Our piece in the first the VoxEU eBook on the Eurozone crisis (Baldwin and Giavazzi 2015) emphasised two fundamental weaknesses of the Eurozone prior to the crisis:
- Firstly, there was a lack of economic and fiscal policy discipline, accompanied by dysfunctional sanctioning mechanisms as well as flawed financial regulation, leading to the build-up of huge public and private debt levels and a loss of competitiveness;
- Secondly, 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 made the economies of some member states vulnerable to the global financial crisis. In its aftermath Greece, Ireland and Portugal experienced government debt crises, which ultimately threatened the cohesion of the entire Eurozone. In Spain, a government debt crisis was averted, as banks obtained European funds for recapitalization.
Causes of the Eurozone crisis: A nuanced view
Thus, our assessment differs in subtle, albeit important aspects from the ‘consensus view ‘ as briefly summarized in Baldwin et al (2015). Specifically, since flows of capital as well as goods and services are market outcomes, we would not implicate the “intra-Eurozone capital flows that emerged in the decade before the crisis” as the “real culprits”. In a monetary union, substantial capital inflows from higher-income regions might very well support income growth in member states with low per-capita income. There is nothing pathological about that, as long as the classical forces of conditional convergence apply.
Problems arise, however, when increased public borrowing is used for consumption spending and not for capacity- and productivity-enhancing investment, as was the case in Greece; or when increased private borrowing is motivated by excessive risk-taking stimulated by an insufficiently regulated and supervised banking sector as in Spain and Ireland.
- Hence, in our view, it is the government failures and the failures in regulation and supervision leading to those excessive developments that should take centre stage in the crisis narrative.
This diagnosis of the underlying causes of the crisis has important implications for our assessment of the crisis policy response. While the consensus summary concludes that “the whole situation was made much worse by poor crisis management”, our view is that the “loans for reforms” rationale underlying the rescue approach was not only sensible, since it was the only way to successfully address the underlying causes of the crisis. It also worked and substantially improved matters. This even holds for Greece whose dismal performance in recent years is mainly a reflection of the fact that its economy has been far further off a sustainable path of economic development than had been realized before the crisis. And Ireland, Portugal and Spain have exited their rescue programmes and are recovering thanks to successful consolidation and structural reforms, and, of course, substantial monetary easing.
Most importantly, such a disagreement about the underlying causes of the EZ Crisis is destined to lead to a different view on how to best design an institutional architecture that is able to safeguard the Eurozone against future crises. Instead of correcting imbalances alleged to be excessive according to a fallible statistical procedure, in our assessment 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.
In this chapter, we briefly outline such a framework, that we have developed in the context of the German Council of Economic Experts (of which we are all members). This framework, entitled Maastricht 2.0, has been developed by the German Council of Economic Experts (GCEE; Annual Economic Report 2012, paragraph 173 et seq.; Annual Economic Report 2013, paragraph 269 et seq.; for a more recent exposition, see GCEE 2015a).
A stable framework: Maastricht 2.0
The distinctive element of any conceivable Eurozone architecture is the extent to which fiscal and economic policy competencies and liabilities are shifted from national to European level. Ultimately, the only convincing and robust candidate proposals are those ensuring that in each relevant policy field control over fiscal and economic policy action is accompanied by liability for the consequences of such action. Any divergence between these two aspects causes moral hazard and can result in serious political tensions.
With our Maastricht 2.0 concept, we propose creating a long-term regulatory framework that is consistent with this underlying principle (Figure 1). This regulatory framework follows the idea of crisis prevention first and crisis management second, and consists of three pillars structured according to the extent to which responsibility is allocated to European level.
Ensuring the stability of the financial system (right column of Figure 1): 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 European level. Such arrangements are a key element of our concept of Maastricht 2.0.
The establishment of the European Banking Union during the last few years indeed created this previously missing counterpart to the common monetary and currency policy. Even though the banking union still needs to be strengthened by further reforms as outlined below, the broad transfer of supervisory, restructuring and resolution competencies to European level ensures the unity of liability and control.
