Blind spots and unintended consequences of the 14 economists’ Policy Insight

Sebastian Dullien 11 April 2018



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

After months of tedious negotiations between its mainstream parties, Germany has finally managed to get a new working government. With a delay of almost half a year, the debate on the reform of the euro area is thus to start in earnest.

For this debate, the recently published CEPR Policy Insight (Bénassy-Quéré et al. 2018) will certainly be a major point of reference. The authors, a group of 14 well-known and well-connected German and French economists, present their package of reform proposals as compromise paper taking into accounts concerns of both the ‘French position’ as well as the ‘German view’ and, politically, from economists from the left as well as from those from the right.

The authors make the basic point that the euro area needs both risk sharing and risk reduction (or crisis mitigation and crisis prevention), and that reforms need to make progress on both fronts in order to be acceptable to both Germany and France.

In short, they propose the following measures:

  • Completion of the Banking Union: Cleanup of banks’ balance sheets; streamlining and strengthening the framework for bank supervision and bank resolution; establishment of a common deposit insurance with the ESM as a backstop; removal of obstacles for cross-border bank mergers; strengthening of the bail-in requirements in cases of bank restructuring.
  • Completion of the Capital Union
  • Reform of the treatment of sovereign bonds in banks’ balance sheets: Regulations to limit banks’ exposures to government bonds; creation of European Safe Bonds (ESBies), structured credit products based on a portfolio of sovereign bonds
  • Reform of fiscal rules: Nominal expenditure rules instead of deficit rules; spending overshoots will have to be covered by junior sovereign bonds which will be restructured first in times of payment difficulties
  • Facilitating sovereign debt restructuring: Changes in voting rules to make holdouts less likely; automatic extensions of junior bonds’ maturities when a country receives an ESM loan
  • Reform of ESM governance
  • Fiscal capacity for the euro area: A fiscal stabilisation scheme (or unemployment reinsurance) offering one-off transfers to national budgets in case of deep recessions

Many of the package’s elements make sense. No one can really oppose the cleaning up of banking sectors still burdened by large amounts of non-performing loans, nor turning the ESM into a fiscal backstop for a common deposit insurance. Also, streamlining the decision procedures and strengthening the competencies of the ESM is a no-brainer.

Nevertheless, as a whole, the package is not convincing. In the end, too many questions remain open, and the package fails to address a number of central problems of EMU architecture.

The three most important problems are that the package:

  • does not address the issue of boom-and-bust cycles in the euro area;
  • puts an excessive trust in the ability of financial markets to stabilise national economies and to discipline governments in a sensible and desirable way; and
  • proposes fiscal rules and rules for sovereign debt restructuring which run the risk of reducing governments’ policy space.

Let us start with the problem of boom-and-bust-cycles. The package does not address the argument that EMU might have led to longer and deeper national business cycles. In a monetary union, all participating countries have to live with the same nominal central bank interest rate. If cycles are not completely synchronised, this interest rate will always be too low for some countries and too high for others. If a country is in a boom, inflation in this country will pick up and the common nominal interest rate will translate into a lower real interest rate, further fuelling the boom. If a country is in a recession, inflation will fall. This will increase the real interest rate and prevent a quick recovery. Overall, this leads to longer and deeper business cycles, with overheating booms and long recessions or at least periods of stagnation.

This logic is important as in all countries affected by the euro crisis (maybe with the exception of Greece), boom-and-bust-cycles played a central role. Both Spain and Ireland experienced a real estate boom prior to the crisis. The construction sector of these countries expanded strongly, and wages and consumption increased. The good labour market situation attracted immigrants, the demand of which further increased real estate prices. As the ECB could not react to the overheating of these economies (but had to set its interest rate with regard to the whole euro area), the boom ran much longer than it otherwise might have. While the construction sector grew far beyond its normal (or appropriate) size, export competitiveness deteriorated.

Problems in the Irish and the Spanish economies emerged when the boom came to an end and the real estate bubble deflated. Suddenly, banks were faced with large amounts of non-performing loans and, as a consequence, they cut back lending. Consumption, employment and tax revenues imploded. And as national governments were seen as responsible for bailing out banks, the banking crisis turned into a sovereign debt crisis.

The paper by the 14 economists addresses this problem only by asking for the completion of the Banking Union. The implicit hope here seems to be that under better supervision, in the future banks will not fuel real estate bubbles again. Moreover, in the future, European institutions will provide funds so that even severe national banking crises can be solved by resolution and recapitalisation without pushing national governments to the brink of default.

Yet, it is highly questionable whether all this is sufficient to prevent deep boom-and-bust cycles at the national level in the future. Historically, in major economies, even after reforms, banking regulation and oversight has not been able to permanently prevent real estate bubbles. Moreover, it is unlikely that a resolution of banks in Ireland and Spain according to the new rules would have prevented the deep downturn these countries have experienced.

It is even questionable if under a completed banking union, Spain would have dodged the confidence crisis in its sovereign bond market. From 2007 to 2016, Spanish public debt increased by €723 billion. The fiscal cost of bank restructuring in Spain has last been estimated to have been slightly more than €40 billion. It is plausible that markets would have turned against Spain even without this extra €40 billion of additional public debt.

