Blog Post

We need a European Monetary Fund, but how should it work?

Many voices are calling for the ESM to be developed into a fully-fledged European Monetary Fund. But what changes would this entail, and how could the new institution be governed? The authors see both need and hope for change.

By: and Date: May 29, 2017 Topic: European Macroeconomics & Governance

Sovereign debt crises and banking crises were not supposed to happen in the euro area. Or more precisely, the Maastricht Treaty, which founded the European Monetary Union (EMU), contained no common provision for dealing with a sovereign or banking crisis. The euro area was therefore totally unprepared when hit first by a banking crisis, then by a sovereign debt crisis and finally by a sovereign-bank “doom loop”.

Under the Maastricht philosophy, or EMU 1.0, each member country was supposed to take care of its sovereign debt or banking problems on its own. The only common instrument that existed, the Stability and Growth Pact (SGP), was for the surveillance (and correction) of public deficits by the European Commission. There was no common instrument in case a sovereign faced a liquidity or solvency crunch. For banks, there was not even a common instrument for the surveillance of risk, and there was no common instrument in case of a liquidity or solvency crisis. Everything was left in the hands of individual member countries. This Maastricht architecture is described in the two columns entitled EMU 1.0 in Table 1.

The situation changed radically after the euro area was hit by a series of banking and sovereign crises. National and European authorities were forced to realise that a sovereign or banking crisis, leave alone a sovereign-cum-banking crisis, has implications for the entire area – even if it occurs in only one euro-area country. As a result, they gradually took steps to create new common tools for the surveillance of sovereigns and banks, for the management of sovereign debt and banking crises, and for the resolution of banking crises. Four major steps were taken:

  1. The first step was the reinforcement of the surveillance of public deficits and debts by the European Commission, with the Two-Pack (2-P) and Six-Pack (6-P) measures, and the Fiscal Compact of the intergovernmental Treaty on Stability, Coordination and Governance (TSCG). Membership is open to all EU countries.
  2. The second step was the creation of the European Stability Mechanism (ESM), an intergovernmental instrument to provide financial assistance to euro-area countries facing temporary financial problems. Membership of the ESM is restricted to countries belonging to the TSCG. Its current members are all the euro-area countries. The ESM offers three main facilities: lending to governments subject to a macro-economic adjustment programme (ex-post conditionality); precautionary financial assistance consisting of credit-lines available to countries meeting certain conditions (ex-ante conditionality); and lending for bank recapitalisation.
  3. The third step was the decision to create a European banking union (BU) to strengthen financial stability in the euro area. The banking union architecture will consist of three separate mechanisms: the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) and the European Deposit Insurance Scheme (EDIS). So far, only the first two mechanisms have been created. Membership of the banking union is open to all EU countries, but its current members are only those belonging to the euro area. After the creation of the Single Resolution Board (SRB) and its Single Resolution Fund (SRF), the ESM decided to extend its bank recapitalisation instrument, initially only available to governments, to banks under strict conditions (see below).
  4. The fourth step was the decision by the European Central Bank (ECB) to create the Outright Monetary Transactions (OMT) facility. The OMT programme allows the ECB to purchase government bonds in the secondary market subject to ex-post or ex-ante conditionality in the form of an ESM macro-economic adjustment programme or a precautionary credit-line.

The current architecture, resulting from these four successive steps taken during the crisis, is described in the two columns entitled EMU 2.0 in Table 1.

Although vastly superior to the previous situation (EMU 1.0), the current state of affairs (EMU 2.0) still suffers from three main weaknesses:

  1. The first weakness concerns the treatment of sovereign debt. The new system reduces the risk of sovereign debt crises, partly thanks to the improved surveillance framework, and greatly thanks to the ESM’s lending capability (€500 billion) and the ECB’s OMT facility, which is potentially unlimited. Thanks to the ESM and the OMT, the new system is well equipped to deal with liquidity crises. However, it still lacks an instrument to deal orderly with insolvency crises.
  2. The second weakness concerns the incompleteness of the banking union. The SSM is completely up and running, and functioning well (see here). The SRB is also up and running, but the SRF is still in transition. In addition, use of the ESM’s direct recapitalisation instrument is subject to such strict conditions that it falls short of a credible ex-ante fiscal backstop to the SRF. Finally, there is still no agreement among governments to set up a European deposit insurance mechanism.
  3. The third weakness concerns the governance of the ESM. Unlike the International Monetary Fund (IMF), where decisions to provide financial assistance to a member country are taken by a majority vote, similar decisions by the ESM are taken by unanimity and require prior approval by some national parliaments. The unanimity rule also applies for lending under the direct recapitalisation instrument . The result is that in practice ESM resources are only granted as a final resort. Earlier intervention, before a country loses market access and provided it meets certain conditions, could mitigate or even prevent full-blown crises, thereby saving money and jobs. The same logic applies to the direct recapitalisation instrument for banks.

