12 February 2016

VoxEU: The way forward - Coping with the insolvency risk of member states and giving teeth to the European Semester

The two challenges for the Eurozone are the specific insolvency risk to which the member states are exposed, which in the longer term it can only be eliminated by some form of debt mutualisation; and its insufficient coordination of fiscal policies and wage trends.

Due to its hybrid structure the eurozone will remain more crisis-prone than other major currency areas. A main challenge is the specific insolvency risk to which the member states are exposed. A formal insolvency regime would intensify this risk instead of mitigating it. With the OMT programme the ECB has provided a pragmatic and so far effective protection against this risk. But in the longer-term it can only be eliminated by some form of debt mutualisation. Schemes with large pools of joint debt would be met with strong political resistance and they would require more political integration. Therefore, as a first step, a mutualisation of debt amounting to 10% of the eurozone GDP should be envisaged. This would create safe assets of about 1.1 trillion euro that correspond with the volume of the ECB’s asset purchase programme and facilitate open market operations.  

In addition, the eurozone suffers from an insufficient coordination of fiscal policies and wage trends. So far the European semester has been a complete failure. Its recommendations for fiscal policy are too vague at the aggregate level and no attempts are made to translate them into specific recommendations for national fiscal policies. Wage developments in the eurozone suffer from an asymmetric adjustment. As a consequence, the aggregate increase in unit labour costs is incompatible with the ECB’s inflation target. In the country-specific recommendations this asymmetry is not addressed at all. Thus, the European semester needs a much stronger focus on the task of coordinating national fiscal policies and wage trends. A better coordination in these areas would lead to more symmetric and more balanced developments in the eurozone. This would reduce the need for monetary policy stimulation and avoid the negative side-effects that are associated with such an overburdening of the ECB.

Full article on VoxEU

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