CHAPTER 11: A NEW FOUNDATION FOR EMU
‘There are two models for Europe: Free access to the printing press, that is, Target credits, Eurobonds and political debt brakes. Europe has already implemented half of this model. The other is the American one: states can go bankrupt… This model relies on control by the market.’
- Hans-Werner Sinn, president of Ifo Economic Research Institute, in 2012[i]
The analysis in the previous chapters suggests that a monetary union in Europe with comprehensive financial transfers between stronger and weaker states is unsustainable. It would require a strong political centre receiving the lion’s share of tax revenues collected in the union and the ability to steer the political debate for the union as a whole, in other words a European government with political and financial clout similar to the federal governments of the United States or Germany. For the foreseeable future, the likelihood that a European government of this sort will emerge from the euro crisis is close to zero. More likely is a halfway house with joint liability for debt issued by EMU member states, liberal use of the money printing press to fund government debt that cannot be sold in the capital markets and futile efforts to ensure fiscal discipline of member governments by intergovernmental treaties that cannot be enforced. Sooner or later, this halfway house would collapse as economically and financially stronger countries will resist the financial exploitation through joint debt liability and inflation created by the liberal use of the money printing press.
In my view, the only way to make EMU work is to embed it into a political union roughly along the lines of the United States of the mid–nineteenth century, i.e., to establish it as a federation of sovereign states where interstate fiscal transfers play only a minor role, member states are fully responsible for their financial affairs, the common currency is managed by a politically independent central bank and economic and financial crises can be effectively dealt with. There would be a transfer of political sovereignty to the supranational level, but in a limited and gradual way, in line with past practice in the context of European integration. Such a structure requires the five fundamental building blocks described in the following.
- Governments are fully responsible for their financial decisions. The bulk of government revenue collection and spending occurs at the state level. The European Union receives only a small part of government revenue and therefore has only limited spending capacity. Insolvent governments must not be bailed out by the community or other governments, but be allowed to go bankrupt. If governments are not only insolvent but economies also suffer from serious overvaluation of their internal real exchange rate and therefore lack international competitiveness, and if they are unable to create the necessary economic flexibility to engineer internal devaluations and observe a hard budget constraint, they must be allowed to exit EMU. To make default within EMU possible, government debt must eventually be reduced below the threshold at which the default of a debtor has potentially disastrous consequences for the financial system. To allow exit of EMU as a measure of last resort, EU treaties have to be changed such that a country leaving EMU can remain a member of the EU.
- The central bank is responsible for price stability. Since price stability cannot be achieved without financial stability, the central bank is the source for funds of last resort for all systemically important debtors. Modern central banks tend to pursue inflation targets defined as a tolerable increase in the price for a basket of goods, bought by a typical consumer to sustain his living. Implicit in this monetary policy strategy is the assumption that economic agents always make their decisions in a rational way, and markets for goods, services and assets are always efficient. When these assumptions hold, controlling the increase of the prices for goods and services is sufficient to achieve monetary and financial stability. Prices of real and financial assets always reflect all publicly available information and hence are consistent with expected returns. All price changes are random, reflecting new information that nobody could foresee. The central bank is only called upon to act as a lender of last resort in the unlikely event of a financial ‘accident’, as it may arise by a random error of an economic agent. Of course, the assumptions of universally rational expectations and efficient markets do not hold, with the consequence that inflation targeting is a suboptimal strategy for monetary policy. Central banks relying on this strategy have closed their eyes to asset price bubbles and neglected regulation aimed at limiting excesses in financial institutions, as well as in markets for financial and real assets. During the financial crisis, they had difficulties in appropriately performing the function of a lender of last resort, in some cases failing to lend in time (such as the Bank of England in the case of the bank run on Northern Rock) and in others failing to wind down emergency lending (such as the US Federal Reserve in the case of continuous purchases of government bonds during robust economic recovery). In EMU, the task of the central bank should be to safeguard the purchasing power of money by countering excessive movements in prices for goods, services and assets. Excessive price movements for assets can be countered through a policy aimed at dampening swings in the credit cycle. This requires a more restrictive stance of monetary policy in the upward phase of the credit cycle and a more expansionary stance in the downward phase. It also requires providing funds of last resort to systematically important debtors when credit markets freeze in a financial panic.
