17 October 2017
By Andrew Watt
Those who wish to leave – so a German saying – you should not seek to dissuade from so doing. To few people is the phrase more applicable than to Wolfgang Schäuble who is resigning the post of German finance minister and, with it, that of de facto head of the Euro Group. He held these roles since 2009, that is virtually since the onset of the Euro Area crisis. While the crisis and the associated double-dip recession was a failure that had many fathers, Dr. Schäuble was arguably the most wanton of those who, to paraphrase Keynes, blundered in the control of a delicate machine, the working of which he does not understand.
On the other hand, the fact that someone who has caused much harm is leaving an influential post does not mean that his or her influence falls to zero. His arty certainly remains the dominant force in German politics. Nor, alas, does it necessarily mean that the successor will be an improvement: it seems likely that he or she will come from the liberal FDP which campaigned on a manifesto of rejecting any form of transfers or bail-outs, and threatening countries that fail to meet tough fiscal targets with being forced out of the single currency.
At his last Eurogroup meeting the departing German finance minister left a chilling message of his own in the form of a short non-paper (read the paper below) on European economic policy. I will go through point by point, but the spoiler is simple: it represents a doubling down of believers in Maastricht and a complete rejection of all the risk-sharing and stability-promoting ideas tabled by the European authorities and, most vividly, by French President Macron.
Reasonable Principles, Dangerous Operationalisation
The non-paper enunciates three basic principles: fiscal responsibilities and control must be kept together (aka avoid moral hazard); Member states need to be forced more effectively to implement structural reforms; and credible stabilization functions are needed to deal with global or domestic shocks. There is not so much wrong with the principles themselves; it is the ends to which they are put and the way they are operationalised.
The first principle could be used to justify increased risk sharing and transfers, going hand-in-hand with greater pooling of economic policy responsibility. This is rejected out of hand as unrealistic, however. Instead a European Monetary Fund (growing out of the existing European Stability Mechanism) is proposed. The EMF would be able to provide emergency lending to member states (like its international name sake), including, subject to conditions, for bank resolution. It would have powers to monitor national economic policy in normal times and impose conditionality in countries in trouble. The threat to let recalcitrant countries go bust would be made credible by, amongst others, introducing state insolvency procedures: a package of measures would ensure that private bondholders would be bailed-in to any default or debt restructuring; as a corollary the zero risk rating on government bonds would be removed.
The non-paper explicitly rejects a role for the EMF/ESM as a fiscal capacity providing transfers (and even backstopping a European deposit insurance). The reason given is terse to the point of meaninglessness: it “would put much too great a strain on the ESM and go against its core purpose of bailing-out countries in severe trouble”.
This approach may seem superficially attractive. The moral hazard point is (if applied judiciously) not wrong. And many left-leaning economists are in favour of private-sector bail-ins to prevent ordinary taxpayers being put on the hook for, ultimately, the excesses of the financial industry. Yet the approach is hugely dangerous on a number of levels. It is also, I argue, politically unworkable.
First, in a very real sense it effectively abandons elements of monetary union altogether and brings back characteristics of the previous European Monetary System (EMS). Even in relatively stable times countries perceived as weak would pay an interest premium over “hard-currency” countries, just as they did in the EMS; it would just reflect the probability of default rather than depreciation. This would, by itself, tend to perpetuate and even exacerbate income differentials within the monetary union. A key incentive for former “soft currency” countries to sign up to the Euro would be removed. (It is true that the substantial lowering of interest rate differentials on joining monetary union, created some problems for periphery countries, but the answer would have been tighter fiscal policy and/or macroprudential policies). German economists tend to emphasise incentive compatibility: but they have failed to consider (or maybe simply do not care about) the incentives of the majority of Euro Area members, who would be effectively tied into a system that, for them, combines the disadvantages of the EMS and the EMU.
Secondly, and much more insidiously – this is not made explicit, indeed it is actively concealed – the job of imposing discipline on national economies is left to the financial markets, that is to that institution that the financial crisis, at the latest, revealed to be systematically incapable of consistently providing measured, fair and predictable assessments of credit-worthiness.
Worse, the fickleness of financial market assessments would suffer from and be amplified by massive cumulative causation properties: any worsening of the economic or fiscal outlook would – perfectly rationally – lead to an increase in risk premiums and interest rates. This would exacerbate the cost of debt servicing, worsening the fiscal outlook and, via knock effects on private loans, also depress the economy, further worsening also the capacity to service debts. Less catastrophically, but in terms of economic management also worryingly, cumulative causation would work the other way, too. The bifurcation tendencies of the pre-crisis years would return with a vengeance. One must really have received a very thorough ordoliberal training not to be able to see that this achieves the exact opposite of creating stability. In order to spite the face of moral hazard this approach cuts off several noses, and makes the Euro Area an economic area in which sudden crisis can appear at any time for the smallest real-economic reason and even, ultimately, from an entirely spurious shift in financial market sentiment.
