The euro after Meseberg
The Meseberg Declaration of June 2018 summarizes the state of play on euro area reform. It indicates areas where there is agreement in principle between leading governments on measures to strengthen the resilience of their monetary union, but no agreement as yet on how to implement those measures. It indicates also areas where there is not even agreement in principle. It thus provides a basis for addressing the question of whether Europe is ready for the next crisis. The absence of bank concentration charges, a European safe asset, European deposit insurance, changes in ESM governance and meaningful fiscal reform suggests that the answer is no. More positively, Meseberg at least recommends some small steps in these directions.
KeywordsMonetary union Euro Reform
JEL ClassificationF00 F30
The architecture of the euro area remains a work in progress as one suspects it always will. For a monetary union to operate smoothly, it must be accompanied by banking, fiscal and political union or at least by something resembling them. The United States is regularly, and rightly, cited as a case in point. This is an observation of which at least some of the framers of the Maastricht Treaty were aware. As proponents of deeper European integration, they promoted monetary union as a way of creating an additional pressure for banking, fiscal and political union. But these values are not universally shared. Powerful voices in a variety of European countries, not least Germany, resist steps in the direction of deeper European integration that entail compromises of national fiscal, financial and political sovereignty. Thus, the challenge of euro area reform is how to provide some of the stabilizing functions of banking, fiscal and political union while at the same time respecting national sovereignty. It is not a challenge that will be easily met.
The most recent round of reform discussions was set off by the 2017 French elections, Emmanuel Macron being a vigorous advocate of measures such as a common budget to deepen the monetary union. But forging an agreement among 19 eurozone members has not been easy. Macron and his German counterpart, Angela Merkel, sought to invigorate the process by convening a joint Franco-German summit in the Brandenburg castle town of Meseberg and presenting the resulting “roadmap” to their 17 eurozone partners. But the Franco-German roadmap left important details unspecified, and other euro area governments voiced reservations about following it.1
For precisely these reasons, the Meseberg Declaration opens a revealing window onto the prospects for euro area reform. It indicates areas where there is agreement in principle between leading governments on measures to strengthen the resilience of their monetary union, but no agreement as yet on how to implement those measures. It indicates also areas where there is not even agreement in principle. It can thus be used to formulate an answer to the question of whether the euro area is ready for the next crisis.
The most widely noted aspect of the Meseberg Declaration called for the establishment a eurozone budget starting in 2021. This proposal built on Macron’s electoral platform but also on the academic literature on the role of fiscal transfers in a monetary union (Ingram 1962; Kenen 1969; Sala-i-Martin and Sachs 1993). The case for a quasi-federal system of transfers in a monetary union is analytically impeccable, and the fact that French and German leaders could agree on the principle, for the first time since the advent of the euro, was an important symbolic step. Their eurozone budget would be funded partly out of national tax revenues and used, in the language of the declaration, “to promote competitiveness, convergence and stabilization.” One can well imagine that that the macroeconomic consequences of the Global Financial Crisis and the Euro Crisis would have played out very differently had a full-fledged eurozone budget featuring a quasi-federal system of taxes and transfers been in place.
Unfortunately, this agreement was not reached under a veil of ignorance. Rather, it was negotiated against the backdrop of German fears that the country would be on the sending end of any and all future transfers. This led drafters to finesse—that is to say, avoid—the question of how large that eurozone budget should be. Macron had earlier proposed a budget of several percentage points of euro area GDP, while Merkel insisted that the total should be “at the lower end of the double-digit billions of euros range” (Gotev 2018). To put this in perspective, a hypothetical €20 billion would be 0.7% of 2018Q1 euro area GDP, not enough to buffer a major macroeconomic shock. Reference in the finance ministers’ draft to “the need for a genuine macroeconomic stabilization function in the eurozone” was removed from the leaders’ declaration. So too was mention of specific mechanisms through which temporary transfers could take place, such as suspending contributions to the budget by country hit by a significant shock and allowing the European Stability Mechanism (EMS) to make up the budgetary shortfall.
One can also imagine building on what for the moment is only an agreement in principle. In time, perhaps, the size of the budget will be increased, the need for a genuine macroeconomic stabilization function will be acknowledged, and the adjustment of tax payments into that budget will be specified. But this will require confidence in Germany that temporary revenue shortfalls will be repaid and that transfers can go both ways. How long it will take for this confidence to develop is, to put it mildly, unclear.
