The crisis in the Eurozone since 2010 is not a mere side effect of the 2008 Global Crisis. It results from a flawed construction that dates back to the Maastricht treaty. It took some time for unprepared Europeans to understand that, to a large extent, the crisis was endogenous to the monetary union. The single currency was not itself the cause of the crisis. What was at stake was the fact that governments had not fully understood the regime change. Quite the contrary, they had enjoyed the comfort provided by the single currency, without keeping an eye on balance of payment and price developments. Five years after the beginning of the Greek crisis, the architecture of the Eurozone has been reshuffled, with more surveillance and coordination, and institutions to address bank and sovereign crises. Still, the end point has probably not been reached yet.
The architecture of the European monetary union was initially based on three simple ideas.
- Most macroeconomic shocks would be symmetric and could be smoothed by the single monetary policy.
Residual asymmetric shocks would be tackled by national fiscal policies. Once national budget would have reached a level ‘close to balance’, there would be ample room for macroeconomic stabilisation trough national budgets.
The simple rule of thumb at that time was that a 1% fall in GDP would deteriorate the fiscal balance by around 0.5% of GDP through automatic stabilisers (Buti and Sapir 1998). Starting from fiscal balance, a government could then face a 6% fall in GDP without coming up against the 3% deficit limit. Automatic stabilisers would thus be fully able to play their stabilising role. With a more realistic 1% fall in GDP, the government could easily go beyond automatic stabilisers and perform discretionary fiscal expansion.
- It was also thought that financial integration would contribute to macroeconomic convergence and stabilisation.
First, the single currency would ease capital flows from north to south, fostering productivity catch up in the south. Second, in case of a negative shock in one EZ member, foreign capital could make up for lacking domestic credit, while portfolio diversification would contribute to sustain national income, in line with the risk-sharing literature pioneered by Asdrubali et al. (1996).
- Fiscal profligacy was correctly viewed as a risk to the stability of the union (Eichengreen and Wyplosz 1996), but there was confidence that the Stability and Growth Pact (SGP) would ensure that each member state keeps its house in order.
Furthermore, it was thought that the impossibility to devalue national currencies would act as a disciplinary device on national wage and price-setting mechanisms.
As for the risks originating in the banking sector, they were largely neglected.
The crisis has profoundly questioned these three pillars of the Maastricht wisdom.
- During the crisis, monetary policy soon reached the zero lower bound.
Although the ECB tried hard to circumvent this constraint through various non-conventional measures, it appeared quite clear in 2012 and 2013 that the policy mix of the Eurozone was not expansionary enough. National governments as a whole were tightening fiscal policy in a period when the output gap was widening again (Figure 1).
At the national level, many member states were constrained to perform counter-cyclical policies, either because they were under an adjustment programme, or because they were under the corrective arm of the Stability Pact. This was not compensated by fiscal expansion elsewhere. For instance, Germany increased its underlying primary surplus by 0.7% of potential output from 2011 to 2012.
Figure 1. Aggregate fiscal policy in the Eurozone, 1998-2014 (% of GDP or potential GDP*)
Source: Author, based on OECD Economic Outlook 97;* Output gap in% of potential GDP. Variation of primary balance in% of GDP; Fiscal stance: variation of underlying primary balance in% of potential GDP; a positive number points to fiscal tightening.
- The idea that financial integration would contribute to both convergence and macroeconomic stability proved rather naïve.
First, capital flows tended to feed non-tradable sectors in the periphery of the Eurozone (Giavazzi and Spaventa 2010). In receiving countries, the increase in liabilities was not sustainable since it did not correspond to the building up of export capacities. Worse, if contributed to house price bubbles that would inevitably burst at some point.
Second, financial integration did not play as a smoothing device when the crisis hit. Quite the opposite, crisis countries suffered sudden stops (Merler and Pisani-Ferry 2012). Third, financial integration did not prevent the bank and sovereign risks to feed each other at the national level due to the over-representation of national sovereign bonds in some bank balance sheets coupled with the ‘too big to fail problem’, i.e. the perceived obligation for national governments to bail out the banks in case of bank insolvency (Figure 2).
Figure 2. Holdings of national sovereign bonds by Monetary Financial Institutions as a proportion of total assets (percentage values)
Source: ESRB (2015).
- Finally, the Stability Pact proved a poor instrument to prevent fiscal profligacy in Greece, and it proved irrelevant to prevent sovereign debt crises in other peripheral countries.