Figure 1. A solid framework for the Eurozone: Maastricht 2.0
Ascertaining fiscal stability (left column of Figure 1)
Concerning fiscal and economic policy, two fundamentally different constellations would, in principle, be able to lead to an alignment of liability and control:
- The transfer of fiscal and economic sovereignty to the European level and simultaneously the assumption of comprehensive joint liability by the European partners.
This approach requires establishing an effective central decision-making authority at the European level endowed with the power to enforce tax increases, spending cuts and structural reforms, i.e., labour market and social policies, in a country if necessary (problem of intervention rights);
- The continuation of national sovereignty over fiscal and economic policy, excluding any joint liability for government debt.
This means that the no-bailout clause applies. Appropriate protection needs to be established to avoid that liquidity or solvency crises of individual member countries spread to the rest of the Eurozone, which may cause the no-bailout clause to be disregarded (problem of credibility).
In our assessment, any attempt to practically implement the first option, which would require Eurozone members to give up their national budgetary autonomy, is doomed to fail for the time being. Given the imperfect state of European integration and the manifold cultural, economic and institutional settings across the Eurozone, it is highly unlikely that a democratically legitimized transfer of fiscal and economic sovereignty to the European level will happen anytime soon. Any half-baked implementation of this option, however, with substantial national control remaining vis-à-vis joint liability, would be the worst of all worlds.
Therefore, we strictly advocate the second option of continuance of national sovereignty over fiscal and economic policy, even though we have to acknowledge that the credibility of the no-bailout clause is not easy to establish either.
For this reason, while fiscal policy should remain largely under national responsibility, according to Maastricht 2.0, member countries 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 or a European unemployment insurance scheme, which partially shift the liability for irresponsible or imprudent national policy actions to European level, would not be consistent with this concept. Thus, member states remain responsible for structural reforms that lead to higher flexibility in their labour and product markets.
Over the course of the crisis, the SGP was effectively tightened, resulting in stronger European control of national financial policy. Five new provisions and one directive (the “Six Pack”) were added in 2011, surveillance and coordination (“Two Pack”) were improved and the fiscal rules were anchored at national level through the Fiscal Compact in 2013. These reforms have addressed the main shortcomings of the original SGP. Specifically, there is an additional focus on debt sustainability, in order to reduce the debt-to-GDP ratio when it exceeds 60%. Furthermore, they embody greater transparency and foresight, in particular with benchmarks for budget planning and the European semester. Finally, options for sanctioning have been expanded and a reverse qualified majority voting procedure has been introduced.
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 Maastricht 2.0.
Providing effective crisis management 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. The case of Greece suggests, however, that the exit of a member country from the Eurozone has to be possible as a very last resort.
The European Stability Mechanism (ESM), which was established during the crisis years, is a permanent crisis mechanism that provides financial assistance under strict terms in the event of crises that endanger overall EZ stability. Its resources are only available to countries that have ratified the Fiscal Compact. The release of funds requires a qualified majority of the votes in the ESM decision-making body, in which each member has a veto right. Thus, it comes very close to the crisis mechanism envisioned in Maastricht 2.0.
Remaining deficiencies of the Eurozone architecture
As indicated above, the reforms of the Eurozone architecture that were conducted during recent years are largely consistent with our concept Maastricht 2.0. We would therefore conclude that these reforms 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, all our considerations adhere to the objective of retaining the unity of liability and control. 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 OMT announcement in summer 2012. Although it was effective, it can hardly be considered a sustainable situation.
Deficiencies to be corrected: Banking union
The effectiveness of the Single Resolution Mechanism (SRM) 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. The recent pushback against bail-in in Italy is telling in this respect. 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 paragraphs 340, 357). Also, the resolution authority should be equipped with additional powers, so that it can also initiate and implement resolutions for smaller banks.
