Euro vision: Less than clear

Euro50 Group and Reinventing Bretton Woods Committee

Conference: The Eurozone of yesterday, today and tomorrow, Florence, 3-4 July 2012

Ousmène Jacques Mandeng, Public Sector Group, UBS

I participated in the Reinventing Bretton Woods Committee/Euro50 Group meeting in Florence, Italy on 3-4 July “The Eurozone of yesterday, today and tomorrow.” The meeting brought together the strongest minds from academia and policy circles on Eurozone issues. My main takeaway of the proceedings is the utter disarray of what went wrong and should or could be done to stabilize the Eurozone. This appears all the more remarkable as we are in the fifth year of the global financial and economic crisis. The conclusion must be then that if a gathering of top technocrats cannot reach agreement on steps towards a resolution it seems inconceivable policy makers can. Strikingly as well, the discussion is only about fixing problems to make the euro work rather than whether the euro remains a good idea, that is, is the euro optimal for what Europe would like to achieve? Equally importantly, it left me with the feeling that even if consensus on needed steps towards stabilisation could be reached sequencing of needed measures and implementation would be far too complex for the current or possibly any crop of policy makers. I’m of course not the first to say it but the feasible set for Eurozone stabilisation may simply be empty. My conclusion from the meeting is that serious discussions about an orderly unwinding of the euro should therefore be considered.

The meeting looked back at the construction of the euro, the current situation and needed next steps to avoid its deconstruction. Most would agree that the euro remains the most ambitious  undertaking  in monetary economic history. The discussion served as a reminder about the objectives of euro introduction, early warnings about its inherent flaws in particular governance deficiencies, complexity of the underlying issues, sequencing of additionally needed measures, early and lasting successes of the euro:

Why the euro: Participants seem to agree that the main motivation for introducing the  euro  was  to overcome the impossible trinity, that is, it is impossible to have all three: monetary policy autonomy, open capital accounts and fixed exchange rates. The predecessor arrangement of the euro, the European exchange rate mechanism (ERM) was judged too unstable to be sustainable. One participant told me in private that without the euro the current crisis would also have featured an exchange rate crisis on top. Another participant emphasised that adjustable pegs are the worst of both world providing neither instilling discipline nor incentives for adjustment. Political motivation was also cited as critical, namely that the euro was the result of “French desire and German concession” after the fall of the Berlin wall.

Early warnings: The euro project has of course been subject to considerable criticism from the start. One participant argued that any monetary system needs to be judged by its adjustment mechanism, source of liquidity and whether it instils sufficient confidence. In case of the euro, the adjustment mechanism was neglected. The participant stressed that the euro is a gold standard but without gold; much of which was know at inception but discarded. Under the gold standard adjustment occurs via inflation and deflation plus migration plus flow of funds, an essential insight that was not heeded. One participant acknowledged that the main philosophy was that monetary stability was enough. In this context it is remarkable indeed that while the euro’s spiritual precursor arrangement, the Bretton Woods system of fixed exchange rates, had adjustment at its core, the problem of internal adjustment had not even been addressed by the treaties underlying the euro. One veteran participant highlighted that he was appalled by the level of the debate about the euro at the time and that many suggestions in particular from Americans were seen as mere hostilities.

Cause of crisis: Participants advanced a series of possible causes of the crisis. Lack of macroeconomic convergence was not seen as a main cause. Private capital flows were blamed by several participants that caused undue build-up of asset bubbles and subsequent collapses in some countries. Another participant indicated that the Maastricht treaty held two major flaws by not establishing a banking union and by leaving the notion of fiscal discipline ill defined. One participant underscored that a system that creates such large diversity in unemployment, labour costs, current account balances, savings behaviour is simply not sustainable.

Crisis resolution: Participants were divided on needed steps to achieve stabilisation of the Eurozone. One participant stressed that the only solution is fully fledged integration (“Full Monty”). Another participant underscored that there are only two solutions being default or the monetization of debt and that all other solutions including Eurobonds and related proposals should be discarded. Other participants were concerned that measures geared primarily to bail-out governments risk severely undermining the independence of the ECB and hence its credibility. Several participants saw in the mutualisation of debt a possible resolution including Eurobonds. Another participant asked if a larger EU budget would not be a better alternative to debt mutualisation.

Euro exit: The view that some countries may be leaving the euro was shared by many. One participant stressed that many investors again talk about individual countries in the Eurozone rather than about the Eurozone as a whole also stressing that the Eurozone may not be a desirable club and that the UK confirms as much. The same participant emphasised that membership may only be desirable for countries with impaired credit. One participant emphasised that an exit clause should have been an integral part of the European treaties. The irreversibility of the euro as an exchange rate regime has already been removed as policy makers have started to openly discuss the possibility of a euro exit one participant stressed. While several participants seem to agree that Greece may need to exit, one participant contemplated that Finland may exit first.

