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ISSUE 2012/01JANUARY 2012 THE EURO CRISIS

AND THE NEW

IMPOSSIBLE TRINITYJEAN PISANI-FERRY

Highlights

The search for solutions to the euro crisis is based on a partial diagnosis that over-emphasises the lack of enforcement of existing fiscal rules. Europes leadersshould rather address the euro areas inherent weaknesses revealed by the crisis.

At the core of euro-area vulnerability is an impossible trinity of strict no-monetaryfinancing, bank-sovereign interdependence and no co-responsibility for publicdebt. This Policy Contribution assesses the corresponding three options for reform:a broader European Central Bank (ECB) mandate, the building of a bankingfederation, and fiscal union with common bonds. None will be easy.

The least feasible option is a change to the ECBs mandate; changing marketperceptions would require the ECB to credibly commit overwhelming forces, andthe ECB is simply not in a position to make such a commitment. The building of abanking federation, meanwhile, involves reforms that are bound to be difficult.Incremental progress is likely, but a breakthrough less so.

This leaves fiscal union. It faces major obstacles, but a decision to move in thisdirection would signal to the markets and ECB a commitment to strongerEconomic and Monetary Union. One possibility would be to introduce a limited,experimental scheme through which trust could be rebuilt.

This Policy Contribution draws on presentations made at the XXIV Moneda y CrditoSymposium, Madrid, 3 November 2011, at the Asia-Europe Economic Forumconference in Seoul, 9 December, and at De Nederlandsche Bank in Amsterdam on 17December. I am very grateful to Silvia Merler for excellent research assistance. I thankparticipants in these seminars and Bruegel colleagues for comments and criticisms.

Telephone+32 2 227 [email protected]

www.bruegel.org

BRUEGELPOLICYCONTRIBUTION


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THE EURO CRISIS AND THE NEW

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JEAN PISANI-FERRY, JANUARY 2012

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1. These provisions are partof the so-called six-pack, a

set of legislative acts result-ing from proposals made by

the European Commissionand from the report on eco-

nomic governance in the EUprepared by Herman VanRompuy, the president of

the European Council. Thesix-pack was adopted bythe European Parliament

and the Council on 16November 2011.

2. See the Euro SummitStatement of 26 October

2011.

3. Speech by Mario Draghi,1 December 2011.

4. Statement by euro-areaheads of state and govern-

ment, 9 December 2011.

5. Interestingly, the Euro-pean Commission report on

the first ten years of EMU(European Commission,2008) emphasised the

errors resulting from theneglect of non-fiscal dimen-sions such as competitive-

ness, credit booms andcurrent-account deficits. Forthis reason the six-pack leg-

islation introduced a newprocedure called the Exces-sive Imbalances Procedure

to address external imbal-ances. However subsequent

policy discussions haverefocused on fiscal issues.

1 INTRODUCTION

Since the euro crisis erupted in early 2010, theEuropean policy discussion has mostlyemphasised its fiscal roots. Beyond short-term

assistance, reflection on reform has focused onthe need to strengthen fiscal frameworks atEuropean Union and national levels. The sequenceof decisions and proposals is telling:

In 2011, the EU adopted new legislation,effective from 1 January 2012, that reinforcespreventive action against fiscal slippages, setsminimum requirements for national fiscalframeworks, toughens sanctions againstcountries in excessive deficit and tightens upenforcement through a change in the votingprocedure1.

On 26 October 2011, the euro-area heads ofstate and government decided to go further andcommitted themselves to adopting constitu-tional or near-constitutional rules on balancedbudgets in structural terms, to basing nationalbudgets on independent forecasts and, forcountries in an excessive deficit procedure, toallowing examination of draft budgets by theEuropean Commission before they are adopted

by parliaments2. A few weeks later, in Novem-ber 2011, the European Commission put for-ward proposals for new legislation requiringeuro-area member states to give the Commis-sion the right to assess, and request revisionsto, draft national budgets before they areadopted by parliament.

Speaking in the European Parliament in earlyDecember, European Central Bank PresidentMario Draghi asked for a 'new fiscal compact'

which he defined as a fundamentalrestatement of the fiscal rules together with themutual fiscal commitments that euro-areagovernments have made, so that these

commitments become fully credible,individually and collectively3.

On 9 December 2011, EU heads of states andgovernment, with the significant exception of

the United Kingdom, committed themselves tointroducing fiscal rules stipulating that thegeneral government deficit must not exceed0.5 percent of GDP in structural terms. Theyalso agreed on a new treaty that would allowautomatic activation of the sanction procedurefor countries in breach of the 3 percent of GDPceiling for budgetary deficits. Sanctions asrecommended by the European Commissionwill be adopted unless a qualified majority ofeuro-area member states is opposed4.

The question is, are the Europeans right to see thestrengthening of the fiscal framework as the main,possibly the only, precondition for restoring trustin the euro? Or is this emphasis misguided?

It is striking that in spite of a growing body ofliterature drawing attention to the non-fiscalaspects of the development of the crisis, otherproblems that emerged during the euro crisis havealmost disappeared from the policy discussion attop level5. Credit booms and the perverse effects

of negative real interest rates in countries wherecredit to the non-traded sector gave rise to asustained rise in inflation were the focus of policydiscussions in the aftermath of the global crisis,but these issues have largely disappeared fromthe policy agenda at head-of-state level. Realexchange rate misalignments within the euroarea, and current-account imbalances, are largelyconsidered to be of lesser importance, or meresymptoms of the underlying fiscal imbalances.Finally, the role of capital flows from northern to

southern Europe and their sudden reversal, aremerely discussed by academics and centralbankers, though the sudden reversal of north-southcapital flows inside the euro area is fragmenting

THE EURO CRISIS AND THE NEW IMPOSSIBLE TRINITY Jean Pisani-Ferry


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the single market and creating major imbalanceswithin the Eurosystem of central banks6.

