Embroiled with the Greek crisis, European policymakers will soon have to step back and reflect on the broader question of the future of the Eurozone. Before calling for an exit or, on the contrary, for further integration, it is worth pondering over the consequences of each option.
Oversimplifying, one could say that there are two strategies for managing the Eurozone: the current one which builds on the 1992 Maastricht treaty and its Fiscal Compact update in 2012; and a more ambitious federalist alternative. Federalism would be my preferred arrangement, but I am not convinced Europeans are ready to do what it takes to make it work.
The Maastrichtian approach infringes member state sovereignty only through the monitoring of public deficits and debts. The founding fathers were presciently concerned that an impending default of a particular country may trigger a bailout: hence the Maastricht Treaty enclosed both a debt limit and a “no bailout clause”. Solidarity towards a troubled country is driven by the fear that spillovers from the distressed country’s default should negatively affect the rescuers. Negative externalities from default can be both economic (reduced trade, exposures for subsidiaries and banks, runs on other countries) or non- economic (empathy, jeopardy of European construction, distressed country nuisance power). The prospect of a bailout in turn may generate moral hazard; in the last decade, cheap borrowing rates triggered by expected bailouts may well have allowed the periphery to continue on unsustainable paths before 2010.
The Maastrichtian approach has failed so far. To understand why, let’s consider the four hurdles it comes up against: uniformity, complexity, implementability, and limited solidarity.
Fearing accusations of discrimination, Europe picked the same constraints across countries, as if there were a magic number for debt sustainability. However, uniformity has no theoretical underpinnings other than its transparency for the citizens of Europe: 40% debt may be unsustainable for one country, while another can sustain 120%. It all depends on a range of factors: a country’s debt sustainability can for instance be boosted by stronger tax- collection and tax-increase capacities, higher growth rates, increased political influence of the political constituencies who would lose from a default, or sovereign debt home ownership (countries don’t like to default on their own citizens or banks).
Complexity refers to the difficulty in measuring a country’s actual indebtedness. Until the recent reform of the Growth and Stability Pact and changes in Eurostat rules, debt statistics included only debts that are owed for sure. Contingent debt (off-balance exposures) can however be substantial: unfunded pensions, guarantees given to public enterprises or social security, potential losses incurred through ECB guarantees or the European Stability Mechanism (the latter are now reported but not included in the debt). Some of the brightest minds had become experts at securitizing future revenue or using derivatives to conceal indebtedness.
On the implementability front, the Eurozone finance ministers have failed to sanction the many violations of the Stability and Growth Pact. This should not come as a surprise. Firstly, finance ministers are reluctant to risk the wrath of a violating country through an intervention that is unlikely to change the collective decision. Political agendas are also relevant; the otherwise very legitimate goal of European construction has often been invoked to turn a blind eye on dubious accounting practices or insufficient preparation to enter the Eurozone. Third, quid pro quos are expected by all.
Given that the political process is unlikely to deliver the desired outcome, the Maastrichtian approach would seem to require a highly professional and independent budget council. Unlike existing ones, this budget council would be European (after all, the crux of the matter is the “agency” relationship between Europe and individual member states) and capable of imposing prompt and corrective action. Moreover, as financial sanctions are not efficient when a country is broke and in recession, alternative measures have to be taken, compounding worries about legitimacy and sovereignty.
Limited solidarity means that, in the absence of a bailout, there is no mechanism to stabilize a distressed economy, which must bear the full cost of the adjustment. Ex-postinsurance is necessarily limited. The whole debate about who would gain and lose from a fiscal stimulus by core countries points to the limitations of ex-post solidarity. This brings me to a discussion of the alternative, federalist approach.
Such a federalist approach, which I support, inevitably involves substantially higher risk sharing. Eurobonds would make European countries jointly liable for each other’s debt. A common budget, deposit insurance and unemployment insurance would act as automatic stabilizers, offering much more protection to countries and making the intended no-bailoutpolicy more credible (stabilizers reduce excuses for poor performance); in this latter respect we should recall that the US federal government stopped bailing out its states in the 1840s.
The federalist vision has two prerequisites. Firstly, countries living under a shared roof must have common laws so as to limit moral hazard. The Banking Union here gives us some hope and may pave the way for common deposit insurance, as centralized regulation makes it less likely that prudentially careful countries should have to pay for lenient ones. But consider unemployment insurance; the rate of unemployment in Eurozone countries is only partly determined by the cycle; most of it is linked to choices concerning employment protection, active labor market policies, social security contributions, professional training institutions and so forth. Clearly countries that pick institutions leading to unemployment rates of 5% won’t want to co-insure with those that create 20%. Europeans struggle still with the idea of giving up their sovereignty.
Secondly, any insurance contract must be signed behind the veil of ignorance. You won’t agree to solidarity within a home insurance scheme if my house is already on fire. The current asymmetry between Northern and Southern countries could perhaps be taken care of by identifying and insulating legacy problems and dealing with them. But the first prerequisite will still stand: we Europeans need to accept the loss of sovereignty that goes together with living under the same roof. And to do so, we must rehabilitate, and stand together for the European ideal, which is no mean feat these days…