It should be remembered that Irish sovereign debt stood at just 25% of GDP before the crisis. As for the disciplinary effect of the single currency on wage and price setting at national level, it failed to prevent large divergences across the Eurozone (Figure 3).
Figure 3. Nominal unit labour costs as percent of Eurozone 18 (100 in 1999)
In the wake of the crisis, EZ members worked hard to address the three flaws mentioned above.
- The ECB was creative enough to engineer different forms of non-conventional policies, including quantitative easing which, without a liquid pool of federal bonds, was not as straightforward as it was for other central banks in the world.
Meanwhile, the creation of the European Stability Mechanism (ESM) aimed at allowing crisis countries to accede to foreign financing under severe conditionality, while the ECB’s Outright Monetary Transactions (OMTs) where aiming at eliminating self-fulfilling expectations of euro exit through keeping sovereign spreads at reasonable levels.
- Recognising the failure of financial integration to foster convergence and resilience over the first decade of the single currency, European leaders added a ‘banking union’ to the monetary union.
Banking union includes: a transfer of bank supervision to the federal level; a single bank resolution procedure with bail-in rules; and a system of macro-prudential policies. A deposit re-insurance scheme is supposed to be added in order to raise the resilience of the banking sector in case of a confidence crisis (Juncker et al. 2015). Leaders also launched a far-reaching project of ‘capital market union’ to foster more diversification of investment finance (see Véron 2014).
- Fiscal and macroeconomic surveillance were strengthened through the ‘six pack’, ‘two pack’, and ‘fiscal compact’.
In particular, the Macroeconomic Imbalance Procedure (MIP) aims at preventing macroeconomic imbalances emerging in non-fiscal areas such as private leverage or unit labour costs, and the ‘European semester’ is designed to allow for a macroeconomic coordination across members prior to national decision making. These different elements, however, ended-up in a complicated, bureaucratic process rather than a fully-fledged coordination of macroeconomic policies (Bénassy-Quéré and Ragot 2015).
More importantly, the Eurozone tended increasingly to function as a ‘gold exchange system’ – like the 1970s Bretton Woods system – where the burden of the adjustment falls on deficit countries, introducing a deflationary bias (Keynes 1942). There are three reasons for the deflationary bias in the Eurozone. The first one is universal. There are limits to borrowing, but no limit to lending, hence only borrowing countries need to adjust at some point. The second reason is the asymmetry of the Stability Growth Pact, which caps the fiscal deficit but not the surplus, and imposes minimum speeds of adjustment but no maximum speed. The third reason is the difficulty in coordinating non-fiscal policies. For instance, governments can easily argue that unit labour costs are beyond their reach, or that they never agreed to transfer any sovereignty concerning the minimum wage or collective bargaining procedures.
Still under construction
The major area where no bold decision was taken so far is the ‘fiscal union’ area. In 2011, the German Council of Economic Experts proposed to create a ‘redemption fund’ where sovereign debts above the 60% of GDP threshold would be pooled, with earmarked national taxes to progressively eliminate these debts. Several variants of Eurobond schemes were subsequently floated but the idea of debt mutualisation was difficult to defend given the evaporation of mutual trust.
In 2012, the Report of the four presidents (Van Rompuy et al. 2012) proposed to introduce a ‘fiscal capacity’ at the level of the Eurozone, but no substantial debate took place at political level. In 2015, the Report of the five presidents (Juncker et al. 2015) followed up with the idea of a budget aimed at macroeconomic stabilisation. There are numerous ways to conceive such budget, based on quasi-automatic rules or discretion, aimed at stabilising idiosyncratic or symmetric shocks, targeting all shocks or only large shocks, etc. In a sense, the ESM is already a form of Eurozone budget aimed at refinancing individual Member states in the event of a liquidity crisis. However, the scope for the ESM is limited by the no-bail-out provision of the treaty.
Trilemma of EZ crisis management
This brings us to a major contradiction that still needs to be worked out by the Europeans.
- Since the treaty excludes both debt monetisation and a bail out of member states, the reluctance of the Europeans to proceed to debt restructuring leads to one of these ‘impossible trinities’ that are widespread in the economic literature (Figure 4).
Figure 4. The internal contradiction of crisis management in the Eurozone
Source: Author’s elaboration.
