Beyond risk sharing and risk reduction: A Spanish view of EMU reforms

Rafael Doménech, Miguel Otero Iglesias , Federico Steinberg 15 June 2018



This column is a lead commentary in the VoxEU Debate "Euro Area Reform"

The euro remains a vulnerable construction. Despite the enormous progress in improving its governance achieved in the last years, its present architecture cannot ensure its long-term survival (Matthijs and Blyth 2015). Much more needs to be done, and the June summit is an opportunity that we cannot afford to miss to advance towards a more genuine monetary, fiscal, economic, and political integration.   

The European Commission’s reflection paper for deepening EMU (European Commission 2017) and the recent proposal by 14 French and German economists (Bénassy-Quére et al. 2018) on how to reconcile risk sharing with market discipline have revitalised an intense debate on euro area reform. A recent manifesto, signed by more than 20 Spanish experts (Almunia et al. 2018), contributes to this debate, emphasising the need of deeper integration beyond the narrow view in some quarters of just completing the banking union and using the ESM as a bank backstop, both necessary in the short run but not enough in the long term. As the manifesto points out, in the long run “there needs to be further fiscal coordination and discipline and a joint facility for macro stabilisation within the currency area, an unconditional lender of last resort and an effective mechanism to break the link between banks and sovereigns, ensuring financial stability, more effective macroeconomic surveillance and coordination, and greater legitimacy in the overall governance structures”. 

However, this cannot be achieved overnight. European construction only moves forward in small, gradual steps. That is why, from the political point of view, it would be a great achievement if all EMU countries could agree that the above-mentioned list constitutes indispensable long-term goals, and then build a strategy to achieve them gradually with consistent steps in the short run. In this vein, Buti et al. (2018) have stressed the need for a “coherent and well-sequenced package, avoiding unsafe steps in the dark”. A shared and clear vision on the euro’s end goals would make the long journey towards deeper economic and political integration easier and help re-establish trust between the member states. In other words, the principle of “ever closer union” of the first architects of EMU cannot be lost (Dyson and Maes 2016).

We share with the French and German economists’ proposal the view that risk sharing and risk reduction need to proceed simultaneously. In fact, the interconnection between the euro area countries’ economies is so intense that they already share many risks, but they do not yet share the costs. Many of these risks (geopolitics, terrorism, globalisation, protectionism, digital revolution, demography, immigration or climate change, among others) may have significant economic, social, and political consequences. They require a proper response by the EU and EMU in particular, and the improvement of their institutions and governance. 

In the case of EMU, as the sovereign debt crisis highlighted, most of the challenges and structural problems can only be tackled with common instruments at the European level, whose mere existence would reduce the risks and their effects. As Lane (2012) and many others (e.g. Doménech and González-Páramo 2017, Martin and Philippon 2017) have noted, the differences in the response to the financial crisis between the US and EMU appeared after 2010, when the euro area experienced sudden stops, financial fragmentation, and sovereign debt crises coupled with the redenomination risks of national currencies and the potential breakup of the currency union. Despite all the important advances in recent years, the redenomination risk is likely to remain a major problem if EMU institutions, rules and governance are not improved (Bini Smaghi 2018). This is a risk that Benassy-Quéré et al. (2018) tend to underestimate.

The need for a central fiscal authority

In the long run, the euro area needs a central fiscal authority (CFA) with its own sources of revenue and the ability to issue joint debt. We understand that this institution will not fit easily in the currently existing governance structure. That is why we suggest that its president be proposed by the Eurogroup to become the Commissioner for the euro and that a newly created Committee for EMU affairs in the European Parliament specifically ratify his/her appointment to ensure democratic legitimacy. Input legitimacy at the European level is important because the CFA’s president, who would be in fact the euro finance minister heading an embryonic euro area treasury, would be responsible for enforcing fiscal and macroeconomic rules. These rules, which should be simplified, as suggested by Bénassy-Quéré et al., have to be more credible, and should be monitored at a technical and independent level by a reformed Fiscal European Stability Board (FSB) that would absorb the current ESM and integrate it into EU law.

Despite significant progress in fiscal and macroeconomic governance, countries still have incentives to delay fiscal consolidation as much as possible. There is still a widespread view in Europe that the main problem is the lack of willingness or inability of countries to comply with the rules. Nevertheless, experience shows that even strict adherence to fiscal rules (which is clearly necessary) is insufficient to guarantee a well-functioning and stable monetary union. 

Going beyond the existing intergovernmental structures of the Eurogroup and the ESM within EMU would facilitate both decision making and legitimacy. We need a common European approach, not that of 19 European countries. The FSB would, therefore, be in charge of the technical analysis of macroeconomic and fiscal stability, while the CFA would take the ultimate political decisions on these matters under the following incentive and governance structures – countries that abide by the rules receive counter-cyclical fiscal support in downturns, but countries that break the rules do not. The president of the CFA would set the overall fiscal stance for the euro area as a whole, with a view to ensuring an adequate stimulus in recessions and consolidation in expansionary periods. 

