13 July 2017

VoxEU: Completing EMU

This column discusses the ideas presented in a new Commission Reflection Paper aimed at relaunching the debate on how to move forward, with a focus on bridging the differences between the member states that stress responsibility and risk reduction and those calling for solidarity and risk sharing.

1) Completing Financial Union to increase risk sharing and reduce legacy risks

An integrated and well-functioning financial system is essential for an effective and stable EMU. Building on what has already been achieved in recent years, a consensus needs to be found on the way forward, including implementation of the elements agreed already, deciding quickly on the other elements that are on the table, and agreeing on additional steps to take between now and 2025.

Reducing risks from and increasing stability in financial markets

The first priority should be to complete the Banking Union. The package to reduce risks in the banking sector put forward by the Commission in November 2016 represents a priority and needs to be concluded swiftly. An agreement on the backstop to the Single Resolution Fund is essential to make the new EU framework for bank resolution effective. Equally crucial is the setting up of the European Deposit Insurance Scheme to ensure that bank deposits are protected to the same extent across the Eurozone. The two measures should be adopted as soon as possible – ideally by 2019 – to be in place and fully operational by 2025. Other elements of the Financial Union should also be achieved by 2019. First, a comprehensive strategy to reduce the non-performing loans should be agreed and implemented. Second, the capital markets union shall be further developed to provide more innovative, sustainable, and diversified sources of funding for households and businesses. As part of this process, a review of European Supervisory Authorities should be undertaken as well as first steps towards a single European capital markets supervisor.3 The acceleration of the Capital Markets Union will contribute to creating a more integrated capital markets in Europe. This would be helpful to increase the capacity of financial markets to absorb shocks (risk sharing through private channels), which is still too low in EMU, and to recycle excess savings in surplus countries to the rest of the Eurozone via equity rather than debt, thereby reducing the risk of financial instability

Addressing risks from sovereigns to banks as well

While the Banking Union and the Capital Market Union will reduce the stress that the banking sector can create for the public sector, the other direction of the 'doom loop' – from sovereigns to banks –remains only partly addressed. Sound fiscal policies and the reduction of public debts will reduce the risks that sovereign bond developments can generate for banks. However, in the presence of a single monetary policy and full capital mobility, keeping the European financial system based on national bond markets creates the scope for sudden shifts of capital between these markets, which puts at risk the stability (and convergence) of the Eurozone (van Riet 2017).

Greater diversification of banks’ balance sheets would help to address the problem of interconnection between banks and their ‘home country’. The Reflection Paper suggests that one possibility of promoting more diversification could be the development of so-called sovereign bond-backed securities (SBBS), as explored by Brunnermeier et al.(2016b). Nevertheless, the Reflection Paper acknowledges that SBBSs are unlikely to become sizeable enough to become the benchmark for European financial markets with the potential to be comparable to US treasuries or Japan's government bonds.

A possible reform of the regulatory treatment of sovereign exposures (RTSE) has been raised in the discussions on how to deliver the Banking Union as an additional measure to sever the bank-sovereign loop. Several options have also been considered to that end (ESRB 2015). However, a possible reform of the RTSE could only be considered once the Banking Union is completed with a functioning backstop to the Single Resolution Fund and a common deposit insurance, and a suitable common European safe asset is in place (and changes to RTSE should be compatible with and supporting it). In addition, such a reform should be coordinated at the global level to ensure a level playing field.

A truly European safe asset

Experience has shown that at times of stress, the current structure of the sovereign bond markets in Europe, and the large exposure of banks to their national sovereign, have amplified market volatility, affecting the stability of the financial sector and the real economies of the Eurozone member states.

Hence, to fully eliminate the 'doom loop', a more ambitious solution changing the structure itself of the European bond markets is necessary. This would require, in the medium term, the development of a genuine Eurozone safe asset (Moscovici 2017). That will also help develop a Eurozone yield curve, important to facilitate both the conduct and transmission of the monetary policy and foster long-term investment and risk capital. It is also essential that the Eurozone be equipped with an asset class that matches more closely the weight of its economy, and offers an alternative investment opportunity for third countries currently investing in the EU mainly in equities. A truly European safe asset should preserve the capacity of governments to finance themselves at reasonable costs and with continuous market access, but at the same time it should improve the incentives for sound budgetary policies.

