Minimal conditions for survival of the euro

Inclusive Economy25 Feb 2016Barry Eichengreen, Charles Wyplosz

For the single currency to survive, Europe needs both more political integration and less political integration. The trick is to understand when less is more.

This expert opinion is part of our living analysis on the Eurozone crisis

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Will European monetary integration now be complemented by the political integration needed for the single currency to survive? The answer, according to the technocrats and political intelligentsia responsible for the euro’s creation, is ‘yes’, as they believe that a monetary union is not possible without a political union. And creating the euro was a way of forcing the pace of political integration.

But the reality is that, over the timeframe relevant for the euro’s survival, political integration in Europe has its limits. The euro’s existential crisis is likely to be resolved one way or the other long before that political destination is reached.

Also, economic theory suggests limits to European political integration, as the costs of centralized provision could be high. This is because populations are heterogeneous and preferences for public goods differ across groups and regions. And because these costs create understandable resistance to pooling responsibility for provision.

Response to the crisis

This tension is evident in how Europe has responded to its crisis. In some areas, where evidence of increasing returns is overwhelming, Europe has moved toward centralized provision. Examples include the centralized provision of backstop facilities for sovereign debt markets (the European Central Bank’s Outright Monetary Transactions) and creation of the Single Supervisor (with responsibility for oversight of the banking system).

But, in other areas, the benefits of centralized provision are dominated by the costs of uniformity, creating resistance to further centralization. This is true most obviously of fiscal policy, as different countries have different tastes (insofar as countries, as distinct from individuals, have tastes) for fiscal rectitude and stabilization, and different degrees of tolerance of debt and deficits. This heterogeneity, in turn, creates a problem of trust, i.e. can those formulating and executing the common policy be trusted to do so in a manner consistent with the group’s tastes.

The implication is that, for the single currency to survive, Europe needs both more political integration and less political integration. The trick is to understand when less is more. Accordingly, here we outline four minimal conditions for survival of the euro.

Condition 1: the ECB has to act as a normal central bank

A normal central bank must be able to pursue flexible inflation targeting and backstop financial markets, thereby protecting the Eurozone from potentially self-fulfilling crises. These are functions in a monetary union that must be provided at a central level, if they are provided at all. As conceived initially, the ECB did not provide these functions.

Under the presidency of Jean-Claude Trichet, the ECB concentrated on headline rather than core inflation, leading it to raise interest rates in 2008 and 2011 when deflation was the fundamental underlying danger. The ECB hesitated to adopt unconventional monetary policies when interest rates fell to the zero lower bound.

Hearteningly, the ECB has now moved some distance in the direction of becoming a normal central bank. Quantitative easing in March 2015 demonstrated that the members of its Governing Council understood the special and especially dangerous nature of deflation. In its day-to-day operations, the ECB effectively shelved the monetary pillar and now, more carefully and systematically, distinguishes core from headline inflation. While a symmetric inflation target and a smaller, nimbler monetary policy committee are still required, these steps are in the right direction.

What is required to cement this progress is, first, for the ECB to heighten its transparency to correspond with its greater discretion and the breadth of powers invested in a normal central bank (see also the expert opinion of John Ryan and Jorg Bibow). Second, the ECB, when undertaking purchases of government bonds in the context of quantitative easing or conventional open market operations, needs assurance that its decisions will not be disallowed by the German Constitutional Court. Changing this aspect of the basic law to conform to EU jurisprudence would be a limited step in the direction of political integration.

Condition 2: a common bank deposit guarantee fund

A second minimal condition for the survival of the euro is completing Europe’s banking union. The crisis has underscored how banking-system stability is a Eurozone-wide public good subject to strongly increasing returns. One need only recall how the lax regulation of French and German banks allowed these institutions to lend hand over fist to southern European countries, helping to set the stage for the crisis.

Experience has shown that this is an area where strongly increasing returns from centralized provision dominate the costs of uniformity. To this end, Eurozone member states (and other EU member states that choose to opt in) have acted in this direction, for example, by creating a Single Supervisor of financial institutions and locating the Supervisory Board in the ECB. Again, these are limited, but necessary, steps in the direction of financial and political centralization.

The ‘political bridge too far’ has been the creation of a common bank deposit guarantee fund in which money from all Eurozone members will be pooled to guarantee that bank accounts up to €100,000 are fully insured. Some countries, notably Germany, worry that other members will be more prone to draw on the fund. They reject the mutualisation of deposit insurance as a de facto fiscal transfer. However, they are wrong for three reasons. First, banking stability is a valuable public good subject to sufficiently increasing returns so that centralization of the deposit-insurance function is warranted. Also all member states are required to implement the banking union’s new resolution rules to limit taxpayer liability. Finally, this is a limited and specific mutualisation of fiscal powers targeted at a specific financial problem intimately associated with the monetary union, not the wholesale centralization of fiscal control at the level of the EU or the Eurozone.

Condition 3: renationalize fiscal policy

Since the Maastricht Treaty and the Stability and Growth Pact, there have been repeated efforts to centralize EU fiscal policies. The one thing these measures have in common is that they do not work. EU member states have profoundly different preferences with regard to fiscal policy. They are reluctant to mutualize fiscal resources or delegate decisions over national fiscal policies to the European Commission and Parliament, as the consequent decisions would differ markedly from the preferences of some members.

Fiscal policy is fundamentally political and distributive, limiting delegation even at the national level. It is true that fiscal instability in one country can create instability in other countries, insofar as one country’s banks invest heavily in other countries’ bonds and fiscal crises are met with multilateral bailouts. But the notion that there are strongly increasing returns from centralization is questionable. The alternative is to renationalize fiscal policy. Having forsaken national monetary policies, national control of fiscal policy is all the more important for stabilization.

If reckless national fiscal policies endanger the banks, then the banks should be prohibited from holding sovereign bonds. And a no-bailout rule must also be implemented to ensure that investors pay closer attention and to make market discipline more intense. Governments, in turn, will have more incentive to strengthen their fiscal institutions and procedures so as to deliver better outcomes.

Condition 4: debt restructuring

The question is not if, but how, debt restructuring can best be organized. On the one hand, countries with unsustainable debts will prefer to see them restructured, whereas more lightly-indebted countries will fear losses and reputational consequences. Public choice theory points to the existence of the costs of uniformity and centralization in the presence of such heterogeneity.

On the other hand, the benefits of a centrally coordinated, encompassing approach are compelling when the survival of a public good, the euro itself, hinges on the outcome. An encompassing approach where debt overhangs are reduced across the Eurozone, allowing fiscal control to be delegated to the governments of all participating member states, will help to restore the macroeconomic and financial stability on which the euro’s survival depends.

Therefore, we prefer a scheme for the collectively restructuring of the debt overhang of Eurozone members. The general point is that comprehensive restructuring is easier and less costly when carried out collectively. Once fiscal discipline and low national public debt are achieved, the no-bailout clause will have to be completed by a prohibition on ECB dealings in an individual country’s debt instruments.

The Eurozone crisis has shown that monetary union entails more than just sharing monetary policies, and that the common central bank must aim at more than just price stability. While completing the architecture is challenging, doing so does not require a forced march to political union. The conditions outlined above, while necessary, are also sufficient, or at least we hope. And, they should be enacted as quickly as possible.

This article is a shorter version of a column that was published under the same title on the website of See here for the original article, which was published on 12 February 2016.

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