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Fixing the euro needs to go beyond economics

The agenda to fix the euro is hampered by conflicting national interests. Creditor countries demand fiscal house cleaning and debtor countries ask for risk sharing. There is currently a political deadlock about how the adjustment burden should be distributed, perpetuating a state of vulnerability that is not in the collective interest of euro area members. This column, part of the Vox debate on euro area reform, argues that overcoming this coordination failure requires reforming the political governance of the EU, rather than just its economic governance.
This post has been first published on VoxEU.
By Anne-Laure Delatte
Post, October 29, 2018

The euro area is stuck in a situation of conflicts of interests between creditor and debtor countries. The political economy of such a situation requires coordinating creditor and debtor countries to distribute the burden of adjustment. Creditor countries require debtors to repay their debt with domestic resources, pushing for spending cuts and tax increases. In turn, debtors are better off if they can delay adjustment and rely on the official euro area safety net if needed. 

Benassy et al. (2018) have designed a plan to eliminate precisely this conflict of interests. Their reform proposals aim at creating a consensus between countries calling for more market discipline (the creditor countries) and those calling for risk sharing (the debtor countries). They argue that a compromise can make both creditor and debtor countries better off.  Countries can reach a new steady state without getting through significant changes in the current political governance because their plan, they argue, produces gains for both sides. In a similar vein, before them, scholars have designed alternative economic plans to reduce debt overhang and neutralise contagion in case of a crisis (Pâris and Wyplosz 2014, Corsetti et al. 2015, Brunnermeier et al. 2016, Corsetti et al. 2016).  

In the end, the Meseberg declaration in June 2018 included a few of their objectives but faced strong opposition by the group of creditor countries forming the ‘Northern alliance’.  In sum, none of these plans has managed to create a consensus around a common political agenda. In turn, the reform agenda has remained frozen since the Banking Union discussions in 2015. National governments with divergent interests stand against one another and the debt of several countries is drifting away. The contention between debtor and creditor countries grows: the wider the divergence, the further the compromise about who should bear the burden of adjustment.  As a result, redenomination risks kick back when political tensions rise (Gros 2018). 

These pervasive conflicts of interests hamper fixing the crisis and keep the euro vulnerable to a shock. The euro is stuck in an inefficient equilibrium where both creditor and debtor countries are worse off. 

There are two reasons why these smart economic plans have not generated a consensus. First, the management of the euro crisis since 2010 has relied on inter-state bargaining. Second, even if the deals produce ‘gains on both sides’, these might consist only in a reduction of net losses compared to the current situation, which makes the status quo a safer solution from a political standpoint.  

The euro crisis has been managed by governments within the Euro Summits between euro area heads of states, and within the Eurogroup meetings between the finance ministers of the euro area (the latter met 206 times between 2010 and 2017, i.e. every two weeks on average). While the European Commission has reinforced its role as a provider of economic expertise, it has not managed to politically bring forward their proposals of issuing common bonds, a form of risk-sharing and of a common unemployment regime, a form of transfers. The only supranational institution which played a key role in keeping the single currency together is the ECB Mario Draghi’s “whatever it takes”.  It was only possible because of the relative isolation of the ECB from the political process (although a political controversy was not totally avoided, a fact that defied the principle of its independence). 

Inter-state bargaining has brought European integration forward so farso why would it be an issue now?   Indeed, Morascvick (1998), who examined five history-making episodes in the evolution of the EU, argues that a liberal inter-governmentalism has driven European integration in a “series of pragmatic inter-state compromise on different national preferences” (p. 479). National preferences were indeed different with respect to customs union, with Germany and Britain seeking industrial liberalisation and being reluctant with regards to agricultural liberalisation, while France held the reverse position. In the end, agreements had distributional consequences reflecting the compromises made by national governments, but the total net outcome was positive and pareto-efficient at the inter-state level, Morasvick argues. 

In contrast, national preferences today are not only different but in conflict. This implies that setting the adjustment burden between creditors and debtors involves both losses and gains for both sides, with high uncertainty on the net outcome. For example, the G7+7 argue for a regulation that penalises concentrated sovereign exposures in bank balance sheets as a quid pro quo for a euro area deposit insurance. This measure carries liquidity risks for the sovereigns under financial market pressure (the debtor countries) as peripheral banks have substituted for the markets by increasing their exposure during periods of tension (Lanotte and Tommasino 2018). Conversely, a euro area deposit insurance is viewed as involving potential losses for creditor countries. In sum, while a compromise could make both creditor and debtor countries significantly better off, both view the final net outcome as risky.Hence, even if the status quo is detrimental for both sides, it is politically preferable to a new deal carrying so much uncertainty.  

As a result, while inter-state bargaining can be efficient in a negotiation on trade tariffs implying a positive net outcome on both sides, this decision-making process is arguably unable to produce a compromise in a debt overhang negotiation. The current situation requires a referee with a capacity to pursue the common interest across national borders. 

