by Abel M. Mateus*
The Euro was created as a single currency area with a centralized monetary authority, the ECB, but with a decentralized fiscal system, with fiscal discipline that was relaxed over time and seriously compromised by sovereign over-borrowing, threatening its own existence. Large public deficits, over-borrowing by some states and credit booms by other countries, led to a crisis that tested the solidarity principle versus no bail-out clause implicit in the EU Treaties. The crisis started as a limited peripheral over-debt crisis and is now spreading to large states “ too large to bail-out “ and even testing the resilience of central countries. Reducing the problem to a case of deleveraging those states and extending some loans for these countries to help in the stabilization process with conditionality has not stabilized the markets. Only a deeper and structural solution that will endure for the next decades, will firmly ground the monetary union.
European leaders need to establish a vision for the future by giving a step forward in the fiscal, financial and political integration of the countries sharing a common currency. Bounding together the Member States by this vision, establishing a clear roadmap and a transition system will reduce substantially uncertainty in the financial markets. This was the step taken forward when the Euro was announced by the Maastricht Treaty, followed later by a clear road map proposed by the European Commission, with a Stability and Growth Pact. Only after a credible scenario was established severe market speculation subsided. Only by then markets were finally convinced that governments were fully committed to the Euro project.
We need a new clear and deep institutional reform, similar to the founding phase of the Euro, in order to complete the political, economic and fiscal integration required for the full functioning of the currency union.
There are only two scenarios: either the EU goes forward and pursues economic and political integration or the single currency area will breakdown. The seriousness of the present crisis requires the creation of new institutions in the EU, deepening economic and political integration, solving the deficiencies in the structure of the single currency area. The profound reform requires a change in the EU Treaties which will take two or more years to implement, finalised with approval by Governments and Parliaments, or other democratic processes. At the same time, a clear and detailed road map has to be drawn-up. In the meantime, a transitory system has to be established in order to calm the markets.
Â Establishing the new architecture for the Euro requires setting-up four pillars: monetary stability, Euro-wide treasury operations, bank regulation and a monetary fund for aiding states in distress. An institutional framework is required to support these pillars. Two of the institutions require clarifying and strengthening their role (ECB and EMSF), one needs to be re-founded (EBSA) and finally one needs to be created from the ground (ETA).
Also crucial to the well functioning of the Euro union is the governance framework in terms of (i) multilateral macro-supervision, (ii) fiscal and budgetary cooperation and the (iii) fiscal and budgetary discipline.
Finally, it is important to define the timing and sequencing of the proposed reform, to make it credible and show to the world that Member States are fully committed to the process of building a fully functioning monetary union.
Let us define the four pillars of the Euro Union.
First Pillar: The European Central Bank (ECB)
The role and statutes of the ECB do not need to be changed. The main objective of the ECB should continue to be ensuring price stability in the Euro area, as enshrined in the EU Treaties. Other objectives are supplying liquidity to the banking system, insure the efficiency and stability of the Euro payment systems and to work closely with the banking supervision regulator to ensure the stability of the financial and banking systems within the Euro area. Consequently, the ECB should not engage in buying bonds in secondary markets to prevent increases in bond spreads of certain states, but may have to perform those functions in a transitory phase.
The ECB is a crucial institution for the credibility of monetary policy and for the preservation of the Euro as a stable currency, as is well established in its statutes and the practice has shown up to date.
Second Pillar: European Treasury Agency (ETA)
The ETA will be responsible for issuing Eurobonds on demand from any state member of the Euro, up to the statutory limit to be established by Treaty. This constitutional law will limit access by members to a bond that has a common risk among all states. The issuance of Euro-bonds will create a large and deep market of state bonds that could rival US bonds. One possibility, in a first phase, is to limit the maturities issued by ETA from 1 to 30 years, excluding short-term securities. A very simple statutory limit of Eurobonds, at the starting point, for each country, is a 20% of GDP, based on the 60% of GDP limit established in the SGP and reserving about two thirds for shorter maturities and national bonds. That limit should increase up to the SGP ceiling of 60% of a country’s GDP, when the full transition period has elapsed.
The statutory limits strictly enforced prevent the moral hazard associated with the euro-ization of the securities.
State Members may issue national bonds that would be subject to market discipline, and thus with spreads increasing with national idiosyncratic risk. For rational players the relevant cost is the marginal cost of borrowing.
Entry to the ETA could be restricted to countries that have already fulfilled the SGP criteria, namely the 60% limit of the public debt over GDP. This rule would reduce the moral hazard, since it would not lower the average cost of debt for countries issuing a significant amount of national bonds. However, there are important drawbacks discussed below. What seems to be essential to avoid moral hazard is for countries with access to the EMSF, already a common mechanism of financing, to have the amounts of financing obtained from EMSF subtracted from the ceiling established for the ETA.