A second positive element was authorization for the ESM to backstop the Single Resolution Fund (SRF). The SRF was established to ensure adequate resources for resolving bank failures and crises, where those resources were to be contributed by the insured credit institutions themselves. Funding can be used to purchase or guarantee the assets and liabilities of institutions under resolution, create a bridge institution or asset management vehicle, and compensate shareholders and creditors who incur larger losses than under normal insolvency proceedings. Over its first 8 years of operation (2016–2023), contributions to the SRF are to be built up to 1% of the deposits of all credit institutions within the Banking Union. The problem is what to do in the interim or if larger-than-expected SRF outlays are required. The solution suggested at Meseberg was that the ESM should make up the shortfall until additional ex-post contributions from financial institutions are raised.
Providing the SRF with an expanded line of credit would be a step forward. However, the proposal was not packaged with measures to streamline the governance of the ESM. ESM decisions require the unanimous consent of shareholding governments, which in some cases (such as that of Germany) obliges those governments to secure the assent of their parliaments. One suspects that the speed with which parliamentary assent can be secured may not match the speed with which a banking crisis unfolds.
A third positive was agreement on steps to facilitate sovereign debt restructuring. Restructuring potentially unsustainable debts can be lengthy and disruptive, which encourages governments to resist it. This creates expectations of emergency assistance to the distressed sovereign, assistance that will be used in part to pay off private creditors, fueling lender moral hazard and increasing the risk of further crises. Paralleling an earlier debate at the International Monetary Fund (Krueger 2001), discussions of how best to facilitate sovereign debt restructuring in Europe focused on the relative merits of statutory and contractual approaches: a European Sovereign Debt Restructuring Mechanism (as in Gianviti et al. 2010) versus the introduction of Collective Action Clauses into bond covenants, as European sovereigns are now required to do (as analyzed by Bradley and Gulati 2013).
The Meseberg Declaration would resolve this debate in favor of the contractual approach by requiring single limb aggregation. Under single limb aggregation, a restructuring agreement becomes binding on all investors upon the assent, in a single vote, of a qualified majority of the holders of all sovereign issues of a government. Previous analysis has shown that bonds bearing such clauses do not pay higher spreads when the issuers are good credits (Eichengreen and Mody 2003). The corresponding problem is that it may take years to retire existing bonds and replace them with new issues incorporating these provisions.
Then there were the negatives, which are revealing of the obstacles to crisis proofing the monetary union. There was no solution to the “doom loop” linking sovereign debt problems to banking problems (see e.g. Farhi and Tirole 2018). Single-limb aggregation clauses are well and good, but wider resort to sovereign debt restructuring is only feasible if doing so doesn’t destabilize the banking system. A straightforward way of breaking the doom loop is by applying sovereign concentration charges (Veron 2017), regulatory surcharges that discourage banks from holding large numbers of sovereign bonds, both those of their own government and also of others. The French and German governments may fear that the early introduction of those charges would make it more difficult and costly for euro area members to place their new issues with financial institutions. If so, their decision is shortsighted.
Second and relatedly, there was no agreement on the creation of a European safe asset to replace sovereign bonds in bank portfolios. The European Commission (2018) previously published a proposal for Sovereign Bond Backed Securities (SBBS) that would use financial engineering to create a safe asset backed by existing sovereign issues. The finance ministers’ draft dismissed the idea on the grounds that it had “significantly more disadvantages than potential benefits and should not be further pursued.” The leaders’ declaration was silent on the matter. But absent an alternative approach to creating a European safe asset, it is not clear that sovereign concentration charges will be feasible. What then will European banks hold as the bedrock of their asset portfolios, one might ask? In turn this puts other elements of the reform agenda at risk.
Third, there is still no immediate prospect for a European system of deposit insurance with a common funding source. The Meseberg Declaration reaffirmed the German view that risk reduction should precede risk sharing and that progress in de-risking banking systems was still inadequate. The declaration suggested that next steps might be agreed following the European Council at the end of June 2018, but at that meeting discussions of a plan were deferred to the next Council meeting in December. This pattern underscores troubling questions about the adequacy of the national deposit schemes of the members of the Banking Union. That said, the Meseberg Declaration marked the first time that Chancellor Merkel has put her name to a document endorsing the principle of Europe-wide deposit insurance.
Fourth, the Meseberg Declaration embraced the concept of precautionary ESM credit lines for members that “risk facing a gradual loss of market access” but without incorporating the lessons of IMF experience. The declaration spoke of precautionary credit lines for countries “without the need for a full [ESM] program,” of “stability support… in case of liquidity shortages,” and that “any decision to provide ESM stability support to a euro area Member State includes a debt sustainability analysis…”. The idea, similar to that underlying a sequence of unsuccessful IMF precautionary lines, would appear to be that this form of liquidity support will be extended only to countries with otherwise strong finances that prequalify for assistance.
