How to better absorb euro area shocks
Guest contribution published in the Frankfurter Allgemeine Zeitung on 15.12.2017
There is no question about it – the economic integration of Europe has boosted our prosperity. However, there is no consensus as to whether we should press ahead towards ever deeper integration and, if so, what form this should take.
Without a doubt the boldest step towards integration has been economic and monetary union. But the financial and sovereign debt crisis exposed its cracks for all to see: unwelcome developments in the member states that left them economically exposed, together with fissures in the institutional framework.
Considerable efforts were made in response to the crisis. It was precisely those member states hit hardest by the crisis that needed to implement structural reform in areas such as the labour market in order to make their economies more flexible and competitive.
At the same time, a safety net was created in the form of the European Stability Mechanism (ESM), an organisation that can provide assistance to member states in dire financial straits – with economic conditions attached – if the financial stability of the euro area is endangered. Furthermore, a banking union was established and the path towards a capital markets union was forged.
However, it would be a mistake to believe that the euro area is now equipped for all eventualities. The future might also hold regional or sectoral crises in store that put the euro area to the test. We must not be lulled into a false sense of security by the upbeat economic situation right now. It is not least the Eurosystem's highly accommodative monetary policy that is contributing to a deceptive air of calm.
Last week, President of the European Commission Jean-Claude Juncker put it like this:
"After years of crises, it's now time to take Europe's future into our own hands." Addressing the favourable economic situation, he quoted Kennedy:
"There is no better time to fix the roof than when the sun is shining."
In actual fact, the whole house needs to be weatherproofed if Europe is to be able to weather future storms. So it is a good thing that new life has been breathed into the debate on the future of Europe. In this context, Europe finds itself at a crossroads between strengthening the principle of individual national responsibility, as enshrined in the Maastricht Treaty, and moving towards greater fiscal integration.
Taking a look across the Atlantic delivers valuable insight into how a currency union can be stable while preserving the principle of individual national responsibility. In the United States, economic shocks that have hit individual US states have been better absorbed than comparable developments in the euro area. Interestingly, fiscal forms of interstate risk sharing via taxes or government spending have only a minor role to play here.
In the United States, and Canada, too, it is primarily private forms of risk sharing that make it possible to spread the burden of regional or sectoral economic shocks evenly across the entire country. Investments are financed by investors across state borders, which spreads the economic risk. As a result, profits and losses are not concentrated in the US state in which a firm's registered office is located. Cross-border borrowing can also serve to further cushion the blow of economic downturns if banks in other US states are in a better position than those within state borders to helps firms bridge economic lean periods. All in all, around 65% of an economic shock is absorbed in this manner.
Compared with the private forms of risk sharing, however, the fiscal risk sharing channel in the United States looks altogether more modest, absorbing no more than approximately 15% of an economic shock. The main fiscal smoothing channel is the fact that the federal tax authorities receive less in income taxes from affected states, while social transfers and federal spending on infrastructure remain static.
Unlike the United States or Canada, the euro area is not (yet) a federal state, but rather a single currency area composed of sovereign member states. Nevertheless, it would also be beneficial for the euro area if cross-border corporate funding, particularly in the form of equity capital, were to gain more ground. The capital markets union project launched by the European Commission is therefore heading in the right direction.
The French scholar Alexis de Tocqueville once said that,
"History is a gallery of pictures in which there are few originals and many copies." The euro area is without doubt a sui generis structure rather than an imitation. In this regard, the idea is not to imitate the United States. But if the euro area were to become more like the United States in terms of private risk sharing, that would certainly not be a bad thing.
A raft of measures will be needed to tear down the walls in European capital markets – in particular, standardising national insolvency regimes. Investors need reliable framework conditions and as level a playing field as possible. The preferential tax treatment afforded to debt over equity capital is also hampering growth in the equity capital markets. While enterprises' debt interest is tax-deductible, the dividend payments to their shareholders are not.
