The Euro’s Narrow Path
With Emmanuel Macron’s victory in the French presidential election, and Angela Merkel’s Christian Democratic Union enjoying a comfortable lead in opinion polls ahead of Germany’s general election on September 24, a window has opened for eurozone reform. But can the two sides agree on how to fix their flawed creation?
BERKELEY – With Emmanuel Macron’s victory in the French presidential election, and Angela Merkel’s Christian Democratic Union enjoying a comfortable lead in opinion polls ahead of Germany’s general election on September 24, a window has opened for eurozone reform. The euro has always been a Franco-German project. With a dynamic new leader in one country and a fresh popular mandate in the other, there is now an opportunity for France and Germany to correct their creation’s worst flaws.
But the two sides remain deeply divided. Macron, in long-standing French tradition, insists that the monetary union suffers from too little centralization. The eurozone, he argues, needs its own finance minister and its own parliament. It needs a budget in the hundreds of billions of euros to underwrite investment projects and augment spending in countries with high unemployment.
Merkel, on the other hand, views the monetary union’s problem as one of too much centralization and too little national responsibility. She worries that a large eurozone budget wouldn’t be spent responsibly. While not opposed to a eurozone finance minister, she does not envision that official possessing expansive powers.
But there is a narrow path forward that should be acceptable to both sides. It starts with completing the banking union. Europe now has a single supervisor in the European Central Bank, but it lacks a common deposit insurance scheme, which German officials oppose on the grounds that there has been inadequate risk reduction in the European banking system. In other words, they worry that the fees levied on German banks will be used to pay off depositors in other countries.
The solution lies in bulletproofing the banks by strictly applying the demanding capital standards of Basel III and limiting concentrated holdings of government bonds. The paradox here is that European regulators, including German regulators, have in fact been arguing for looser application of those regulations in negotiations with the United States. In doing so, they have been arguing against their own best interests.
Next, Europe needs to transform the European Stability Mechanism, its proto-rescue fund, into a true European Monetary Fund (EMF). Its resources could be augmented by increasing governments’ capital subscriptions and expanding its ability to borrow. Decision-making could be streamlined by moving from the current unanimity rule to qualified majority voting.
The EMF could then take the place of the ECB and the European Commission in negotiating the terms of financing programs with governments. The final decision of whether to extend an emergency loan would no longer fall to heads of state in all-night talks. Rather, it would be taken by a board made up of eurozone representatives, including from civil society, nominated by the European Council and confirmed by the European Parliament, giving the process a legitimacy it currently lacks.
But Germany will agree only if it sees steps limiting the likelihood of expensive intervention. This brings us to the vexed question of fiscal policy. It is past time to abandon the fiction that the ultimate source of fiscal discipline is a set of strictly enforced EU rules. Taxation and public spending remain sensitive national prerogatives, rendering outside oversight ineffectual. Assigning oversight to the European Commission in Brussels promises, inevitably, not discipline but a dangerous populist backlash.
The alternative is to return control of fiscal policy to national governments, abandoning the pretense that policy can be regimented by EU rules. Governments could then make their own decisions; if they make bad decisions, they will have to restructure their debts. Adopting a European debt-restructuring mechanism would help to avoid the worst fallout. Any adverse consequences would no longer spread to other countries, because their banks would no longer hold concentrations of government bonds. They would not bankrupt the EMF, which would be able to lend only in cases of illiquidity, not insolvency.
These ideas will horrify dedicated euro-federalists. One bone they can be thrown is a pilot unemployment insurance fund amounting to, say, 1% of eurozone GDP. This would be analogous to US arrangements under which the federal government provides partial funding for state-administered unemployment insurance. And it would give the eurozone finance minister something to do. If the initial modest program was shown to work, it could be scaled up.
But German politicians are aware that unemployment is 2.5 times higher in France than at home, raising the danger that transfers would all go one way. That’s why such proposals are contingent on structural reforms that reduce unemployment where it is high and increase the flexibility of labor and product markets.
This is essentially the bargain Macron has offered Merkel. To paraphrase, “I’ll undertake deep structural reforms if you agree to modest steps in the direction of fiscal federalism, completing the banking union, and creating a European Monetary Fund.”
No one on either side of the Rhine will regard this bargain as perfect. But with the euro in the balance, the perfect should not be allowed to become the enemy of the good.
Does Europe Really Need Fiscal and Political Union?
There is a growing sense in Europe, among conservatives and progressives alike, that fiscal and eventual political union is necessary to maintain the euro without damaging economic performance or democratic values. But there is also an alternative, much less ambitious view, according to which only banking union is needed.
