Eurozone, the summer of reform
The political and economic climate is favourable. Now is the time for deepening the eurozone architecture. Before the next crisis.
- Thursday, 01 March 2018
There is real hope that this year there will be an agreement on substantial eurozone reforms, possibly as soon as June. The politics is favourable following the election of France’s Emmanuel Macron last year on an unashamedly pro-EU – but reformist – agenda, and now the likelihood (by March) of a coalition government in Germany that is open to deepening the eurozone architecture. The economic backdrop is benign too, with the eurozone economy currently experiencing its strongest cyclical upswing in a decade. There is no time to waste.
The lessons of the financial and sovereign debt crises have not yet fully been learned. At some point the next downturn will come, and the eurozone needs to create the mechanisms to reduce the damaging effects of it. This is salient because vulnerabilities remain, including high public debts and low potential growth in a number of member states.
The single most important issue is to break the “doom loop” between banks and their sovereigns, which caused the financial crisis to evolve into the sovereign debt crisis. The “doom loop” refers to how weak banks weakened the public finances (via public support) and vice versa, creating a vicious circle. Some progress has been made over the last five years. The first two pillars of the banking union are in place – the single supervisory mechanism (SSM) for the uniform supervision (and tighter capital standards) of large EU banks, and the single resolution mechanism (SRM) for the orderly resolution of failing banks.
However, progress on the third pillar of banking union, a European deposit insurance scheme (EDIS), has stalled as a group of member states led by Germany have called for “(unspecified) risk reduction before risk-sharing”. The EDIS would ensure that depositor confidence in a bank does not depend on the geographical location of that bank, which is crucial to mitigate deposit flight in the event of a large shock – for example, Greece. Almost everyone agrees that EDIS is needed to break the causation from weak banks to sovereign stress. Still unresolved is the causation that runs from sovereign stress to bank stress (both through bank holdings of domestic sovereign debt and via the sovereign typically setting the floor for bank credit ratings and financing costs). Recently, a group of 14 prominent French and German economists published a blueprint for eurozone reform in which they propose a “sovereign concentration charge” for banks (requiring banks with sovereign exposures to any eurozone state above some threshold to hold more capital) and the creation of a eurozone safe asset (known as European safe bonds, or ESBies). In the latter, financial intermediaries would purchase a diversified portfolio of eurozone sovereign bonds, based on a fixed set of portfolio weights, and securitise this into several tranches.
Both have their problems. First, a concentration charge would have to adjust for the co-movement in yields across sovereign states in order to reap the diversification benefits, and that’s difficult to implement. Second, banks are not only exposed to the domestic sovereign, but more importantly, banks are exposed to the credit risk of domestic households and firms, which is highly correlated with that of the sovereign (therefore, pan-European banking should be encouraged). Neither sovereign concentration limits nor ESBies will solve this. Third, I see many practical problems with ESBies. For instance, how a collateralized debt obligation (CDO) – a derivative (construct) of the underlying pool of government bonds of member states – would be created and declared as the eurozone’s safe asset (the role of CDOs in the financial crisis should be a warning), how the portfolio weights are chosen (if fixed weights, then what role is there for market discipline?), and who would buy the junior tranches?
A better solution is simply to encourage pan-European banks. A good start would be to remove the de facto geographical ring-fencing of capital and liquidity requirements, which exist precisely because deposit insurance remains national, on banking group entities.
More generally, a number of studies find that risk-sharing in the eurozone is well below the levels in the US, Canada and Germany and, contrary to common perception, most of the risk-sharing in the latter group is through private sector financial flows rather than fiscal transfers. Therefore, the capital markets union should be a priority. The lack of risk-sharing in the eurozone is exacerbated by it being ‘overbanked’, which has crowded out capital market financing. Also, with Brexit, the eurozone will no longer want to rely so heavily on the UK to access the capital markets.
There is also a role for public risk-sharing in the form of a macro-stabilisation fund. It would operate like a (re)insurance contract, with each member state initially contributing, say, 0.1% of GDP per year and ongoing contributions adjusted according to a member state’s usage of the scheme. The scheme would pay-out if a member state experienced, for example, a large rise in the unemployment rate. Importantly, such a macro-stabilisation fund (and public risk-sharing in general), if properly constructed, has nothing to do with a transfer union. That is, risk-sharing does not imply (permanent) fiscal transfers nor does it require a large eurozone budget, both of which are politically a no go.
In order to build support for risk-sharing three things should happen. First, the laggards must continue with reforms to enhance macro and fiscal convergence, thereby reducing the legacy issues. Second, more risk-sharing should go hand in hand with more sharing of national sovereignty. So, there should be a further push to level the playing field (e.g. on national differences in regulation and taxation, including corporate tax). By implication, where there has been the pooling of sovereignty, such as with banking union (joint supervision and resolution), risk-sharing should follow (EDIS).
Third, risk-sharing can create a moral hazard problem; that is, an incentive to take on more risk (e.g. irresponsible fiscal policy in the knowledge that the costs will be shared). Therefore, there is a need for better fiscal rules and management so fiscal policy becomes counter-cyclical rather than procyclical. The Stability and Growth Pact doesn’t work; it didn’t stop the build-up of public debt in the good times and forced austerity upon the worst hit states during the crises. Member states flouted it, and the no-bailout clause wasn’t credible. A simpler rule with the aim of stabilising the debt-to-GDP ratio (or lowering the debtto-GDP ratio if, say, above 90%) over the medium- to long-term is the way to go.
There’s now a window of opportunity to push ahead with reforms in order to prepare for when the next crisis comes. Reforms should promote private and public risk-sharing through the completion of the banking union and capital markets union, the removal of geographical differences in taxes and regulation, and the addition of a public macro-stabilisation tool. I believe this is politically achievable. Indeed, the Europe chapter of the German coalition agreement even accepts the ideas of a eurozone budget for macro-stabilisation, the gradual creation of a EDIS, and incorporating the European Stability Mechanism into EU law – things that didn’t look possible just a few months ago.