Last but not least, imposing a risk weighting on state bonds creates a risk which taxpayers then have to compensate bond-holders for taking on. Interest payments will crowd out other sending priorities to a greater extent. The private sector produces risky assets with high returns at will. Only the state can provide (nominally) risk-free, low return assets. In normal times there is considerable demand for such assets. And that demand rises precipitously in a crisis. If countries are not then able to issue (nominally) risk-free debt, crises are much more likely to be self-fueling: this was a crucial lesson of the Euro Area crisis and a fundamental difference between the Euro Area countries vis-à-vis non-members like the US. One wonders what other country/monetary union would be mad enough to voluntarily deprive itself of the ability to create risk-free assets?
On the second principle I can be much briefer. The insistence on “structural reforms” is predictable. The phrase is, though, in itself meaningless. Reforms that genuinely do raise productivity (or employment) are anyway in the national interest and there is no overriding reason why incentivizing them should be a crucial issue for EU or EMU policy. Voters in country A can vote out the government that fails to implement welfare enhancing reforms; whether or not they choose to do so is not a matter of great concern to Country B. Many structural reforms – that are based on cost cutting – have negative externalities, indeed they only work as a beggar-thy-neighbour mechanism. The principle – and the rather confused language in the non-paper about budgetary support for reforms – is merely testament to an erroneous belief that supply side is the key to managing the Euro and that there is a clearly identified set of reforms that need to be implemented in all countries.
Given that the measures proposed under the first principle would – depending on how they are implemented, possibly dramatically – increase the instability of the Euro Area, the emphasis on principle 3, the need for stabilization capacity seems odd. Nevertheless it is doubtless correct in itself.
And not all the points raised by the non-paper are entirely wrong-headed. The national automatic stabilisers do have a role to play. (However, so-called structural reforms have tended to weaken them. As I have long argued there is a cross-border externality here that would justify making strengthening of national automatic stabilisers an issue of common concern, subject to monitoring and benchmarking at the European level to bring about an upward convergence). The fiscal rules areindeed excessively complex and dysfunctional. (However, a reform should not focus on debt and deficit levels per se but tie the fiscal stance symmetrically to the national inflation rate/output gap).
Yet the main firepower here is directed to shooting down all ideas involving common debt-raising capacities, automatic cross-border stabilization (e.g. through a EU unemployment insurance fund) and debt mutualisation of any kind. The cursoriness of the argumentation given the importance of the issues and the amount of debate and literature on them is hard to interpret otherwise than as an expression of an attitude that force of argument is not required as the authors have the argument of force on their side.
For instance the hundreds of pages of detailed study on an EU unemployment system in its myriad possible manifestations are swept aside with the terse rebuff that it “would have to deal with very different income levels in the Euro area”. So? A new common debt capacity “would only buy time and repeat national mistakes of the past”. One scratches one’s head. No evidence is provided for the airy and implausible claim that there is no demand for a safe asset, while debt mutualisation would allegedly, far from stabilizing, actually “put the stability of the whole Euro area at risk”.
I am decidedly not a paid-up member of the Varoufakis fan club, but if this is the level of debate within the Eurogroup, then the former Greek finance minister at least has a point with his critique.
Status Of And Reaction To The Non-Paper
To sum up the above analysis, Wolfgang Schäuble’s parting gift to the Euro Area is a recommendation, first, to destabilize the Euro Area through measures (sovereign debt restructuring) designed to remove moral hazard, second to reject the most prominent various measures on the table in the direction of a deepening of economic policy integration and, third, instead to rely on “structural reforms”, a deepening of the Single market including a true banking and capital union to bolster resilience. There is nothing on the table here to encourage crisis-hit countries to see their future and economic advantage firmly in continued Euro Area membership. And nothing to indicate to the European institutions – who have jointly signed up to the idea of deepening EMU – and the new French President that Germany is willing to jump over its own shadow,m despite some warm words from the Chancellory in recent weeks.
Of course it is a paper from the German finance ministry. Schäuble is responsible to German voters. At least in a short-term perspective, some of these measures might be in Germany’s interest. The CDU, Merkel, and Schäuble personally, has certainly not been harmed electorally. Yet Germany’s interests cannot be divorced from those of its partner countries within the EMU in the medium and longer run. In any case a vision going beyond national borders that takes account of partners’ interests must be expected of someone of Schäuble’s stature.