To address the issue I start in section 2 by brieflyreviewing the evidence on the link between fiscalperformance and market tensions. I then turn topresenting in section 3 why the crisis hasrevealed a more fundamental weakness in theprinciples underpinning the euro area. In section4, I discuss options for the way out. Policyconclusions are presented in section 5.

2 IS FISCAL DISCIPLINE THE ISSUE?

It is undoubtedly true that the euro area in its firstten years suffered from a lack of fiscal discipline,that from the standpoint of sustainability of publicfinances good times were wasted, and that thecredibility of fiscal rules was compromised(Schuknecht et al, 2011). Greece notoriouslymisreported budgetary data and flouted theEuropean fiscal-discipline rules. In spite of havingpromised that they would avoid excessivedeficits, and in spite of the thorough monitoringdone by the European Commission, from 1999 to

2008 six countries out of twelve (excluding recentadditions to the euro area) found themselves inan 'excessive deficit' position. And the now-infamous Council decision of 25 November 2003to hold the excessive deficit procedure for Franceand Germany 'in abeyance' is rightly regarded ashaving weakened significantly the credibility ofthe European fiscal framework.

Two observations however caution against anexclusive emphasis on strengthening fiscal disci-

pline through tougher and more automatic rules.

First, behaviour vis--vis the rules of the Europeanfiscal framework (the Stability and Growth Pact orSGP) is a very poor predictor of the difficultiesexperienced nowadays by euro-area countries.Figure 1 shows recent spreads vis--vis theGerman Bund against past infringements of theSGP7. It is apparent that there is no relationshipbetween the two: countries such as Ireland and

6. Recent contributions tothe literature on the non-fiscal roots of the eurocrisis include De Grauwe(2011), Gros (2011), Laneand Pels (2011), and Sinnand Wollmershaeuser(2011).

7. In order to avoid theresult being biased by polit-ical weight (for example, acountry could have escaped

being singled out as infring-ing the SGP because ofpolitical clout within theCouncil of Ministers, whichvotes on sanctions and thesteps leading to them), Itake instead the number ofyears between the Euro-pean Commission recom-mendation that the countrybe declared to be in exces-sive deficit, up to its recom-mendation of abrogation ofthe excessive deficit proce-dure. Data relating to theexcessive deficit procedureis taken from the EuropeanCommissions website.

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The euro area in its first ten years suffered from a lack of fiscal discipline, while from thestandpoint of sustainability of public finances good times were wasted, and the credibility of

fiscal rules was compromised.

Spain that were never found to have infringed therules, suffer from large spreads, whereas Germanyand the Netherlands, which were found guilty of it,enjoy remarkably low rates. This suggests that thesimplistic view that a thorough enforcement of therules would have prevented the crisis should betreated with caution.

The second piece of evidence is that several euro-area countries are experiencing elevatedgovernment-borrowing costs in spite of being inmuch sounder positions than the US, the UK orJapan. Calculations by the International MonetaryFund (2011) suggest that future adjustmentsfacing non-euro area countries are of the sameorder of magnitude as those confronting euro-areacountries in trouble. Pairwise, Japan and Irelandseem to be in similar situations, as do the US and

Portugal. However, only the two euro-areacountries have experienced a rise in bond yields(Figure 2).

As observed by Paul De Grauwe (2011), thecomparison between Spain and the UK isparticularly telling. Even taking into account thepotential cost of recapitalising Spanish banks, thetwo countries face broadly similar fiscalchallenges (Figure 3), yet at the end of November

Jean Pisani-Ferry THE EURO CRISIS AND THE NEW IMPOSSIBLE TRINITY

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 50

5

10

15

20

25

30

Duration of Excessive Deficit Procedure (years)

Avg.

10yrgvt.

bond

yield

Sept-Nov2011(

%)

GR

IE

ES

BESL

AT

FI

NL

IT

MT

FR

SK

DE

PT

Figure 1: SGP infringements (1999-2008) andcurrent bond yields (Sep-Nov 2011)

Source: Bruegel based on European Commission, Datastream.


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2011, Spanish 10-year bond rates were 6.5percent against 2.3 percent in the UK. Yields on UK

gilts even reached a lower level than those oncomparable German bonds.

This comparison is prima facie evidence that thefiscal situationper se fails to explain tension in theeuro-area government bond markets. Or, to put itslightly differently, although their levels of deficitand public debt are the same, euro-area countriesseem to be more vulnerable to fiscal crises thannon-euro area countries. Explanations for thisneed to be considered.

3 THE NEW IMPOSSIBLE TRINITY

To understand what makes euro-area states morefragile, it is best to start from the basic tenets onwhich the European currency is based. Three are

especially relevant: the absence of co-responsibility for public debt; the strict

no-monetary financing rule; and bank-sovereigninterdependence, ie the combination of stateresponsibility for supervising (and if necessaryrescuing) banking systems and the holding bythese very banks of large stocks of debt securitiesissued by their sovereigns.

No co-responsibility for public debt

Governments in the euro area are individuallyresponsible for the debt they have issued. It iseven prohibited for the EU or any of the nationalgovernments to assume responsibility for the debtissued by another member country. This principle,known as the no bail-out clause, is enshrined inthe EU treaty, the relevant article of which (Art.125) deserves to be quoted in full: The Union


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Required budgetary adjustment (% of GDP) 10-year government bond yields

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Portugal

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Figure 2: Required 2010-2020 budgetary adjustments and government bond yields

Source: Left panel: IMF (2011). The bar represents the adjustment in the cyclically-adjusted primary balance required toreduce the debt ratio to 60 per cent in 2030, assuming constant CAPB between 2020 and 2030. Calculation assumes a uni-form interest rate-growth rate differential. Right panel: Datastream

Gen eral gov t. net lending/borrowing (%GDP ) Gen eral gov ernment gross debt (%GDP )

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Forecast

Figure 3: Government deficit and public debt in Spain and the UK, 1995-2013

Source: AMECO database and European Commission forecasts of November 2011.


