Ending the euro area crisis: crossing the river by feeling the stones
Europeans face a fourfold crisis: a sovereign debt crisis, a banking crisis, a competitiveness crisis and a crisis of governance. CEPII's first Policy Paper highlight the key issues that need to be addressed for a comprehensive solution to be found.
By Benjamin Carton, Christophe Destais, Sophie Piton, Agnès Bénassy-Quéré, Yves-Emmanuel Bara
Post
The first G-MonD Policy Paper [1], co-edited by CEPII and Paris School of Economics (PSE), starts by analyzing the key causes of the euro area crisis. It underlines that the crisis resulted from the underestimation by national policymakers of some clearly identified risks, such as real interest-rate divergence or the possibility of sovereign debt crises, and the failure of the community to correctly identify some other risks, such as the problem of “too-big-to-fail” banks. These failings can partly be understood by the fact that, at the time of the creation of the euro area, those who designed the euro focused mainly on the risk of inflationary monetary policies. Together with the political necessity of reaching an agreement, this led to the adoption of an incomplete and ill-designed treaty.
Because the treaty lacked clear crisis-management guidelines, national governments and European institutions had to invent new mechanisms in a trial-and-error process. This process has been severely criticized by financial markets and foreign countries. However, it should be acknowledged that the euro area remains a unique experiment of regional monetary integration, and ready-made solutions to this sort of crisis were not available, especially within the framework of institutions that are consensus-based such as the European Council. It has therefore taken time to address the four aspects of the crisis. At the time of writing (autumn 2012), the euro area was still far from a comprehensive strategy that would show the way out of the crisis. However, the beginning of such a strategy was slowly emerging out of the various debates, and from the pieces of the puzzle that were already on the table.
Perhaps the most advanced axis of crisis containment by then concerned the sovereign debt crisis, through the creation of a permanent rescue fund financed by EU member states, and the complementary European Central Bank programme announced in September 2012. On the banking crisis, the steps taken towards a “banking union” and common crisis resolution procedures were encouraging but still very preliminary. The European banking sector still lacks adequate capital and there is a risk of the perpetuation of “zombie banks”, a phenomenon that cost Japan dearly in the 1990s. As for the competitiveness crisis, the programmes in crisis countries that aimed at simultaneously achieving the deleveraging of the over-indebted economic agents and an internal devaluation risks creating self-fulfilling depressions.
Finally, the strengthening of fiscal surveillance and its extension to macroeconomic imbalances, although very welcome, has still not been tested. There are doubts that the decisions made in this respect (the “six pack”, the fiscal compact and the “two pack”) will provide appropriate surveillance, not least because of their high complexity and reliance on sanctions. The combination of provisions at European level and of more stringent restrictions at national level will add to the complexity while, subject to the interpretation of certain rules and the macroeconomic context, the actual implementation of the Compact by the countries to which it applies will be challenging. We argue that surveillance should be prioritized more clearly and that efforts towards further national ownership should be pursued.
In addition, at the time of writing there was still a disagreement among Europeans on a number of key issues, notably: (i) the short-term adjustment strategy, (ii) debt restructuring and mutualization, (iii) and new transfers of sovereignty, especially in the areas of fiscal policy and bank supervision.
Looking forward, we recommend:
On deleveraging and macroeconomic adjustment
The process of macroeconomic adjustment in crisis countries should include scrutiny of the evolution of domestic demand so that a deflationary environment is avoided. Indeed, allowing domestic demand to plunge makes deleveraging self-defeating. Something like an aggregate fiscal policy at the euro-area level should be designed, with fiscal retrenchment being delayed in those countries not in crisis when demand falls at the euro-area level. The process of macroeconomic adjustment should also consider the restructuring of debts to a sustainable level with adequate safeguards so that a new systemic crisis is not triggered.
On enhancing the competitiveness of the peripheral countries
A firm ECB commitment to keep a loose monetary stance over a significant period of time could help to weaken the euro and foster the rebalancing of competitiveness within the euro area through inflation differentials. Suppressing rents in the non-tradable sectors would help create jobs in these sectors and encourage capital to move towards the tradable sectors through relative price adjustment.
On debt mutualization
We argue that the partial mutualization of sovereign debts could help fiscal surveillance to switch from ex post to ex ante. We however recognize that there may be too much debt and not enough trust among member states to allow for the mutualization of existing stocks of debts, except maybe through a debt exchange with haircuts on the secondary market. We also argue that bundling national government bonds (with no mutual liability) could be considered as a first step towards fully-fledged eurobonds.
On Banking sector and banking union
The provision of liquidity to the banks was necessary in order to avoid a new crisis. It is however of utmost importance that European banks are adequately recapitalized, in particular through the retention of profits. The supervision of banks at euro-area level (banking union) is necessary in order to align supervisors' strategies with the interests of the euro area as a whole, to limit regulatory capture and to reverse the current withdrawal of banks to their home countries. However, this should not be considered as a substitute for strict and simple prudential regulation, or for effective restructuring when needed.
On transfers
Some sort of transfers between member states will be inevitable for at least two reasons. In the short run, official sector involvement will be unavoidable in Greece. In the medium term, the willingness of EU citizens to move forward will critically depend on the ability of governments and institutions to manage adjustments in a socially-acceptable way, and to rebuild lost confidence. In the long term, since a monetary union allows production factors to agglomerate where marginal productivity is highest, less productive regions should consistently be compensated to a certain extent. A Euro-wide unemployment benefit system could play this role.
On policy mix and institutional reform
We argue that there is a need for a profound revamping of fiscal policy-making in the monetary union, with a “euro-area government” given the authority to design a sensible aggregate fiscal policy at euro-area level and allowed to be more intrusive in national affairs when rules are infringed.
