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