Reforming the political governance of the EU, rather than just its economic governance

The euro crisis is one of a series of crises seriously threatening the European project and feeding the rise of nationalist euro-sceptic political parties. Similarly, the management of the migration flows since 2015 has been plagued by serious coordination failures as Europe is deeply divided on how to share the migration burden. The fact that the countries located on external borders of the EU are both exposed to the largest migration flows and are also the largest debtor countries (Italy, Spain and Greece) adds complexity.  It is misleading to deal with the euro and the migration crises as two isolated issues. Unable to act in concert, the current governance has pushed crisis management down to the national level and impeded the provision of transnational compromises. 

We need coordinated, representative decision-making to make Europe functional again. 

But national governments are very reluctant to transfer sovereignty to non-national parliamentarians.  In order to go beyond this either-or logic of integration or sovereignty, we need to co-opt the members of elected national parliaments within a new, second, parliamentary chamber at the European level. This new parliament, composed of national MPs, could arguably do better at creating transnational compromise on policies in three ways: 

  • First, by transferring responsibility: A European Assembly would fix the inefficient asymmetry between the EU-wide interaction of heads of government and the domestic parliamentary check when they are back home. It would also create a direct interaction between national MPs who would have the double responsibility of representing their constituents in national arenas and in the Europe-wide body. 
  • Second, by creating affectio societatis: The Assembly would bring national MPs together and contribute to form habits of co-governance. 
  • Lastly, by fostering information and accountability: The chamber’s regular meetings and public debate on European and domestic issues would be brought at the same level of attention. It would arguably increase transparency compared to emergency summitry prone to deal making behind closed doors.

In sum, enhancing accountability would restore legitimacy and breaking the opposition between national and supranational political agenda would help create a greater capacity for interest-generalisation across national borders.

This new legislative body would arguably have the legitimacy to vote new common European taxes to finance common public goods. Citizens expect Europe to break the stalemate, to deliver macroeconomic stability and inclusive growth, to implement efficient measures against global warming, and to enforce a coordinated migration policy and a human hosting of refugees. To reduce the potential creditor-debtor conflict of interest, a cap on transfers could be introduced in order to avoid permanent transfers between creditor and debtor countries (a maximum of 0.1% of GDP, for example). Giving the EU a capacity to deliver common public would contribute to address the anti-elite and restore the citizens confidence. 

Not all member countries may presently be willing to go along with reforms to the political governance. It may therefore be sensible to come up with legal solutions allowing the Assembly to start with a subset of countries willing to go forward and not wait for a new Treaty to be signed. These solutions exist (Henette et al. 2017). 

In sum, reforming the economic governance is not enough; we need to reform the political governance. The plan as sketched above has limits worth discussing. The 2019 European elections will offer a platform for a debate. It is time to debate alternatives. 
 
 

References

Bénassy-Quéré, A, M Brunnermeier, H Enderlein, E Farhi, M Fratzscher, C Fuest, P-O Gourinchas, P Martin, J Pisani-Ferry, H Rey, I Schnabel, N Véron, B Weder di Mauro and J Zettelmeyer (2018), “Reconciling risk sharing with market discipline: A constructive approach to euro area reform”, CEPR Policy Insight No. 91.

Brunnermeier, M K, L Garicano, P R Lane, M Pagano, S Reis, T Santos, D Thesmar, S Van Nieuwerburgh and D Vayanos (2011), “ESBies: A realistic reform of Europe’s financial architecture”, in T Beck (ed.), The Future of Banking, a VoxEU.org eBook, CEPR Press.  

Corsetti, G, L Feld, P Lane, L Reichlin, H  Rey, D Vayanos and B Weder di Mauro (2015), A New Start for the Eurozone: Dealing with Debt, Monitoring the Eurozone 1, CEPR Press.

Corsetti, G, L Feld , R Koijen, L Reichlin, R Reis, H Rey and B Weder di Mauro (2016), Reinforcing the Eurozone and Protecting an Open Society, Monitoring the Eurozone 2, CEPR Press.

Gros, D (2018), “Italian risk spreads: Fiscal versus redenomination risk”, VoxEU.org, 29 August .

Hennette, S, T Piketty, G Sacriste and A Vauchez (2017), Pour un traité de démocratisation de l'Europe,  Le Seuil.

Howarth, D and L Quaglia (2016), The Political Economy of European Banking Union, Oxford University Press.

Lanotte, P and P Tommasino (2018), “Recent developments in the regulatory treatments of sovereign exposure”, VoxEU.org, 5 February.

Moravcsik, A (1998). The choice for Europe: social purpose and state power from Messina to Maastricht,Cornell University.

Pâris, P and C Wyplosz (2014), PADRE: Politically Acceptable Debt Restructuring in the Eurozone, Geneva Special Report on the World Economy 3, ICMB and CEPR.


The original version of this article was published on Vox EU

Europe  | Money & Finance  | Economic Policy 
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