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8. Marzinotto, Pisani-Ferryand Sapir (2010) discusswhy the EU could not relyon its traditional balance-of-payment assistance instru-ments and explain why theexclusion of euro-areamembers from this assis-tance cannot be regardedas resulting from the no-bail-out clause.

9. Shortly after Greece

joined the euro in 2001,rating agencies upgradedits status to upper invest-ment-grade levels. Accord-ing to Sara Bertin, thenGreece analyst at Moodys,this was done in the beliefthat Greece was now part ofthe euro zone and thatnobody was ever going todefault. See Julie Creswelland Graham Bowley, Rat-ings firms misread signs ofGreek woes, The New York

Times, 29 November 2011.

10. See Buiter and Sibert(2005) for an early discus-sion of ECB collateral policy.

shall not be liable for or assume the commitmentsof central governments, regional, local or other

public authorities, other bodies governed by publiclaw, or public undertakings of any Member State,without prejudice to mutual financial guarantees

for the joint execution of a specific project. AMember State shall not be liable for or assume thecommitments of central governments, regional,local or other public authorities, other bodies

governed by public law, or public undertakings ofanother Member State, without prejudice to mutual

financial guarantees for the joint execution of aspecific project.

In plain English this means that sovereign defaultis a risk to consider, and the rationale for thisprovision was indeed to set the rules of the gameclearly and ensure that markets would pricesovereign risk accordingly. Unlike in the US, wherethe no bail-out principle emerged over a longperiod (Henning and Kessler, 2012), the aim wasto prevent moral hazard and thereby to providefrom the start clear incentives for governments toabide by fiscal discipline.

No provision unfortunately stated what wouldhappen in the event of a euro-area sovereignlosing access to the market. One possibleinterpretation of the treaty was that it would haveto restructure its public debt. A second one is thatit would have to turn to the IMF and be subject tostandard procedures for conditional support or, ifneeded, insolvency. A third one was that despitethe lack of an instrument to this end, the othereuro-area member states would find ways toprovide temporary conditional assistance. There

was therefore significant ambiguity in theinterpretation of one of the treatys fundamentalprinciples8.

For ten years, from 1999 to 2008, markets in factdid not differentiate euro-area borrowerssignificantly (Figure 4).

Anecdotal evidence suggests that there was awidely held view that in case of problems, the nobail-out principle would not be strictly enforced9.

Why markets failed to price sovereign riskappropriately is a matter for discussion; howeverit is clear that from banking regulation (until BaselII started to be implemented in the late 2000s,

sovereign bonds were deemed risk-free) to ECBcollateral policy (bonds issued by all euro-areasovereigns were treated similarly), policy in thefirst decade of Economic and Monetary Union(EMU) contributed to the narrowing of spreads10.It is only when the Greek crisis erupted andmarkets realised that Greece might have to defaulton part of its debt, that perceptions changed and

the sovereign risk began to be priced in the bondmarket.

Strict no-monetary financing

The second tenet is the strict prohibition ofmonetary financing. Art. 123 of the EU Treatystates that Overdraft facilities or any other type ofcredit facility with the European Central Bank orwith the central banks of the Member States(hereinafter referred to as national central

banks) in favour of Union institutions, bodies,offices or agencies, central governments, regional,local or other public authorities, other bodies

governed by public law, or public undertakings ofMember States shall be prohibited, as shall the

purchase directly from them by the EuropeanCentral Bank or national central banks of debtinstruments.

This article can be read as a prohibition ofinstitutionalised fiscal dominance in the form of

explicit agreements between a government and acentral bank similar to the Fed-Treasuryagreement of 1942, which set the US central bankthe goal of maintaining relatively stable prices


0

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35Austria Belgium Germany France

Greece Ireland Italy Netherlands

Portugal Finland Spain

June 1990 Dec 2011

Figure 4: Yields on 10-year government bonds,selected euro-area countries, 1990-2011

Source: Datastream.


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11. See for example Wood-ford (2009).

12. Whether or not thisinsurance amounts to an

implicit guarantee of debtmonetisation is a matter for

discussion. Central banksgenerally maintain that

they would not preserve thesovereign from funding

crises in case of unsustain-able fiscal policy but thatthey would act to preventself-fulfilling debt crises.

and yields for government securities11. The ECBstill has the option of buying government bonds

on the secondary market and actually it made useof this with the launch of the so-called SecurityMarkets Programme in May 2010, first topurchase Greek and Portuguese bonds and later,in August 2011, to purchase Italian and Spanishbonds (for a total amount of about 200 billion atend-November 2011). But the provision isindicative of a broader philosophy of strictseparation between fiscal and monetary policy,and the purchase of government securities makesthe ECB clearly uncomfortable.

Furthermore, the ECB does not have a strongfinancial-stability mandate that could justifyintervention to prevent turmoil on the bondmarket. Its mandate is only to contribute to thesmooth conduct of policies pursued by thecompetent authorities relating to the prudentialsupervision of credit institutions and the stabilityof the financial system(Art. 127-5). The reasongiven by the ECB for the launch of the SecurityMarkets Programme was in fact not thepreservation of financial stability, but rather the

prevention of disruption to the propertransmission of monetary policy decisions.

In this respect the ECB is a very special type ofcentral bank compared to other monetaryinstitutions that are not constrained by theprohibition of purchases of government bonds andhave often been given an explicit financialstability mandate. To the extent that such centralbanks are seen by markets as ready to embark onwholesale bond purchases if required in the name

of financial stability, they provide an implicitinsurance to the sovereign and contribute to theavoidance of multiple equilibria12. This is not thecase with the ECB.

