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Making the Eurozone work: a risk-sharing reform of the European Stability Mechanism

  • S.I.: Recent Developments in Financial Modeling and Risk Management
  • Published:
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“Those Who Reap the Benefits must Bear the Costs” (Walter Eucken, as quoted by Jens Weidmann, 2016).

Abstract

This work presents an original proposal for the reform of the Eurozone architecture according to an approach based on risk sharing (aiming to reach in the long-term the mutualization of public debt). The proposal envisages a new role for the European Stability Mechanism (ESM) which should gradually become the guarantor of the public debts of the European Economic and Monetary Union (EMU). In this way, the new ESM would support the full transition from national debts to a single Eurozone public debt (e.g. Eurobonds) with a single yield curve for all countries. Our proposal would benefit both core and peripheral EMU countries. Indeed, the riskiest countries, which would gain from the ESM conditional debt guarantee, should give up the possibility of redenominating their national debt and would pay to the ESM the corresponding market price of the guarantee. This would strengthen the capital endowment of the ESM and also allow it to use its leverage capability to support the realignment of the economic cycles of the different countries through profitable public investment plans concentrated in the weakest regions of the EMU. Such plans would be coordinated and implemented by the European Union. After a transition period, our Insurance Fund proposal would contribute to a much more resilient monetary union, with a European fiscal policy and mutualized debt. Admittedly this proposal presupposes a political consensus at the EU level to reinterpret the no bailout rule enshrined in the treaties so that risk sharing institutions implemented with fairly priced insurance scheme can be allowed. New risk sharing institutions will foster a common vision of belonging to the same federal, political union in the making, the only one compatible with the abdication of fiscal sovereignty by national governments.

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Fig. 1

Source: ESM website (www.esm.europa.eu)

Fig. 2

Source: ESM website (www.esm.europa.eu)

Fig. 3

Source: Authors’ calculations

Fig. 4

Source: OECD

Fig. 5

Source: Authors’ calculations

Fig. 6

Source: Authors’ calculations

Fig. 7

Source: Authors’ calculations

Fig. 8

Source: Authors’ calculations

Fig. 9

Source: Authors’ calculations

Fig. 10

Source: Authors’ calculations

Fig. 11

Source: AMECO database

Fig. 12

Source: AMECO database

Fig. 13

Source: Authors’ calculations

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Notes

  1. Denmark, Estonia, Finland, Ireland, Latvia, Lithuania, the Netherlands and Sweden.

  2. This phenomenon is also referred to as a remarkable increase in the home country bias by banks of peripheral countries (Battistini et al. 2013) although there is not a full consensus about its causes. Some authors consider distorted incentives and/or the zero-risk weighting of sovereign exposures as the main reasons behind the re-nationalization of public debts in peripheral countries. Another hypothesis is that banks invest massively in their own countries’ government bonds during the crisis in order to match the redenomination risk (Affinito et al. 2016). In our view, all these hypotheses have been at work, including our argument based on deleveraging and risk segregation—as opposed to the flight-to-quality towards safe assets (Croci Angelini and Farina 2015)—which is also supported by the data (Minenna 2019).

  3. Cherubini and Violi (2015) for an earlier thorough explanation as to why securitization of bond portfolios cannot deliver (credit) risk mutualization. In essence, creating a pool of “risk-free” assets does not necessarily require nor imply any risk mutualization among bond issuers.

  4. The argument is similar to De Grauwe (2011): the ultimate goal of risk sharing is to escape bad equilibria and to access a new and better equilibrium with a mitigated risk profile compared to the one before mutualisation.

  5. See Basu and Stiglitz (2015) for an economic model showing how joint liability for sovereign debt can be Pareto superior to the status quo by entering into the appropriately designed insurance contract. Also, Tirole (2015) and Claessens et al. (2012) for an analysis of borrower solidarity in the Eurozone in the wake of the sovereign crisis.

  6. Input data as of September 2017.

  7. Estimates exhibited in Table 1 refer to average data, also because the term structure of sovereign bonds includes securities whose residual maturity is longer than 10 years.