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 also 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 (SSM) is also needed. The combination of monetary policy and banking supervision in the ECB under the SSM carries the risk of conflicts of interest and objectives. This was evident, for example, in the ECB's approval of ELA 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 or even integrated financial supervisor, which is institutionally independent from monetary policy and integrates micro- and macroprudential supervision, is desirable.
For now, we take a critical view of a common deposit guarantee scheme. As national economic and fiscal policy 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. Before common deposit insurance can be considered, legacy problems would have to be solved and regulatory privileges of sovereign debt would have to be removed.
Deficiencies to be corrected: Crisis mechanism
While the ESM 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 ESM will not bring about full market discipline until it is complemented by insolvency proceedings for sovereigns, such that in severe crises a restructuring of sovereign debt becomes a precondition for ESM support. The current version of the treaty already mentions private creditor participation. However, this is limited to the mandatory assumption of collective action clauses (CACs) in government bond contracts that, however, do not automatically bind all outstanding government bonds. So far, these CACs have not led to a 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 accurately 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.
We have repeatedly discussed different possible designs for an insolvency mechanism for states. For details on its most recent proposal the reader is referred to GCEE (2015a,b). A key element of the proposal is a comprehensive debt sustainability analysis conducted by the ESM. If a debt crisis is asserted and there is no further capital market access, the ESM may give financial assistance on strict terms. If the ESM diagnoses a severe debt crisis, for example because the sustainability analysis demonstrates that a 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 this proves insufficient, a debt restructuring.
It is undoubtedly preferable to execute any debt restructuring following an orderly procedure rather than ad hoc (Zettelmeyer et al, 2013). Our proposal is in many respects similar to the IMF proposal (IMF, 2014b), adding stricter rule orientation and reducing discretion. 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 Monetary Union's member states would be a key step towards completing the Maastricht 2.0 crisis mechanism with a sovereign insolvency code. There have been proposals how to deal with legacy debt but there are no simple solutions (Pâris and Wyplosz, 2014; Corsetti et al, 2015). As the GCEE has explained, a European Redemption Pact would no longer work because of the existence of OMT (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
The reforms of the fiscal framework since the onset of the crisis have almost completed the fiscal pillar. The framework now in place is generally suited to improve the fiscal discipline of member states. Improvements are needed for the reformed fiscal pillar 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 SGP's corrective arm (European Commission, 2015a) and Italy for compliance with the 1/20 debt reduction rule under the SGP'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 (TFEU) 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 (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.
Deficiencies to be corrected at national level: Insufficient structural reforms
The economic developments in Ireland, Portugal and Spain show that the adopted rescue approach – loans for reforms – has been successful (GCEE 2015a). Economic growth has been vigorous and unemployment rates have been declining. Structural reforms of the labour and product markets as well as of pension and social security systems are responsible for this success to a significant extent. Moreover, sluggish growth in Italy and France and lack of significant improvement in unemployment rates show that structural reforms there have been insufficient to date.
Structural reforms must be decided and implemented at national level in the member states’ responsibility. Each member state’s labour and product markets contain different provisions and regulations leading to different rigidities and barriers to entry that prevent competition from working properly. Member states can best tailor reforms to the particularities of their labour and product markets. Of course, such reforms are difficult to accomplish given the opposition of insiders in those markets obtaining rents from the current rigidities. It is the responsibility of each member state to overcome such opposition.
Especially Italy and France need bold structural reforms that provide new opportunities for private investors to earn profits in the future. Without such reforms, economic growth in these countries is very likely to remain sluggish. Moreover, recent elections in Portugal and Spain should not induce a reversion of the reforms already implemented so successfully. Similarly, member states currently in more favourable economic conditions should improve their labour and product market frameworks. This holds for Austria, Belgium and also for Germany.
Conclusion: Avoid premature integration
The concluded reforms have moved the Eurozone in the direction of our concept Maastricht 2.0 and have stabilized 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. We repeat our 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 in the light of 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.
As long as member countries are unwilling to transfer national sovereignty over economic and financial policy to European level, all reform proposals must withstand a critical evaluation of the incentives they set for national economic and financial 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 their good intentions.
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