Eliminating this bias would make using equity capital as a funding instrument a relatively less costly option – and that would facilitate greater private risk sharing whilst at the same time reducing enterprises' debt. The sensibly envisaged harmonisation of the corporation tax base at the European level would provide an additional opportunity to eliminate this bias.
Cross-border bank loans are another potential vehicle for boosting private risk sharing. At the very point that such private risk sharing would have helped – in the midst of the financial crisis – the euro area saw this mechanism founder, however. Trust in the banking systems of the crisis-hit countries evaporated, investors withdrew their money, and the interbank market was brought virtually to a standstill. And in the face of pressure to reduce risks and shrink balance sheets, banks scaled back their cross-border activities.
In a sense, national financial systems were being fenced off from one another during the crisis. Yet fragmented financial markets hamper lending, particularly when times are hard. The establishment of the banking union in the euro area was, in large part, a bid to dismantle these fences. The Single Supervisory Mechanism was created and a set process for resolving distressed banks agreed upon. This makes a loss of confidence in national banking systems less likely.
A common European deposit guarantee scheme could in theory even heighten this confidence. As a general rule, however, insurance policies only cover future losses, not pre-existing ones. To be eligible to join any common deposit scheme, euro area banks would therefore either need to have sufficient provisioning to fully cover any non-performing loans on their books or be required to offload them.
However, as with any insurance policy, it is also important to ensure that the insurance does not end up encouraging reckless behaviour, not just in terms of careless lending to the private sector but, in particular, excessive lending to sovereigns.
The sovereign debt crisis made it abundantly clear that loans to general government are not risk-free. But European banking regulation is still operating as if loans to sovereign debtors come with no risks attached. Banks can therefore acquire sovereign bonds without needing to hold additional capital for the purpose. This may entice banks to invest in sovereign bonds rather than giving loans to the private sector.
In addition, banks have a – by no means irrational – tendency to prefer bonds issued by their own country, especially in times of crisis. This is because, in so doing, a bank yokes its own fate to that of its country. If that country becomes insolvent, lots of banks will fail anyway and, if that country remains solvent, the banks come up trumps as they benefit from the sovereign's increased interest payments.
As a result, a considerable portion of sovereign bonds are on the books of domestic banks, a state of affairs which has remained largely unchanged by the large-scale purchases of government bonds by Eurosystem central banks. In some euro area countries, they still represent 10% of the total assets held by domestic banks.
Banks with so many sovereign exposures would certainly not be in a position to absorb the impact of a haircut, thus triggering a compensation event in the deposit insurance scheme. A European deposit insurance scheme would therefore serve to co-insure the risk of a sovereign default in another country.
It is possible that this could even exacerbate the already problematic incentive structure generated by the preferential treatment afforded to sovereign debtors: countries' propensity to run up debt could increase even further.
In the United States, this problem does not arise in quite the same way. Most states have a balanced budget amendment in their constitution. The US Federal Deposit Insurance Corporation (FDIC) therefore insures only private bank risks, not the fiscal risks of individual states.
This is why an end to the preferential regulatory treatment of sovereign debt would be a sine qua non for establishing a European deposit insurance scheme. Loans to sovereigns should not be treated any differently from loans to enterprises or individuals. They should be subject to caps and be backed by adequate capital.
Other essential prerequisites for a single deposit insurance scheme include the harmonisation of insolvency rules, which I touched upon above, and effective access to loan collateral.
Another important lesson that we can draw from the US model of fiscal federalism is that each level is responsible for its own financial actions. The United States has its own budget at the community level, which is also monitored at the federal level. But the individual US states bear responsibility for the way they manage their finances. For example, neither the US federal government nor any other US states came to the aid of California when it experienced financial difficulties in the wake of the financial crisis.
That is why many US states maintain "rainy day" funds. Since they are required to run balanced budgets, they set aside budget surpluses in such funds so that they are available to use during economic downturns.