The way the Europeans have worked out of these constraints so far has been to provide official assistance (liquidity support) in exchange for strict fiscal adjustment programmes (to ensure solvency without debt restructuring). But these programmes have raised the question of the very nature of the Eurozone – a monetary union without political union. Indeed, national adjustment programmes, monitored by the ‘troika’ and subsequently by the ‘institutions’ can be viewed as a form of ‘federalism by exception’ (Trichet 2012), albeit with limited accountability (European parliament 2014).
This fundamental problem culminated with the 12 July 2015 agreement concerning Greece. This appeared as a ‘diktat’ from creditor countries (especially Germany), with deep intrusion in Greek national affairs. A few weeks before, the people in creditor countries were asking themselves why only the Greeks were offered (through a referendum) the opportunity to express their opinion on a systemic, Eurozone question.
In fact, there are two ways to introduce more democratic accountability in crisis management:
- The first one is shared sovereignty; allow for intrusion in national affairs, but in a more democratic way.
In the Greek case, this would have meant allowing a Eurozone committee of the European parliament to vote on the adjustment programme imposed in exchange for further financial assistance. This would involve the EMS becoming a European institution (whereas it was created through a separate treaty, as an inter-governmental body).
- The second path is to allow for sovereign default, which would force both debtors and creditors to face up to their own responsibilities.
The problem is whether such default is possible within the Eurozone, when banks are loaded with national sovereign bonds. The risk is that a sovereign default could trigger bank insolvency. The latter would then trigger a liquidity crisis since insolvent banks cannot get refinancing within the lender-of-last-resort procedures. To avoid a collapse of the national economy, there would be no other way than to re-introduce a national currency to refinance the banks.
In order to make default possible within the Eurozone (hence, to make the no-bail out clause credible), it would first be necessary to diversify the asset side of bank balance sheets. There are basically three ways to do it: Through sovereign risk weighting; through large exposure limits; and through a substitution of federal for national sovereign bonds. One of these three options still needs to be decided.
It will probably be necessary to combine shared sovereignty with the possibility of a national government to default. The reason is that none of these two extreme solutions is fully reliable, and because financial integration in the Eurozone translates into large spillovers when a sovereign default is at stake.
One possibility to combine the two has been proposed by Corsetti et al. (2015). Above a certain threshold of debt, a government would get access to ESM financings provided existing debts are restructured.
Conclusion: What’s next?
Looking back to initial Maastricht thinking, it is impressive how things have changed over a rather limited period of time. Still, the new instruments introduced have raised the issue of national sovereignty within a monetary union. To what extent can a national government follow the preferences of its own people as expressed by democratic vote?
For sure, national sovereignty of debtor countries is always constrained when creditors are no longer willing to roll over their debts, and this rule applies in a monetary union. However, monetary union does reduce the scope for debt restructuring to the extent that it raises the issue of euro membership.
Given the burden of legacy debts, it is necessary to make debt restructuring (with possible haircuts) possible within the Eurozone. In particular, the risk loop between sovereigns and banks needs to be stopped through more diversified balance sheets. Failing to do so will keep the Eurozone vulnerable to any large event that could affect a member state.
Sustainable euro membership, however, also requires more shared sovereignty, not only for debtor countries, but also for creditors. Surplus countries, especially Germany, should recognise the need to reduce the gap between aggregate supply and demand, and to contribute to price re-convergence within the Eurozone. Should a ‘Minister of Finance’ of the Eurozone be introduced, he or she would be in charge of ensuring a symmetric convergence within the Eurozone and to coordinate a common response to symmetric shocks; not just to check that member states comply with fiscal rules.
The second issue that needs to be addressed is the question of a common budget for the Eurozone. At a minimum, the Eurozone needs a fiscal backstop for its banking union. But a common budget could also provide support to labour mobility or unemployment re-insurance when a country is hit by a very large shock.
Unlike the EU budget, a Eurozone budget aiming at macroeconomic stabilisation would need to allow for surpluses and deficits, depending on the Eurozone business cycle. This would involve a capacity to borrow on bond markets, and to repay based on a common tax. These evolutions would require a Eurozone parliament to vote the budget (and the tax), and Minister of Finance to execute.
These are far-reaching changes that would require a new treaty. It could appear a remote perspective. However, the difficulty in tackling the Greek crisis reminds us of the need to improve the institutional setting of the Eurozone – even without the perspective of a fully-fledged budget. The risk today is less that of debt unsustainability than that of political unsustainability.
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