Comment of September 27, 2017
The euro area has recently seen some good news. A broad-based economic recovery is under way. Significant institutional reforms have been achieved, particularly in the area of banking union. Significant economic reforms are under way in several countries, including in France. As French and German economists committed to Europe and to the friendship between our countries, we are nonetheless concerned that the Euro area continues to face significant fragilities. Addressing these requires a comprehensive, collaborative push for reforms. If this effort fails, the chances that a major fiscal and financial crisis will reoccur in the Euro area in the foreseeable future remain high. And if there is a crisis, attempts to address it will be economically painful and likely re-open the political divisions that appeared during the crisis. At a time when global prosperity and security are under threat by economic and political nationalism, Europe cannot afford such divisions.
First, Euro area stabilization has relied too much on the European Central Bank (ECB). Subdued inflation induced highly expansionary monetary policy. This has helped Euro area countries that were shaken by the crisis recover (even if it may give rise to undesirable side effects, such as financial bubbles). But as price stability is gradually restored, the ECB will remove stimulus, and interest rates will rise. This could put countries under pressure that have not gone far enough in reforming their economies and reducing debt levels.
Second, the financial stability of the Euro area remains threatened by the legacies of the global and Euro area crises. While sovereign debt and non-performing loan ratios have begun to decline, their stock remains high in several countries. A particular concern is the continuing high exposure of banking systems of several countries to the debts of their own governments. This means that any difficulties in the sovereign debt market will promptly translate into difficulties for the financial system, and hence the real economy. This “doom loop” poses a major threat not only to individual member states, but to all of the Euro area. Despite good progress on banking union, too little has been done to reduce financial fragmentation and strengthen the financial system.
Third, the Euro area’s instruments for promoting sound policies at the level of each member countries remain blunt and are often ineffective (in particular in averting public debt accumulation). They are also a source of political tension, and expose the European Commission – which is supposed to enforce these rules – to criticism of being too tough in some countries and not tough enough in others.
Fortunately, the French and German governments have recognized the imperative for reform. Informal discussions started before the German elections, and will hopefully gain momentum in the coming months. The leaders of both countries have expressed support for a Eurozone budget, a European finance minister, and a European Monetary Fund.
Unfortunately, however, both sides have rather different views on what these terms mean. During his tenure as French Economy Minister, Mr. Macron argued for a Euro area budget, based on a dedicated revenue stream, that would “provide automatic stabilization and allow the European level to expand or tighten fiscal policy in line with the economic cycle”. He has during and after the presidential campaign repeated his support for such a budget although with less precision on the economic rationale. Mrs. Merkel, in contrast, is thinking of a small fund that would support structural reform in Euro area countries. On the European Monetary Fund, ideas are similarly divergent. The German government wants to strengthen the current European Stability Mechanism (ESM) so it can engage in tough surveillance of member states’ policies. France wants to give it more financial firepower.
These differences are mirrored by deep divisions between the two countries. German officials usually take the view that the problems of the Euro area stem mostly from inadequate domestic policies. They have long rejected calls for additional Euro area stabilization and risk sharing instruments, and instead want tougher enforcement of fiscal rules and more market discipline. French officials, on the other hand, have called for additional stabilization and risk sharing via a Euro area investment budget, a Euro-area wide common unemployment insurance scheme, a European deposit insurance, and a permanent common backstop for the single resolution fund (SRF). They concede that this requires strengthening fiscal discipline at the national level, but reject more market discipline, proposing instead to tighten national fiscal rules.
If both sides stick to their current positions, the outcome of the incipient Franco-German push for Euro Area reform is predictable – and depressing in that it would not solve any of the key challenges. It might result in a symbolic, very small Eurozone budget with a “Minister of Finance”, but without a borrowing capacity. The quid pro quo will not be greater market discipline, as the Germans are hoping, but tougher Euro-area level intervention powers, possibly accompanied by a symbolic strengthening of national fiscal rules.
