French President Emmanuel Macron and German Chancellor Angela Merkel say they want to make the common currency area more resilient and adaptable, but their two countries have traditionally disagreed over how that should be achieved. Can crack economists from the relevant countries solve the problem for them? They are giving it a shot — but building a European consensus will be hard.
A month ago, a group of 14 French and German economists co-authored a detailed proposal to bridge the policy differences between the two countries. Their main argument is that the euro area needs a combination of market discipline and risk sharing to reduce its vulnerability to financial shocks.
Last week, in a sign of how contentious the policy debate will be, a group of Italian economists issued a robust rebuttal. The Italian riposte argues that, far from fostering stability in the euro zone, the Franco-German proposal heightens the risk of financial chaos by asking too much from weaker euro-zone states.
Their critique centers around two main points. The first relates to a call in the Franco-German proposal for a mechanism to restructure sovereign debt when a country asks for financial assistance. The Italians argue that if the rules are too tight, they can prove self-fulfilling, prompting bond investors to flee a country with high debt.
The Italians also object to proposed rules governing bank failure: In the Franco-German paper, the authors would like the euro zone to be more stringent in preventing government bailouts. The Italians argue that there is a risk that “bailing in” investors in a situation of fragility could cause widespread financial panic.
So which team of academics is right? The ideas on “risk-reduction” put forward by the French and the Germans appear broadly sensible. The euro zone must take into account the possibility of restructuring sovereign debt before offering financial support to a member state. Not only is this a way to ensure that public funds do not bail out private creditors, but it also gives high-debt countries (think Greece) the chance of a fresh start.
Of course, a sovereign-debt restructuring mechanism should not be too rigid. For example, a recent proposal by the German Council of Economic Experts recommended setting debt thresholds above which a country applying for financial help should be forced to restructure. This idea ignored the simple fact that there are many factors that determine debt sustainability, including for example interest rate levels, the proportion of sovereign bonds held by domestic investors, or their average maturity. The Franco-German proposal rules out such simplistic triggers. Instead it asks more generally for a data-driven and transparent framework to determine when a debt must be restructured. This would limit the room for politicians to engage in the kind of “extend and pretend” which has been so damaging for Greece.
The Italians are right that there should be some discretion in determining when to impose losses on bondholders (the Franco-German proposal seeks to limit it). But, as the banking crisis in Italy has shown, these rules can be abused. The Italian government and the Bank of Italy did all they could to avoid bailing in bondholders of two Venetian banks, even though these lenders were too small to cause contagion. The ensuing rescue plan made a mockery of the EU regime for handling bank failure. The Franco-German economists are right to demand a stricter application of the rules.
The real problem with the Franco-German proposal is that it does not go far enough in terms of so-called “risk-sharing.” Take, for example, the plan to set up a stabilization fund to ensure that countries can rely on the help of fellow governments when they face an economic shock. The Franco-German economists propose that countries contribute 0.1 percent of gross domestic product each year. This is sufficient to help out a small member state, but would be plainly inadequate in the event a number of countries, say Italy and France, should get into trouble. The fund should have the capacity to borrow on the market if needed, but this is explicitly ruled out in the paper.
Similarly, on the banking sector, the Franco-German plan calls for the creation of a common deposit guarantee, which would protect depositors everywhere in the euro zone. Setting up a joint safety net is essential to ensure that governments do not have to handle a banking crisis on their own. However, the proposal demands that the European scheme prices country-specific risks in the calculation of insurance premia. It would also intervene only when the corresponding national funds are depleted. This would put some banking systems at a competitive disadvantage and perpetuate the problem of fragmentation. The euro zone should limit the risks in the banking system, for example reducing the level of non-performing loans and gradually cutting lenders’ exposure to sovereign debt. Once sufficient progress has been made, however, a truly joint deposit guarantee scheme should be rolled out as soon as possible.
The Italian economists should have called for more risk-sharing in the euro zone. However, this would entail a greater amount of prior risk-reduction at the national level — in the form of stricter rules on bank bailouts and debt restructuring — than they (or Italy’s government) are prepared to accept.
The hard truth is that, academic arguments aside, the two concepts go hand in hand. The more of both (risk-sharing and risk-reduction) member states are prepared to accept when the real negotiations begin, the better for the euro zone as a whole.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
To contact the editor responsible for this story:
Therese Raphael at [email protected]