Future of Eurozone: Participants seemed broadly in agreement that the future of the euro is uncertain. The risks to the Eurozone are economic, fiscal but also constitutional. In the short term, one participant in private stressed that the  current  lawsuits at  the German  constitutional court (Verfassungsgericht)  may represent the greatest threat. The court may rule as early as end-July that the recent measures in relation to the Fiscal Compact and ESM violate the German constitution that gives sole prerogative in budgetary matters to the German parliament which could mean that a referendum would have to decide on whether such measures can be upheld. Over the medium term, one participant saw as the greatest risk to the euro project a referendum in the UK thus undermining the European Union itself. Another participant indicated that it is essential that agreement is found on the medium-term objective of the Eurozone first in order to be able to formulate a meaningful road-map to attain it.

Fiscal union: Participants were divided on whether a fiscal union would constitute a sufficient condition to stabilise the euro crisis and whether it was desirable. One participant stressed that the main problem was the socialisation of debt as this would undermine fiscal discipline. Another participant explained that the need for fiscal rules were recognised at the time of formulating the Maastricht treaty and widely discussed and common bank supervision was also seen as important. The underlying assumption, the participant indicated was that the EU budget would grow overt time to reach about 3 percent of EU GDP (it’s about 1 percent today) highlighting that in 19th century U.S. the federal budget was only 1 percent of GDP. One participant underlined that the no-bail out rule of the Maastricht treaty was not credible and that rules for fiscal policy are not optimal but a good second best. Another participant stressed that while a rules-based system may in principle work, the main problem is that the large number of possible rules makes it virtually impossible to know which rules to reasonably apply. One participant indicated that agreement needs to be found on deeper integration based on institutions rather than rules-based government. Within the context of whether the U.S. could provide guidance, participants seemed to disagree about the relevance of the U.S. model. One participant highlighted that the U.S. federal budget only faces a soft budget constraint amid the dollar’s role as the main reserve currency but that the states face hard budget constraints while indicating that state debt in the U.S. is very low. One participant stressed that Germans are very skeptical regarding any sort of transfer union as the federal system in Germany is seen as highly dysfunctional. Another participant stressed that the main problem is that France, Spain and Italy would not be willing to give up their sovereignty to allow a fiscal union to work. The fundamental issue of whether a monetary union requires a fiscal union was not debated. The fact that currency board arrangements work without any common fiscal framework may indicate that a fiscal union may be a desirable but not necessary condition.

Eurobonds: Participants were divided on the usefulness of Eurobonds for crisis resolution. One participant stressed the need for Eurobonds to restore a safe asset for the periphery. Several participants stressed that debt mutualisation is necessary to contain instability and risks of runs on countries reviewing the different options including blue and red bonds, eurobills and redemption bonds.1 The participant focused on the redemption bonds indicating that this proposal would actually at the end of its life exhibit no mutualisation and stressing that it had received certain support. One participant underlined that Eurobonds would not solve the problem of underlying economic divergence. Another participant emphasised that Eurobonds would constitute the end of monetary union by politicising the union with adverse political consequences due to the lack of democratic legitimacy. One participant remarked that considerations for debt mutualisation must be preceded by the question of what sort of fiscal union the Eurozone would like to adopt over the long run. Another participant explained that the EFSF/ESM exhibited elements of debt mutualisation and constitutes the most advanced Eurozone fiscal pillar.

Supervision and banking union: Several participants saw a banking union as an important step towards crisis resolution but there was no agreement on needed elements. The risk of financial sector fragmentation was seen by many. However, uncertainty remained as to whether policy makers envisage common banking supervision and bank deposit insurance and resolution for only systemically important banks or the entire banking system. The risk of financial fragmentation would increase with a two tier banking supervision while expected resistance to common supervision by some financial institutions notably Sparkassen (credit unions) in Germany was cited by one participant in private as critical. Another participant indicated that the choice to give the role of supervisor to the ECB has been made and that supervision will be conducted by the national central banks. The assumption of supervision was seen by some participants as severely undermining the independence of the ECB as possible needed closures of banks was seen as far too controversial. Some other participants seemed to think that the ECB’s independence would be a critical element for effective supervision and bank resolution. Several participants highlighted that any deposit guarantee would need to be backed by some government guarantee to be meaningful. Another participant underscored that deposit insurance does not guard against redenomination risk. One participant highlighted that a banking union was simply a fiscal union but off-balance sheet while another participant saw as a contradiction that Germany would on the one hand resist Eurobonds while agreeing to a banking union. One participant proposed that a common bank deposit scheme could be financed upfront from future revenues from participating banks.

