22 December 2017

PIIE: A New Roadmap for EU Reform in 2018

The recent publication of the European Commission's new roadmap for completing the Economic and Monetary Union signals that progress toward economic reform in Europe is on track for 2018. Jacob Funk Kirkegaard analyses the Commission's four main proposals.

A new European Monetary Fund (EMF)

This proposal would convert the existing European Stability Mechanism (ESM), an emergency lending agency, into a new organization. As my colleague Nicolas Véron has noted, its name is inapt, in that it has nothing to do with monetary policy. Rather the proposal represents a return to an earlier proposal(link is external) by former German finance minister Wolfgang Schäuble of adding responsibilities to the ESM framework. The EMF would become the common fiscal backstop for the European banking union's Single Resolution Fund, for example, enabling it to join the management of future assistance programs and develop financial instruments to support European policy priorities. Logically, an EMF would also eventually become the fiscal backstop for a common European deposit insurance scheme to help manage future bailouts.

In terms of governance, however, the Commission's EMF proposals seem timid. By retaining the shareholding structure(link is external) and voting rights of the ESM, the EMF would let France and Germany continue to exercise vetoes over issues not governed by simple majority. (Italy would have a national veto over issues requiring reinforced qualified majorities). This arrangement is not suitable given the new fund's broader responsibilities. The proposal also does not mention additional financial resources, despite the obvious need if it is to live up to its new expanded mandate.

Integrating the intergovernmental treaty on stability, coordination, and governance into the regular EU treaty 

This proposal amounts to sensible legal housekeeping for which there is no pressing political or economic justification at the moment, but it may be opposed by several euro area member states regularly at risk of infringing European fiscal rules.

New budgetary instruments 

The aim is to promote economic convergence of non-euro-area members, help EU members design and implement structural reforms, and create a "stabilization function" in the EU budget to help preserve public investment during large asymmetric shocks. The first two objectives echo a previous German proposal to reward member states for undertaking reforms, but with new financial incentives, a worthwhile step though one with little economic impact across the EU.

A new stabilisation function

The proposed new stabilization function for the euro area aims to address economic shocks among member states. The euro area institutional architecture has long lacked a central shock absorber beyond ex post facto mechanisms like the ESM and the European Central Bank's Outright Monetary Transactions capability. The euro area needs a centralized capacity to quickly assist member states before they lose market access and have to be rescued outright.

The common currency area has in recent years been minimizing the risk of large asymmetric shocks through other means. The banking union is designed to help national governments cope  with the costs of a crisis among resident banks, but it does not protect against government revenue loss from an economic slowdown caused by a financial crisis; the EU's cash border deals with Turkey and various Libyan factions help insulate individual members from sudden refugee inflows; and French president Emmanuel Macron's broad idea of a European "Civil Protection Force" is envisioned to protect residents and governments of member states against sudden natural (and/or man-made) disasters. But a new euro area stabilization function is needed to protect against future crises.

Such a function does not need any permanent budgetary structures. Rather it needs a centralized euro area entity able to borrow and make financing available to member states that have lost market access.

Quick low-cost loans imply at least some fiscal transfer to troubled or errant states. If the International Monetary Fund's (IMF) historical experience with its different lending facilities(link is external), including the Flexible Credit Line (FCL) and Precautionary and Liquidity Line (PLL), are any guide, however, such financial savings tend not to be sufficient to convince a government to actually use outside funds, even when available on favorable terms.

To date, only three IMF members, Colombia, Mexico, and Poland, have ever used the IMF FCL facility and none of them has ever drawn on it, while only Macedonia and Morocco have ever used the PLL facility. Severe political stigma remains attached to countries' participation in such "hypothetical rescue programs," and concerns about moral hazard causing "objectively unneedy countries" to join such programs are vastly overblown. Indeed, the real risk is that no member state would use a new euro area stabilization function, even though peer pressure in the Eurogroup is higher than among IMF members.

Because of the history of states' reluctance to turn to the IMF, the European stabilization function must be designed to ensure that euro area members in need actually use it. The ESM/EMF has one important advantage in this regard: Due to very long lending horizons it can provide concessional loans at low interest rates, which greatly reduces the net present value of its loans. This has been done repeatedly with ESM loans to Greece(link is external).

Such stealth transfers through the ESM/EMF could make a new euro area stabilization function far more appealing to member states, especially if those transfers were also supplemented with grant-like transfers from the regular EU budget, which has that capability. Hence it would seem most sensible for the ESM/EMF to play the leading role in providing any stabilization financial assistance to member states, with the regular EU budget playing a potential supplementing role.

A crucial issue for quick access to any stabilization mechanism is the conditionality imposed. To encourage countries to take advantage of such aid, several terms for conditionality could apply.

The new EMF could start doing its own fiscal surveillance of member states, independent of the European Commission, granting automatic access to the stabilization mechanism if the EMF approves a member state's economic fundamentals. Automatic access as part of a more targeted EMF fiscal surveillance would also eliminate any political stigma of having to apply for the stabilization function. Qualifying fiscal surveillance of member states could also be part of the Commission's regular European Semester process, though given that EMF resources would remain intergovernmental, it seems unlikely that member states would want such surveillance carried out solely by the Commission.

Lending could also be limited to well-known high fiscal multiplier issues, such as a member state's public infrastructure investments, unemployment/pension benefits, educational expenditures, and other areas needing preservation in crises.

In the end, the European Commission's caution is understandable. The euro area does not need a huge new central budget. But it does require a new central budget function for quick financial support to member states. The Commission's roadmap can help get Europe's political leaders to such an institutional improvement.

Full article on PIIE

© Peter G Peterson Institute for International Economics