Only central governments should be allowed to issue Euro-bonds, to simplify monitoring.
Third Pillar: European Monetary and Stability Fund (EMSF)
The EMSF will build on the current EFSF and the proposed ESM. This is an institution that is crucial in the transition process and will continue to play a major role before all current sovereign debt crisis are solved and all the governance rules of financial discipline are fully complied. Afterwards will certainly remain dormant for most of the time, except in case of distress situations that cannot be completely eliminated, due e.g. to the possibility of financial crisis.
The role of the EMSF will continue to be to assist the deleveraging of states that come under stress for lack of market access, against a stabilization program, incorporated in strict conditionality and with a fixed term. The collaboration of the European Commission, EBA (note not the ECB) and International Monetary Fund, that may also establish parallel programs, should also be continued in the future.
The proposed 1 trillion Euros fund seems enough if the other complementary mechanisms are in place. After repayment of all the loans outstanding to distressed countries its total assets will be zero, and will remain dormant, unless another debt sovereign crisis flares up in the future.
An alternative is to wind down the EMSF, once its assets reach a zero level, and reactivated it only if needed.
Fourth Pillar: European Banking Supervision Authority (EBSA)
Financial and especially banking crisis can originate severe sovereign debt crisis. The recent cases of Ireland and Iceland, as well as the Nordic crisis of the early 1990s, shows that sometimes sovereign debt crisis may arise from the socialization of banking or financial crisis. Moreover, monetary policy and stability of the financial system may conflict, requiring that both be addressed by public agencies.Â Thus far, the solution after the 2007 crisis has been to establish the European Banking Authority mainly with a coordinating function of national regulators. The Euro union needs a fully functioning central regulator by directly supervising all Euro-systemic banks, establishing a fully harmonized system of bank regulation and directing national supervisory institutions. National regulators would still be needed because they have better information on national and local environment and banks. A clear division of responsibilities would thus be needed.
Besides EBSA, two other institutions are needed that should complement the regulatory framework, directed at banks and other financial institutions that are Euro-systemic : (i) a Bank Stabilization Fund, financed by taxation of bank assets, to be used to recapitalize banks and provide temporary assistance to banks that are solvable but suffer from liquidity problems, and (ii) a Bank Resolution Authority that would intervene in Euro-systemic banks or financial institutions being able to conduct an orderly winding down of their operations.
Governance and Multilateral Supervision
The Stability and Growth Pact established some procedures to avoid large government deficits and to conduct some multilateral supervision. The recent proposals of the Commission and the strengthening of sanctions for violation of fiscal discipline are important steps forward.Â However, we still need a more clear mandate and forceful implementation of governance framework in the following areas (i) multilateral macro-supervision, (ii) fiscal and budgetary cooperation and the (iii) fiscal and budgetary discipline.
The core rules that should be respected by all countries is the fiscal discipline defined by: (i) balancing the budget over the cycle with a limit of 3% of GDP of the budget deficit, except in exceptional circumstances, and (ii) a target of 60% of GDP of overall government debt.
The present Six Pack for strengthening the SGP, including the new Excessive Imbalances Procedure, limiting the budget deficits and public debt with automatic sanctions, is essential to establish fiscal discipline. The two new regulations recently proposed by the Commission will also further strengthen budgetary surveillance.
We are of the opinion that no common scheme will ever work without a strong fiscal discipline to avoid free riding and moral hazard. Thus, incorporating this discipline in the EU Treaties is a sine qua none for putting in place all these institutions.
The announcement of the four pillars above should go a long way to calm the markets. However, there is a need to establish a transition system to (i) maintain an healthy growth in the Euro region, (ii) help the adjustment program of distressed highly leveraged countries, and (iii) fight speculation in sovereign bond markets. Several countries have experienced acute economic and financial crisis. Greece, Portugal and Ireland have been cut from access to international financial markets, and Italy, Spain and to a lesser extent Belgium have been required to pay high spreads on the sovereign debt. Paying higher spreads is an important market mechanism that reflects country risk, and is necessary as a discipline mechanism. However, there might been speculative movements that may aggravate the process. It is very difficult to distinguish in practice both, but what is required is an orderly and gradual program for deleveraging these economies.
The EFSF has been established to assist countries that have been cut off from market access, under strict conditionality. Experience has shown that some of these distressed countries may require assistance for a longer period for obtaining market access at reasonable rates “ four to six years may be a more realistic horizon.
The problem is to assist countries with large public debt relative to the total EU market. For these cases, a mix of loans from the EFSF and IMF, combined with interventions from the ECB in secondary markets will still be necessary, while these countries deleverage enough until marginal rates become sustainable.
