The opportunity for euro-area reform is closing
The rift among northern and southern euro-area members is widening, limiting the scope to create stabilisation measures
In the EU, macroeconomic governance reform is focusing around the creation of a euro-area budget and a European Deposit Insurance Scheme (EDIS) -- the final pillar for the completion of the European Banking Union (EBU) which would provide stronger insurance coverage for member states. However, northern countries are reluctant to pay for crisis-prone ones in the south, so compromise on detail could take years while the initiatives will have limited scope in responding to crises.
What next
In its Spring outlook, the European Commission revised its euro-area growth forecast from 1.9% to 1.3%, while stating that downside risks are ‘‘prominent’’. Such risks include downward trends in industrial production owing to issues such as global trade uncertainty and the prospect of no-deal Brexit. Whether such uncertainty will convert a downturn into a recession is too early to say but nonetheless raises concerns regarding the euro-area’s resilience in coping with a future crisis.
Subsidiary Impacts
- The ECB’s Single Supervisory Mechanism will continue to focus on ‘risk reduction’ measures, including the disposal of non-performing loans.
- The EU is unlikely to give Italian budget concessions perceived as acceptable by Rome, possibly hardening the position of Italy’s populists.
- If Manfred Weber’s candidacy to become European Commission president fails, Berlin will likely insist that it gets the ECB president post.
- The rise of migration flows in the Mediterranean and the lack of EU resolution on burden-sharing will worsen north-south relations.
Analysis
The EU has made progress in developing institutions for the management of financial crises comparable to the one that hit Europe during 2007-12: in 2012 the European Stability Mechanism (ESM) and the EBU were established, the former to bail out distressed member states and the latter for enhancing supervision and deepening integration of euro-area banks.
Crisis management shortcomings
Nevertheless, there are important unaddressed gaps in the crisis management framework:
- The resources available to the ESM are limited to 500 billion euros (561 billion dollars), which would be insufficient to address a crisis that engulfed both Italy and Spain, for example.
- The Single Resolution Fund, a procedure within the EBU, is inadequate to contain a crisis that strikes the financial system more broadly.
- National deposit insurance schemes continue to rely on national fiscal resources as a backstop.
- The EU lacks a common mechanism for fiscal stabilisation, it has no common risk-free asset, and no coherent framework for sovereign debt restructuring.
These shortcomings are important for two reasons. Firstly, the link between sovereign finances (government budget) and national financial institutions (central bank) remains strong -- which means that a sovereign debt crisis can evolve quickly into a systemic financial crisis, and a systemic financial crisis can quickly undermine sovereign finances.
Secondly, the ECB is less able to respond to a crisis now than it was when Mario Draghi gave his July 2012 'whatever it takes' speech.
This is because the ECB has already lowered policy rates below the zero-lower-bound while it has expanded its balance sheet through the direct, large-scale acquisition of sovereign debt instruments, meaning that the ECB is running out of room to expand.
The ECB will have much lesser scope to respond to a future crisis
Additionally, Mario Draghi's tenure as ECB president is coming to an end and it is unclear whether his successor will be willing to support further monetary accommodation (see ECB: Next president will have to revive weak activity - April 1, 2019).
New approaches
There has been active debate within the European Council about how best to address the shortcomings, with much of it focusing on the development of instruments that will make it less likely that a financial shock will ever reach crisis proportions.
These include the following:
- Finding ways to engage the ESM more directly in pre-crisis monitoring and crisis prevention.
- Clarifying the pattern and scale of losses that will be imposed on bank creditors and investors.
- Minimising the risks that accumulate on the asset side of bank balances and to limit cross-border exposures by matching liabilities to assets within regulatory jurisdictions.
- Stressing the importance of national fiscal consolidation in order both to create the space for macroeconomic stabilisation to take place within countries and to strengthen the creditworthiness of national sovereign debt instruments as safe-haven assets during periods of distress.
North-south divide
However, the Council's position is ultimately compromised, needing to balance the growing divergence between northern member states, such as Germany and the Netherlands on the one hand, and Mediterranean ones on the other, such as Spain and Italy (see PROSPECTS H2 2019: EU - June 3, 2019).
The Mediterranean position is that a euro-area budget should -- in addition to enhancing convergence and competition across the bloc-- be expansive enough to guarantee macroeconomic stabilisation. Also, an EDIS should become a key risk-reducing pillar of the EBU.
Northern and southern European countries are at odds over the detail of euro-area reform
However, such ambitions require greater pooling of resources by member states, something which northern countries are unwilling to countenance.
Italy's ongoing conflict with the European Commission is indicative of northern suspicion vis-a-vis substantially bolstering macroeconomic governance. For example, Rome is more concerned with promoting growth than engaging in fiscal consolidation, such as reducing its debt and budget deficit.
The presumption of the northern euro-area member states is that any concessions made to European solidarity will serve to help countries such as Italy pursue growth and neglect fiscal consolidation, as stabilisation mechanisms could be used to shelter it from detrimental risks, such as a sovereign debt crisis.
More generally, northern governments fear their voters, who could align themselves with populist movements if more money is essentially transferred to southern countries.
Furthermore, the Commission's revised forecasts suggest that divergence on euro-area reform will deepen. With slow growth forecast in Mediterranean countries, their governments will demand greater stabilisation tools at the euro-area level. Conversely, Germany -- whose growth was cut from 1.1% to 0.5% -- will be even more reluctant to contribute money directly.
Unprepared?
Thus, with northern members unlikely to offer substantial contribution towards euro-area institutions, initiatives such as the euro-area budget may have to rely on funding from the EU28 budget -- this would significantly limit its scope as a mechanism for advancing macroeconomic stability.
This means that the euro-area will continue to rely on the ECB to advance monetary policy, but its declining capacity will likely inhibit its ability to intervene effectively in future crises.
The euro-area will likely be ill-equipped to withstand a future crisis
The combination of internal and external developments -- such as global trade disorder, Italy's fiscal policy, yellow vest concessions in France, Germany's sluggish industrial output, the prospect of a hard Brexit and the deepening fragmentation of politics across the bloc – will narrow the opportunity to reform the euro-area to respond adequately to the next crisis.