Unlike the US states, euro area countries are allowed to take on debt in order to stabilise the economy in a cyclical downturn. If a member state adheres to the Stability and Growth Pact and limits its structural government deficit to 0.5% of GDP as envisaged, in a downturn this still gives some fiscal room for manoeuvre of at least 2.5 percentage points before they reach the 3% limit, and in any case the fiscal rules allow for exceptions if large macroeconomic shocks occur. The euro area therefore has no need of "rainy day" funds like in the United States or even of funds that allow for intergovernmental risk sharing.
Still less is there any need for a European facility that helps out a member state during a cyclical downturn, potentially without setting any economic conditionality, in order to stabilise public investment there.
Countries can only be expected to have a responsible fiscal policy when they have to pay for their own debts themselves. In line with the principle of each country being responsible for its own budget, the rules of the Stability and Growth Pact should therefore also be observed more consistently. Budget rules have to be made more straightforward and transparent so that the public can also assess how well they are being followed.
The most recent proposals by the European Commission to transpose the fiscal compact into European law would not make budget rules simpler and would not make the Commission's assessments any less subject to discretion. The proposals are of little help when it comes to the important aim of strengthening the binding effect of fiscal rules and of putting member states' public finances on a more stable footing in the long term.
The Commission's proposal to create a European finance minister, who would be both Eurogroup President and Commission Vice-President, also does not portend any additional fiscal discipline. In the past, the Commission has too often accepted compromises to the detriment of budgetary discipline.
A better idea would be to transfer fiscal surveillance to an independent authority. This would then clearly show where unbiased analysis ends and political concessions begin. The ESM may also be an option, and in any event, the Commission hopes to convert it into a European Monetary Fund (EMF). This would not pose any problems so long as this EMF were also to focus on crisis prevention and crisis management in future, because the euro area crisis has shown that a lender of last resort to countries can make perfect sense in exceptional circumstances. An abrupt loss of market access would result in extremely high adjustment costs for the country concerned.
On the other hand, financial assistance under the ESM does allow governments to make an orderly economic adjustment over an extended period of time. In return, the government concerned undertakes to implement economic reforms to ensure stable public finances in the long term and to make the country more competitive.
Yet the ESM is only allowed to help member states that are temporarily illiquid – not those that are insolvent. It can be very difficult to tell the difference in an emergency, however. This is why the contractual terms for newly issued government bonds in the euro area should be changed so that an automatic maturity extension of, say, three years is triggered for all bonds as soon as a government applies for an ESM programme.
This buys time to distinguish between illiquidity and insolvency without releasing investors from their liability or transferring the risks to the European taxpayer. This would also significantly reduce the need for financial assistance under an ESM programme and thus greatly broaden the scope of the rescue mechanism.
This can all be done with an EMF. It would, however, be alarming if it were to introduce further fiscal risk sharing through the back door. The EMF, for example, should not become the lender of last resort for the bank resolution fund until legacy assets on banks' balance sheets have been completed reduced.
Instead of contemplating increased fiscal risk sharing, I believe it would make more sense to define tasks that can be managed better jointly rather than as individual governments and then to finance these together as well. However, most of these tasks affect all EU countries and not just the euro area.
The European Union's budget could therefore direct greater focus towards future tasks, ranging from defence and border protection to education and digital infrastructure, all the while upholding the principle of subsidiarity. Economically weaker countries and regions could benefit from the joint financing of tasks which are defined in common – ultimately, contributions to the EU budget are based primarily on the size of each member state's economy.
There is therefore a whole range of approaches towards making the euro area more stable and evolving the European Union further. Comprehensive fiscal risk sharing, on the other hand, is not necessary for a functioning monetary union.
"whoever reaps the benefits must also bear the costs" should also apply to public finances in the euro area. This liability principle is a constitutive element of a social market economy and helps to ensure responsible decisions are made. A forward-looking debate about those tasks that members can reasonably undertake jointly would also move Europe forward.