Editor’s note: Originally published on 12 February 2016, this is a chapter from the eBook How to fix Europe’s monetary union: Views of leading economists.
Throughout the Crisis years, European policymakers conducted a series of reforms of the Eurozone architecture. By and large, these reforms were consistent with a road towards the concept of Maastricht 2.0 that has been advocated by the German Council of Economic Experts1 in a series of publications starting with the onset of the Crisis (Annual Economic Reports 2012, GCEE 2015a). This regulatory framework combines crisis prevention and crisis management, and consists of three pillars structured according to the extent to which responsibility is allocated to European level.
This concept of the architecture of the Eurozone is designed to provide the answer to the two fundamental weaknesses of the Eurozone prior to the Crisis:
- First, there was a lack of economic and fiscal policy discipline, and this government failure was compounded by dysfunctional sanctioning mechanisms – in addition, a flawed financial regulation and supervision led to the build-up of excessive public and private debt levels and a loss of competitiveness;
- Second, there was no credible mechanism for crisis response regarding bank and sovereign debt problems that would have been able to reign in moral hazard problems and establish market discipline.
These institutional deficits amplified economic imbalances in the economically heterogeneous currency area and rendered the economies of some member states vulnerable to the Global Crisis. In our assessment, the quest for an institutional architecture that is able to safeguard the Eurozone against future crises should directly address these underlying problems. Instead of correcting imbalances alleged to be excessive according to a fallible statistical procedure, this framework should foster economic and fiscal policy discipline so as to avoid an excessive build-up of public and private debt, and effectively reduce moral hazard problems in the public and private sector.
We would therefore conclude that the recent reforms to the Eurozone architecture have already increased the stability of the framework. Yet there are a number of important deficiencies that still need to be corrected. Taking the current framework as the starting point of our discussion, we subordinate all our considerations to the objective of retaining the unity of liability and control, which already had been the guiding principle in designing the concept. Most importantly, this requires rendering the no-bailout rule far more credible than in the past.
In addition to enhancing the future stability of the Eurozone, completing Maastricht 2.0 would relieve the ECB of its role as a crisis manager. As many of the recent reforms were implemented incompletely or too late, the ECB felt compelled to intervene, threatening to blur the line between monetary and fiscal policy. This particularly applies to the “whatever it takes” speech by ECB President Draghi and the related outright monetary transactions announcement in summer 2012. Although there may have been no other option at the height of the crisis, this can hardly be considered a sustainable situation.
Deficiencies to be corrected: Banking union
The danger of systemic financial crises justifies a strong governmental role for regulatory and supervisory authorities. In a system that predominantly relies on national responsibility, risks might easily be shifted from national level to the shared central bank balance sheet. It is therefore advisable to design common supervisory and resolution mechanisms at the European level. Therefore, these arrangements are a key element of our concept of Maastricht 2.0. The establishment of the European Banking Union during the last few years has indeed created this previously missing counterpart to the common monetary and currency policy, even though it still needs to be strengthened by further reforms.
In particular, the effectiveness of the Single Resolution Mechanism remains uncertain. The complexity of the decision-making structures could prevent a sufficiently quick reaction. Moreover, creditor participation is not yet fully credible due to a lack of commitment, thus not fully ruling out repercussions for governments in case of banking problems. This also shows up in the current pushback by some countries against the bail-in framework, which is made responsible for recent turbulences in financial markets. Discretionary leeway in creditor participation should be reduced considerably. Exceptions from creditor participation should only be allowed in the case of a systemic crisis and should be accompanied by high institutional hurdles (GCEE 2014). Also, the resolution authority should be equipped with additional powers, so that it can also initiate and implement resolutions for smaller banks.
For now, we take a critical view of a common deposit guarantee scheme. As national economic and fiscal policies still have considerable influence on banking sector risks, a common deposit guarantee scheme harbours the danger of risks being transferred to the community of other member states. Moreover, legacy problems would have to be solved first. Currently the banking sectors of several countries are still burdened with high levels of non-performing loans, the risks of which have to remain at national level.
The reverse transmission channel of governments to banks has hardly been addressed thus far. The existing regulatory privileges granted to government bonds in terms of capital, liquidity and large exposure rules bias banks' investment behaviour toward investing in government bonds and thus affect government bond pricing. Since the start of the Crisis, many banks, particularly in the Eurozone, have accumulated large exposures to domestic government bonds. Since banks might suffer severe losses in the event of a sovereign default, this makes the restructuring of government debt more difficult. Thus, high priority must be given to revising regulations regarding adequate regulatory capital and large exposure limits with regard to sovereign risks (for a detailed exposition and proposal, see GCEE 2015b). Similar regulations should apply to insurance companies. While it is advisable to phase in these regulations gradually, a prompt decision on this reform would clearly be desirable.