CAMBRIDGE – Greece’s combative former finance minister, Yanis Varoufakis, and his nemesis, former German finance minister Wolfgang Schäuble, were at loggerheads on Greek debt throughout Varoufakis’s term in office. But they were in full agreement when it came to the central question of the eurozone’s future. Monetary union required political union. No middle way was possible.
This is one of the interesting revelations in Varoufakis’s fascinating account of his tenure as finance minister. “You are probably the one [in the Eurogroup] who understands that the eurozone is unsustainable,” Varoufakis quotes Schäuble as telling him. “The eurozone is constructed wrongly. We should have a political union, there is no doubt about it.”
Of course, Schäuble and Varoufakis had different ideas regarding the ends that political union would serve. Schäuble saw political union as a means to impose strong fiscal discipline on member states from the center, tying their hands and preventing “irresponsible” economic policies. Varoufakis thought political union would relax creditors’ stranglehold on his economy and create room for progressive politics across Europe.
Nevertheless, it is remarkable that these two officials from opposite ends of the political spectrum arrived at an identical diagnosis about the euro. The convergence is indicative of the growing sense of the need for fiscal and eventual political union if the euro is to be maintained without damage to economic performance or democratic values. French President Emmanuel Macron has advanced similar ideas. And the leader of Germany’s Social Democrats, Martin Schulz, has also thrown his weight behind a “United States of Europe” in recent days.
But there is also an alternative, much less ambitious view, according to which neither fiscal nor political union is needed. What needs to be done instead is to de-link private finance from public finance, insulating each from the malfeasance of the other.
With this separation, private finance can be fully integrated at the European level, while public finance is left to individual member states. This way, countries can reap the full benefit of financial integration while national political authorities are left free to manage their own economies. Brussels would no longer be the bogeyman, insisting on fiscal austerity and drawing the ire of countries with high unemployment and low growth.
Martin Sandbu of the Financial Times has been a strong proponent of the view that a workable monetary and financial union does not require fiscal integration. He believes the critical reform is to prevent bank bailouts by public authorities. The price of bank failures should be paid by the banks’ owners and creditors; we should have bail-ins rather than bailouts.
Sandbu argues that this would not only insulate public finance from the follies of banks; it would also lead to an equilibrium that mimics fiscal risk-sharing between countries that are net borrowers and countries that are net lenders. When banks in the former fail, it is creditors in the latter that would bear the cost. “With banking union, there is no need for fiscal union,” he argues.
In a forthcoming book, the University of California, Berkeley, economist Barry Eichengreen also makes the case for re-nationalizing fiscal policy, which he views as essential to stemming the tide of European populism. Eichengreen thinks returning fiscal policy to national authorities would require preventing banks from holding too much government debt, in order to minimize the risk that national fiscal mismanagement topples the banking system. Governments that go bust would have to restructure their debts rather than get bailouts from other EU states.
Advocates of cutting the Gordian knot between private and public finance recognize that governments’ approach to banks must change radically if this separation is to work. But it is not clear that their proposed remedies would work. As long as economic policy remains the province of national governments, sovereign risk will likely continue to distort the operation of cross-border finance. Sovereign states can always change the rules ex post, which means full financial integration is impossible. And the costs of local financial shocks cannot be diversified away as easily.
Consider what happens when a large bank goes bankrupt in the US – an economic union where the Sandbu and Eichengreen rules already apply. The regional economic spillovers are limited by the fact that other borrowers can continue to function normally: creditworthiness is determined by a borrower’s fundamentals and not its state of residence. No one expects a state government to interfere in inter-state payments, rewrite bankruptcy rules, or issue its own currency in case of extreme distress.
State governments in the US exercise little sovereignty in large part because they have less need of it: their residents receive transfers from the center and send their representatives to Washington, DC, to help make federal policy.
But EU member states are in a very different position vis-à-vis the EU institutions in Brussels. Because they retain sovereignty, they cannot make similarly credible commitments not to interfere with financial markets. So the risk remains that a severe enough financial shock in the EU will affect all other borrowers in the same country in a self-fulfilling manner. Pretending that we can separate private from public finance may exacerbate, rather than moderate, financial boom-and-bust cycles.
In contemporary societies, finance must serve a public purpose beyond the logic of financial market profitability. So it is irrevocably politicized – for good as well as bad reasons. It appears that conservative and progressive policymakers alike are resigning themselves to this reality.