Banks-sovereign interdependence

The third important tenet is bank-sovereigninterdependence, which results from both policyprinciples and the inherited structures of nationalfinancial systems.

Whereas the euro area is integrated monetarily,banking systems are still largely national. To startwith, states are individually responsible for

rescuing banks in their jurisdictions. As aconsequence, states are highly vulnerable to thecost of banking crises especially when they arehome to banks with significant cross-borderactivities. In 2010, total bank assets amounted to45 times government tax receipts in Ireland, andthe ratio was very high in several other countries(Figure 5).

The consequences of this situation becameapparent when Ireland had to rescue its bankingsystem after it suffered heavy losses in the creditboom of the 2000s. Ireland at the end of 2007 hada 25 percent debt-to-GDP ratio and it was deemeda fiscally super-sound country. At the end of 2011its debt ratio was evaluated at 108 percent andthe country had had to file for an IMF-EUconditional assistance programme. But Ireland isonly an extreme case: in fact, all western European

sovereigns in the euro area (but much less so thenew member states, where banks are largelyforeign-owned) are heavily exposed to the risk ofhaving to rescue domestic banks.

The other side of the coin is that banks areexposed to their own governments through theirholdings of debt securities. Figure 6, which reportsdata for 2007, the last year before the globalfinancial crisis, shows that this was at least truefor the continental European countries, where

banks held large sovereign-debt portfolios, thoughmuch less so for Ireland where, as in the UK andthe US, banks do not (or at least did not) holdmuch government debt.


Ireland

Cyprus

Malta

Spain

Netherlands

France

Portugal

Austria

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ermany

Belgium

Greece

Italy

Finland

Estonia

Slovenia

Slovakia

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Figure 5: Ratio of total bank assets togovernment tax receipts, 2010

Source: Bruegel based on Eurostat, ECB.


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Bank holdings of government securities would notrepresent a risk if they were diversified, but in factthey are heavily biased towards the sovereign(Figure 7). This home bias is apparent in mosteuro-area countries and it implies that wheneverthe sovereign finds itself in a precarious situation,banks are weakened as a consequence. This forexample happened in Greece, where banks are

relatively strong but are highly vulnerable to therisk of default of the Greek sovereign.

Home bias diminished after the introduction of theeuro eliminated currency risk, and regulationsthat treated foreign euro-denominated bonds dif-ferently from national bonds were scrapped. Aspointed out by Lane (2005, 2006) and Waysand,Ross and de Guzman (2010), EMU triggered a sig-nificant increase in cross-border bond investment

within the euro area, beyond the diversification ofportfolios resulting from financial globalisation.

Nevertheless, as late as in 2010 domestic homebias persisted to a surprising degree13.

As banks held significant government bondportfolios, and as these portfolios exhibited ahome bias, in 2007 about one-fourth of the bondsissued by the state were held by domestic banksin Germany, Italy, Spain and Portugal (Table 1).The proportion was less, but still noticeable, inFrance, the Netherlands and Greece. Only inIreland were banks negligible holders ofgovernment securities.

Furthermore, the exposure of domestic banks tosovereign risk increased in recent times as theylargely substituted non-residents in countriessubject to market pressure. In fact, between 2007and mid-2011 the share of outstanding debt heldby domestic banks increased markedly in Greece,Portugal and Ireland, and to a lesser extent inSpain and Italy, while it decreased significantly inGermany (Figure 8).

The exposure of governments to their banks andof banks to their governments makes publicfinances in the euro area particularly prone toliquidity and solvency crises. Markets haverealised that such a configuration is a source ofsignificant vulnerability and they are pricing therisk that governments go further into debt as aconsequence of bank weaknesses, or that banksincur heavy losses as a consequence of theirsovereign holdings.


Italy

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rmany

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ortugal

US

France

Netherlands

Ireland

UK

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30

Domestic banks (incl. NCB)

National central bank (NCB)

Figure 6: Bank holdings of debt issued by theirsovereign as % of GDP, selected countries, 2007

Source: Bruegel, based on national data.

GR MT ES PT IE IT DE AT SI LU FI BE NL FR CY0

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100

Share of domestic exposure in overall sovereign exposure

Share of country in total euro-area general gov. debt

Share of country in total euro-area central gov. debt

Figure 7: Indicator of home bias in bank holdings of government debt, 2010

Source: Bruegel based on EBA, Eurostat.

13. Data in figure 7 is for2010. Data for prior yearsare not available.


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Implications

The coexistence of these three tenets makes theeuro area unique. Existing federations may or maynot apply the no-coresponsibility principle(arrangements in this respect vary); they may ormay not prevent the central bank from purchas-ing government bonds (in fact they rarely do); butthey do not leave to states the responsibility for

rescuing banks, which in turn do not hold largeamounts of state and local government paper. Inthe US in particular, (a) banks hold very little fed-eral, let alone state and local debt; (b) the Federal

Reserve would be able to intervene to avoid thefederal government losing access to markets; (c)the federal government has no responsibility forstate debt, and the federal government, not stategovernments, is responsible for rescuing banks.

These features can be summarised in the form ofa trilemma. The euro was imagined in the late1980s in response to what was known asMundells trilemma, according to which no countrycan enjoy at the same time free capital flows,stable exchange rates and independent monetarypolicies. Twenty years later the euro area facesanother trilemma between the absence of co-responsibility over public debt, the strictno-monetary financing rule and the national

character of banking systems (Figure 9).


