Europe inches closer to a plan for fixing its financial flaws
Jun 2nd 2017 by Luis Garicano | London School of Economics
DONALD TRUMP and Theresa May may have done more to push Europeans together, and open up an opportunity for reform of its institutions, than any pro-European American president or British prime minister could ever have dreamt. The Commission’s “Reflection paper on the deepening of the Economic and Monetary Union”, issued on May 31st, points the way towards a package deal that could be acceptable to Northern and Southern euro area countries. But some key elements are still missing.
Encouragingly, the Commission sets out a tight calendar for completing the banking union, with the creation of a common deposit insurance scheme and a common backstop for the European Resolution fund intended to be in place by 2019. These two elements are crucial if we are to stop the banks posing an existential risk to the states where they operate.
But avoiding the “diabolic loop” between banks and states also requires cutting the other link—from state insolvency to banking failures. Right now, bank loan portfolios are even more concentrated on their own home countries' sovereign debts than before the crisis. It is essential to ensure banks have a diversified portfolio that would resist a sharp deterioration in the ability to pay off their home country government.
To accomplish this, the Commission proposes creating a new safe asset: “sovereign-bond-backed securities”. The Commission argues that these new securities could, together with a change in the regulatory treatment of sovereign bonds, drastically reduce the vulnerability of the financial system. The lack of concreteness on the design, however, makes this claim dubious.
A group of economists led by Markus Brunnermeier, of which I was part, proposed a two-tier design for such sovereign-bond-backed securities in 2011. We called them European Safe Bonds or “ESBies”. A European debt agency would buy euro-zone sovereign bonds and issue two securities. First, it would issue European Safe Bonds, with a senior claim on the payments from the bonds in the portfolio. This way payment would be safe, as we calculated, even in the event of a default by Greece, Portugal and Ireland and a haircut on Italian and Spanish debt. Second, it would issue the junior tranche, backed by the portfolio of sovereign bonds, a security that would be risky, as it would absorb the first losses.
Such a two-tier system would make Europe's financial system safer, since banks would hold ESBies instead of their own government's debt. It would avoid panics and ensure that any flight to safety would benefit all euro countries, not just Germany. And, crucially, it would do all this without introducing joint liability, thus increasing its political viability.
In banking and finance, the proposed package is therefore a positive step, even though it is somewhat vague.
Where the package leaves a lot to be desired is in tackling the abysmal political and economic failure of fiscal policy and of the Stability and Growth Pact (SGP). This failure that has been at the heart of the perceived weakness of the European project over the last six years. Debt has continued to grow and aggregate fiscal policy has been procyclical. Lately, the SGP itself has become irrelevant, as shown by the “0 euro” fine imposed on Portugal and Spain for (correctly) ignoring it.
To remedy this failure the only thing the Commission proposes to do by the 2020 is to simplify the rules of the SGP.
Instead of simplifying the rules, the Commission should suggest ditching the SGP. It would be economically sensible to allow for differing, countercyclical fiscal policies in the member states to counter the uniform monetary policy required by a single currency. It is also politically imperative to terminate the SGP, since it involves the Commission excessively and fruitlessly in the core function of a democratic parliament: the approval of a national budget. As a result, it makes the Commission, and by extension Europe, unpopular in the South (“stop Europe meddling!") and in the North (“the Commission is failing to rein in spendthrift Southerners!").
To replace the SGP we would need a new, decentralised disciplining device. Economists such as Jeromin Zettlemeyer and lawyers such as Lee Buchheit have developed a solution over the past decade: a sovereign bankruptcy procedure within the euro zone that would allow for an orderly renegotiation of sovereign debts with private creditors. Such a mechanism would reintroduce market discipline on the states, allow for the necessary flexibility in fiscal policy without absurd rules, and make the “no bail-out” promise credible. Once the ESBies and European resolution and deposit insurance funds are in place, the financial system should be robust enough to make such an insolvency procedure credible.
Finally, there has been no stabilisation or risk-sharing element in the European budget up to now. The commission very timidly suggests “Decision on design, preparation of implementation and beginning of operations” of a “Central stabilisation function” for the 2020-2025 period, and broaches two ideas: an investment protection scheme, a sort of insurance for investment, and an unemployment reinsurance fund that would back the unemployment insurance schemes in member states.
Here the Commission is too technocratic and too timid. The current package deal must include a calendar for the implementation of a Euro budget with a true European Unemployment Insurance with European rules, based on flex-security principles. Such a scheme would not only be anticyclical, but it would make structural changes possible in member states. This system should be financed through a (small) European surcharge on corporate tax. An added benefit of such a system would be the harmonization of corporate tax bases, which right now are being eroded by tax engineering.
To sum up, the Commission proposal is ambitious and timely on banking and finance, but falls short of giving European citizens a Europe they can love. Unemployment is where the difference made to citizens' lives, both cyclically and structurally, can be larger. A package that involves no joint liability on bonds and sovereign insolvency should be sufficiently reassuring towards the “North”; in exchange, the “South” should demand a treasury, a European Unemployment insurance scheme, and single deposit insurance.
Destiny has handed Europe a unique opportunity to put its house in order. If we fail to take this chance, the rise of populism in Europe´s core countries will become inevitable. What would come next is too sad to imagine.
Luis Garicano is a Professor of Economics and Strategy at the London School of Economics, and vice president of the Alliance of Liberal Democratic parties in Europe (ALDE). This piece expresses his personal views, and not those of ALDE.
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