  8. Benefits are displayed with the minus sign.

  9. Input data as of September 2017.

  10. See Sect. 10.

  11. See Lanotte et al. (2016) for a thorough critical assessment of the overall desirability of reforming the favorable treatment of banks’ sovereign exposures allowed by the current banking supervision prudential rules in Europe. They conclude that the microeconomic and macroeconomic costs of a reform could be sizeable, while the benefits are uncertain. Furthermore, they highlight considerable implementation issues.

  12. The Modigliani–Miller theorem states that the structure how a corporation finances itself is irrelevant for how to much it is worth. By extension, some authors (Kopf 2011) claim that, in case of liability split, the weighted average interest rate of the two different tranches in which the debt is partitioned (and of which, only the senior enjoys the joint liability of all member States) should be identical to the interest rate before the split. Building on this argument they conclude that implementing split proposals—such as the Blue/Red bonds proposal of Delpla and Weizsacker (2010)—would immediately force most peripheral euro area countries into a partial sovereign default. Varoufakis (2012) argues that the Modigliani–Miller effect is irrelevant to a debate on restructuring the Eurozone public debt for two reasons. First, because some of the underlying assumptions (prices follow a Brownian motion, same information set for all relevant decision makers, etc.) do not apply to the case of the Euro area. Secondly, because Eurozone’s member States are not corporations, which in turn implies: (a) their financing is not based on equity all but, rather only on different debt instruments (consequently, there may well be better debt solutions than the existing ones); and (b) member States’ revenues (i.e. tax take) cannot be deemed independent of their expenditure (unlike it holds for corporations).

  13. At the most there could be an increase in the outstanding floating-rate debt that, however, represents a small portion of the debt of Eurozone governments. Thus, not enough to produce the invariance effect on the aggregate interest expenditure as provided by the Modigliani–Miller theorem.

  14. This provision will be phased out gradually between 2017 and 2020. The new framework, governed by the Capital Requirements Directive IV (CRD IV) entered into force since January 2014, supersedes the treatment enshrined in CRD III. It requires that, following the phasing-out, the corresponding exposures rely on credit rating agencies’ assessments (BIS 2013, pp. 10–11).

  15. Obviously, since the ESM Insurance Fund is not a bank, the considerations of this Section are valid at a hypothetical level. In addition, it is worth to observe that the specific role envisaged for the reformed ESM under the present proposal implies that the Mechanism does not properly have a sovereign exposure to the insured debt, but only a contingent liability that would materialize only if well-defined states of world should occur.

  16. The underlying rationale is that “in a recession monetary policy may keep the interest rate very low whilst inflation is subdued, which implies that an additional aggregate demand will trigger higher real output growth and lower price increases” (Boitani and Pierdichizzi 2018).

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Authors and Affiliations

  1. EMbeDS and Institute of Economics, Scuola Superiore Sant’Anna, Piazza Martiri della Libert‘a 33, 56127, Pisa, Italy

    Giovanni Dosi & Andrea Roventini

  2. Consob, Rome, Italy

    Marcello Minenna

  3. OFCE, Sciences Po, Nice, France

    Andrea Roventini

  4. Banca d’Italia, Rome, Italy

    Roberto Violi

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  1. Giovanni Dosi
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  2. Marcello Minenna
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  3. Andrea Roventini
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  4. Roberto Violi
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Correspondence to Marcello Minenna.

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The authors are grateful to Alberto Bisin, Nicoletta Batini, Paul Beaumont, Umberto Cherubini, Ronald Janssen, Roberto Perotti, Andrea Presbitero, Willi Semmler, Vincenzo Visco for useful discussions and comments. All usual disclaimers apply. The views and opinions here expressed are those of the authors and do not necessarily reflect the official policy or position of the opinions of the institutions to which they belong. Giovanni Dosi and Andrea Roventini acknowledge financial support from European Union’s Horizon 2020 grants: No. 822781 - Project GROWINPRO.

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Dosi, G., Minenna, M., Roventini, A. et al. Making the Eurozone work: a risk-sharing reform of the European Stability Mechanism. Ann Oper Res 299, 617–657 (2021). https://doi.org/10.1007/s10479-019-03325-9

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  • DOI: https://doi.org/10.1007/s10479-019-03325-9

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