Europe’s monetary union is still unfinished work

This article first appeared in The Edge Financial Daily, on June 26, 2018.
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LEADERS of the European Union (EU) meet in Brussels this week to discuss the future of the eurozone. In recent years, governments have strengthened the system a lot, making it less likely that a crisis in one member state would jeopardise the currency area as a whole. Even so, they have not done enough.

Today the eurozone is much more robust than it was at the start of the Greek sovereign-debt crisis. There is a rescue fund (the European Stability Mechanism); a tried-and-tested central bank equipped with new tools; and the beginnings of a so-called banking union. 

All this is valuable, but it falls short in two main ways. 

First, the banking union needs to be completed. Second, lacking the adjustment mechanism provided by individual exchange rates, the eurozone needs better ways to absorb economic shocks.

The good news is that Europe’s efforts to strengthen the system have put much of what is required in place. The European Stability Mechanism (ESM) is there to help countries should they lose access to capital. 

Governments have to apply for an adjustment programme, which offers financial support in return for fiscal discipline and structural reform. 

To be sure, the system bungled the case of Greece: Excessive fiscal restraint and the government’s lassitude on structural reform have prolonged the agony unduly. 

But Portugal, Ireland, Spain and Cyprus all benefited from the ESM’s intervention and are now expanding at a healthy pace.

In addition, European Central Bank (ECB) President Mario Draghi has ensured that the central bank has the tools it needs. The most important innovation is “Outright Monetary Transactions” — the power to buy unlimited quantities of short-term sovereign bonds once a country has applied for an ESM programme. This scheme is a vital backstop. Investors know the ECB can step in, so they will be more reluctant to bet against a country in financial difficulty.

The other big step was the banking union. The ECB has taken over from national central banks as the leading authority in overseeing the eurozone’s largest lenders. This has resulted in stronger oversight. 

The Single Resolution Board decides how to wind down a bank deemed “failing or likely to fail,” and can use funds for the purpose from the Single Resolution Fund. This ought to mean that individual governments don’t have to bail out a bank on their own.

The system faced a test just last month, when political instability in Italy caused a sharp sell-off in the country’s sovereign bonds. Other countries were also affected — but less than in the past. As Draghi put it, “Contagion was not significant. It was a pretty local episode.” The reforms have made the eurozone more resilient.

Nonetheless, the work is not complete. As yet, the banking union is not really a true banking union. The resolution fund, capped at €55 billion (RM258.23 billion), is too small. The ESM should therefore be empowered to support it when necessary, and to act without delay (since resolutions typically take place over a weekend).

The banking union also needs a joint scheme for deposit insurance, covering deposits up to €100,000. Germany is opposed, fearing it would mean perpetual transfers from its own banks and taxpayers to those of distressed member states. That need not be so. 

A strong safety net would help to prevent panics and thereby reduce the need for cross-border support. Germany should also recall that it had to deal with its own failing banks during the financial crisis. There is no reason to suppose that under a stronger collective system, the help would all flow one way.

Banking aside, the eurozone’s biggest challenge is to cope with economic shocks — especially those that strike one or more countries but not the zone as a whole. Once, exchange rates could move to help countries adjust to such shocks, making it easier to restore competitiveness without cutting wages, thus avoiding protracted recessions. Within the eurozone, that method is no longer available.

In principle, some of the shock-absorbing could be accomplished through capital markets. 

When a company goes bust in Tennessee, creditors and shareholders in New York and Texas share in the losses; Tennessee’s investors, by the same token, are not wholly invested in their home state, but hold assets across the American currency union. 

In Europe, in contrast, investors tend to keep their money closer to home, so financial risk is more concentrated in individual countries.

Eurozone leaders say they want to build a “capital-market union” like that in the US — but they have gone about it very slowly. 

A good next step would be to improve the capital-markets infrastructure by converting the European Securities and Markets Authority into a truly pan-European capital-market regulator.

Even if Europe had a US-style capital market, though, closer fiscal cooperation would also be necessary. In a single-currency system, monetary policy cannot be attuned to the needs of particular countries. 

And the eurozone’s rules on fiscal policy limit the use of budget deficits in fighting recessions. The system as a whole has a so-called deflationary bias, in effect asking too little of fiscal policy and too much of the ECB.

Last week French President Emmanuel Macron and German Chancellor Angela Merkel said they had agreed in principle to create a common budget (with its own taxes and spending) for the euro area. 

Unfortunately, as yet, there is less to the idea than meets the eye. 

The plan is vague, the proposed budget would apparently be small, and its main purpose would not be to provide economic stabilisation — which is the essential thing. 

Perhaps this budget could eventually turn into what is needed, but as the idea stands, it is far too timid.

Draghi suggested a more promising approach in a recent speech in Florence: Create a fund to disburse money according to cyclical conditions. For instance, the eurozone could launch an unemployment reinsurance scheme, which would replenish national funds when joblessness rose above a country-specific threshold. 

With this in place, governments could spend more on unemployment benefits or retraining programs without having to cut other spending or raise taxes.
German Finance Minister Olaf Scholz has endorsed a narrow version of this scheme, involving loans and not transfers. 

Berlin should go further. A well-designed joint unemployment insurance scheme would not entail the dreaded “transfer union,” since countries face different conditions at different times. In the early years of the euro, Germany had to contend with very high unemployment.

If the EU one day renews its commitment to ever closer union, it will need to consider other, more far-reaching, innovations. A genuine fiscal union, for instance, would involve substantial joint programmes for taxes and spending — in the limit, letting euro-zone budgets play the same role in Europe as the federal budget plays in the US Joint borrowing by means of a pan-European bond is another possibility. That is maybe not so remote as full fiscal union, though again it is not yet on the agenda.  

For now, a more limited set of changes is both necessary and urgent. Yes, the system is stronger than before, and an impressive achievement — but it is not strong enough to handle the next major crisis. Reinforce it now, or risk seeing it swept away. — Bloomberg