Under these circumstances I have no sympathy whatever for those political obituary writers who hailed, even when critical of Schäuble’s policy stances, the outgoing German finance minister a Great European. That may be Mr. Schäuble’s sincerely held belief. But in real terms nothing could be further from the truth. Unnecessarily deepening and prolonging the crisis and calling for a fundamentaly unstable monetary union is not a European legacy to be proud of.
Wolfgang Schäuble is leaving the finance ministry. But most of its senior officials will remain. A finance minister from the FDP, whose election manifesto argued in a similar vein to the non-paper, seems likely. This short non-paper cannot therefore be dismissed as a mere parting shot, as some have done, but must be taken seriously as a statement of intent going forwards by the leading European power.
Those within Germany with influence must make it count to ensure that this potentially disastrous line is not followed: it’s a big ask, but, liebe Grüne, Europe needs you now. Meanwhile those outside Germany must mobilise a coalition that that makes it clear that this approach can never be a blueprint for a stable Euro Area and never be acceptable to the large and heterogeneous group of countries that (rightly or wrongly, it now matters little) were permitted to join the common currency. That currency is destined to collapse already in the next downturn if such a plan were to be implemented.
This article originally appeared on the author’s blog.
*Andrew Watt is Head of the Department Macroeconomic Policy Institute (IMK – Institut für Makroökonomie und Konjunkturforschung) in the Hans-Böckler Foundation. He was previously senior researcher at the European Trade Union Institute.
Non-paper for paving the way towards a Stability Union
In parallel to keeping the EU 27 together, improving the short-, medium- and long term governance of the EMU is indispensable, along the following three core principles:
(1) We must keep fiscal responsibilities and control together, to avoid moral hazard.
(2) We need better instruments to foster the implementation of structural reforms.
(3) We need credible stabilization functions to deal with global or domestic shocks.
(1) Fiscal responsibilities and fiscal control belong together, whatever it takes. On the institutional side there are two possible ways that should ensure this symmetry: Either we transfer parts of national sovereignty and control of fiscal rules to the EU level (“Euro Finance Minister”), together with a greater democratic legitimacy. This would certainly require EU treaty changes to be credible. Or we agree on an intergovernmental solution. As long as there is little willingness for treaty changes, we should follow a pragmatic two-step approach: Intergovernmental solution now, to be transposed into EU law later on.
The European Stability Mechanism (ESM) is the right vehicle for such an intergovernmental solution. The ESM has proved its worth since it was established in 2012. It embodies the principle of providing solidarity in return for sound public finances. The ESM has a welldeveloped crisis-management system with a set of instruments and financial capacities at its disposal. They are kept ready for the ESM’s core function, namely to provide temporary financial support under strict reform conditionality.
The ESM, to become a European Monetary Fund, has to devote more resources to better crisis prevention: The ESM does not yet have a mandate to carry out crisis prevention or to help reduce risks at an early stage. It is therefore important to expand the ESM’s radar and give it a stronger role in terms of monitoring country risks. The aim is to identify, in cooperation with other institutions, stability risks for and in Eurozone member states more effectively and at an earlier stage than in the past, and to monitor these risks so that they can be reduced by the affected countries themselves. The IMF’s Article IV consultations could serve as a blueprint for this new role.
Such a role for the ESM should also include monitoring compliance with the Member States’ obligations under the Fiscal Compact that was adopted in 2012. The ESM could gradually be given a stronger, neutral role with regard to the monitoring of the Stability and Growth Pact. Tasking the ESM later on with the complete monitoring of compliance with the Fiscal Compact and the European fiscal rules would make it necessary to amend both the Fiscal Compact and the ESM Treaty.
A second new ESM mandate should include a predictable debt restructuring mechanism to ensure fair burden-sharing between the ESM and private creditors. The rationale is: In the future, private investors would benefit from having better risk-related information, which the ESM would provide.
Logically, these investors would then also have to contribute if, contrary to expectations, a country did indeed get into difficulties and required ESM assistance again. As well as the new analysis-related functions, the ESM should therefore also take on responsibility for the future debt-restructuring process and its coordination. The important aim is to provide the private sector with clear and predictable principles ahead of time, to avoid ad hoc solutions.
The following elements should be incorporated into the legal text of the ESM Treaty: (a) the automatic extension of the maturities of sovereign bonds in the event that an ESM programme is granted, (b) the obligation to carry out comprehensive debt restructuring if this is necessary to ensure debt sustainability, and (c) for the purpose of preventing holdouts, an amendment of the collective action clauses that were introduced, moving to “single limb aggregation” (i.e. a requirement for only one vote on the debt restructuring of all the bonds involved without additional votes on the individual bond series).