IMF experience shows that countries are sometimes reluctant to apply for prequalification, fearing that their doing so will be interpreted as a sign of economic and financial vulnerabilities. The ESM or European Commission could unilaterally prequalify a country, but it would have to prequalify groups of countries in order to avoid sending an adverse signal about one, and even then there would be destabilizing consequences for countries that are not prequalified. Were this problem somehow avoided, there would remain the question about how to un-prequalify a country that was no longer deemed sufficiently sound, and how to do so without further tarnishing its financial reputation. The prequalification decision could be kept confidential, but then the reassurance provided by the knowledge that a country had an ESM credit line would be lost and the mechanism would operate less powerfully. In neglecting these lessons of IMF experience, European officials show signs of reinventing the wheel, and not a wheel capable of gaining much traction.
Fourth, no progress was made in fixing Europe’s fiscal morass. There were no suggestions about how to simplify the EU’s complex fiscal rules (the Stability and Growth Pact, the Six Pack, the Two Pack, the European Semester). Rules that are too complex to understand tend also to be too difficult to enforce and incapable of inducing the intended behavior. Rules that are too rigid to provide adequate flexibility over the cycle tend to aggravate macroeconomic instability. Rules that are imposed on governments by an outside power—in this case the European Commission—offer a rich target for populist politicians who are critical of foreign interference in national fiscal affairs. French and German leaders at Meseberg failed to acknowledge these problems, much less suggest solutions. They showed no readiness, for example, to offer national governments anxious to regain a modicum of fiscal autonomy, such as Italy’s, a bargain in which they would be granted more fiscal discretion in return for structural reforms putting public debts on a sustainable path.
The very case for centralizing control over the fiscal policies of the member states of a monetary union is weak once the doom loop connecting those policies to banking and financial stability has been broken. The direct cross-border spillovers of national fiscal policies are limited, since the positive spending channel and negative interest rate channel work in opposite directions (Eichengreen and Wyplosz 2016; Attinasi et al. 2017). Given their failure to definitively break the doom loop, however, it is understandable the French and German leaders chose not to address the contradiction at the heart of their fiscal governance strategy.
Finally, there was no discussion of reforms to enhance the ability of the European Central Bank to act as a true lender and liquidity provider of last resort. Because the national central banks that are components of the European System of Central Banks (ESCB) lend to banks in their own jurisdictions and purchase mainly financial instruments issued there, one regularly observes large differences in the riskiness of their balance sheets (Buiter 2018). Sovereign concentration charges, European Sovereign Bond Backed Securities, and other debt-mutualization schemes would go some way toward addressing this issue but are not, as noted, on the table. Losses on its investments in, inter alia, domestic government bonds could therefore leave a national central bank insolvent (since it can’t issue central bank money and the sovereign, having defaulted, is in no position to recapitalize it).
This presents the national central bank with the choice of either limiting its support of the banking and financial system (by not buying the bonds of the troubled sovereign) or risking de facto expulsion from the monetary union (if it is forced to impose capital and exchange controls and print a domestic substitute for central bank money). The first option creates undesirable levels of liquidity risk, the second undesirable levels of break-up risk. The ESCB could of course consolidate the assets and liabilities of its members into a single balance sheet, as in the case of the central banks of other monetary unions such as the United States, and European governments could aver their readiness to recapitalize the ECB, as necessary, following an agreed formula (Cohen-Setton and Vallee 2018). But this possibility was evidently too troubling to be addressed at Meseberg.
These observations are closely related to the debate over TARGET2 balances, which are claims and liabilities of national central banks on the ECB. In this case the fear is that the break-up of the monetary union will subject a country with a positive TARGET2 balance to capital losses. The best way of addressing such worries is of course by eliminating the risk of a break up, although complementary schemes have been proposed, such as abolishing separate national central bank balance sheets in favor of a single Eurosystem balance sheet, allowing the ECB to fund local national central banks as branches, and having it return profits to the governments of participating states (Whelan 2017).
The Meseberg Declaration leaves us with two questions. First, are other countries likely to sign up to the Franco-German compact? And second, is this enough to prepare the euro area for the next crisis?
There is a long history of French and German governments negotiating bilaterally and presenting the result as an action agenda to their European partners. Agreeing on an agenda is difficult, bordering on the impossible, with 19 governments at the table. The French and German governments are representative of two poles of thought about the euro area. France is a proponent of flexible solutions that entail further elaborating economic and monetary union, whereas Germany is suspicious of anything that substitutes technocratic discretion for rules and anything that smacks of transfer union. Thus, if it is possible for these two countries to agree on a substantive agenda, then it should be possible to bring both the Dutch-Scandinavian-Baltic coalition and the “Club Med” countries on board.
