January 18, 2018
A Franco-German blueprint for eurozone reform
With the German coalition pre-agreement, we now have Germany and France potentially agreed on the need for bold reforms of eurozone governance. Yesterday the CEPR released a complementary policy paper by a group of 14 German and French economists which lays out a detailed proposal for eurozone reform. While the authors claim to avoid political judgements, their six main proposals are peppered with political considerations. The choice to approach fiscal policy from the point of view of debt reduction and to exclude all discussion of the countercyclical stabilisation function of public spending is political. So is the choice of market discipline over prudential supervision as a crisis-prevention framework, and the focus on avoiding moral hazard and permanent fiscal transfers. Both of which are political.
But these economists are nevertheless making an honest attempt at bridging the German and French political-economy positions. Given the balance of power in the EU, this is as good as it's going to get. As Henrik Enderlein (@HenrikEnderlein) puts it on twitter, both countries will have to cross some of their red lines, and any push for more risk-sharing will be met by a counter-push for more discipline.
The paper focuses on solving three problems:
- Breaking the doom loop between banks and governments - we recall this was promised by the European Council in 2012!
- Fixing the eurozone's fiscal architecture as the fiscal rules are divisive and ineffective at actually reducing debt; and
- replacing the current crisis management by means of crisis loans with tough policy conditionality, which has fuelled nationalist and populist resentment in creditor and debtor countries alike.
To do this, the authors make six policy proposals that should be implemented as a package. Just implementing some of them will not achieve the desired objectives. The proposals are:
- Breaking the doom loop through a combination of bank capital charges for banks' concentrated exposures to governments, and a common deposit reinsurance. Also, bank resolution should be streamlined, bail-in mechanisms strengthened, and regulatory standards further harmonised. Supervision should focus on reducing nonperforming loans.
- Replacing the fiscal rules based on the structural deficit by an expenditure rule on a long-term debt-reduction trend. Violations of the spending limits should be financed by governments issuing junior bonds with a clause to extend their maturity in the event of an ESM programme, as a way to introduce market discipline.
- Introduce the necessary structures for government debt restructuring, by breaking the doom loop as above, creating (unspecified) stabilisation tools and a euro area safe asset as below. In addition, governments undergoing a restructuring should be protected from hold-out investors. The ESM should not bail out countries with unsustainable debt loads.
- Creating a auro-area fund financed by the member states to help absorb large asymmetric shocks. To avoid permanent transfers, countries more likely to draw on the fund would contribute more, and to avoid moral hazard, countries would take first loss before tapping the fund. They could only do this when they complied with the fiscal rules.
- Creating a synthetic euro area safe asset - essentially a CDO of the government debt of participating member states. This has been previously known as ESBies (European Safe Bonds) or SBBS (Sovereign-bond backed secutities). The junior bonds referred to above would be excluded from this.
- Separating the fiscal decision-making from the surveillance, by creating an independent fiscal watchdog, possibly within the Commission. The eurogroup presidency could be assigned to the commission, following the model of the high representative for the common foreign and security policy.
All in all, there is very little new in this paper: it is a condensation of what has been an emerging consensus for the past several years. Or, if not a consensus, at least what's left after taking into account all the various red lines, but mostly Germany's. It is not clear that you need economists to come up with something like this. Politicians, lawyers, or civil servants would have agreed broadly the same. Also, despite the protestations that this is not a political paper, this is clearly written with a certain set of political constraints in mind, as well as some favourite concepts of economists which are at heart political, too. And what is politically possible is largely determined by what economists have spent years whispering in the ear of politicians: risk-sharing, market discipline, moral hazard, debt sustainability, you name it.
As to the specific proposals, a concentration charge for banks is a good idea because it does not put a capital cost on the bulk of the government debt holdings but excludes a first portion of them. However, as with a uniform capital charge, this will disproportionately impact countries with high debt loads such as Italy. Despite the fact that the paper recognises the current fiscal rules as opaque and divisive, what they propose can be no less divisive. Debt sustainability, admittedly more tangible than the structural balance but still a matter of judgement, determines who gets to benefit from various schemes, or how much is paid into them. Reinsurance mechanisms require contributions on the basis of "likelihood to use" determined by whom? Or drawn from sovereign CDS spreads? And, finally there is really no concept of macroeconomic stabilisation worth its name in all of this. Not to speak of the faith in structured finance to produce a safe asset out of unsafe assets, as opposed to a debt-issuing EU treasury with its own tax-raising capacity, which would actually produce a safe asset.