Towards a New Architecture of the Euro Area

Alberto Majocchi
Emeritus Professor of Finance at the University of Pavia. Vice President of the Centre for Studies on Federalism

The paper “A Constructive Approach to Euro Area Reform”[i] prepared by 14 Franco-German economists represents a major step forward in the debate on the problems and reform of the euro area – after the various contributions of the European Commission – and has strong political significance, in particular thanks to the contribution of Jean Pisani-Ferry, who was responsible for the programme during Emmanuel Macron’s presidential campaign.

This paper addresses various issues related to the euro area, starting from proposals to complete the banking union aimed at breaking the vicious circle between the banking sector and public debt, such as introducing a limit to the concentration of national bonds in banks and the creation of a common deposit insurance. The authors are aware that this hypothesis must be handled with care, to prevent the  proposal announcement from having devastating consequences, as happened in October 2010 when Sarkozy and Merkel announced their intention to involve the private sector in the resolution of the debt crisis.

However, the analysis and novelties of this paper focus mainly on fiscal architecture. The current fiscal rules are considered important but questionable in many respects. The deficit-reduction target has clear pro-cyclical effects. It is true that the deficit should be adjusted to take into account cyclical developments, but doing so is notoriously difficult and imprecise. The application of the rules is mainly linked to the imposition of fines, which are actually never used and which would aggravate an already difficult fiscal situation. However, rules are necessary not only to promote sound public finances at the national level, but also to prevent negative effects on the other members of the monetary union.

The first proposal put forward by the Franco-German economists is to replace the deficit limit with a ceiling on public-expenditure increases. Public expenditure should not increase faster, in monetary terms, than the long-term nominal income-growth rate, while it should remain below this rate in countries that need to significantly reduce their debt stock. Each year, in every country, an independent fiscal body should set a medium-term debt-reduction target, and a projection of the nominal income growth rate. The same body should define a growth path for the nominal net public expenditure, calculated by subtracting interest payments, unemployment benefits spending and discretionary measures aimed to change the tax structure (to avoid, for example, tax cuts that are not offset by compensatory expenditure-reduction measures).

Any expenditure exceeding the preset level must be financed by issuing junior bonds, i.e. securities that will be the first to be restructured in the event of debt reduction, to ensure their sustainability and that will have an automatic clause to extend their maturity if the country in question receives a loan from the European Stability Mechanism (ESM - the bailout fund). In addition, junior bonds will be less attractive as they will not benefit of a zero-risk rating, like the senior bonds held in banks’ portfolios.

Ultimately, this hypothesis will make the financing of excessive debt more expensive, thereby discouraging conducts that are not in line with the objective of deficit- and debt-stock reduction. An escape clause would anyway allow countries to deviate from this rule under “exceptional circumstances”. A hypothesis similar to the one outlined in the paper may be found in the draft Directive presented by the Commission on 6 December 2017.

The second important point in the paper by the Franco-German economists concerns the proposal to create an intervention instrument aimed at stabilising the economic cycle, which exceeds the provided limits on the use of EMS funds, available only in exceptional cases. What it essentially proposes is creating a stabilisation scheme that provides for extraordinary transfers – through a line in the EU budget or an EMS subsidiary – in the event of a recession affecting one or several euro area countries.

This is a reinsurance fund, which implies that the “first loss” deriving from an exogenous shock is to be borne by the country that has suffered it. Fiscal stabilisation is linked to the use of employment-based indicators, which are more directly ascertainable. In addition, the instrument should provide for an automatic transfer, equal to a fixed percentage of national GDP for every percentage point increase in the unemployment rate, or decline in employment or in the wage bill. Finally, the system should be financed by member countries through contributions based on GDP, the level of which will vary according to the likelihood of that country using transfers from the common reinsurance fund. These measures must serve as a disincentive to non-virtuous behaviors by Eurozone countries.

The third important proposal in the paper concerns the creation of a “Euro-area safe asset”, backed by sovereign bonds. One significant contribution in this regard has already been made in a paper by the European Systemic Risk Board. The proposal provides the purchase by financial intermediaries of a diversified portfolio of sovereign bonds, excluding junior securities, and the use of these bonds as collateral for a security issued on the market in diversified, calibrated tranches, in the case of junior and mezzanine debt, so that the expected loss of the senior tranche – i.e. of the European Senior Bond (ESB) - is equal to that of a sovereign bond with an AAA rating. These ESBs would be very reliable instruments for banks, replacing sovereign bonds, and would reduce the volatility of the most vulnerable countries’ bonds.

All these proposals are accompanied by a support for the idea put forward by Juncker, and taken up by Macron, to create a euro-area Finance Minister, who would be part of the Commission, chair the Eurogroup, oversee the application of tax rules, define the appropriate fiscal stance for the euro area as a whole, and represent it internationally.

What this excellent paper lacks is a development perspective, in particular the definition of an investment policy to facilitate the transition to a carbon-free economy. The Juncker Plan is a first step in this direction, but it must be accompanied by the funding of the External Investment Plan and the new Social Infrastructure Plan of the Task Force co-chaired by Romano Prodi.

An efficient investment plan for the production of European public goods, needed to carry out the Union’s new tasks (internal and external security, environmental protection, renewable energy, cultural heritage, research and development), requires however adequate own resources at the Eurozone level. It is a matter of introducing, as proposed by Macron, a carbon tax – with an equivalent border tax on imported goods – and, in perspective, a web tax and a tax on financial transactions. These measures would ensure both the financing of an enlarged budget – controlled by the European Parliament –, with a specific line for the Eurozone countries, and the funding of Eurobonds issues to finance investments. In this way, an effective policy could be launched,  making also use at last of the euro-area’s enormous trade surplus.

[i] “Reconciling Risk Sharing with Market Discipline: A Constructive Approach to Euro Area Reform”, CEPR, Policy Insight No. 91, January 2018