The argument against this approach is that the euro area in fact comprises a broad range of countries whose views are no longer adequately encompassed by those of France and Germany. Those other countries object to a process in which the French and German governments delegate agenda-setting power to themselves. These objections were clear in the joint statement on the architecture of euro area reform issued by finance ministers from Denmark, Estonia, Finland, Ireland, Latvia, Lithuania, the Netherlands and Sweden earlier in the year (Finance Ministers 2018). Both observations help to explain why the Dutch government, among others, rejected the Meseberg Declaration in no uncertain terms, echoing sentiments voiced in that earlier joint statement of eight finance ministers.
Even if fully implemented, would the Meseberg roadmap adequately equip the euro area for dealing with the next crisis? The absence of concentration charges, a European safe asset, European deposit insurance, changes in ESM governance and meaningful fiscal reform suggests that the answer is no. But Meseberg does recommend small steps in at least some of these directions. So, if not the next crisis, maybe the euro area will be ready for the crisis after that.
Two versions of the Franco-German Roadmap were in fact published, the draft agreement of finance ministers (French and German Finance Ministers 2018) and the declaration of leaders (Press and Information Office of the Federal Government 2018), where the latter was a not-so-lightly expunged version of the former. For more on this see below.
- Attinasi, M.-G., Lalik, M., & Vitlov, I. (2017). Fiscal spillovers in the Euro Area: A model-based analysis (ECB Working Paper no. 2040).Google Scholar
- Buiter, W (2018). The future of the Eurozone: Saving the Eurosystem from itself. In: Global Economics View, New York: Citibank.Google Scholar
- Cohen-Setton, J., & Vallee, S. (2018). Euro area reform cannot ignore the monetary realm. Voxeu.Google Scholar
- European Commission. (2018). Proposal for a regulation on sovereign bond-backed securities. Brussels: European Commission.Google Scholar
- Farhi, E., & Tirole, J. (2018). Deadly embrace: Sovereign and financial balance sheet doom loops. Review of Economic Studies (forthcoming).Google Scholar
- Finance Ministers. (2018). Joint Statement of Finance Ministers from Denmark, Estonia, Finland, Ireland, Latvia, Ltiuania, the Netherlands and Sweden.Google Scholar
- French and German Finance Ministers. (2018). French German Roadmap for the Euro Area.Google Scholar
- Gianviti, F., von Hagen, J., Krueger, A., Pisani-Ferry, J., & Sapir, A. (2010). A European mechanism for sovereign debt crisis resolution: A proposal. Bruegel Blueprint.Google Scholar
- Gotev, G. (2018). Macron wins Merkel’s backing on budget for Eurozone. Euractiv. https://www.euractiv.com/section/economy-jobs/news/macron-wins-merkels-backing-on-budget-for-eurozone/1249250/. Accessed 4 Sept 2018.
- Ingram, J. (1962). Regional payments mechanisms: The case of Puerto Rico. Chapel Hill: University of North Carolina Press.Google Scholar
- Kenen, P. (1969). The theory of optimum currency areas: An eclectic view. In Robert Mundell & Alexander Swoboda (Eds.), Monetary problems of the international economy. Chicago: University of Chicago Press.Google Scholar
- Krueger, A. (2001). A new approach to sovereign debt restructuring. Address by Anne Krueger, First Deputy Managing Director. https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp112601. Accessed 4 Sept 2018.
- Press and Information Office of the Federal Government. (2018). Meseberg declaration: Renewing Europe’s promises of security and prosperity. https://www.bundeskanzlerin.de/Content/EN/Pressemitteilungen/BPA/2018/2018-06-19-meseberg-declaration.html. Accessed 4 Sept 2018.
- Sala-i-Martin, X., & Sachs, J. (1993). Fiscal federalism and optimum currency areas: Evidence for Europe from the United States. In Matthew Canzoneri, Vittorio Grilli, & Paul Masson (Eds.), Establishing a Central Bank: Issues in Europe and lessons from the US (pp. 195–227). Cambridge: Cambridge University Press.Google Scholar
- Veron, N. (2017). Sovereign concentration charges: A new regime for banks’ sovereign exposures. Study provided at the request of the Economic and Monetary Affairs Committee, European Parliament.Google Scholar
- Whelan, K. (2017). Should we be concerned about TARGET balances, monetary dialogue of the directorate-general for internal affairs. Brussels: European Commission.Google Scholar