The future of the euro area in an age of uncertainty
The EU and the eurozone are facing a major crisis. They are being challenged from outside – from Russia, Turkey, and possible protectionist measures of the new US administration – and from within – from growing discontent of its citizens, strong nationalist movements and, of course, Brexit.
Even though the recent economic development of the euro area as a whole is – for the first time in years – positive, there is growing frustration of many member states of the current system of economic governance, especially the stability and growth pact (SGP). In some member states like Germany and some northern states, there prevails a feeling that the SGP is being bent beyond its limits. In others like Italy, France and Portugal, there prevails a feeling of being put into a straightjacket.
Because of these contrasting feelings, there seems to be a deadlock in the reform debate. The white paper of the Commission on the Future of Europe did not dare to give any real guidance, and member states could not agree on any euro area reform agenda, most prominently displayed in the Rome Declaration. In order to overcome this stalemate, it is necessary to understand the nature of the current system of economic governance and the antagonistic political dynamics in the member states. If we are to overcome uncertainty, we need to accept that there is not the “either/or” solution – either market-based, or transfer-oriented. It can neither be “only” the German, nor the French way, neither “only” the northern-European way, nor the southern approach. It has to be an intelligent and comprehensive combination of the two. This is politically clever and can be economically advantageous if wrong alternatives are overcome. Only if we accept this, uncertainty may be ended and a constructive discussion of the future of the euro area may begin.
The status quo – growing discontent on all sides
The current fiscal regime of the euro area consists of fiscal policy at the level of member states which are constrained by the SGP and loosely coordinated via the European semester. This regime has a number of shortcomings:
- Limited stabilisation options over time. Since the focus of the SGP is to prevent excessive deficits at the national level, fiscal policies may be either too loose (in an upswing) or too tight (in a downturn) for the euro area as a whole. This is not a problem if monetary policy is effective in keeping euro area inflation and output stable.However, the experience of recent years has shown that this has not been easy, even with very creative ECB policies like outright monetary transactions and quantitative easing.
- Limited stabilisation across countries. The current regime has no automatic stabilisers that act across countries. Asymmetric shocks need to be dealt with exclusively through country-level fiscal policies. But these in turn are constrained by the SGP, particularly given large sovereign debt levels in some countries.
- Lack of dedicated European level spending channels. Spending with implications for the stability and growth of the EU or the euro area as a whole – for example, on European networks, on protecting the EU external borders, or on critical reforms – ought to be undertaken at the European level. This is currently not possible, except to a very limited extent through the EU budget.
As a consequence of these problems, many citizens view the EMU as a straightjacket which pays insufficient attention to growth. At the same time, the ECB is under intense pressure to make up for the deficiencies of the euro area fiscal regime, which in turn leads to accusations that it is overstepping its mandate. Interest rates which are too low, again, can lead to a destabilisation of the banking system and can cause political disruption. And the feeling that the rules are not being abided by leads to growing frustration in Germany and elsewhere.
In addition, while European banking supervision and banking resolution have seen important progress in recent years, the single resolution mechanism once established with a capacity of €55billion is still too small to contain a major banking crisis. The common backstop is still missing. In the same vein, a common deposit insurance scheme is not yet in place. Both mechanisms would, in case of a shock, act as stabilisers.
An as-well-as approach
The solution to these problems is to transfer some fiscal functions from the national to the euro area level – hence creating a fiscal counterpart to the ECB – while giving member states more leeway to manage national-level fiscal policy. In the same vein, market mechanisms are to be strengthened. To make this work, however, it is essential to (i) design mechanisms which can act as, at least, countercyclical shock-absorbers enshrined in a clear institutional mandate; (ii) ensure a clean division of labour between euro area and national level fiscal responsibility, so as to prevent the two levels from freeriding on each other; (iii) create mechanisms that maintain — or indeed strengthen – incentives for fiscal sustainability a the national level. This is the combination of instruments increasing, on the one hand, targeted fiscal solidarity, whilst strengthening, on the other hand, market based instruments.
This can be achieved by combining four institutional reforms:
1. The SGP ought to be reformed in a way that gives countries credit for a broader set of policy actions, beyond short-term deficit reduction, if these broader policies can contribute to improving fiscal sustainability in the medium term. Such actions should include, for example: fiscal-structural reforms, which reduce spending responsibilities or broaden the revenue base, and growth-enhancing reforms, which allows the denominator to grow faster than the numerator, thereby reducing the debt-to-GDP ratio. In a recession, it may well make sense to combine such policies with fiscal stimulus, leading to a temporary increase in the deficit – something that is ruled out by the current SGP.