- To ensure that the central bank does not monetize the debt of insolvent systemically important debtors, be they banks or governments, it acts as a lender of last resort only in close cooperation with the European Systemic Risk Board (ESRB) and a EMF. The ESRB was created toward the end of 2010 for the macroprudential surveillance of the financial sector in the European Union. It took up operations in 2011.[ii] This board is charged with monitoring and analysing financial developments with a view to identifying risks to the financial system. It could also critically accompany any central bank lending as a last resort to banks and governments. To avoid monetary funding of insolvent governments, central bank lending to governments should only occur through the EMF. The EMF would give financial support to governments cut off from capital markets in return for binding commitments to pursue economic policies aimed at restoring the trust of the markets in their solvency. It would be governed by the finance ministers of EMU member countries, the Eurogroup. In normal times, the EMF would fund its activities in the capital market, issuing bonds backed by its capital and guarantees from its shareholder, the member states of EMU. In times of financial panic, when capital markets seize up, the EMF would have access to ECB funds to carry out its tasks. Credit from the central bank would be given on an application from the EMF, a positive opinion from the ESRB and eventual approval by the ECB’s Governing Council.
- The EMF supervises national economic policies for consistency with the requirements of monetary union, provides sovereign bond insurance, manages and funds adjustment programmes in case policies do not meet these requirements and manages an orderly debt restructuring of governments and banks in cases of insolvency. As discussed in previous chapters, flexibility of the economies of member countries – especially in the labour market – and strict fiscal discipline are the prerequisites for the smooth functioning of a common currency area. In the past, surveillance by the European Commission was helpful, but not always effective (e.g., the commission long underestimated the risk emanating from the build-up of current account imbalances among EMU member countries). Hence, like the IMF at the global level, the EMF would monitor developments in EMU countries so as to ensure that economic developments and policies are consistent with the requirements of EMU. A positive result of the review would qualify a country to have its government bonds insured by the EMF up to the equivalent of 60 per cent of the country’s GDP. A negative review would trigger suspension of the insurance of new debt and negotiations of an economic adjustment programme, if necessary coupled with temporary adjustment funding from the EMF. On the launch of a programme funded by the EMF, there would be a standstill on the repayment of outstanding private debt (except interest payments). Debt repayments would resume after the successful conclusion of the programme. In the case of failure of the fiscal policy part of an adjustment programme, the EMF would arrange a debt restructuring. If the restructuring would create risks to the financial stability of the euro area at large, Brady Plan–type debt swaps (similar to those arranged for Greece in February 2012) could be used to contain the external effects of the debt restructuring. If in addition the programme would fail to restore the balance of payments equilibrium of the country, participation of the country in the ECB’s interbank payment system would be ended, triggering the country’s exit from the euro. The EMF would also provide funds for the restructuring or resolution of insolvent banks and manage the restructuring or resolution in cooperation with the banking authority (EBA, see below).
- The ESFS, through its banking, insurance and financial markets agencies, ensures appropriate financial and banking regulation to safeguard financial stability, and through its banking agency provides common deposit insurance and manages the restructuring or resolution of insolvent banks. The ESFS with its banking (EBA), insurance (EIOPA) and financial market (ESMA) authorities became operational in 2011. Its purpose is to ensure an EU-wide approach to supervision. Banks would be required to set aside equity for government debt holdings (which are presently exempted from equity backing, or ‘zero-risk-weighted’ in the Orwellian language of supervision) and bank exposure to government debt would be treated like exposure to any other single-name debtor (presently government debt is exempt from regulatory ceilings for single-name exposures). With this and the reduction of outstanding government debt, over time the systemic importance of public debtors would decline and eventually end. At the same time, a privately funded euro area–wide deposit insurance scheme (with the EMF as backstop) would eliminate the risk of bank runs caused by concerns over the viability of national guarantee schemes. At present, EU regulation requires deposit insurance for up to EUR 100,000. However, insurance is provided at the national level and hence not credible when a government suffers from a liquidity or solvency crisis. Deposit insurance at the EU level would of course have to go hand in hand with bank restructuring or resolution also at the EU level (or, if this is politically not feasible, at least at the euro area level). To avoid that unresolved financial problems from the past lead to transfers from strong to weak banks or countries, banks would have to successfully pass a financial health check before they are allowed to join the common deposit insurance scheme.
A graphical sketch of the proposed new architecture for EMU is given in Figure 1.
Figure 1.