Table 1: Breakdown of govt debt. by holding sectors (% of total), selected countries, mid-2011

Domestic

banks

Central bank ECB Other public

institutions

Other

residents

Non-residents

(excl. ECB)Greece 19.4 2.6 22.9 10.1 6.5 38.5

Ireland 16.9 n/a 16.1 0.9 2.43 63.8

Portugal 22.4 0.8 11.2 - 13.5 52.1

Italy 27.3 4.0 5.3 - 26.7 36.7

Spain 28.3 3.5 4.8 - 30.2 33.2

Germany 22.9 0.3 - 0.0 14.1 62.7

France 14.0 n/a - - 29.0 57.0

Netherlands 10.7 n/a - 1.1 21.4 66.8

UK 10.7 19.4 - 0.1 39.5 30.2

US 2.0 11.3 - 35.5 19.9 31.4Source: Bruegel. Note: The variable considered is central government marketable debt for Greece (2011Q2); central govern-ment long-term bonds for Ireland (2011Q2); general government debt for Portugal (2010Q4); general government debt for Italy(2011Q2); general government debt for Spain (2011Q2); central, state and local government debt for Germany (2011Q1);OATs for France (2011Q2); federal government treasury securities for the US (2011Q2) and central government gilts for theUK (2011Q1). For Ireland, holdings by the National Central Bank are included in domestic banks and not in public institutions,due to data availability.

UK

Ireland

Portugal

Greece

Italy

US

Spain

Netherlands

France

Germany

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0

5

10

15

20

25

30

352007 2011

Figure 8: Share of domestic banks in totalholdings of government debt, selectedcountries, 2007 and mid-2011

Source: Bruegel based on national data. Note: data forPortugal is end-2010. National central bank holdings areaggregated with domestic-bank holdings.

Fis

calu

nio

n

Lendero

flastre

sort

fors

ove

reigns

Financial unionStrictno-monetary

financing

No co-responsibilityfor public debt

Bank-sovereign interdependence

Figure 9: The new trilemma

Source: Bruegel.


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This impossible trinity renders the euro area fragilebecause adverse shocks to sovereign solvency

tend to interact perversely with adverse shocks tobank solvency, and because the central bank isconstrained in its ability to provide liquidity to thesovereigns in order to stem self-fulfilling debtcrises. Like the old trilemma, the question aboutthe new one is which of the constraints will giveway.

4 WHICH WAY FORWARD?

The euro areas stated strategy to escape thetrilemma is budgetary consolidation. The goal isfor states to reach debt levels low enough toensure that solvency is beyond doubt. It is indeedindisputable that public finances have to bebrought under control and that this requiressustained budgetary consolidation. The questionis if this strategy is likely to deliver at a closeenough horizon. The already-mentioned IMFsimulations (Figure 2) suggest that this isunlikely: to reach in 2030 a 60 percent of GDP debtratio, several countries have to implementadjustments of unprecedented magnitude

amounting to 5 to 10 percent of GDP in France,Spain and Portugal, and exceeding 10 percent ofGDP in Greece and Ireland. The economicslowdown that started in the second half of 2011and the acute recessions experienced by severalsouthern European countries only add to thechallenge14.

Furthermore, 60 percent of GDP is a very arbitrarytarget. As discussed by the debt crisis literature,defaults in emerging economies actually exhibit

lower debt intolerance thresholds. Reinhart,Rogoff and Savastano (2003) report that from1971 to 2001, more than half of the defaultepisodes in middle-income countries took placedespite the debt ratio being lower than 60 percentof GDP, while Eichengreen, Hausmann and Panizza(2008) point out that a countrys public-financerecord may not be the only motive for low levelsof debt intolerance: inability to borrow in ones owncurrency (the original sin) matters quite a lot too.Another factor is the size of the implicit liabilities

a state may have to take on. On the basis of therecent experience, especially of Spain and Ireland,it might well be that the safe threshold issignificantly below 60 percent of GDP. This would

postpone even further the landing on safeterritory.

Ultimately budgetary consolidation isindispensable, but it is an illusion to assume thatby itself it will restore stability to the euro area. Tocount on it would leave the euro area vulnerablefor many years. Furthermore precipitatedadjustments of the kind implemented in 2011 bycountries under market pressure tend to rely onquick fiscal fixes and for this reason to bedetrimental to medium-term growth, therebyadding to sustainability concerns. To ward offthreats to stability and cohesion, Europe needs tomove on other fronts too and to consider threenon-competing options corresponding to the threepoints of the triangle.

Give the ECB the role of lender-of-last-resort forsovereigns

The first solution, which was widely discussed inthe autumn of 2011, is to give the ECB the role oflender of last resort in relation to the sovereigns.As in the case of a central bank vis--vis

commercial banks, this would not amount togiving it the task of making insolvent countriessolvent. Rather, the ECB could either lend for alimited period to a sovereign at a rate that is abovethe risk-free rate but below the rate the sovereignhas to pay on the market; or, as in the Gros-Mayer(2011) proposal, it would provide a credit line to apublic entity (the European Financial StabilityFacility, or EFSF, in the Gros-Mayer proposal) inorder to leverage its capital and give it enoughfirepower. This entity would then intervene in the

market, preferably following a policy rule of somesort. Either way, the ECB would provide liquidity toprevent states from being cut off from financing,and it would help put a ceiling on what they haveto pay to borrow, thereby stemming potentiallyself-fulfilling debt crises. In a way, ECB supportwould serve as a deterrent and it could well be thatgovernments would never have to draw on it.

There have been intense discussions in the euroarea about this approach, which was advocated

by many experts, expected by markets, endorsedby several European governments, includingFrance, supported by the US, but in the endresisted by Germany. The ECB has taken a step

14. These calculations weremade before the 26 Octoberagreement on Greek debtreduction.



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towards it with the launch of the Security MarketsProgramme, but its action has not been

demonstrably effective, in part because thecentral bank acted half-heartedly and withoutclear policy objectives.

As a permanent device, and even leaving asideobjections of principle, the lender of last resort forsovereigns approach however raises a number ofdifficulties.