The way to correct these problems is to turn the ESM into a European Monetary Fund (EMF). This EMF would be fully capable of acting as the fiscal counterpart of the ECB to guarantee the financial stability of the euro area in the event of a sovereign or banking crisis, or a threat thereof.

This reform would respond to important questions about governance. It is important to integrate the governance of sovereign and bank crises within the ECB on the one hand and within the EMF, as the fiscal agent of euro area governments, on the other. The reason is that ultimately the standing of a banking system depends on the strength of the fiscal authority behind it and its ability to provide a fiscal backstop. A banking crisis can turn into sovereign crisis when the sovereign cannot credibly backstop its banking system. In the euro area, the ECB can or should be able to prevent or to manage a sovereign or a banking crisis as long as it is a matter of providing liquidity on a temporary basis, but beyond that it should be the responsibility of the EMF to protect the stability of governments and banks.

In practice, what should the EMF do? Basically, it should take over the existing responsibilities from the ESM, but expand them and adopt a different governance model.

The first expansion of the EMF compared to the ESM concerns the governance of sovereign debt crises. Some, like Minister Schäuble, have argued that the EMF should take over from the European Commission the responsibility for the surveillance of fiscal rules. In their view, the European Commission is too political and not sufficiently independent from the countries it is meant to watch over to enforce the rules with sufficient rigour. However, it is doubtful that the EMF will be less political and more independent from its member countries than the European Commission. The ESM is certainly not. In fact, it is unlikely that any official European body – the EC, the ESM or the EMF – could have the power (bestowed upon it by the member states) to strictly enforce the EU fiscal rules and completely avoid debt sustainability problems.

A more promising approach would be to give teeth to the no-bail-out clause of the European treaty by setting up a European Sovereign Debt Restructuring Mechanism (ESDRM) to ensure orderly resolution in the euro area (see here for an early proposal). The creation of this mechanism would strengthen market discipline and help prevent future sovereign debt crises.

The ESDRM would carry both a judicial and a financial function. The former would involve a procedure to initiate and conduct negotiations between an insolvent sovereign debtor and its creditors resulting in an agreement on how to reduce the present value of the debtor’s future obligations so as to re-establish the sustainability of its public finances. This task should be left to a special court, whose role is to make the settlement between the debtor and creditors binding on all parties. The court would work in close partnership with the EMF, whose role should be to assess when a sovereign debtor has become insolvent, by how much its debt should be reduced, and what its future primary surplus should be to restore its debt sustainability. The EMF would also have the task of providing financial assistance to the debtor country to help it undertake the necessary economic adjustment towards fiscal sustainability. Such assistance should only be provided after an agreement between the debtor and the creditors re-establishing solvency has been reached.

We do not propose that all financial assistance by the EMF be conditional upon debt restructuring. Rather we envisage that, like the ESM, the EMF continues to lend money to solvent sovereigns who face temporary difficulties. Only in exceptional situations, when the EMF would have judged a sovereign to be insolvent and when the insolvency procedure by the judicial arm of the ESDRM would have led to an agreement between the sovereign debtor and its creditors, should lending by the EMF be conditional upon debt restructuring.

The creation of the ESDRM and the possibility of sovereign debt restructuring should be accompanied by important changes in the regulatory treatment of sovereign exposures by banks. As argued elsewhere (here), this could take the form of risk weights or large exposure limits for sovereign bonds held by banks. Such changes would further strengthen market discipline and limit the risk of future sovereign debt crises.

The second area where the new EMF should have an expanded remit compared to the current ESM is the governance of banking crises. Here the guiding principle should be “he who pays the piper calls the tune”.  Now that the ECB supervises significant banks and calls the tune, it should also be responsible for Emergency Liquidity Assistance (ELA) to banks experiencing liquidity problems, a function currently carried by national central banks (see here).

