How to Pave the Road towards the Euro End

In Germany, there is dissatisfaction with how the European Commission is implementing the Fiscal compact. Now,  Schäuble proposes to attribute the control to the ESM , which should have the task of sanctioning those who do not respect it.

When Schauble resigned as Treasury minister to go to office as President of the German Parliament, he handed over a document (Non-paper for paving the way to a Stability Union) that can be defined as the way to the euro-end.

The Non-paper is very clear. The main problem, or rather unique, of the euro-zone is the moral hazard, that is, the opportunistic behavior of national governments that take advantage of the single currency. Fiscal responsibility and control must go hand in hand, being two faces of the same coin. The English version says that the goal should be pursued "whatever it takes", using the same famous phrase by which Mario Draghi ended speculation on Italian and Spanish bonds in July 2012.

The idea that the difficulties for the single currency could only come from the public finances of member countries is an old idea that lies in the Maastricht Treaty (Excessive deficits), with the next Stability and Growth Pact (the second term was added on French request). Obviously, everyone knows that the 2008 financial crisis was caused by USA private finance and hit the European banks that had been too much indebted to speculate on derivatives.
Except for Greece, other affected countries such as Ireland and Spain had very low public deficits and debt; Italy had a high debt but the deficit was under control. However, on the Franco-German impulse (Deauville's walk of Merkel and Sarkozy), the budget austerity of "homework" became the rule, and the spreads of the southern countries began to grow until the recalled Draghi’s intervention.

For a long time in Germany there was dissatisfaction with how the European Commission is implementing fiscal compact rules; the truth is that, since these are absurd rules, you had to resort to some concessions. Non-paper aims to eliminate all forms of discretion, and therefore proposes to remove the control of the fiscal compact from the Commission and attribute it to the ESM (European Stability Mechanism), which should have the task of controlling compliance with the fiscal compact and sanctioning those who do not respect it. To ESM should also be given the power to activate sovereign debt restructuring mechanisms to share the burden between ESM itself and sovereign debt holders of various countries. The hypothesis, that ESM can also serve as deposit insurance support, is explicitly discarded.

It must be said that the Germans do have some reasons to get tired of fiscal policy measures such as the Italian ones; measures mainly aimed at obtaining electoral consensus. But the idea of absolutely strict compliance with the rules is unrealistic, especially in the case of sovereign debt restructuring. this is a theme in which the discretion of intervention is in the very nature of the problem. What should the rules set out? When does debt exceed a predetermined percentage of GDP? Any rule to be fixed would be a stimulus to financial speculation, getting the opposite of a "Stability Union".

A second significant point of Non-paper is a clear no to a Macron proposal; it excludes that there may be a macroeconomic stabilization role in the Euro-area with tax capacities, such as unemployment insurance. Non-paper doesn’t see any need because national mechanisms are enough and, of course, because there is fear that this would imply an implicit mechanism of solidarity, which for the Germans is nothing more than a transfer system to one direction (that is north-south).

As for the banking union, according to the Non-paper, "further significant risk reduction is necessary, including the regulatory treatment of sovereign bonds”. This statement needs some explanation. When you buy a bond issued by some country in its own currency, there may be a currency risk, but not a default risk, because the national bank has the right to guarantee and support the securities. In the case of the euro countries, the rule, with regard to bonds issued by the member countries, was that the banks would consider them without risk, and thus without the need for capital reserves.

This is still the case, but in the last years there has been a contradiction between this rule, which implies that the ECB is the backstop of all sovereign securities, and spreads (or credit default swaps) which, on the contrary, show different degrees of risk between different countries, members of the same money. In addition, after the outbreak of the financial crisis, there was a process of re-nationalization of sovereign debt, with a strong growth in government bonds held by banks in various countries, a phenomenon particularly strong in southern countries.

To German eyes, this situation is too much akin to moral hazard, and therefore, according to the "more bail-in and less bail-out" line, it must be changed. The new rules on banks should establish that government bonds are risky, so they need capital provisions, and those held by banks have to be reduced to smaller percentages. These measures, to which we can add the ECB's supervisory proposals on non-performing loans, would lead to a deadly credit crunch in countries such as Italy where the role of banks in financing companies is very high (indeed too much).

Non-paper also offers directions for a different road. In the sense that in theory it should be possible to move to the opposite way to that indicated on all issues: expansive fiscal policies, sharing risks both on public debts and banks, and transfer mechanisms in the context of anti-cyclical policies. In order to avoid moral hazard, a significant proportion of investments and welfare expenditures should be shifted at a supranational level, say by multiplying the Commission's budget by ten. Probability equal to zero, as the most optimistic federalist supporters should recognize.

The end of the euro is not imminent. In this economic phase, growth is strengthening everywhere, interest rates are low and the ECB's latest decisions have convinced the financial operators that an expansive monetary policy will remain there for some time; the spreads of all countries diminish. But it will not last so long, the QE will come to an end, and one year later the succession to Draghi will be decided .... As Matthew’s Gospel says: estote parati (be ready). 

Ruggero Paladini

Economist - Professor of "Scienza delle Finanze" at University "La Sapienza" Roma; Member of the Economic Board of Insight -