First, the ECB does not have an explicitmandate for it. Changing the mandate toinclude financial stability would raiseconsiderable difficulties as it would requireunanimous agreement (of the 27 EU members,because the ECB mandate is defined by aprovision of the Maastricht treaty).

Second, beyond the mandate a key reason whythe ECB is uncomfortable buying governmentpaper is that unlike the Fed when it buys UStreasury bonds or the Bank of England when itbuys gilts, such a move inevitably involvesdistributional dimensions. Should it incur

losses on its bond portfolio (not an abstractpossibility since it has already incurred losseson its purchases), the ECB would have torequest from its shareholders the injection ofadditional capital, thereby becoming thevehicle for a transfer in favour of the countriesbenefitting from the purchases.

Third, the ECB does not have the rightgovernance for deciding on such actions.Within its governing council, all governors of

national central banks have the same vote,unlike in a shareholder-based organisation. Acoalition of small-country governors could thustheoretically trigger intervention in favour oftheir countries at the expense of the largercountries which would contribute the bulk ofrecapitalisation.

Fourth, unconditional support, or supportassociated with weak conditionality, is a recipe

for creating moral hazard, as illustrated by theItalian parliamentary coalitions response to

the initiation of bond purchases by the ECB: ittook only days for it to backtrack (temporarilyat least) on its fiscal commitments. Theproblem for the ECB, however, is that it is notequipped to exercise conditionality. Venturinginto this field is a risky strategy for aninstitution whose independence hinges on thespecified character of its mandate.

None of these arguments is final enough toprevent action in emergencies. But taken togetherthey suggest that there are significant legal andpolitical obstacles to giving the ECB a roleequivalent to those played by other major centralbanks. Even assuming the Governing Councilwould agree on playing this role, its commitmentwould most probably lack the credibility that isrequired to make this strategy effective, becausemarkets would anticipate the obstacles and thelimitations they would imply.

Break the banking crisis-sovereign crisis viciouscircle: (a) regulatory reforms

It has been long known that because it rules outthe possibility of inflating away crises, monetaryunion necessarily increases the risk of sovereigndefault. In the same way that countries thatborrow in foreign currency are more prone todefault, a country that borrows in a currency thatit does not control is also more prone to default.This was indeed the very rationale behind theprohibition of excessive deficits and thesurveillance of national budgetary policies. Long

before the fact, however, scholars such as BarryEichengreen and Charles Wyplosz (1998) haddescribed how a sovereign crisis in the euro areawould spill over into the banking system and theother sovereigns. Their conclusion was that theefficient policy response would be to tightensupervision and inspection of European banksrather than placing fiscal authorities in astraightjacket.

There are significant legal and political obstacles to giving the ECB a role equivalent to thoseplayed by other major central banks. Even assuming the Governing Council would agree to play

this role, its commitment would most probably lack the credibility that is required.


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Until very recently, however, bank and insuranceregulation overlooked this logic. As already

discussed, exposure to a sovereign wasconsidered safe but there were furthermore nolimits to exposure to a particular sovereign and asa consequence, banks and insurers were not givenincentives to diversify. Consistent with therecognition that sovereign bonds are not risk-free,a case can therefore be made for reformingprudential regulation in order to limit bank (andinsurance) exposure to a single borrower.

Several caveats must however be introduced:

First, such a reform amounts to a fundamentaltransformation of the financial systems ofeuro-area countries. These are mostly bank-based systems (rather than market-basedsystems) and banks were used to consideringthe government bond as the ultimate safeasset. A different treatment of the governmentbond would entail a chain of transformations ofmajor significance, affecting for example theentire structure of pension funds assets.

Second, diversification would merely distributethe risk more widely within the euro area. Whileit would help break the national banks-sovereign vicious circle, it would not makedefault innocuous. The often-made comparisonwith the US and the suggestion that adequateregulation would allow the euro area to treat asovereign debt restructuring as a minor eventis largely misleading. The default of California,the largest US state, would indeed be arelatively minor financial event as its total debt

amounts to less than one per cent of US GDP. Bycontrast the default of Italy, the country withthe largest debt in the euro area, would be amajor shock whatever the distribution of Italianbond holdings because its debt amounts to 18per cent of euro-area GDP (Figure 10). In facteven Ireland, which ranks tenth in the euro areaby size of its public debt, has a greater debt asa proportion of the monetary areas GDP thanCalifornia. No financial tinkering will make thedefault of a medium-sized euro-area member a

minor financial event.

At any rate this diversification is far fromproceeding smoothly. As discussed in the

previous section, by mid-2011 banks had becomemore, rather than less exposed to their ownsovereigns. Since they were asked in autumn2011 by the European Banking Authority todisclose their holdings of government debt andvalue them at market prices, many bankers in theeuro area have embarked on a precipitousdisposal of government securities, which they

now see as reputationally damaging as well as asource of earning volatility. As a consequence,concerns have mounted about the ability ofsouthern European sovereigns to refinancethemselves on bond markets.

It may therefore be desirable to change the statusof government debt in the euro-area financialsystem but it would be a mistake to assume thatthis can be a quick, easy and adequate process.

Break the banking crisis-sovereign crisis viciouscircle: (b) a banking federation

The other aspect to banking reform would be tomove both the supervision of large banks and theresponsibility for rescuing them to European level,as advocated for several years by manyindependent observers and scholars (see forexample Vron, 2007). Mutualisation would endthe mismatch between tax revenues and thestates potential responsibilities, would help

reduce states' vulnerability in the face of bankingcrises, and would therefore alleviate concernsabout their solvency.

0

2

4

6

8

10

12

14

16

18

1 2 3 4 5 6 7 8 9 10Ranking

%ofeuroareaorUSGDP

Italy

California

France

NewYork

Germany

Massachusetts

Spain

Illinois

Greece

NewJersey N

etherlands

Pennsylvania

Belgium

Florida A

ustria

Texas P

ortugal

Michigan

Ireland

Connecticut

Figure 10: Relative size of state/country publicdebts, US and euro area

Source: Bruegel based on Eurostat, US Census.


