?, published 19 July 2017.
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