The same guiding principle should apply to crisis resolution. The SRB is already in charge of resolution in the euro area, and manages the SRF, which is still in a transition phase. A European Deposit Insurance Scheme should also be created and should be managed by the same institution that manages resolution, as in the United States (US) with the Federal Deposit and Insurance Corporation (FDIC). The integrated Single Resolution and Deposit Insurance Board (SRDIB) could apply the least cost principle, which requires the resolution authority to choose the resolution method in which the total amount of expenditures and (contingent) liabilities incurred has the lowest cost to the resolution and deposit insurance fund. The combination of functions would allow for swift decision-making.

The role of the EMF would be to serve as fiscal backstop to the euro-area banking system. This would mean two things. First, the procedure for the implementation of the Direct Recapitalisation Instrument should be simplified (see below) so it can actually be deployed. Second, the EMF should be able to provide a credit line to the Single Resolution and Deposit Insurance Fund (SRDIF) managed by the SRDIB, just like the US Treasury can provide, and has provided, to the FDIC.

It is important to note that the risk of moral hazard associated with the EMF acting as a fiscal backstop to the banking system would be much reduced if, as we proposed above, the regulatory treatment of sovereign exposures by banks was tightened in conjunction with the creation of the ESDRM.

The proposed architecture is described in the two columns entitled EMU 3.0 in Table 1.

The new roles assigned to the EMF would require a new form of governance compared to the ESM. The most important change would be to abolish the unanimity rule that hampers ESM decisions. All financial support decisions by the EMF, whether to governments, banks or the SRDIB, should be taken by a supermajority. Beyond that, there is the question as to whether the EMF should be intergovernmental like the ESM and the IMF, or a European institution like the European Investment Bank (EIB) or the ECB. Note, however, that the question of unanimity vs. supermajority voting is separate from the question of intergovernmental vs. European institutions. Unanimity is absent in the intergovernmental IMF as well as in the EU-treaty based ECB and EIB.

Establishing the EMF as an EU institution would give it greater European legitimacy. In the ESM, all the important decisions are taken by the Board of Governors, which is made up of the finance ministers of the Eurogroup. In the EMF, the Board of Governors could comprise not only the Eurogroup ministers but also a euro-area “finance minister” and a few other representatives of the euro area, which would together constitute a “Eurosystem of Fiscal Policy” (EFP). The EFP would replace the Eurogroup as the body responsible for all the fiscal decisions in the euro area. The euro-area “finance minister” and the other euro-area representatives would be appointed by the European Council subject to approval by the European Parliament to which they would be accountable.

The transformation of the European Stability Mechanism into a European Monetary Fund should not be viewed as a stand-alone initiative. On the contrary, it should be considered as part of a wider institutional reform of the fiscal dimension of the euro area, which should be aimed not only at better managing sovereign and debt crises, but also at improving economic conditions in less severe situations.

The election of Emmanuel Macron as president of France has sparked a new debate about the possible need for a euro-area treasury and finance minister as well as a euro-area budget and parliament. At this stage, we can only echo the view of our colleague Guntram Wolff who has recently argued that “[d]eveloping the fiscal dimension of the euro area will have profound implications for the legal order, for economic resources and for moral hazard. It will raise major questions about legitimacy, the role of the European Parliament, the role of national parliaments and the link between national fiscal resources, federal fiscal resources and the European Central Bank. The euro area will need a sincere debate about the pros and cons of all options.”

Table 1 – EMU governance: from Maastricht (EMU 1.0) to the EMF (EMU 3.0)

Forms of EMU governance


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.

Read article More on this topic
 

Blog Post

For the euro there is no shortcut to becoming a dominant currency

As an international currency, the euro has always been a distant second to the dollar. The idea of a greater international role for the euro has been floated, but without major institutional reform, the euro will not become a dominant currency.

By: Grégory Claeys and Guntram B. Wolff Topic: Global Economics & Governance Date: October 13, 2020
Read article Download PDF More by this author
 

Parliamentary Testimony

European Parliament

Strengthening the international role of the euro

Testimony before the European Parliament on the International Role of the Euro.

By: Guntram B. Wolff Topic: European Parliament, Testimonies Date: October 1, 2020
Read article More on this topic More by this author
 

Opinion

Europe’s recovery gamble

Next Generation EU, was rightly hailed as a major breakthrough: never before had the EU borrowed to finance expenditures, let alone transfers to member states. But the programme and its Recovery and Resilience Facility amount to a high-risk gamble.