On the Banking Union side, further significant risk reduction is necessary, including the regulatory treatment of sovereign bonds. Current proposals on risk reduction need to be stepped up. Only on this basis the ESM could play a backstop role in financing of bank resolution. If, at the end of the ongoing discussion process, we do decide to mandate the ESM with a backstop function in the form of a credit line for the SRF, it would also require an amendment to the ESM Treaty. This is because the ESM Treaty in its current form only provides for assistance to support Member States, but not to support institutions such as the SRF.
J.-C. Juncker has currently proposed to alternatively use the EU budget as a back stop. There is a whole range of open questions in this context. If such a backstop is created at the ESM, an amount of approximately €55 billion (= target level of the SRF) would have to be reserved for this purpose. In this respect, it would seem reasonable to carry out, in parallel to the creation of this new instrument, a critical review of direct bank recapitalization, an existing instrument that is less practical, but much riskier (€60 billion is reserved internally at the ESM for this purpose). As part of an overall package, we should be open to eliminate the instrument of direct bank recapitalization.
More ambitious scenarios and plans for the ESM and its financial capacities, either regarding the possible role as an additional backstop for the controversial European Deposit Insurance Scheme, or regarding a brand new fiscal capacity as a transfer mechanism for the Eurozone would put much too great a strain on the ESM and go against its core purpose of bailing-out countries in severe trouble.
(2) On the implementation of structural reforms we have to increase ownership by the concerned countries themselves. Structural reforms are necessary to modernize economies and to catch up with the rest of the Eurozone and with global developments. Mutualizing existing or future challenges instead of tackling them would end up in a weakened currency union as a whole. Structural reforms might be costly in the short term. We should therefore examine ways to incentivize reforms. Do we need another new and intergovernmental fiscal capacity? Not necessarily. The EU budget is under review anyway and members are expected to contribute more in future times to compensate for the Brexit. Hence there is some leverage to set new and sound priorities towards a future budget, also supporting the Eurozone.
The Commission has made interesting proposals for improving the EU budget. In this respect we should examine whether future Euro members´ contributions to the EU budget could be better linked with structural reforms in the Euro area, based on the Commission`s country specific recommendations (CSRs). This approach based on EU budget and on CSRs would, compared to any alternative intergovernmental approach, ensure the important role of the Commission and allow an integrated EU-policy, linking policy coordination (European semester with CSRs) with cohesion policy (structural funds) and the EU-budget. Following J.- C. Juncker´s speech, this approach could prepare a nucleus for a Eurozone budget. Once established, it should be evolved further, based on solid financing and own revenues.
(3) On the stabilization function we have to much better use the national automatic stabilizers to absorb shocks. The flexibility in our fiscal rules exists exactly to allow them to work. Prerequisite for that is of course that member states create the necessary fiscal room for maneuver by sticking to their budgetary objectives. The idea of the Medium Term budgetary Objectives (MTO) is precisely to build buffers for the absorption of shocks.
The IMF is right to conclude in its Art. IV consultation that the European fiscal rules have unfortunately become much too complex and less predictable. This is why we have to develop these rules further, with the debt rule at least on an equal footing with the deficit rule. As long as national debt is on a declining path, national deficits could be treated flexibly.
A macroeconomic stabilization function e.g. through a new fiscal capacity or unemployment insurance is economically not necessary for a stable monetary union. Countercyclical public spending is never in time and a Euro zone-wide unemployment insurance would have to deal with very different income levels in the Euro area. Our developed welfare states in the EU make a large difference to the US: they work as significant automatic stabilizers – if the member state concerned has the fiscal margin (MTO).
In addition to that, we have to look closer at our Single Market of the EU 27. A more flexible single market would be able to better absorb shocks, especially those hitting single member states (so called asymmetric shocks). Banks in a true banking and capital market union can maintain lending even if one member state is in a crisis because banks can better work cross border and are supervised at EU-level. And better migration within the EU 27 could offer a much stronger possibility to keep unemployment – especially for young people – under control in case of crisis.
Decreasing convergence is often due to national structural factors and cannot be overcome through a fiscal capacity. A new stabilization function in form of a new Euro debt capacity would only buy time and repeat national mistakes of the past. It would be much more efficient to support reforms to increase resilience through effective policy coordination and in future through a well redesigned EU-budget (see above).
Debt mutualization would create wrong incentives, raises fundamental legal issues and would therefore put the stability of the whole Euro area at risk. Whatever the future name will be: For European Safe Bonds or Sovereign Bond Backed Securities (some would call them “new Eurobonds”) there is no demand in the market. We must be able to create real stability through reforms, not through complex and expensive financial engineering.