Further improvement of the Single Supervisory Mechanism is also needed. The combination of monetary policy and banking supervision in the ECB under the Single Supervisory Mechanism carries the risk of conflicts of interest and objectives. This was evident, for example, in the ECB’s approval of emergency liquidity assistance loans in the case of Greece. Similarly, the close links between macroprudential supervision and monetary policy at the ECB may create conflicts of interest. The creation of an independent European banking supervisor or even integrated financial supervisor, which is institutionally independent from monetary policy and which integrates micro- and macroprudential supervision, is desirable.
Deficiencies to be corrected: Crisis mechanism
According to Maastricht 2.0, explicit rules should govern how member states’ liquidity and solvency crises will be handled. Preparing for any ensuing crisis beforehand will have the important side-effect that the ECB will be prevented from feeling obliged to act as crisis manager, a step that will always be putting its independence at risk. The crisis mechanism in Maastricht 2.0 is designed to make funds available in a joint effort, but these funds can only be accessed with the approval of national governments and under strict conditionality. The rules should also ensure that government debt restructuring, if required to restore debt sustainability, proceeds in an orderly manner. By providing financial assistance under strict terms in the event of crises that endanger overall Eurozone stability, the European Stability Mechanism, which was established as a permanent mechanism during the crisis years, comes close to the crisis mechanism envisioned in Maastricht 2.0.
While the European Stability Mechanism limits the risk of contagion effects, thereby increasing the credibility of the no-bailout clause, government creditors may undervalue risks due to the availability of crisis assistance. The European Stability Mechanism will not bring about full market discipline unless it is complemented by insolvency proceedings for sovereigns, such that in severe crises a restructuring of sovereign debt becomes a precondition for European Stability Mechanism support. While the current version of the treaty already mentions private creditor participation, this is limited to the mandatory inclusion of collective action clauses in government bond contracts that, however, do not automatically bind all outstanding government bonds. So far, these collective action clauses have not led to any notable differentiation of spreads (Corsetti et al. 2015).
An insolvency mechanism for sovereigns that credibly stipulates a creditor bail-in would not only help with burden sharing (similar to the bail-in rules for the banking sector), but also give creditors incentives to assess the default risks of government bonds and loans as accurately as possible and factor them in when calculating risk premiums. This should result in ex ante disciplining of government budgetary policy and would, thus, support crisis prevention. However, there could be an incentive for highly indebted countries anticipating the possibility of bailing in creditors to amass even more debt. Any restructuring therefore has to be accompanied by a macroeconomic adjustment programme that corrects these adverse incentives.
The German Council of Economic Experts has repeatedly discussed different possible designs for an insolvency mechanism for states. For details on its most recent proposal the reader is referred to German Council of Economic Experts (2015a,b). Our proposal is in many respects similar to the current IMF proposal (IMF 2014b). A key element of the proposal is a comprehensive debt sustainability analysis conducted by the European Stability Mechanism. If a debt crisis is asserted and there is no further capital market access, the European Stability Mechanism may give financial assistance on strict terms. If the European Stability Mechanism diagnoses a severe debt crisis, for example because the sustainability analysis suggests that the member country can only return to sustainable public finances via debt restructuring, there will be a one-time maturity extension of existing bonds, and if necessary, a debt restructuring.
It is undoubtedly preferable to execute any such debt restructuring according to an orderly procedure rather than ad hoc (Zettelmeyer et al. 2013). It is important to decide on the implementation of such an insolvency regime today to avoid it being postponed to an indefinite future. A transition period could be included during which the insolvency mechanism gradually comes into effect.
Debt reduction in the Eurozone's member states would be a key step towards completing the Maastricht 2.0 crisis mechanism with a sovereign insolvency code. There are no simple solutions as yet (Corsetti et al. 2015). As the German Council of Economic Experts has explained, a European Redemption Pact would no longer work because of the existence of Outright Monetary Transactions (GCEE 2013). Proposals to redistribute funds from countries with lower debt to countries with higher debt through a temporary transfer are not politically feasible, nor do they consider differences in debt sustainability. Lastly, fiscal transfers always create negative incentives for borrowers.
Thus, the responsibility for consolidating their public finances solely rests with the member states themselves. The legacy problem of public debts cannot be solved without a willingness to consolidate on the part of the highly indebted member countries. The fiscal pillar of ‘Maastricht 2.0’ may help them in doing so.
Deficiencies to be corrected: The fiscal pillar
According to Maastricht 2.0, while fiscal policy should remain largely under national responsibility, member states would be obliged to adopt responsible fiscal policy following three rules:
- The no-bailout clause strengthens market discipline by ensuring that private lenders – not the other member countries – bear the consequences of unsustainable fiscal policies;
- National fiscal policy is monitored on the basis of common fiscal rules defined by the Stability and Growth Pact (SGP) and infringements are seriously sanctioned; and
- National debt brakes and their monitoring prevent the accumulation of excessive public debt.
The forthcoming development of the rulebook should underpin above all the credibility of the no-bailout clause.
Due to their intimate link with the state of public finances, the Maastricht 2.0 concept stipulates that key aspects of economic policy and the economic policy framework, such as the organisation of the labour market, also remain a national responsibility. Supplementary arrangements such as a fiscal capacity, which partially shift the liability for irresponsible or imprudent national policy actions to European level, would not be consistent with this concept.