Indeed, the SGP already possesses quite a wide range of built-in flexibility. In the preventive arm, the mid term objective is calculated in a way trying to take away cyclical effects determining the output gap. Furthermore, there are provisions granting member states more room for structural reforms and investments. However, it is questionable if these mechanisms are sufficient to allow for growth friendly consolidation and if a mechanical estimation of output gaps provides a sufficiently robust basis for fiscal policy planning.
2. A fiscal capacity could be created. It would – and should – not lead to permanent transfers. One possibility would be to develop the European Stability Mechanism into a fiscal capacity with the aim to counteract short, asymmetric shocks.
Another, politically and technically more complicated way would be to reform the EU budget with a view to strengthen its stabilisation capacity and, possibly, to create a euro area budget based on a dedicated revenue source, such as a small euro area corporate tax, an financial transaction tax, and/or a small portion of VAT; a borrowing capacity, and dedicated spending functions. The primary functions of the euro area budget would be fiscal stabilisation of the euro area as a whole – that is, ensuring that that the euro area “fiscal stance”, given national policies, is the right one – as well undertaking spending on projects and reforms with cross-border significance. In addition, it could play a stabilisation role across countries (stabilisation in the face of asymmetric shocks).
3. A “common backstop” and a European deposit insurance scheme once the sovereign bank nexus is mitigated. This would help to make the eurozone more shock-resistant. However, an important precondition has to be met: the sovereign bank nexus has to be at least reduced. That means that banks have to reduce their exposure to sovereign debt of their respective member states. One mechanism to achieve this could be to require equity for sovereign debt.
4. A euro area or EU-level sovereign insolvency/debt restructuring regime is needed to create an alternative to taxpayer-funded bailouts of countries with unsustainable debts. It is the counterpart of allowing countries more leeway to conduct fiscal policy at the national level, and will ensure that the creation of the euro area budget or the fiscal capacity does not lead to an implicit guarantee of national debt. Should deep debt reoccur, it will help also help avoid economically damaging and socially unjust “austerity orgies”, when governments attempt to restore debts sustainability against all odds, and in the process allow private sector creditors to escape unscathed.
Of course, in order to implement this, ample transition time would be needed. This mechanism could be included in programs administrated by a European Monetary Fund.
These propositions do not have to be implemented in a “big bang”. They can be implemented progressively, over time, even without treaty changes. The SGP is being constantly reformed – there already is a lot of build in flexibility which can be used and increased. A fiscal capacity can be progressively established, either as a euro area fund like the structural funds, or by giving the ESM this function. Debt restructuring elements are reality already today, since new bonds all have collective action clauses which provide for debt restructuring as a last resort. And the banking union has seen great advances – if we are successful in reducing the sovereign bank nexus, we will be able to finalise it.
The implementation would have to be accompanied by a new staged process of convergence that would involve structural reforms (labour, business environment), institutional reforms (functioning of the economic governance) but also social and tax convergence where necessary (consistent, though not necessarily equal, minimum wages, and a harmonised corporate tax). This would strengthen our individual economies, establish a real level playing field across the euro area and ensure that tax competition and social dumping do not create races to the bottom and uncooperative fiscal devaluations. It would bring our economies closer, improve the economic potential of the EMU and allow establishing clearly which policies should be centralised, harmonised or simply coordinated.
Strengthening the euro is not only about the euro area itself. It cannot be isolated from a broader rethinking of the EU, not least because we need to be able to answer the key question: “what about the other member states?” A stronger eurozone should be the core of a deepened EU. Of course, it should be open for everybody. We need a simpler and more efficient union, with more subsidiarity and streamlined governance. The fundamental instrument of EU integration is the single market: we should therefore make a new step towards a better integrated internal market – an “economic Schengen” – with a targeted approach on key sectors like energy and digital economy.
The uncertainty felt by many citizens in the EU can be met if a clear project for a stronger, more resilient and more equitable euro area as the nucleus of a stronger EU is presented – as the victory of Emmanuel Macron has shown. Let us live up to the challenge and follow.
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