Since the outbreak of the euro crisis in early 2010, we have stumbled towards a new architecture for EMU. At first glance, with the exception of the EMF, the institutions necessary for the above-sketched new architecture for EMU are already in place. Moreover, EU leaders have pledged to strengthen fiscal discipline and improve economic policy coordination among EMU member countries. In principle, the European Stability Mechanism (ESM) could quickly lead to the EMF when the confusion over the role of the ECB as a lender of last resort is resolved. There is nothing in the statutes of the ESM that would prevent it from becoming a counterparty of the ECB and hence gaining access to ECB lending.[iii] We have gained experience with adjustment programmes (of a positive nature in the case of Ireland and a negative one in the case of Greece) and with debt restructuring (with Greece as the guinea pig). Last but not least, we are slowly moving towards a European banking regime, which has been dubbed ‘banking union’. Hence, it seems that we are firmly on track to rebuild the architecture of EMU in the right way.
Unfortunately, policymakers are still very confused about how a stable architecture of EMU has to look like and may well arrange the building blocks in the wrong way, setting the stage for an eventual break-up of EMU. In my view, the right model for ensuring fiscal discipline in EMU is that of the US in the nineteenth century, where market forces played the most important role. But it seems that key policymakers at the EU level and in Germany are leaning more to the problematic and unstable model of the German Empire, characterized by a weak political control of fiscal policy leading eventually to the monetization of public debt. German chancellor Merkel has insisted that it is necessary to fortify EMU with fiscal or even political union. To this end, she has wanted national sovereignty in key fiscal policy areas transferred from the national to the European level and has held out mutualization of debt as a possible reward. However, as I have explained before, I regard it as very unlikely that the peoples of Europe are willing to cede more sovereignty in key policy areas to European institutions. More likely would be that public debt is mutualized and sovereignty remains national. In that case, EMU would almost certainly break apart as national electorates in stronger countries would refuse to stand in for debt incurred by sovereign decisions in weaker countries. According to EU president Herman van Rompuy, debt restructuring for Greece is supposed to remain ‘exceptional and unique’, while it should have been held up as an example for the way government insolvency can be treated. Instead of market forces, an intergovernmental treaty is supposed to enforce fiscal discipline of EMU member governments, although experience suggests that such treaties will be broken in times of financial stress. Adjustment funding is kept in place, even when adjustment has failed, as has been the case for Greece. And the ECB is supplying weak banks generously with liquidity so that they can fund their impaired balance sheets and their weak governments. To contemplate the exit of a country from EMU is still difficult in official circles and regarded as politically incorrect when mentioned by critical economists. But it should be clear to all readers who have followed my line of argument so far that this approach to saving EMU will only extend its agony before political disunity over unpaid bills causes its eventual demise.
Because of my relatively pessimistic assessment of the efforts undertaken to rescue EMU, I cannot conclude this book without discussing scenarios for a potential failure of EMU in the remainder of this chapter and in the next. Clearly, the voluntary or forced exit of a smaller country may damage EMU but it would not break it. This is different when a larger country, say Spain or Italy, fails to adjust to the economic and fiscal policy requirements of a common currency area. Given the size of these countries, the funding of government budget and/or current account deficits through the IMF and EFSF/ESM would seem hardly possible.[iv] The only source capable of coming up with sufficient funds to replace market funding for these countries would be the ECB. The central bank would continue and expand its unlimited liquidity support for banks in these countries and co-opt them into providing funds for financially troubled governments. Money in search of safe havens, flowing from these countries to the AAA rated countries, would flood the ECB’s interbank payment system with liquidity, eventually creating a level of inflation that electorates there would no longer tolerate. But could these more powerful countries possibly escape from being ensnared in an inflation and transfer union by the weaker countries without creating a major economic, financial and political rupture in Europe?
The printing of money to settle debts inevitably leads to a transfer of real wealth from creditors to debtors. The latter are paid with notes whose power to purchase goods, services or real assets declines. Hence, the inflation created by printing money to stabilize weak governments and banks will inevitably devalue the already outstanding claims of the AAA countries in the form of loans or balance of payments credits through the TARGET system. But creditor countries could try to protect themselves against a continued drain of real resources to their weaker partners by pushing up the euro prices for their goods, services and assets so that they are harder to acquire by the debtor countries. To defuse the political and social tensions created by accelerating inflation in the creditor countries themselves, they could temporarily index wages and prices of nominal assets to the rise of their domestic price levels. Thus, higher wages would lead to higher prices for their goods and services, reducing the demand for their products from the debtor countries. Depreciation of the euro against other currencies, caused by the ECB’s monetization of government debt and weak bank balance sheets, would maintain competitiveness of the creditor country economies in global markets. In the event, there would be a reduction of exports by creditor countries to debtor countries and an increase of imports of the former from the latter. Creditor country exports to and imports from non–euro area countries would remain stable. Debtor countries would see their total exports rise and their total imports fall.