To deliver its full potential, first, the European safe asset should carry the lowest possible credit, market, liquidity, contagion, and supply risks – compared to other such assets in Europe and globally – and have a sufficiently transparent structure to allow investors to price it with ease and to be considered of the safest standard. Second, the European safe asset should be sizeable enough to become the reference bond for collateral and liquidity purposes in the Eurozone and to meet global demand. Third, it should encompass a wide maturity structure that can serve the objectives of various investors, including those with a very long-term horizon.

In recent years, several proposals have been put forward with different design features to create a European safe asset, ranging from full to partial or common issuance, some based on mutualisation and others entailing no joint liabilities (European Commission 2011). Figure 3 illustrates the various options put forward in the literature and how they fare in the trade-off between liquidity, stability, and governance on the one hand, and incentives and discipline on the other hand. Eurobonds – with full mutualisation of liabilities – have significant potential benefits in terms of size, liquidity, and pooling of risks, but could have large drawbacks in terms of distribution of legacy debt and incentives for future national policies. Partly mutualised common issuances such as the "Blue Bonds" (von Weizsäcker and Delpla 2010) could attenuate both positive and negative effects of a full mutualisation. Pooling of sovereign bonds and tranching of the common issuance – as the SBBS mentioned above – could avoid mutualisation by shifting all risks to private holders, but may not be sufficiently sizeable. A reverse approach – doing first the tranching of sovereign bonds and then the pooling of the common issuance within a reasonable size – would also avoid the transfer of risks and mutualisation across member states.4 Proposals of this type include E-Bonds (Monti 2010) and the Eurobills (Philippon and Hellwig 2011, Bishop 2013). Any further reflections in this area – which has been announced by the Commission – would need to focus on the necessary features of such an instrument, to make potential benefits materialise.

Achieving a better balance between market discipline and fiscal surveillance to promote reforms and fiscal responsibility

Achieving a more effective market discipline could allow a better balance in the way governance in EMU works. This requires first of all addressing the uneven stringency with which markets have been exercising their role in disciplining fiscal policies over time and across the Eurozone. The need to revive market discipline should be addressed without creating the risk of sudden stops (Philippon 2015). The recent evidence is that market discipline operates too late and in an abrupt fashion under the current framework. A new institutional regime (including a truly European safe asset) compared to the current (crisis) and pre-crisis regimes could increase the degree of ‘linearity’ in financial market reactions and help avoid ‘cliff effects’ in interest rates generated by perceptions of redenomination risks. The completion of the Banking Union and the setting up of the common Eurozone safe asset could allow risks pertaining to excessive exposures to sovereign bonds to be recognised and – supported by stronger economic, fiscal, and financial integration over time – would also open the door to simplifying the current EU fiscal rules based on the Treaty concept of avoiding 'gross policy errors' (Article 126.2).5

2) Achieving a more integrated Economic and Fiscal Union

The Five Presidents' Report (along with others, such as Enderlein, Letta et al. 2016) already recognised the convergence towards more resilient economic and social structures in member states as an essential element for a successful EMU in the long run. There exist several instruments that could be used better to achieve this goal, such as: (i) strengthening coordination of economic policy under the European Semester; (ii) reinforcing links between national reforms and existing EU funding; and (iii) further developing technical assistance to member states to support capacity development.

Convergence towards resilient economies – able to withstand shocks and recover quickly to potential – is fundamental for improving the functioning of EMU. The experience of the past years has shown how lack of resilience in one or several economies of the Eurozone can have persistent effects not only on those countries concerned, but also on other member states and the Eurozone as a whole. Resilience also fosters cyclical convergence and the effectiveness of the single monetary policy. Ultimately, policies identified as having a material impact on economic resilience in EMU could become part of the convergence standards – advocated by the Five Presidents' Reportand the Reflection Paper. Compliance with these standards would be a requirement to access the new stabilisation capacity.