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This reform would require creating fiscal capacityat European level, firstly by assigning to the

European Financial Stability Facility theresponsibility for backstopping national depositinsurance schemes (Vron, 2011), and secondlyby creating a permanent European DepositInsurance Corporation financed by banks butbenefitting from a backstop provided by theofficial sector. To this end Marzinotto, Sapir andWolff (2011) propose to give the euro area theright to levy taxes within the limit of 1 or 2 percentof GDP. If exclusively devoted to this end, a limitedtax capacity of this sort would suffice to provide alarge enough and therefore credible backstop.

The dispute over the distribution of supervisoryand rescue responsibilities has been going on fortwo decades. Advocates of European integrationand outside observers who assess arrangementsfrom an consistency perspective, haveconsistently argued in favour of giving theEuropean level more responsibilities for banks ofpan-European dimension, without any significantimpact until the 2008 crisis. The creation of theEuropean Banking Authority and the European

Systemic Risk Board are significant steps in thedirection of a banking federation but thus far,governments have consistently rejected anymove that potentially implies mutualisingbudgetary resources. There is no indication thatthey are willing to change attitude.

Establish a fiscal union

The third solution is to create a fiscal union amongthe members of the euro area. This is an old

proposal, indeed a very old one as it was part ofthe 1970 Werner report, the first blueprint forcreating a monetary union in Europe. At the time itwas thought, essentially on stabilisation anddistribution grounds, that a monetary union couldonly be sustained if accompanied by the creationof a federal budget. When the euro was created,however, it was not accompanied by any increasein the (very small) EU budget.

The fiscal union idea has now come back in very

different clothes. The question policymakers havebeen debating since spring 2011 is not whetherto increase public spending at euro-area level, butrather if there should be both a tighter common

fiscal framework and a mutual guarantee of part ofthe public debt. Instead of maintaining the

responsibility of each country for its own debt, asenshrined in the current treaty, debt would beissued in the form of 'Eurobonds' benefitting frommutual guarantee (all participating states wouldtechnically be joint and several liable). As a quidpro quo, states would have to lose the freedom toissue debt at will (subject only to ex-post sanctionin case of infringement of common rules) andthey would need to accept submission of theirbudgets for ex-ante approval. Should a draftbudget fail to respect common principles, it couldbe vetoed by partner countries before enteringinto force.

Different variants of Eurobonds have beenproposed, from the original Blue Bond/Red Bondproposal of Delpla and von Weizscker (2010) tothe Redemption bonds of the German Council ofEconomic Experts (2011) and the Eurobills ofHellwig and Philippon (2011). The EuropeanCommission (2011) has outlined what it calls'stability bonds'. What these proposals have incommon is that they all envisage the creation of a

class of assets benefitting from the jointguarantee of participating governments15. In thecase of default by one, the guarantee would beinvoked and the other governments would assumethe corresponding liability. This would make theseassets both super-safe and representative of theeuro area as whole. They would also be liquidbecause of the large size of the correspondingmarket. It is therefore expected that overseasinvestors would, eventually at least, find themattractive.

Eurobonds would in principle have three types ofbenefits. First a new, safer asset class would becreated. Eurobonds should constitute the primeinvestment vehicle for banks and other investorsin search of safety. Second, states able to issueunder the scheme would benefit from favourableborrowing conditions. Banks would be moresecure and states would be protected from self-fulfilling solvency crises. Third, by subscribing toEurobonds and their necessary counterpart a

thorough scrutiny of national public finances the members of the euro area would signal theirwillingness to accept the full consequences ofparticipation in the monetary union.

15. The Commissionconsiders also limited

guarantee as an option.


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It should be noted that the first benefit could alsobe secured without Eurobonds through the

creation of synthetic asset-based securities, asproposed by Brunnermeier et al (2011) under thename ofESBies. As for the second, it should beobserved that (abstracting from liquidity andincentive effects) a Blue Bond scheme la Delpla-Weizscker would not change a sovereigns totalcost of borrowing: the yield on the blue part woulddecrease and that on the red part would increase,leaving the average constant16. However it wouldprotect states from acute funding crises as theywould always retain access to issuance, at leastfor amounts corresponding to the redemption ofmaturing blue debt.

There are significant obstacles to Eurobonds. First,Eurobonds and ex-ante approval would representa major step in the process of Europeanintegration. Such as step would require asignificant revision of the treaty in order tosubstitute for the current 'no-responsibilityprinciple' a different principle based on thecombination of solidarity and ex-ante approval.This ex-ante approval would have to be legally and

effectively enforceable in case of disagreementbetween the European and national levels.

Second, the potential benefits from Eurobondswould be unevenly distributed. Germany inparticular benefits from a safe-haven effect andwould almost certainly experience higherborrowing costs, with consequences for its publicfinances. From a German perspective such achoice could therefore only make sense as aninvestment into the sustainability and the stability

of the euro area. For Germany to agree on makingsuch an investment, firm guarantees from itspartners would inevitably be required, startingwith the acceptance of a surrender of budgetarysovereignty.

Third and not least, a system of ex-ante controland veto, without which no Eurobond could belastingly stable, requires political integration. Thebody exercising the veto could not possibly be a

partner country, but would rather be an EU/euro-area body, either the Court of Justice or a

parliamentary body consisting of representativesfrom the European Parliament and nationalparliaments. This EU body would rely on theprimacy of European law over public law, but adegree of political integration would also berequired to confer legitimacy on the potential vetoof a national parliament vote. In order to providestability, Eurobonds would therefore need to besupported by a new institutional framework.Without an agreement to create such a framework,Germany's reluctance about Eurobonds or atleast its great caution is thereforeunderstandable, especially in view of Francesrefusal to contemplate federalist solutions17.