Trust: The importance of restoring trust has been emphasised repeatedly. Several participants stressed that trust has ebbed and that considerable uncertainty had been created by the management of the crisis. One participant also stressed that Germans feel that they have been tricked into accepting the latest resolution proposals.

Democratic deficit: The lack of adequate governance structures was seen as a significant threat to the survival of the euro. One participant stressed that equal treatment also needs to be upheld firmly and that exceptions obtained by France and Germany in 2002 amid violations of the Stability and Growth Pact and for Spain today against provisions in the ESM treaty undermine severely confidence. Several participants stressed that  the principle of no taxation  without representation must prevail and guide strengthening governance structures.

ECB and monetary policy: The ECB’s monetary policy stance was seen as ambiguous and some participants criticised adequacy of policy measures. One participant stressed that the similarities between the ECB, Bank of England and Federal Reserve outweigh the differences. While the ECB expanded its balance sheet about three times mostly through repos, the BOE and Fed expanded their balance sheets four times mostly through outright purchases. The participant stressed the increased risk on central banks’ balance sheets due to the extraordinary measures but remained confident about an orderly exit through issuance of fixed-term deposits or securities. The need for monetary policy differentiation across the Eurozone was emphasised by some participants while one participant stressed that such differentiation reveals the inherent problems of the monetary union. One participant explained that in the U.S. state debt can be used as collateral for refinancing operations with the Fed but that differential haircuts are applied depending on the state’s finances. Another participant explained that the ECB employs the same approach by which haircuts are applied depending on market prices or internal models such that ex-post after applying  a  haircut  all securities or other assets exhibit the same risk. Participants seem to agree that the Eurozone payment system TARGET needs to avoid limits otherwise the euro would become a simple fixed exchange rate regime.

Banking stress: Balance sheet impairment and the effect of new bank regulation weigh on financial stability. One participant emphasised that Basle III reduces considerably incentives for banks to buy bank debt while currently banks hold about 50 percent of bank debt posing an important risk to financial stability. Another participant indicated that a large proportion of Spanish banks suffer from mortgages paying less than their funding costs. One participant also highlighted that European banks withdrew from lending to Asia and that Basle III will make banks more reluctant to lend to emerging markets. One participant showed that bank leverage is still high compared with other crises and that the interbank market remains dysfunctional.

Economic growth: The resumption of economic growth was seen as essential to allow restoration or strengthening of debt sustainability. One participant remarked that there is no historic precedent where a debt to GDP ratio was lowered by reducing GDP. The participant indicated that the risk  of  sectoral stagnation that when everybody saves there will be no growth. One participant outlined that the European Investment Bank (EIB) capital is to increase by EUR10 billion by year-end to lend about EUR70 billion per year which would constitute about 2.5 percent of total EU investment spending and about 7 percent when taking into account co-financing. Several participants saw recent growth supporting measures as insufficient.

The discussion about the euro appeared highly asymmetrical by focusing on resolution rather than dissolution. The euro risks being treated as dogma by its defenders causing deep divisions possibly a generational conflict between euro architects and the rest. The path dependence of the  euro  debate therefore avoids answers to critical questions such as whether it is efficient for the Eurozone to maintain the euro. This would allow to study whether the euro is superior to other regimes to support the Eurozone’s present and future objectives while those would of course need to be defined first. If Europe wants to become something like a United States of Europe then the euro will be a necessary element but if Europe has other plans it may not be.

The euro failed to produce the desired economic convergence it was meant to achieve and seem to be producing undue incentives for undermining the regime itself. The discussion above appears to suggest that the euro may simply be too complex to work or the array of conditions to make it work too many or too costly. The Bretton Woods agreement collapsed in its 13th year, was a lesser project and involved stronger minds. The euro is now in its 13th year. It is probably a good time to pause and reflect on whether going further still makes sense for Europe. If it does not then a plan for unwinding the euro needs to be contemplated and its economic costs compared to those of maintaining the current course.

1 The proposals share the common problem of introducing market segmentation and associated adverse market impact of the junior claim class. The proposals also seem to violate the fundamental notion of creditor preference avoidance (by which certain creditors benefit as their claims are being moved prior to bankruptcy). The proposals also leave open the problem of the selection of claims to be included in one or the other claim class.