Creating a central stabilisation capacity

The concept of Fiscal Union being intimately connected to national sovereignty creates strong emotional reactions. In reality, a minimalistic interpretation is warranted, without transfer of competences in the areas of allocation and distribution, which would remain under national control. The Fiscal Union could be built on a set of fiscal surveillance rules codified in a simplified Stability and Growth Pact, on a fiscal backstop for the Single Resolution Fund, and on a stabilisation capacity.

The Five Presidents Report made a case for a central fiscal capacity in the Eurozone to improve macroeconomic stabilisation of the Eurozone,6 providing guiding principles: it should not lead to permanent transfers, should minimise moral hazard, and be strictly conditional on clear criteria and continuous sound policies; it should be developed within the EU framework; and it should not duplicate the role of the ESM. There are several options for setting up this function, which the Commission will look into, that are not mutually exclusive:

• A European Investment Protection Scheme would protect investment in the broad sense, in the event of a downturn by supporting well-identified priorities and already planned projects or activities at national level, such as infrastructure or skills development.
• A European Unemployment Reinsurance Scheme would act as a ‘reinsurance fund’ for national unemployment schemes. The scheme would provide more breathing space for national public finances and help economies to emerge from the crisis faster and stronger. The unemployment reinsurance scheme would, however, probably require some prior convergence of labour market policies and characteristics.7
• A rainy day fund could accumulate funds on a regular basis. Disbursements from the fund would be triggered on a discretionary basis to cushion a large shock. The rainy day fund, however, would normally limit its payments strictly to its accumulated contributions.

Stabilisation from these instruments should be delivered in the case of large shocks – it should not be a fiscal fine-tuning exercise. To increase its stabilisation effects, the function should be equipped with the capacity to borrow. This would need to be accompanied by a design that clearly provides for savings at other times and limits indebtedness. Finally, a Eurozone budget could ensure broader objectives, covering both convergence and stabilisation, and would need a stable revenue stream. More importantly, though, it implies a more significant transfer of competences to the European level. It is therefore a far-reaching option for which further integration progress would seem needed before it can become a concrete possibility.

3) Strengthening Eurozone institutions and accountability

For EMU to be stronger, member states must accept to share more responsibilities and decisions on euro area matters, within a common legal framework. There is a need for a “quantum leap in institutional integration” (Draghi 2015). Completing the EMU means greater democratic accountability and higher transparency about who decides what and when at each and every level of governance. The European Parliament and national parliaments need to be equipped with sufficient powers of oversight, including by extending and formalising the dialogue between the European Parliament and the other institutions acting on behalf of the Eurozone, starting with the Eurogroup, whose members remain accountable to their national parliaments. Further political integration could involve a rethinking of the functioning of the Eurogroup as a formal and more transparent decision-making body and could justify the appointment of a full-time, permanent Eurogroup chair, which could be merged with the Member of the Commission in charge of EMU. The unification of the Eurozone's external representation should also proceed. Several competences and functions could be regrouped under a single umbrella provided by the Eurozone Treasury, as the institutional envelope for the functions of the Fiscal Union, within the EU framework. The Treasury – possibly with a Eurozone budget – could be responsible for the economic and fiscal surveillance, the macroeconomic stabilisation function, and the issuance of the European safe asset (including all issuances currently made by European institutions).

The European Stability Mechanism (ESM) in its current form provides liquidity assistance to member states and in the future could act as a common backstop to the Banking Union, which needs to be put in place as soon as possible. The ESM could evolve into a European Monetary Fund (EMF) to give the Eurozone more autonomy from other international institutions when it comes to financial stability. Different possible designs can be envisaged in the more general framework of the possible creation of a Eurozone Treasury. For instance, the EMF could be the financial stability arm of the Treasury. As a pre-condition, it is important that the ESM or this evolved EMF is integrated into the EU legal framework to improve the efficiency of its decision making and to allow adequate oversight by the European Parliament. [...]

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