Thursday, November 27, 2014
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EMU 2.0?

BRUSSELS – For a year, European policymakers have been busy fixing bugs in the design of Economic and Monetary Union (EMU). As with defective software, they have introduced successive new versions of EMU at a frantic pace – only to discover remaining vulnerabilities shortly afterwards. After two summits in March, however, European officials claim to have produced an enhanced, bug-free version. Can we trust them this time?

Answering that question starts at the origin of all of EMU’s troubles: crisis-prevention. Before 2010, it was almost entirely based on surveillance of budgetary deficits, which was conducted within the framework of the Stability and Growth Pact (a procedure for broad economic surveillance existed as well, but lacked political traction). The crisis revealed major enforcement problems with this framework, but also major design problems: no light ever flashed red to indicate that Ireland or Spain was in danger.

The new regime will take into account the debt/GDP ratio (removing Italy’s ability to maintain its outsize debt burden) and implicit liabilities (for example, a country with an oversized banking sector will have to confront potential rescue costs). Decisions on sanctions will be streamlined by a “reverse majority rule,” under which a European Commission recommendation for decision is considered adopted unless rejected by a majority of the member states’ ministers. All of this is encouraging.

A second positive sign is the recognition that not all crises are rooted in a lack of fiscal discipline; it is now agreed that financial and macroeconomic stability also matter. But the new policy framework looks somewhat unclear. There will be no less than three different, partially overlapping, European procedures – for budgets, macroeconomic imbalances, and financial stability. Clumsy intergovernmental processes risk blurring priorities, confusing policymakers, and exhausting civil servants.

For this reason, it is to be feared that the governance model will soon require reform, and that the EU will have to decide where to rely more on reformed national frameworks (for example, for budgetary discipline) and where to allocate more responsibility to the European Union (for example, for banking supervision). The new emphasis on national budgetary rules is a welcome development – but it is only a first step.

Crisis management and resolution, meanwhile, could not be reformed, because nothing existed. So a new pillar has now been added to the European edifice. As a result, EMU will now be equipped with the ability both to provide assistance to a member country that loses market access and to organize the restructuring of its public debt. Agreement to create both a liquidity-provision facility and an insolvency procedure has implied revisiting fundamental principles – not least the no-bailout clause – showing that Europe can learn from experience.

But the new regime is not without defects. First, it is strange that Europe has agreed to provide assistance only as a last resort, by unanimity and with harsh conditionality, at a time when the International Monetary Fund has created first-resort, near-automatic, and low-conditionality facilities to help countries hit by sudden capital outflows. So there is now a risk that the European framework will create an avenue for financial speculation.

Second, the European Union has taken the least legally difficult route to debt-crisis resolution: the so-called “contractual approach,” which aims at facilitating agreement with private creditors. But the most contentious part of debt restructuring could well be reaching inter-governmental agreements. A formal legal procedure would have helped.

Third, just as a new version of existing software often creates compatibility problems with files created with older versions, for EMU, too, transition to the new regime may prove difficult. Even excluding Portugal, which is now in serious trouble, several problems still await solutions. There is an urgent need to expedite the resolution of the banking crisis, for which credible and comprehensive stress tests are an indispensable first step. Ireland’s recent move is good news but foot-dragging elsewhere – not least by Germany – is blocking the return of confidence.

There is an equally important need to distinguish between state insolvency and illiquidity. Greece is likely to find itself insolvent, and questions surround the solvency of Ireland and Portugal as well. Markets need to understand what will happen if some sort of debt restructuring takes place before the permanent regime is introduced in 2013, and the ECB must figure out how it will get rid of the peripheral bonds on its balance sheet. Again, confidence will return only after answers are provided.

Last but not least, any solution presupposes the most important ingredient of all: an effective EU strategy to revive and sustain growth in southern Europe. The EU is not deprived of instruments – the so-called “structural funds” that finance investment in poorer regions – but it does not have a strategy to use them.

So the outcome of months of discussion might be better characterized as “EMU 1.7.3” than “EMU 2.0.” More bugs will have to be fixed, including new bugs found in the fixes. For investors, the reform process may seem impossibly long and hesitant. But, by the standards of international negotiations and European governance, it has been exceptionally fast.

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