Establishing the full financing of the EFSF and its successor mechanism should be enough to solve these problems, once the complete architecture is firmly and credibly announced. In this case it is not necessary either to leverage the EFSF, by allowing financing from the ECB, issuing guarantees for national bonds as well as for the EFSF to buy bonds in secondary markets.
Timing and Sequencing
A crucial aspect of these proposals is the timing and sequencing of the different measures. As when the Euro was created, it is essential to establish a simple and credible road map for the next decade. In fact, some countries like Italy that have a general government debt of about 120% of GDP (end of 2010), may need up to 15 years to reach the 60% target of public debt. To reach that target it needs to generate a sizeable primary surplus and also to jump start growth, which certainly require massive structural reforms.
The following phasing is proposed:
Phase 1 (next 3-4 years): first transition phase, when the new architecture is agreed, Treaties are changed (incorporating new governance principles), countries in distress adjust. EBSA is established.
Phase 2 (year 5 to 9): ETA established and Eurobonds issued. Ceiling for Eurobonds increase gradually from 20 to 60% per year. Countries graduating from surveillance. EMSF becomes dormant.
Phase 3(year 10 and after): Fully functioning system.
Major alternatives, risks and mitigation
There are some major problems to solve and challenges ahead in implementing this program. The first relates to the implementation of transition from national bonds to Euro-bonds. If Eurobonds are just launched without strict ceilings in issuance by country, it will be the perfect instrument for creating moral hazard in state lending. It will immediately lead to an increase in the German spreads, which will certainly trigger an increase in the cost of capital for that country and a political backlash. Moreover, the introduction of Eurobonds cannot be an additional way for Member States to finance their deficits, but strictly a substitution of Euro for national securities. The substitutability of those securities is crucial and additionality has to be prevented. Â By establishing a ceiling in terms of percent of GDP in issuance of Eurobonds, without establishing a substitution requirement, countries would have an additional source for increasing indebtedness in a period of high leverage.
The substitutability requirement can be set by establishing the rule that Eurobonds can only be issued to replace national debt that comes to maturity.
To solve the problem of the excess portfolio of national bonds bought by the ECB due to interventions in secondary markets, ETA could be allowed to swap bonds with the ECB.
The second major problem is the proposal that only countries with triple A sovereign rating should be allowed to issue Euro-bonds. The main reason is that there should be a ring-fence between elite countries and the other countries, preventing the rise in interest rates for the elite countries, contaminated by the others. However, there are several drawbacks to this proposal. First, there is a problem of definition of triple A: are rating agencies to determine the elite group? Second, it is a serious breach of the solidarity principle in the EU Treaties. Third, what happen to a country that is downgraded? Is then prevented from benefiting from further financing from Euro-bonds? But the most important argument is that a country confronting rising marginal interest rates by issuing national bonds could be rescued by the EMSF, which is backed by elite countries “ in the end a similar mechanism from the markets perspective. In the end, no mechanism is viable and efficient unless the principles of governance of the Euro, that will enshrine fiscal discipline, are fully implemented.
Third, the transition from the present situation of high-leveraged states to a situation were the SPG criteria are all fully respected (namely the 60% debt ratio over GDP, requiring a substantial cut from the 85.4% mean presently observed in the EU) requires a broad and cumulative process of budget retrenchment, which may lead to a deep and prolonged recession in the EU. To avoid this danger it is necessary to coordinate budgetary policies and impose asymmetric adjustment among member states, as the experience of the 1990s showed.
Fourth, it is necessary to shift country adjustment programs in distressed states from an overwhelming focus in budget retrenchment to a more balanced program of fiscal and structural adjustment to spur competitiveness and growth. This rebalancing will also help solve the previous problem.
It could be argued that the Euro does not need further mechanisms than the ones already existing. The ESM will socialize enough the risk among State Members and is already a kind of Eurobonds, and it addresses the main problem that is gradual adjustment of distressed states. Moreover, there is still not enough political will to transfer sovereignty to Euro-wide authorities. The first argument focus only on the mechanisms created for a crisis on a very restricted number of countries with a very small amount of debt in distress. It does not solve the structural problems of the Euro union. The second argument is not tenable in an environment with a deepening a serious crisis: either the Euro member states want to establish a fully function currency union immune to shocks and crisis or the union will dissolve into a core of a restricted number of states and the rest will have to leave the Euro, threatening the existence of the EU itself.
*Abel Mateus is theÂ former head of the Portuguese Competiton Authority and Vice Chairman of the Portuguese Central Bank, where he was involved in the creation of the Euro, and is currently on the Board of the International Bank for Reconstruction and Development.