Given its broad mandate, decisions by the CFA should be taken by qualified majority of the euro area member states. Moreover, crucial ones such those related to debt limits, sums destined to pan-European projects or countercyclical support measures should be approved by the Committee for EMU affairs of the European Parliament.

Banking union and the role of the ECB

We also agree with other proposals in the need to complete the Banking Union with a common deposit guarantee mechanism, further convergence in bankruptcy laws, deepening the capital market union, and a credible fiscal backstop, ultimately provided by the CFA mentioned above. As Schnabeland Veron (2018) have argued, in the short run, a limited package aimed at breaking the doom loop between banks and sovereigns would be a great success.

We agree with Bénassy-Quéré et al. that debt restructuring should be possible as a last-resort option. However, this should not raise expectations that some of the present debts of high-debt countries will inevitably be restructured. Moreover, we disagree with their proposal of transparent and consistent across countries ESM criteria for debt restructuring based on a data-driven method that can be reproduced and checked by the public, because that would contribute to create the conditions for financial instability. As Wolff (2018) points out, constructive ambiguity currently prevents unwarranted market speculation. ESM rules may be useful to assess the potential risks of debt sustainability. However, it should also be clear that these rules would not trigger insolvency automatically. There is a need for some discretionality since, at the end of the day, the commitment of a country to honour its public debt depends on political and social factors and uncertainties that are difficult to measure and to impose systematically upon all countries. All these factors make quantifying how close different countries are to their fiscal limits very challenging (Leeper and Walker 2011).

We think that, as long as there is no large euro area treasury with a sizable budget capable to deal with asymmetric shocks, all euro area sovereign bonds should continue to be considered risk-free assets, implicitly backed by the ECB, leaving the possibility of public debt restructuring as a very last-resort option and preserving the current constructive ambiguity. Questioning the risk-free nature of public debt carries the risk of instability in the bond markets, worsening the current financial fragmentation and threatening to create another episode of market turmoil.

We therefore think that the ECB needs to be able to act as the lender of last resort for illiquid but solvent member states stressed by financial markets but not under a CFA programme of debt restructuring, as it does for the banking sector. Building on its current Public Sector Purchase Programme (PSPP), the ECB has to be the ultimate provider of unconditional liquidity, through the secondary sovereign debt markets, for circumstantially illiquid countries that might suffer market panics or speculative attacks. As Constancio (2018) has recently emphasised, after the experience of the sovereign debt crisis, the ECB has no excuse not to fulfil its mandate by intervening in the sovereign bond market. 

However, in the event of an official insolvency of a member state, the CFA would take control of its public finances and negotiate a memorandum of understanding with the country under stress, which would lose part of its sovereignty. The CFA, drawing on the independent technical work of the FSB, would then be in charge of monitoring and implementing the adjustment programme under the parliamentary scrutiny of the Committee for EMU affairs of the European Parliament.

Economic convergence and structural reforms 

Finally, there is a need to promote more economic convergence between different euro area countries. Therefore, positive incentives need to be put in place for countries to undertake unpopular structural reforms on an ongoing basis so that their economies are sufficiently flexible, innovative, and socially inclusive to live within a single monetary area. The CFA, with its capacity to issue joint debt and raise its own fiscal resources (under the supranational democratic control explained above), could provide finance for pan-European public goods, such as security, border protection, the digital transformation, and country-specific reforms that are essential for the area as a whole. The work of the European Semester and its country-specific recommendations could be useful, but they need to be enforceable by designing an intelligent incentive structure. 

The euro area experience has shown that countries joining the currency union have insufficient incentives to implement the structural reforms needed to make their economies more flexible and convergent, and that external pressure only works in exceptional circumstances. In order to provide the adequate incentives and avoid the problem of moral hazard, only countries that commit to reforms should be able to receive financial support from the CFA to help stabilise their economies cyclically. This conditional mechanism would facilitate politically difficult structural reforms and reduce the risk of deflation.

Of course, this unavoidable level of deeper integration will require a greater degree of political union to provide democratic legitimacy and accountability. We are fully aware that our proposals imply a significant transfer of sovereignty from member states to European institutions, some of which will require a treaty change. However, we believe they are necessary for the euro’s long-term sustainability. This is the consensus in Spain, both among the elites and the public at large. Ultimately, the euro area needs to create its own sovereignty, for only a European sovereign can make EMU last for centuries, as in the case of the US.

Such reforms require in the long run the support of the people, expressed in the approval of the treaty change in each of the member countries. Euro area citizens need to be given a real choice between continued fragmentation (which leaves the euro exposed to structural weaknesses and recurrent crises) and greater integration (which pools more sovereignty at the same time as it strengthens EMU governance). In a world subject to ceaseless technological transformation and revived geopolitical tensions, with increased rivalry among the great powers, kicking the proverbial can much longer down the road is no longer an option.


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Topics:  EU institutions EU policies

Tags:  Risk sharing, euro area reform, VoxEU debates, EMU

Head of Macroeconomic Analysis of BBVA Research and Professor of Economics at the University of Valencia

Senior Analyst, Elcano Royal Institute and Professor IE School of International Relations

Professor, Universidad Autónoma de Madrid and Senior Analyst, Elcano Royal Institute Madrid, Spain


CEPR Policy Research