09 September 2011

Citi: The future of the euro area: fiscal union, break-up or blundering towards a ‘you break it you own it Europe’

Conventional wisdom suggests that there are only two possible destinations for the euro area: fiscal union or break-up. In this study, Citi's Willem Buiter and Ebrahim Rahbari suggest a third alternative as the most likelyeventual outcome: 'You Break it, You Own it Europe' (YBIYOIE).

The continuing sovereign solvency and liquidity crises in the euro area periphery and the closely related banking sector solvency and liquidity crises throughout the European Union (EU) are supportive of the view that the euro area and the EU either have too little Europe or too much Europe, but not the right amount of Europe. This in turn suggests that it makes sense to consider two scenarios for the evolution of the euro area and the European Union that are polar opposites. The first of these broad scenarios for the future of the euro area is a fiscal union or fiscal pooling for the euro area to complement the monetary union. The polar opposite is a break-up of the euro area (EA). But we will also present a third alternative – ‘You break it, You own it Europe’ or YBIYOIE, which will comprise the minimum institutional, fiscal and regulatory framework to ensure the long-term survival of the EA.

We will argue that fiscal union has its merits, particularly if it comes in the ‘fiscal federalism’ rather than the ‘Transfer Europe’ or the ‘E-bond’ variety, but will not be the direction the EA will take over the medium term, mainly because the appetite for further political integration and in particular for potentially uncapped and open-ended cross-border fiscal transfers is running low both among the EA’s electorate, notably in the fiscally strong core EA countries, and among its political elite. We will also argue that we do not expect the EA to break up, both because the political capital invested in the ‘European project’ remains large and because from an economic perspective an EA break-up would be very costly as well. EA exit by one of the fiscally and competitively weaker economies would be very costly for the exiting country involved. EA exit by the core EA Member States would still be very costly for the ‘abandoned’ EA periphery countries (but likely slightly less costly than EA exit by the weaker EA states) and costly for the exiting countries and for the global economy.

Instead of either of the two polar solutions, we expect the euro area to evolve, in the medium term and in a higgledy-piggledy fashion, towards YBIYOIE. YBIYOIE stops well short of a full federalist structure. Yet it would remedy the existential shortcomings in the design of the euro area: It comprises i) large enough liquidity facilities to prevent illiquid, but insolvent EA sovereigns and banks from being forced into default by way of a market ambush; ii) a debt restructuring mechanism for insolvent EA sovereigns; iii) a special resolution regime for EA banks and a Euro-Tarp for sibanks and other SIFIs.

One important beneficial consequence of these institutional arrangements is that the legitimacy of the top decision-making bodies of the EU and the EA would be strengthened. This is particularly true in the case of the ECB, which would be able to extricate itself from its unwanted and unwelcome role as provider of quasi-fiscal solvency support to troubled EA sovereigns and banks. A second beneficial consequence of the gradual institutional reform process leading to YBIYOIE is that losses from imprudent behaviour by banks, sovereigns or investors would no longer be socialised – YBIYOIE would only include very limited ex-ante bail-outs or subsidies and would thereby reduce rather than promote future moral hazard.

It may appear rather fanciful to ruminate about the ability to prevent, mitigate or resolve future crises when the outcome of the current one is still in the balance. As regards the resolution of the current EA sovereign and EU banking crises, it will most likely involve a mixture of the fiscal union and the YBIYOIE archetypes of enduring monetary unions – but importantly, no EA break-up. Capped (and possibly time-limited) issuance of E-bonds for specific purposes, such as recapitalising parts of the EA banking system, continued outright purchases of EA sovereign debt at abovemarket prices and continued lending against collateral of questionable value to EA banks by the ECB and further partial bail-outs of sovereigns and banks will imply substantial, but limited ex-post fiscal and quasi-fiscal transfers from the core to the periphery of the EA (and also from taxpayers in the core to investors in the core, including sovereign creditors and bank creditors). These transfers will be the price to be paid for the fact that the design of the eurozone was fundamentally incomplete at its inception. But the likes of Germany, the Netherlands, Finland, Austria, Slovakia and Slovenia will push hard both to prevent future ex-ante bail-outs and subsidies, and to include a substantial element of YBIYOIE as part of the resolution of the current crisis, insisting on private sector involvement in the near-inevitable debt restructuring of the insolvent EA sovereigns and of insolvent EU banks.

Our view: The road ahead will still be rocky. Volatility in financial markets will remain high. EA policymakers and the ECB will not be proactive and will continue to disappoint. Jean-Claude Trichet or his successor, Mario Draghi, will neither guarantee vast amounts of EA bank debt, pre-announce the capping of yields for EA sovereigns, nor take enough of the toxic assets of EA banks off their balance sheets at prices that make today’s effectively insolvent banks solvent again. Merkel and Sarkozy will not agree to unlimited E-bond issuance. Progress will generally be preceded by, and indeed dependent on, repeated crises and it will be painfully slow.

But make no mistake - the EA does have the institutional and political capacity to take the necessary decisions to deal with the near-term problems and to make the necessary reforms to ensure its long-term survival. Even if fiscal union is out of the question for the foreseeable future, EA break-up does not necessarily follow. On the contrary, once the crucial elements of YBIYOI Europe are in place, there is little doubt that the EA will be in a much stronger position to prevent and withstand further crises than before. Until then, better bring a helmet.

Full study

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