Against this background proposals such as thoseof the German Council of Economic Experts(2011) and of Hellwig and Philippon (2011) havethe significant advantage of being reversible.Unlike the move to a fully-fledged Blue Bondsscheme, they could be implemented on anexperimental basis and be used to build trust arguably the scarcest commodity on the European

scene.

5 CONCLUSIONS

The euro area is fighting for survival and its leadershave given every possible indication that theyintend to do whatever it takes to save it. Yet theirdiscussions and the search for solutions arebased on a partial diagnosis that puts excessiveemphasis on the lack of enforcement of theexisting fiscal rules. True, poor enforcement has

been one of the causes of the current difficulties.True, ambitious budgetary consolidation isrequired. But the budgetary dimension is by nomeans the only one, not even the most importantone18. Europes fiscal obsession has deep roots inthe history of EMU, but to look at the problemsthrough the fiscal lens only is a recipe fordisappointment.

The European leaders would be well advised to

16. This is a consequenceof the Modigliani-Millertheorem.

17. This reluctance wasvery explicitly stated inNicolas Sarkozys speech inToulon on 1 December2011.

18. One should also distin-guish between problems inthe enforcement of the SGPand problems in the designof the fiscal rule. Arguably,the latter are at least asimportant as the former.

The euro area is fighting for survival, yet the search for solutions is based on a partial diagnosisthat puts excessive emphasis on the lack of enforcement of the existing fiscal rules. But the

budgetary dimension is by no means the only one, not even the most important one.


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Turning to the feasibility of the three options, theleast feasible is probably to change the mandate

of the ECB in a way that would lastingly affect therules of the game and their perception by markets.It is one thing for the ECB to possibly step up itsintervention in response to an escalation offinancial tensions, and it is another to let marketsunderstand that it would permanently behave ina way that ensures continued access to liquidityfor solvent sovereigns. Even a change in themandate, to include financial stability, would notbe enough to quell impediments to future actionresulting from strong reservations in importantparts of the Eurosystem, and tensions betweenthe governance structure and the nature of thedecisions to be taken. Effective deterrence impliesthat one is able to credibly commit overwhelmingforces, and the ECB is simply not in a position togive such a commitment.

The building of a banking federation involves morethan one reform. The setting of regulatory limitson bank exposure to any single borrower, euro-area or EU supervision of large banks, the creationof a common deposit insurance scheme

backstopped by a common fiscal resource, and, inthe medium run, support for national insuranceschemes by the EFSF/ESM, are important aspects.None of these reforms amounts to an overhaul ofthe EMU structure; rather they are mostly naturalconsequences of the single currency that havebeen delayed for political reasons. However, theprocess of financial reform is bound to be complexand political economy obstacles are significant.Governments have strong incentive to resist thismove. As noted by Carmen Reinhart and Belen

Sbrancia (2011), periods of public deleveraginghave historically been accompanied by financialrepression, which is exactly opposite to what theenvisaged transformation is about. Furthermore,any reform in this field raises the sensitive issueof EU versus euro-area responsibility. For thesereasons incremental progress is likely, but abreakthrough is less likely.

This leaves fiscal union as the field in which

Against the background of widespread doubts about the viability of the euro area, the lack ofclear-cut solutions contributes to lingering policy uncertainty. A strong case can therefore be

made for comprehensive reform involving simultaneous moves on more than one front.

take a broader view and contemplate reforms thatwould address the inherent weaknesses of the

euro area that were revealed by the crisis.

In this paper I have emphasised that animpossible trinity of no-coresponsibility overpublic debt, strict no-monetary financing andbank-sovereign interdependence is at the core ofeuro-area vulnerability. I have assessed thecorresponding three options for reform a broadermandate for the ECB, the building of a bankingfederation, and fiscal union with common bonds and I have argued that none is easy. Economic,legal and political obstacles make all threedifficult. This explains why Europe is agonisingover reform choices.

The two important questions for the future are,first, if it would be sufficient to concentrate on oneof the three options only and, second, what is theirrelative feasibility.

Progress on any of the three fronts would helpaddress the fragility of EMU. But the optionsoutlined in this paper are by no means

contradictory. At the stage the crisis has reached,comprehensive action is desirable, if only becauseof inevitable delays in the transition to a newregime. The only change that can be introducedalmost overnight is the introduction of a new ECBpolicy stance, but such a stance without a changein the mandate and/or the governance of thecentral bank would hardly be regarded aspermanent by markets. The other changes, thebuilding of a banking federation and theestablishment of a fiscal union, are of a medium-

term nature. Political agreement to act can bereached in the short term, but implementation isbound to take years and credibility will only buildup gradually. Against the background ofwidespread doubts about the viability of the euroarea, the unavailability of clear-cut solutionscontributes to lingering policy uncertainty. Astrong case can therefore be made forcomprehensive reform involving simultaneousmoves on more than one front.


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decisions by European leaders could change thegame and create the basis for a return to stability.

True, there are major political obstacles on theroad, not least because, as indicated in this paper,the issuance of Eurobonds implies ex-anteapproval of national budgets, which in turn impliesa form of political union. By the same token,however, a decision to move in this direction wouldportend a stronger EMU and would be regarded inthis way by markets and the ECB. One possibility

would be to introduce a limited, experimentalscheme that would rebuild trust. This would also

leave time for negotiations on political union.

There is not only one way out of the euro crisis.There are several possible choices, or at least sev-eral possible short-term priorities. But one at leasthas to be selected for implementation, because tonot choose any would amount to keeping the euroarea in a state of dangerous fragility.

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Buiter, Willem, and Ann Sibert (2005) How the Eurosystems treatment of collateral in its openmarket operations weakens fiscal discipline in the Eurozone (and what to do about it), DiscussionPaper No 5387, CEPR

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