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Transforming the European Stability Mechanism (ESM) into a “European Monetary Fund” has come to dominate the debate on euro area reforms, albeit no one has actually proposed it to become “monetary”. Instead, in a recent interview, Germany’s chancellor Angela Merkel raised the idea of a short-term credit facility for member states hit by external shocks. Countries satisfying certain conditions could receive an ESM loan for maybe five years, with the loan size capped and repayable in full.
While hardly a leap forward for euro reform in the eyes of most, this augmentation of the ESM’s lending toolkit could be quite meaningful – if it is done right. By providing a stronger backstop against coordination failures in financial markets, it better guards against crisis. And by rewarding compliance with European rules and sound economic policies, it sets the right incentives.
Needless to say, an ill-designed instrument can be dangerous. If conditions for access to the credit line are watered down, the ESM may have to lend to member states that pursue inappropriate policies or pose a credit risk. At the same time, the ESM may find itself between a rock and a hard place if it has to fear that cutting the credit line may trigger a crisis. Too-easy terms may lead to overuse of the facility, so that the ESM becomes a regular source to satisfy member states’ financing needs. But also the opposite may occur – that no member state ever signs up for the facility, a fate that has already befallen some existing precautionary instruments.
This blog post outlines some principles for incentive-compliant lending instruments before delving into some of the details of the design of a precautionary credit line. This may serve to inform the debate that is likely to unfold in anticipation of the euro summit at the end of this month. However, fleshing out the details of a new instrument’s design will take much longer. Hence, this blog post can only provide a starting point for a deeper debate. [...]