16 July 2018

VoxEU: Risk sharing and market discipline: Finding the right mix

The euro area has two main fragilities. 

• First, because it does not have a lender of last resort that can support the sovereign, it is exposed to risks of financial crisis induced by sudden stops. 
• Second, it does not have a fiscal stabilisation tool to help monetary policy when interest rates are at the zero lower bound. 

The risk-sharing mechanisms financed by rainy day funds and the ex-ante ESM lending facility suggested in the Bénassy-Quéré et al. (2018) are too modest to address these fragilities. On the contrary, the proposals to enhance market discipline may destabilise the entire euro area, because they increase the vulnerabilities of countries with high legacy debts. More ambitious reforms are probably not politically feasible now. What should be done, then? 

• First, we should not make the system even more fragile, by removing shock absorbers or increasing the risk of debt runs. The CEPR Policy Insight is not careful enough in this respect. 
• Second, a fast reduction of legacy debts should be a priority for all. The asymmetries between countries induced by such debts are the main obstacle to reforms, and high debts are one of the main sources of instability. To achieve a faster debt reduction, institutional constraints on national fiscal policy can be strengthened. It is not true that external constraints have been ineffective. Fiscal policy in the euro area has been more disciplined than elsewhere, and progress in reducing public debts has taken place in several countries. Bénassy-Quéré et al. (2018) contains some useful ideas on how to make such institutional constraints less pro-cyclical and more effective. 
• Third, there is no reason not to complete the banking union, with the ESM acting as a fiscal backstop for the Single Resolution Fund and initiating a system of European deposit re-insurance.

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