Savers in the creditor countries could be protected by inflation-indexed fixed income instruments. For instance, creditor country governments could issue bonds to their residents whose principal and interest payments are linked to the domestic consumer price inflation rate. Since revenues of these governments would profit from inflation, they would have no problems servicing inflation-indexed debt (as long as this debt does not exceed the share of government revenue in GDP). Governments could also issue inflation-indexed bonds to domestic banks in private placements, allowing these banks to offer inflation-protected savings products backed by these bonds to their customers. To contain fears possibly unleashed by rising inflation, despite the indexation of wages and nominal claims to inflation, governments could offer public assurance and include clauses in their inflation-indexed debt instruments that all financial obligations and claims of the government would be converted into a new currency when domestic euro inflation exceeded a certain level. Private sector participants could calculate the value of the new currency against the euro based on the development of inflation even before the trigger level for a formal switch of currencies is reached. This would allow denominating private contracts in the new currency and establish it initially as a private parallel currency. Savers worried about future weakness of the euro could move their euro assets into the parallel currency, fuelling demand for inflation-linked government debt. Following the formal currency conversion, the new currency would be legal tender only for non-cash transactions with the government and would continue to coexist in all private transactions as parallel currency with the euro, against which its exchange rate would float freely.[v] Thus, all taxes and other government levies would need to be paid in the new currency and the government would settle all payments – including those for wages, government purchases and debt servicing – also in the new currency. Private sector participants would have the choice of making non-cash payments in the new currency or in euros at the prevailing market exchange rate. In view of the diminishing importance of cash payments and the costs of introducing new cash, the euro would still be accepted for cash payments throughout the monetary union. Such a two-tiered system – one could call it a union within the union – would mimic some elements of the Latin Monetary Union, where common coins coexisted with national paper money. But it would of course differ from the LMU in that only creditor countries would have an incentive to introduce a second-tier currency to protect themselves from the debasing of the euro by debtor countries, and that the exchange rate of the second-tier currency would float – and over time appreciate – against the euro.
Perhaps the creation of such a second-tier currency by the creditor countries may not become necessary after all. The mere option for the creditor countries to do this might be enough to induce the debtor countries to rely less on inflation to devalue their debt and instead strengthen their efforts to fully repay their debt in real terms. Presently, the creditor countries seem to be trapped into a currency that the debtor countries could debase by forcing the central bank to print money so as to prevent default of the debtors and financial collapse. Creditor countries could regain leverage over the debtor countries by developing the option to leave EMU and leave the debtors behind with a debased currency.
[i] ‘We are trapped’, Frankfurter Allgemeine Zeitung, 18 February 2012, 12.
[ii] For a review of the new arrangements for financial supervision in the EU, see Bernhard Speyer, ‘Financial Supervision in the EU’, Deutsche Bank Research EU Monitor84 (4 August 2011).
[iii] For a discussion of the economic and legal aspects of turning the ESM into a bank – and hence effectively into an EMF – see Daniel Gros and Thomas Mayer, ‘Liquidity in times of crisis: Even the ESM needs it’, CEPS Policy Brief 265 (March 2012).
[iv] Moreover, given the seniority of the IMF and ESM, the greater the financial support from these institutions becomes, the more difficult it is for countries to return as borrowers to private markets, because investors demand an additional risk premium for having to bear the first loss in case of default. Hence, should the architecture of EMU be overhauled again, lending by the ESM (or better the proposed EMF) should become pari passu with private sector lending (as has been case for the EFSF).
[v] There have been numerous proposals for introducing a common European currency as a parallel currency. Notably, in November 1989, the UK government proposed such a scheme as an alternative to the Delors plan. In principle, a parallel currency could also be introduced by the private sector on its own. It could quickly gain acceptance as a means of payment and store of value if banks back it with gold holdings. When issuance of the private parallel currency has reached a critical mass, the public sector may get involved by creating a central bank to serve as a lender of last resort of the gold-backed currency to commercial banks.