As for monetary policy, the ECB will have to take the narrow passage between the risk of not doing enough for the preservation of the euro and the risk of being tied up by fiscal policies that are not sustainable.
All steps taken towards a new architecture for the euro will help solve the short-term challenges by providing the markets with a long-term perspective. This is why governments and European institutions should not scale back their euro-area crisis resolution efforts.
Because the treaty lacked clear crisis-management guidelines, national governments and European institutions had to invent new mechanisms in a trial-and-error process. This process has been severely criticized by financial markets and foreign countries. However, it should be acknowledged that the euro area remains a unique experiment of regional monetary integration, and ready-made solutions to this sort of crisis were not available, especially within the framework of institutions that are consensus-based such as the European Council. It has therefore taken time to address the four aspects of the crisis. At the time of writing (autumn 2012), the euro area was still far from a comprehensive strategy that would show the way out of the crisis. However, the beginning of such a strategy was slowly emerging out of the various debates, and from the pieces of the puzzle that were already on the table.
Perhaps the most advanced axis of crisis containment by then concerned the sovereign debt crisis, through the creation of a permanent rescue fund financed by EU member states, and the complementary European Central Bank programme announced in September 2012. On the banking crisis, the steps taken towards a “banking union” and common crisis resolution procedures were encouraging but still very preliminary. The European banking sector still lacks adequate capital and there is a risk of the perpetuation of “zombie banks”, a phenomenon that cost Japan dearly in the 1990s. As for the competitiveness crisis, the programmes in crisis countries that aimed at simultaneously achieving the deleveraging of the over-indebted economic agents and an internal devaluation risks creating self-fulfilling depressions.
Finally, the strengthening of fiscal surveillance and its extension to macroeconomic imbalances, although very welcome, has still not been tested. There are doubts that the decisions made in this respect (the “six pack”, the fiscal compact and the “two pack”) will provide appropriate surveillance, not least because of their high complexity and reliance on sanctions. The combination of provisions at European level and of more stringent restrictions at national level will add to the complexity while, subject to the interpretation of certain rules and the macroeconomic context, the actual implementation of the Compact by the countries to which it applies will be challenging. We argue that surveillance should be prioritized more clearly and that efforts towards further national ownership should be pursued.
In addition, at the time of writing there was still a disagreement among Europeans on a number of key issues, notably: (i) the short-term adjustment strategy, (ii) debt restructuring and mutualization, (iii) and new transfers of sovereignty, especially in the areas of fiscal policy and bank supervision.
Looking forward, we recommend:
On deleveraging and macroeconomic adjustment
The process of macroeconomic adjustment in crisis countries should include scrutiny of the evolution of domestic demand so that a deflationary environment is avoided. Indeed, allowing domestic demand to plunge makes deleveraging self-defeating. Something like an aggregate fiscal policy at the euro-area level should be designed, with fiscal retrenchment being delayed in those countries not in crisis when demand falls at the euro-area level. The process of macroeconomic adjustment should also consider the restructuring of debts to a sustainable level with adequate safeguards so that a new systemic crisis is not triggered.
On enhancing the competitiveness of the peripheral countries
A firm ECB commitment to keep a loose monetary stance over a significant period of time could help to weaken the euro and foster the rebalancing of competitiveness within the euro area through inflation differentials. Suppressing rents in the non-tradable sectors would help create jobs in these sectors and encourage capital to move towards the tradable sectors through relative price adjustment.
On debt mutualization
We argue that the partial mutualization of sovereign debts could help fiscal surveillance to switch from ex post to ex ante. We however recognize that there may be too much debt and not enough trust among member states to allow for the mutualization of existing stocks of debts, except maybe through a debt exchange with haircuts on the secondary market. We also argue that bundling national government bonds (with no mutual liability) could be considered as a first step towards fully-fledged eurobonds.
On Banking sector and banking union
The provision of liquidity to the banks was necessary in order to avoid a new crisis. It is however of utmost importance that European banks are adequately recapitalized, in particular through the retention of profits. The supervision of banks at euro-area level (banking union) is necessary in order to align supervisors' strategies with the interests of the euro area as a whole, to limit regulatory capture and to reverse the current withdrawal of banks to their home countries. However, this should not be considered as a substitute for strict and simple prudential regulation, or for effective restructuring when needed.
On transfers
Some sort of transfers between member states will be inevitable for at least two reasons. In the short run, official sector involvement will be unavoidable in Greece. In the medium term, the willingness of EU citizens to move forward will critically depend on the ability of governments and institutions to manage adjustments in a socially-acceptable way, and to rebuild lost confidence. In the long term, since a monetary union allows production factors to agglomerate where marginal productivity is highest, less productive regions should consistently be compensated to a certain extent. A Euro-wide unemployment benefit system could play this role.
On policy mix and institutional reform
We argue that there is a need for a profound revamping of fiscal policy-making in the monetary union, with a “euro-area government” given the authority to design a sensible aggregate fiscal policy at euro-area level and allowed to be more intrusive in national affairs when rules are infringed.
As for monetary policy, the ECB will have to take the narrow passage between the risk of not doing enough for the preservation of the euro and the risk of being tied up by fiscal policies that are not sustainable.
All steps taken towards a new architecture for the euro will help solve the short-term challenges by providing the markets with a long-term perspective. This is why governments and European institutions should not scale back their euro-area crisis resolution efforts.
[1] “Ending the Euro Crisis: Crossing the River by Feeling the Stones”, G-MonD Policy Paper, n°1, by Agnès Bénassy-Quéré, Yves-Emmanuel Bara, Benjamin Carton, Christophe Destais and Sophie Piton, November 2012.
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