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August 03, 2018

What we think about reforming the eurozone

Today’s briefing is unusual. We have decided to devote this briefing to a single item - our own ideas for eurozone reform. It is the fifth and final part of our irregular series. We think this is a good moment in part because the news flows has slowed to a trickle. We note, however, that the FT has another story today about the EU's shifting red lines in the Brexit talks - this time on the Irish border. Big obstacles remain, but there is now clearly a greater willingness to engage with the UK.

The purpose of our series on eurozone reform has been to focus attention away from the mainstream proposals currently under discussion, which we think waste precious political capital on the wrong issues. 

Regular readers will have a broad idea of our thinking. But our views have evolved over time, and we thought it would be a good idea to write them down in a coherent form.

Our starting point is the eurozone itself - what it needs to prosper, and to withstand political and economic shocks. We do not start from the premise of a particular economic theory, or from the red lines of a government. Our guiding principle is to produce the shortest list that gets the job done.  

The three priorities for reform in our view are: 

  1. strengthening of the EU's geopolitical position; 
  2. reduction of structural imbalances within the eurozone; and
  3. greater resistance to financial shocks. 

These problems can be solved in different ways - the creation of a federal union would in our view constitute an optimal response. But we acknowledge that, while sufficient, a political federation is not a necessary pre-condition for sustainability and success. This acknowledgement should not be mistaken as the capitulation of a federalist. The instruments we propose still require stronger political will than what governments have expressed so far. They have elements of political union. They would be strengthened by further political integration, but do not require it from the outset.  

In the following, we provide brief sketches on the three goals of reform before turning to the instruments.

1. The euro as a geopolitical tool

In the Hobbesian world of the 21st century, geostrategic considerations should play a role at least as important as the maximisation of growth and employment. Exorbitant privilege accrues to the US because of the dollar’s role as the world’s most important currency. It gives the US the ability not only to fund current account deficits permanently, but also to impose third-country sanctions as it did recently in respect of EU companies involved in Iran. This is a tool the eurozone and the EU are lacking.

That lack of this tool is a conscious choice. The euro was not designed to achieve global leadership. After the euro was introduced in 1999 it quickly became the world’s second most important currency, but it still lags behind the dollar on most metrics. Its share of foreign exchange reserves was under 20% at the end of 2016, compared with 64% for the dollar, according to the ECB’s most recent survey on the international role of the euro. The gap was of similar magnitude in the categories of international debt and loans. The dollar leads the euro in foreign exchange turnover by a factor of three to one. The only category where the euro has almost caught up is as a global payment currency. In the past decade the gap narrowed, but it has widened again since the financial crisis.

The advent of modern financial markets should be able to remove the Kindleberger effect, according to which market frictions prevent the co-existence of a several competing currencies as global anchors. In today world’s there is no reason why the euro should not increase its relative position vis-a-vis the dollar on all metrics, or even surpass it in some. A stronger international role for the euro would make the EU less susceptible to trade sanctions by the US, and more able to impose its own. It would give an EU that is reluctant to deploy military force a potent soft-power policy instrument.

2. Reduction of internal imbalances

The biggest foreseeable economic risks to the eurozone stem from its permanent structural imbalances. A permanently divergent monetary union with no fiscal transfer mechanisms is unlikely to be politically sustainable. We already see tensions arising in Italy. Italy does not lack competitiveness. Net return on capital invested is higher than in Germany. But Italy nevertheless has deep-rooted structural problems in many areas of its socio-economic system: a low rate of female labour participation; the weakness of its welfare system; political corruption; chronically high youth unemployment now going into the second generation; a dysfunctional legal system; and an inefficient and overstaffed public sector. Italy will no doubt need to implement structural reforms to maintain its membership in the monetary union in the long run, but it will also require different policies at the eurozone level. Since none of the mainstream political parties offers a strategic vision, we see little reason to be optimistic. 

Different structural issues are weighing on the opposite side of the imbalances. Germany’s vast current account surplus is the result of two political decisions: the first, dating back to 2003, was a structural shift in labour laws. It was followed, in 2009, by a constitutional amendment requiring Germany to run a balanced budget over the economic cycle. None of this was coordinated with the rest of the eurozone.  

3. Robustness in financial crises 

We feel that the discussion about banking union is currently not moving in a positive direction. While we disagree with the German position on risk sharing, we also feel that excessive attention is paid to deposit insurance. The bank resolution process is not working well, as we saw in Italy in recent years. We believe that the crucial next steps in the banking union will require important changes in the fundamental relationship between banks and governments, and in bankruptcy law. 

The recent compromise on the fiscal backstop for bank resolution constitutes a retrograde step in our view, because what is sold as a backstop still requires the assent of national parliaments. This is an impractical impediment, especially during a crisis. The robustness of this system will thus depend critically on whether the budget committee of the Bundestag, currently under AfD leadership, agrees to meet on a Sunday. 

