I propose five questions that eurozone politicians will have to answer. Identifying these questions is useful because in the debate on the future of the eurozone an answer to one of these questions is often dismissed by arguing that it does not address the other ones, an unsatisfying state of affairs. In addition, I argue that economists have been unable to provide clear answer to these questions.
- Why are countries in a monetary union more prone to sovereign debt crises than countries outside a monetary union?
An analysis of the crisis and its remedies should start by identifying the economic mechanisms that make a monetary union so fragile. Given a clear view of these mechanisms, policy proposals can be better tailored to address them.
Here are three stories. A first story (see e.g. Feldstein) puts monetary and fiscal policy at the forefront. It argues that while individual countries are subject to asymmetric shocks, they are unable to conduct their own monetary policy that would allow countries to react to and cushion such shocks. Because financing of deficits is not centralised and interest rates can not adjust to function as an automatic shock-absorber at the country level, this exposes individual countries to debt crises.
A second story takes as a starting point the convergence in interest rates paid by individual countries that started in 1997 and ended in 2008. In spite of the so-called no-bailout clause financial markets allegedly assumed an implicit guarantee of other EU countries in case one of them would get into trouble. The resulting too-low interest rates, the argument goes, bred real estate bubbles and intra-country imbalances which are now unwinding. Instabilities arise due to the absence of transfers (in the US the federal system absorbs most of the shock from deflating real-estate bubbles in some individual states) and the existence of feedback loops through the banking sector (in the US the safety net is at the federal level, while banks hold US government debt).
A third story views markets as the centrifugal force. De Grauwe argues that in the current EMU an individual country might be forced to leave the monetary union because it lacks a credible lender of last resort. This exposes countries in monetary union to self-fulfilling debt crisis and allows financial markets to speculate upon such an event. Because politicians have been unable to come up with a sufficiently ‘big bazooka’, they have failed to restore market expectations to their ‘good’ equilibrium.
Although there is significant truth in all of these stories, in isolation each of them is unsatisfying. The first doesn’t feature a central element in the current crisis: contagion. The second fails to explain why markets expected such a bailout. In addition, the theory of bubbles is very heterogeneous (see e.g. the literature review in this paper by Allen and Carletti), while the empirical literature offers limited perspective of identifying bubbles. The third implies rather implausibly that if we allowed the ECB to act as a lender of last resort the whole crisis would be solved. To date no unified view exists on the relative importance of the mechanisms that have driven the eurozone towards a sovereign debt crisis. As a result, economists disagree on the minimum conditions for a crisis-proof monetary union.
- How to insure a burning house?
In the aggregate, levels of private and public debt in the EU are comparable to or below those in Japan and the US. Although we lack the instruments to deal with its four core elements - liquidity problems, solvency problems, contagion between countries, and negative feedback loops between banks and their sovereigns - the eurozone in principle has the resources to stop the crisis. This, however, will require some level of debt pooling and sharing of losses to the extent that debt has become unsustainable.
Here’s an –admittedly imperfect but nevertheless illuminating - analogy. Compare Europe to a city with several housing blocks. Some of these housing blocks have invested in fire-extinguishers. Others haven’t. Now one of the housing blocks without fire extinguishers is on fire. The fire threatens to spread throughout the city (but this is by no means certain). The discussion among the housing blocks that have invested in fire extinguishers is whether they should put out the fire. Some argue it is unfair they should use their expensive apparatus to put out the fire. Doing so will spread discontent among its citizens, undermining the democratic support upon which the city is built. Others claim it will reduce incentives to invest in proper fire fighting apparatus in the future. Giving in now will therefore increase the likelihood of a devastating fire in the future. A final claim is that the fire extinguishers have limited capacity and might suffice to protect their own building blocks, but not the whole city.
What should the people in the city do? Should they put down the fire now and worry about moral hazard and fairness later, with the risk that once things get back to normal opportunistic politics will result in continuation of the status quo, or should they make sure moral hazard and fairness are guaranteed first and only then put out the fire, with the risk that the city will be laid in ashes?
The answer to this question depends very much on your view on what the bigger risk is: disintegration of the eurozone if risk is not pooled, or a democratic deficit if risk is pooled (which may result in disintegration later on). This is a political choice in which economists can only contribute by pointing at important trade-offs: between increased insurance on the one hand and increased moral and reduced insurance capacity on the other, which leads us to the third question.
- How to share liquidity risks and solvency risks in a monetary union?
Unfortunately, economists currently have little empirical evidence or theoretical analysis to guide us in answering this nevertheless classical insurance question. Although the theory of insurance with moral hazard is well-developed, it remains very general and not tailored to the situation at hand. We do not understand the precise nature of the liquidity and solvency shocks that hit countries. What is the nature of runs on a country? Why do bubbles in real estate market arise? How to prevent them? We do not understand the bargaining process between the countries involved. What are the outside options? Who has private information on what? How big are the externalities?
Instead of trying to answer these questions, economists have contributed mainly by proposing solutions, ranging from truly European banking regulation to a full-fledged fiscal transfer union. In this respect it is illustrative to consider one popular proposal for risk sharing: eurobonds. There are currently more than ten different proposals. Stated goals range from cutting the feedback loop between sovereigns and banks, preventing liquidity runs, to simply restructuring unsustainable debt. In addition the proposals differ in the several dimensions: whether they are temporary or permanent, the amount of debt pooled (ranging from 10% to 60%), the type of risk shared (ex post or ex ante, liquidity risk or solvency risk), the disciplining mechanism they use to address moral hazard (markets or institutions), and the type of common debt issued (short-term or long-term).
Some of these proposals will outperform others. But economists to date lack theoretical models to analyse this issue. The conclusion should be that there are simply too many goals, too many proposals and too little economics to make a balanced judgement. In this context, the following statement of Jean Tirole is refreshing: “my understanding of the implications of these [three] innovative proposals is still very imperfect (...) formal analyses will in the future substantially clarify their properties”
- How to enforce prudent macro-economic policy in individual countries
Given that countries share risks, the insurance literature tells us that we need somehow to contain ‘moral hazard’. Strictly speaking, a particular country’s economic policy is relatively easily to observe. Some might argue that moral hazard is therefore not a problem. First, there might be certain areas, such as banking regulation, where policy is indeed unobservable. More importantly, we can not write enforceable contracts that specify what policies a country should implement because countries are sovereign. From an economic point of view, this has the same consequences as moral hazard.
How to address this issue? There are roughly two ways: via institutions and through markets. Institutions can take the form of further fiscal integration, but also of development of carrots and sticks. Currently, the eurozone is relying on the latter, through a combination of soft institutional pressure, conditioning future loans on compliance with pre-agreed measures, and market forces. The trouble with conditionality is that we can not force countries to enter into an EFSF / ESM program and that, once in a program, there is always a possibility to renegotiate while for some countries withdrawing lending is simply not credible. The trouble with market forces is that, while they are credible, they may overshoot and suffer from self-fulfilling expectations.
- How to ensure the long-run political legitimacy of the EMU?
How much further down the road towards a political union can we go without citizen involvement? On this question, economists can help politicians to decide which route to take by identifying what types of monetary union are economically viable in the long run. In a recent speech Jens Weidman sees two possibilities. In one, sovereignty remains with nations while European rules and financial markets enforce discipline. The other is that of a fiscal union with transfers of sovereignty to the supra-national EU level. To find the conditions sine-qua-non for these two options - and to identify potential alternatives - takes us full-circle to our first question.