Europe’s Monetary Union Is Still Unfinished Work

(The Bloomberg View) -- Leaders of the European Union meet in Brussels this week to discuss the future of the euro zone. In recent years, governments have strengthened the system a lot, making it less likely that a crisis in one member state would jeopardize the currency area as a whole. Even so, they haven’t done enough.

Today the euro zone is much more robust than it was at the start of the Greek sovereign-debt crisis. There’s a rescue fund (the European Stability Mechanism); a tried-and-tested central bank equipped with new tools; and the beginnings of a so-called banking union. All this is valuable, but it falls short in two main ways. First, the banking union needs to be completed. Second, lacking the adjustment mechanism provided by individual exchange rates, the euro zone needs better ways to absorb economic shocks.

The good news is that Europe’s efforts to strengthen the system have put much of what’s required in place. The ESM is there to help countries should they lose access to capital. Governments have to apply for an adjustment program, which offers financial support in return for fiscal discipline and structural reform. To be sure, the system bungled the case of Greece: Excessive fiscal restraint and the government’s lassitude on structural reform have prolonged the agony unduly. But Portugal, Ireland, Spain and Cyprus all benefited from the ESM’s intervention and are now expanding at a healthy pace.

In addition, ECB President Mario Draghi has ensured that the central bank has the tools it needs. The most important innovation is “Outright Monetary Transactions” — the power to buy unlimited quantities of short-term sovereign bonds once a country has applied for an ESM program. This scheme is a vital backstop. Investors know the ECB can step in, so they’ll be more reluctant to bet against a country in financial difficulty.

The other big step was the banking union. The ECB has taken over from national central banks as the leading authority in overseeing the euro zone’s largest lenders. This has resulted in stronger oversight. The Single Resolution Board decides how to wind down a bank deemed “failing or likely to fail,” and can use funds for the purpose from the Single Resolution Fund. This ought to mean that individual governments don’t have to bail out a bank on their own.

The system faced a test just last month, when political instability in Italy caused a sharp sell-off in the country’s sovereign bonds. Other countries were also affected — but less than in the past. As Draghi put it, “Contagion was not significant. ... It was a pretty local episode.” The reforms have made the euro zone more resilient.

Nonetheless, the work is not complete. As yet, the banking union isn’t really a true banking union. The resolution fund, capped at 55 billion euros ($63.5 billion), is too small. The ESM should therefore be empowered to support it when necessary, and to act without delay (since resolutions typically take place over a weekend).

The banking union also needs a joint scheme for deposit insurance, covering deposits up to 100,000 euros. Germany is opposed, fearing it would mean perpetual transfers from its own banks and taxpayers to those of distressed member states. That needn’t be so. A strong safety net would help to prevent panics and thereby reduce the need for cross-border support. Germany should also recall that it had to deal with its own failing banks during the financial crisis. There’s no reason to suppose that under a stronger collective system, the help would all flow one way.

Banking aside, the euro zone’s biggest challenge is to cope with economic shocks — especially those that strike one or more countries but not the zone as a whole. Once, exchange rates could move to help countries adjust to such shocks, making it easier to restore competitiveness without cutting wages, thus avoiding protracted recessions. Within the euro zone, that method is no longer available.

In principle, some of the shock-absorbing could be accomplished through capital markets. When a company goes bust in Tennessee, creditors and shareholders in New York and Texas share in the losses; Tennessee’s investors, by the same token, aren’t wholly invested in their home state, but hold assets across the American currency union. In Europe, in contrast, investors tend to keep their money closer to home, so financial risk is more concentrated in individual countries.

Euro-zone leaders say they want to build a “capital-market union” like that in the U.S. — but they’ve gone about it very slowly. A good next step would be to improve the capital-markets infrastructure by converting the European Securities and Markets Authority into a truly pan-European capital-markets regulator.

Even if Europe had a U.S.-style capital market, though, closer fiscal cooperation would also be necessary. In a single-currency system, monetary policy can’t be attuned to the needs of particular countries. And the euro zone’s rules on fiscal policy limit the use of budget deficits in fighting recessions. The system as a whole has a so-called deflationary bias, in effect asking too little of fiscal policy and too much of the ECB.

Last week French President Emmanuel Macron and German Chancellor Angela Merkel said they’d agreed in principle to create a common budget (with its own taxes and spending) for the euro area. Unfortunately, as yet, there’s less to the idea than meets the eye. The plan is vague, the proposed budget would apparently be small, and its main purpose would not be to provide economic stabilization — which is the essential thing. Perhaps this budget could eventually turn into what’s needed, but as the idea stands, it’s far too timid.

Draghi suggested a more promising approach in a recent speech in Florence: Create a fund to disburse money according to cyclical conditions. For instance, the euro zone could launch an unemployment reinsurance scheme, which would replenish national funds when joblessness rose above a country-specific threshold. With this in place, governments could spend more on unemployment benefits or retraining programs without having to cut other spending or raise taxes.

German Finance Minister Olaf Scholz has endorsed a narrow version of this scheme, involving loans and not transfers. Berlin should go further. A well-designed joint unemployment insurance scheme wouldn’t entail the dreaded “transfer union,” since countries face different conditions at different times. In the early years of the euro, Germany had to contend with very high unemployment.

If the EU one day renews its commitment to ever closer union, it will need to consider other, more far-reaching, innovations. A genuine fiscal union, for instance, would involve substantial joint programs for taxes and spending — in the limit, letting euro-zone budgets play the same role in Europe as the federal budget plays in the U.S. Joint borrowing by means of a pan-European bond is another possibility. That’s maybe not so remote as full fiscal union, though again it isn’t yet on the agenda.  

For now, a more limited set of changes is both necessary and urgent. Yes, the system is stronger than before, and an impressive achievement — but it isn’t strong enough to handle the next major crisis. Reinforce it now, or risk seeing it swept away.

©2018 Bloomberg L.P.

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