The most important vulnerability of the eurozone relates to a situation in which sovereign or bank bonds of a country are under systemic attack without an ECB backstop option. The OMT programme is too limited to be of practical use in many plausible crisis scenarios - though it would have been appropriate for Italy in 2012. In particular we agree with Daniela Gabor and Jakob Vestergaard (for more details see our briefing on Wednesday) that the latest safe-asset proposals are not likely to work.

The instruments 

One instrument should normally be used to achieve one target but, to meet the three objectives set out above, two tools alone would go a long way. The first is a rule requiring the eurozone's current account to remain close to balance, together with a corrective policy trigger. The second instruments is a safe asset with a mutualised tranche.

A policy to force a broad degree of external balance would not imply that each member state must balance its current account all the time. This would be a eurozone-wide rule, not a country rule. It would be similar to Germany’s old stability law of the late 1960s, which required the government to achieve economic stability in a broad sense - on prices, on the fiscal balance and on the current account. It was a qualitative target with no binding numbers. Germany ditched this rule in favour of a numerical fiscal rule. The result has been a fiscal policy bang on target, and the rest of the economy out of control. 

So, how would such a eurozone-wide rule work in practice? If some countries - say, Germany and the Netherlands - insist on running current account surpluses of today’s magnitude, this would have to imply compensatory eurozone policies. The eurozone should have an instrument to either force these countries to lower their surpluses, or other countries to raise their deficits; or incur deficits at eurozone level. We do not believe it is necessary for the eurozone to have a fixed central budget, especially not one funded by member states. What it needs instead is a fiscal capacity that includes debt issuance, together with tax-raising powers, to correct imbalances. The greater the German current account surplus, the greater the eurozone's deficit would need to be in compensation. This would constitute a useful incentive for countries not to run excessively-large current-account surpluses. If they do, the offsetting central adjustment would kick in. The best use of the funds would be for investment. It is possible to use the existing political infrastructure - the EU itself or the ESM - for such a task. We have no strong views on such inter-institutional issues, which dominate the debate in Brussels and Luxembourg. But we feel that a central fiscal instrument to use as a macroeconomic balancing tool would be useful.

Of the two proposed instruments, the safe asset is the one that would do the heavy lifting. We would not waste precious political capital on producing a complicated fiscal union without tax-raising or debt-issuing capacity. Or on the next steps of a banking union that has not even digested the steps already taken. We are content to live in an imperfect world, but see no point in reforming the eurozone without a common safe asset even on the horizon.

As we have argued before, we see no benefit even in a vanilla-type securitised structure, a eurozone bond that contains national bonds as its input components and is tranched into slices of varying risk. We have no objections to the principle of securitisation, but not if the purpose is to fool investors and to hide risk. There is a positive correlation between the government bonds of the erstwhile crisis-countries, as we saw most recently after the appointment of a Five Star/Lega government in Italy. If the markets had an appetite for such a securitised product, some bank would have issued it a long time ago. For a securitised safe asset to provide stabilisation in a time of crisis, it would require a degree of mutualisation. We would be happy to start off with a small mutualised slice, so long as the principle is agreed that the level of mutualisation is raised to such a level that the product itself maintains a minimum rating. We don’t think full mutualisation is necessary, but securitisation with an element of mutualisation would constitute a more flexible alternative to the red-bond-blue-bond proposal. That fixed the rate of mutualisation as the first 60pp, in terms of GDP, of each country’s national debt. The number was motivated by the 60% debt ceiling in the Maastricht Treaty, but it is possible to set the degree of mutualisation at a lower or higher number. A securitised structure allows for more flexibility by allowing a lower percentage initially, and raising it as the need arises.

The availability of a proper safe asset would make the eurozone more robust during financial turmoil, and would strengthen the euro’s international role. A commitment to overall macroeconomic balance, as opposed to fiscal balance only, would also contribute to a stronger international role as well as to a reduction of internal imbalances. Together, those two instruments would work hand-in-hand.

None of this has much overlap with the Meseberg declaration, let alone the European Council’s much-watered-down action plan that resulted from it. We are aware that debt mutualisation, even if constrained to a small slice, stands no chance in Germany at this point, let alone any penalties on excessive current account surpluses. But you can draw as many red lines as you wish, and still they do not change the minimum necessary to turn the eurozone into a viable monetary union. The completion of an already dysfunctional banking union should not be a priority. Nor should the focus be on a eurozone budget or a finance minister. Without a decent safe asset and a broader policy rule, we would not waste precious political capital on eurozone reform. We should focus on the few things that are needed, not the many that are acceptable.

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