Apart from allowing both the French and German governments to claim victory at home, such a “small bargain” would accomplish very little. It would not make the Euro area more stable. It would not address the fundamental causes of why fiscal rules have not worked well. And while the idea to strengthen Euro area-level decision making is sound in principle, it will set up Euro members for more fights with “Brussels” if it does not go along with better incentives for adopting national policies consistent with European rules. Worse still, a bargain of this sort may induce a false sense of security, hindering needed reforms both at the national and European levels.
To move Europe forward, France and Germany will need to aim beyond this small bargain. This does not imply the need for full fiscal union let alone a fully-fledged United States of Europe, which is neither necessary nor feasible at this point in time. But it needs more far-reaching reforms, in three respects.
First, they will need to expand their discussion beyond fiscal policy. While a Eurozone budget could be helpful for risk-sharing purposes, it may remain too small, is difficult to design appropriately, and there may be legitimate reasons to expand common fiscal resources at the European Union rather than Euro area level (this may be the better place to provide essential public goods such as infrastructure investment, security and defense). But if this is the case, it will become even more important to facilitate euro-area risk-sharing through non-fiscal and non-monetary instruments. This will require a discussion on how to resolve the continuing deadlock on European deposit insurance, and how to promote capital market integration, which is underdeveloped in the euro area, particularly compared to the United States.
Second, they will need to do some serious thinking on how to address the legacy problems from the crisis – particularly the large continued exposure of banks to their national sovereigns – which trigger the diabolic loop between banks and sovereigns and destabilize cross-border capital flows. This calls for regulatory curbs on such exposure, which are a natural complement to European deposit insurance. It also requires a discussion on whether, and if so how a European safe asset could be implemented to switch off the diabolic loop.
Finally, and most importantly, French and German officials will need to take a leap of faith away from their traditional positions – while insisting that the legitimate concerns that motivate these positions are addressed.
Germany needs to accept the idea of more risk sharing in the Euro area – but should insist that this is done in a way that maintains sound incentives, does not become a vehicle of permanent redistribution and increases the credibility of the no-bailout rule for sovereigns and of the bail-in framework for banks. Eliminating the vicious circle between sovereigns and domestic banks supports these objectives by enhancing the feasibility of a sovereign debt restructuring without a banking panic, and of large-scale banking sector restructuring without massive public cost.
France needs to accept the idea of more market discipline – but should insist that this is introduced in a way that does not lead to financial instability. A possible approach could be an obligation to finance excessive new deficits through bonds which would be restructured if the country loses market access. More generally, sovereign debt restructuring should be recognized as a tool of last resort to restore solvency inside the Eurozone. But this must only happen after exposures of banks to their home sovereigns have been sharply reduced from current levels, and must go along with better risk sharing instruments, so that any debt restructuring becomes very unlikely.
And both sides should throw their weight behind a simplification of the devilishly complex fiscal rules of the Euro area, in order to reduce the need for micromanagement from Brussels, which has become a recipe for populism.
As economists who speak a common intellectual language – but are also aware of our own national biases – we believe that meaningful Euro area reforms that meet these aims are difficult, but possible. There are solutions, although never simple ones. In the coming months, we hope to contribute some of our own thinking toward finding them. The French and the new German governments will need to lead and work closely with its European partners and Europe’s institutions on reforming Europe and the euro.
Agnès Bénassy-Quéré (Paris School of Economics, University Paris 1, and French Council of economic analysis), Markus Brunnermeier (Princeton University), Henrik Enderlein (Hertie School of Governance and Jacques Delors Institute, Berlin), Emmanuel Farhi (Harvard University), Lars Feld (University of Freiburg, Institut Walter Eucken, and German Council of Economic Experts), Marcel Fratzscher (DIW Berlin and Humboldt University), Clemens Fuest (Ifo Institute and University of Munich), Pierre-Olivier Gourinchas (University of California, Berkeley), Philippe Martin (Sciences Po, and French Council of Economic Analysis), Jean Pisani-Ferry (Hertie School of Governance, Berlin, and Sciences Po, Paris), Hélène Rey (London Business School), Isabel Schnabel (University of Bonn, and German Council of Economic Experts), Nicolas Véron (Bruegel, and Peterson Institute of International Economics), Beatrice Weder di Mauro (Insead and University of Mainz) and Jeromin Zettelmeyer (Peterson Institute of International Economics)