Over the course of the Crisis, the Stability and Growth Pact was effectively tightened, resulting in stronger European control of national financial policy. These reforms have addressed the main shortcomings of the original Stability and Growth Pact. It has also become clear that the general economic and fiscal policy will remain to be regarded as a national responsibility for the time being. These developments have moved the regulatory framework of the Eurozone in the direction of our concept of Maastricht 2.0 and have almost completed the fiscal pillar. The framework now in place is generally well-suited to improve the fiscal discipline of member states. Improvements are needed for the reformed fiscal pillar, though, to effectively prevent a repetition of undesirable fiscal developments. The rules need to be simplified in order to limit destabilising discretionary leeway, such as in forecasting the economic cycle and structural budgets. It is particularly important for the credibility of fiscal rules that the responsible European institutions – Ecofin and the European Commission – consistently apply the existing rulebook in order to maintain fiscal discipline.
Tolerating temporary deviations, for example, in the cases of France being granted longer time to achieve the deficit limit under the Stability and Growth Pact 's corrective arm (European Commission 2015a) and Italy for compliance with the 1/20 debt reduction rule under the Stability and Growth Pact's preventive arm (European Commission 2015b), is a repetition of past mistakes. Compliance in regard to reducing structural deficits is particularly important in view of the high debt ratios of many Eurozone members, which continue to hamper economic recovery and cast doubt on the stability of the Monetary Union. Even if not obvious to individual member states, the future of the Eurozone will depend on consistently reducing legacy debt.
The Greek crisis has demonstrated that the credibility of the no-bailout clause depends on the willingness of a member country receiving financial assistance to cooperate under the terms of an adjustment programme. If a country does not want to cooperate at all, its membership in the currency union is put into question. The exit of a member country from the Monetary Union is a violation of the treaty and thus of European law. This also applies to a member country introducing its own or a parallel currency. The Treaty on the Functioning of the European Union does not provide an exit option, because this could trigger speculation about exit from the Monetary Union among other member countries that have economic problems in the future.
However, the permanent lack of willingness to cooperate on the part of a member country could undermine the currency union's architecture to such an extent that its very existence is under threat. The currency union's member states would be susceptible to blackmail. In such cases, a country's exit from the Monetary Union must be possible as a last resort (known as ‘ultima ratio’). In this event, measures must be taken for the exit to be completed in an orderly manner and for the member country to receive economic support to avoid a humanitarian disaster.
Conclusion: Avoid premature integration
The concluded reforms have mostly moved the Eurozone in the direction of our concept of Maastricht 2.0 and have stabilised the Eurozone. But more needs to be done. All three pillars of Maastricht 2.0 – financial regulation, the crisis mechanism, and the fiscal framework – require further strengthening as outlined above. This concerns most of all a further strengthening of the resolution mechanism, a removal of regulatory privileges for sovereign debt, the introduction of an insolvency mechanism for sovereigns and an enforcement of existing fiscal rules. These measures need to be accompanied by further structural reforms to be decided on the national level.
Last year’s turbulence in Greece should not be the cause for hasty moves towards closer integration. The German Council of Economic Experts thus repeats its criticism of proposals that cannot be reconciled with the unity of liability and control and instead stray further away from this principle. For example, the creation of a fiscal capacity at European level based on the concept of fiscal transfers from countries with above-average economic performance to countries with weaker economic performance is impractical given measurement problems, creates false incentives, and harbours the risk of permanent unilateral transfers. This also applies to the potential creation of a European unemployment insurance scheme.
For as long as member countries are unwilling to transfer national sovereignty over economic and fiscal policy to European level, all reform proposals must withstand a critical evaluation of the incentives they set for national economic and fiscal policy. The institutional framework of the single currency area can only ensure stability if it follows the principle of unity of liability and control. Reforms that violate this guiding principle plant the seeds for further crises and may damage the process of European integration, despite any good intentions.
References
Baldwin, R. et al. (2015), Rebooting the Eurozone: Step 1 – Agreeing a Crisis narrative, CEPR Policy Insight No. 85.
Baldwin, R. and F. Giavazzi (2015), The euro zone crisis: A consensus view of the causes and a few possible solutions, CEPR Press.
German Council of Economic Experts (2013), Against a backward-looking economic policy, Annual Economic Report, Wiesbaden, November 2013.
German Council of Economic Experts (2014), More confidence in market processes, Annual Economic Report, Wiesbaden, November 2014.
German Council of Economic Experts (2015a), Consequences of the Greek crisis for a more stable euro area, Special Report, Wiesbaden, July 2015.
German Council of Economic Experts (2015b), Focus on future viability, Annual Economic Report, Wiesbaden, November 2015.
Endnotes
[1] The Council is politically independent and stipulated by law to support all decision-makers in the economic and political sphere as well as the general public in Germany in forming their views about economic policy and its potential risks. To this end, every November it presents an annual report to the German federal government and the general public.