By: Jean Pisani-Ferry Topic: Finance & Financial Regulation Date: September 25, 2020
Read article Download PDF
 

External Publication

How Can the European Parliament Better Oversee the European Central Bank?

This paper, written at the request of the Committee on Economic and Monetary Affairs, assesses how the European Parliament holds the European Central Bank accountable. The same exercise is done for the Bank of Japan, in order to identify possible lessons for the ECB and the European Parliament.

By: Grégory Claeys and Marta Domínguez-Jiménez Topic: European Macroeconomics & Governance, Global Economics & Governance Date: September 23, 2020
Read about event
 

Past Event

Past Event

The Sound of Economics Live: The State of the Union going forward

In the first Sound of Economics Live episode after summer we look at the State of the Union address delivered by Ursula von der Leyen.

Speakers: Giuseppe Porcaro, André Sapir, Guntram B. Wolff and Alicia García-Herrero Topic: Energy & Climate, European Macroeconomics & Governance, Innovation & Competition Policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: September 16, 2020
Read article More on this topic More by this author
 

Opinion

Without good governance, the EU borrowing mechanism to boost the recovery could fail

The European Union recovery fund could greatly increase the stability of the bloc and its monetary union. But the fund needs clearer objectives, sustainable growth criteria and close monitoring so that spending achieves its goals and is free of corruption. In finalising the fund, the EU should take the time to design a strong governance mechanism.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: September 15, 2020
Read article Download PDF
 

Policy Contribution

Is the COVID-19 crisis an opportunity to boost the euro as a global currency?

The euro never challenged the US dollar, and its international status declined with the euro crisis. Faced with a US administration willing to use its hegemonic currency to extend its domestic policies beyond its borders, Europe is reflecting on how to promote it currency on the global stage to ensure its autonomy. But promoting a more prominent role for the euro is difficult and involves far-reaching changes to the fabric of the monetary union.

By: Grégory Claeys and Guntram B. Wolff Topic: European Macroeconomics & Governance, Global Economics & Governance Date: June 5, 2020
Read article More on this topic
 

Opinion

The Independence of the Central Bank at Risk

The ruling of the German Federal Constitutional Court (GFCC) of May 5 on the ECB’s monetary policy affects not only the relation of Germany to the European Central Bank (ECB) and the Court of Justice of the European Union (ECJ) but also the constitutional foundations of monetary policy.

By: Peter Bofinger, Martin Hellwig, Michael Hüther, Monika Schnitzer, Moritz Schularick and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: June 2, 2020
Read article Download PDF
 

Policy Contribution

COVID-19’s reality shock for external-funding dependent emerging economies

COVID-19 is by far the biggest challenge policymakers in emerging economies have had to deal with in recent history. Beyond the potentially large negative impact on these countries’ fiscal accounts, and the related solvency issues, worsening conditions for these countries’ external funding are a major challenge.

By: Alicia García-Herrero and Elina Ribakova Topic: Finance & Financial Regulation, Global Economics & Governance Date: May 28, 2020
Read article Download PDF More by this author
 

Policy Contribution

European Parliament

The European Central Bank in the COVID-19 crisis: whatever it takes, within its mandate

To keep the euro-area economy afloat, the European Central Bank has put in place a large number of measures since the beginning of the COVID-19 crisis. This response has triggered fears of a future increase in inflation. However, the ECB's new measures and the resulting increase in the size of its balance sheet, even if it were to be permanent, should not restrict its ability to achieve its price-stability mandate, within its legal obligations.

By: Grégory Claeys Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: May 20, 2020
Read article Download PDF
 

Policy Brief

Rebooting Europe: a framework for a post COVID-19 economic recovery

COVID-19 has triggered a severe recession and policymakers in European Union countries are providing generous, largely indiscriminate, support to companies. As the recession gets deeper, a more comprehensive strategy is needed. This should be based on four principles: viability of supported entities, fairness, achieving societal goals, and giving society a share in future profits. The effort should be structured around equity and recovery funds with borrowing at EU level.

By: Julia Anderson, Simone Tagliapietra and Guntram B. Wolff Topic: Energy & Climate, European Macroeconomics & Governance Date: May 13, 2020
Read article More on this topic More by this author
 

Opinion

The message in the ruling

The German Constitutional Court's ruling on the ECB's asset purchase programme is open to much criticism but it can hardly be blamed for raising an important question.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: May 12, 2020
Load more posts