The authors of the Policy Insight might claim that their proposed fiscal stabilisation scheme could have helped. According to their proposal, countries in which unemployment rises in a single year by more than a certain number of percentage points (they propose a threshold of two percentage points) would receive a one-off transfer. However, upon closer inspection, it quickly becomes clear that the proposed scheme is much too small to be able to have a significant impact. First, pay-outs are supposed to be capped above a certain amount, and second, if a number of countries go into a recession simultaneously and reserves are not sufficient, pay-outs are scaled down to prevent the fund having to go into debt.

A simple rule-of-thumb calculation with the parameters proposed by the 14 economists yields that this scheme would not have made much difference in the case of Spain and Ireland. Over the whole crisis period, in an ideal case, Spain would have received a total of about 1.3% of GDP (roughly €14 billion), and Ireland of less than 1% of GDP.

If one puts these numbers into comparison with the drop in tax revenues (Spain’s annual tax revenues after 2007 dropped by about €70 billion, or 7% of GDP), one quickly sees the inadequacy of this proposed scheme. Again, the transfers would hardly have made any difference in terms of debt sustainability.

One gets the impression that the 14 economists here have thrown out the baby with the bathtub. Being afraid of moral hazard in a transfer system, they have shrunk it to a level at which it does not yield any real benefits anymore.

Some economists might claim that the proposed completion of capital market union would do the trick. The hope here is that more cross-border financing outside the banking system might help to bolster growth in times when domestic investors and banks cut back lending. Yet, while the hypothesis of cross-border financial market integration as a stabilisation tool is very popular, it is empirically questionable (see Dullien 2017). Instead, most empirical evidence points to cross-border capital flows being extremely pro-cyclical. In the run-up to the euro crisis, foreign capital propped up real estate bubbles. When the crisis hit, these flows quickly dried up.

This links to the second major criticism. In many aspects, the 14 economists count on financial markets to stabilise economies and correctly discipline governments. The central idea of forcing governments to finance overshooting expenditure with junior bonds is that markets will allow such borrowing if the funds are put to good use and prohibit this borrowing if funds are wasted. Yet, as we have seen prior to the euro crisis, in good times, financial markets tend to lend to governments irrespective of imbalances (as they did to Greece), while in bad times, they might cut off financing indiscriminately.

The third problematic point is the facilitation of debt restructuring and the automatic maturity extension which could actually make sovereign debt crisis more likely, not less likely, relative to the status quo with ESM and OMT in place.

The underlying idea of the 14 economists is that public expenditure (except cyclical costs for unemployment and interest rate) above a certain nominal public expenditure path has to be financed by junior bonds which can easily be restructured and the maturity of which is extended automatically if the country gets an ESM loan. The expenditure path is to be set taking into account potential growth rates, and would be lower for countries with large debt-to-GDP ratios.

In principle, the public expenditure rule has the advantage over the current rules that fiscal policy most likely would be less pro-cyclical. However, the automatism of maturity extension carries the risk that it actually creates new incentives for speculation. According to standard procedure, rating agencies would count a maturity extension as ‘default’. Hence, if fears of an ESM programme grow among market participants, they will have an incentive to dump these bonds, pushing up the interest rate and potentially cutting countries off from market access. This might then make the ESM programme necessary, and turn the fear of debt restructuring into a self-fulfilling prophecy.

As a result, one could expect more frequent, smaller-scale sovereign debt restructurings in the euro area which actually make the expenditure path a hard boundary. Hence, over time, the 60% debt-to-GDP threshold of the Maastricht Treaty would finally be enforced.

However, whether this leads to better economic policy in the euro area is questionable. The 60% threshold always has been arbitrary. Pushing highly indebted countries today quickly towards this threshold by limiting public expenditure growth would mean years of constrained public expenditure, and because of political economy considerations, it is likely that this will first be seen in further cuts to public investment. (The 14 economists might argue that countries could still increase taxes to finance more public investment, but empirical evidence with expenditure rules like the PAYGO system in the US in place during the 1990s shows that these rules carry an inherent bias to cut public investment). Given that public investment in the euro area is already at a record low, and given the fact that demand for government bonds overall remains strong, it is questionable whether such a strong push for a quick return to a debt-to-GDP level of 60% is sensible.

So, in conclusion, while the package contains a lot of good ideas, it will hopefully not be taken at face value by politicians. A compromise between the archetypical German and French position might have the virtue that it has better chances of being implemented. However, if the compromise is struck at the expense of adding some elements to the euro area architecture which will weaken the already wobbly structure, it might not be worth implementing it.


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.

Dullien, S (2017), “Risk sharing by financial markets in federal systems”,  FMM Working Paper No. 2.



Tags:  Euro crisis, euro area, Risk sharing, risk reduction

Professor of International Economics at HTW Berlin – University of Applied Sciences; Senior Policy Fellow at the European Council on Foreign Relations


CEPR Policy Research