Greater political integration is needed for a sustainable euro


Read an excerpt from the book Europe or Not by Luigi Zingales in 2014.


On November 30, the Stigler Center hosted a panel discussion on the future of the euro between Nobel laureate Joseph Stiglitz and Markus Brunnermeier, both authors of recent books on the subject (watch the panel discussion here). The event was moderated by Luigi Zingales, professor at the Booth School of Business at the University of Chicago (also one of the editors of this blog). Ahead of this event, we published the following excerpt from Zingales’ 2014 book on the euro crisis, Europe or Not (Europa o No, Rizzoli 2014; translated from Italian by Sarah Niemann).


In designing the rules of the single currency, the not too hidden objective was to minimize the risk of inflation that could arise from a monetization of the budget deficit, i.e. a situation similar to that of Italy before the “divorce” between the Treasury and the Bank of Italy. This is why constraints on the deficit have been imposed: the higher the deficit, the greater the risk of its monetization.

In truth, the problem in all crises in peripheral countries except Greece is not the budget deficit, but the perverse relationship between government solvency, bank solvency, and monetary policy. In the case of Ireland and Spain, the lack of solidity of the banks calls into question the solvency of the State, in the Italian case it is the reverse. In all cases, however, the end result has been a sharp contraction in the money supply.

The central bank “prints” only a small part of the money supply. The majority are made up of bank deposits. When a bank grants a loan, it actually opens a bank account for the benefit of the debtor. Doing this increases the amount of available payment methods, or the money supply. However, when canceling a loan, the bank reduces the amount of money available. We know that a troubled bank tends to cut credit. In doing so, it reduces the volume of money and produces contractionary effects on the economy, worsening the budget deficit and making the banks even more insolvent.

While all of these mechanisms were known when the euro was created, the devastating effect of their interaction was not fully understood. In particular, they did not understand (or did not want to understand) that the single currency can only be supported with greater political integration. Insofar as the ECB does not intervene in support of governments (and banks) or both, each country risks that a crisis of confidence triggers a vicious circle from which it cannot escape on its own, as we have seen in Italy in 2011.

Insofar as the ECB intervenes instead, it poses the problem that arises whenever an individual does not pay for all the consequences of his actions: that of moral hazard. A government that knows that it will be helped by the ECB in the future, for example, tends not to honor its commitments, like Berlusconi, the Prime Minister in August 2011. And a bank that will be helped by the national government does not. not worried enough about the level of risk he assumes. Finally, the national government does not care enough about how much risk the bank is taking because it knows that in the end the ECB or the European Union will save it.

This problem can be mitigated by ex ante control mechanisms. The banking union, decided at the European summit in June 2012, goes in this direction. One of the most important advances of this agreement is the transfer of the supervision of the big banks to the ECB, removing the national supervisors. This reduces the pressure on the banks of national policy, but hardly eliminates the close link between the solvency of the state and the solvency of the banks. The other important step forward is the creation of a European interbank fund to ensure the solvency of banks. But the Fund will only be able to collect 55 billion euros, and only in ten years. In the meantime, European banks will continue to depend on national governments for emergency assistance. The problem is therefore not resolved. A true banking union is needed to make the monetary union effective and reduce the unfair competitive advantage German businesses have through lower costs and greater availability of credit. But in order to do this, you need to completely eliminate the possibility of the state saving the banks. As long as this possibility exists, as is the case in the current banking union proposal, the more financially stable countries offer an unfair competitive advantage to their national banks. Alternatively, such a restriction is not credible (and it is hard to believe that the EU can prevent Germany from saving its banks) a common European guarantee should be extended to all banks, regardless of their nationality.

But the biggest problem lies in controlling the solvency of governments. This would mean an EU commission overseeing and approving all member state budgets. The transfer of this level of sovereignty to Brussels would be difficult to bear for most of the member countries. From my point of view, the only possible solution is to leave it to governments to monitor national governments. But if the ECB is obliged to intervene, what discipline should be left to the market?

Two economists from the Bruegel think tank suggested a reasonable compromise. The debt of euro-zone countries should be divided into two categories: blue bonds, with an upper limit of 60% of GDP, guaranteed by the EU; and red bonds backed only by the issuing nation state that will only be redeemed after full payment of the blue bonds. While blue bonds would be risk free, red bonds would remain subject to market discipline.

With this distinction, even the most heavily indebted countries would have a percentage of safe debt that banks could invest in without risking heavy losses. Limiting the regulation of domestic banking system investments to red bonds would sever the perverse relationship between the state and the banks.

There is an additional advantage to the introduction of these two types of debt: it would allow a reduction in the weight of Italian public debt without default. Often, companies with too much debt solve their problem
lems through a public exchange offer. The problem is how to get creditors to forgive their bonds for bonds with a lower face value. The secret is to offer bonds with shorter maturity priority in the repayment of capital. For this reason, a joint offering of a bundle of blue and red bonds with a combined face value lower than the original debt may meet the target. My estimates suggest that this could easily reduce the debt burden of Italy’s GDP by 15 percentage points.
With a solid plan to divest state-owned businesses and assets, it is not unreasonable to consider reducing the debt burden by an additional 15 percentage points. This would therefore bring it to around 100% debt to GDP: a much more manageable figure.

This is how we can solve the big financial problems, but not those of the real economy. For the latter, we must rethink the theory of optimal currency areas.

An area with a common currency must have automatic stabilization mechanisms to compensate for regional shocks with European funds. The automatic stabilization mechanism that we know best is unemployment benefits. The advantage is that it is not a permanent transfer from the North to the South. Remember, for example, that in 2005 Germany had a higher unemployment rate than Italy, Spain and Greece, so the transfer would have gone from Southern Europe to Germany and not the other way around. In addition, stabilization mechanisms not only serve to help struggling countries, but also serve to reduce overheating in expanding economies. During the first half of the 2000s, Spain was in a real estate bubble with unsustainable growth rates causing high price inflation at the local level. If there had been a European taxation of this excess growth, it would have slowed down Spanish expansion a bit at that time, with the advantage that local prices would not have increased too much, and therefore would have been more. easily absorbed in recent years. Because unfortunately what we see, especially in Spain, is a need for deflation to compensate for the local inflation that developed ten years ago.

The real battle that we must wage at the fiscal level is for an unemployment insurance mechanism at European level. The risk of this type of subsidy is that it increases the incentives not to work. But it is precisely here that the European dimension can help. Germany has absolutely no interest in subsidizing falsely unemployed Italians, just as Italy has no interest in subsidizing falsely unemployed Germans. So the only possible deal is one that minimizes waste and inefficiencies. It would be best if the German inspectors control the payment of subsidies to the Italian unemployed and vice versa, which would make abuse more difficult. Finally, the big advantage of this kind of initiative would also be political. Today, Europe suffers from a crisis of general support; if the unemployed received a check printed with the union symbol, a stronger attachment to Europe than exists today would develop.

The third reform to make the euro sustainable concerns the objectives of the ECB. If the ECB wants to achieve average inflation of 2%, it must have symmetrical costs when it exceeds or misses the 2% target. Today, the costs are asymmetrical: high if it exceeds, zero if it misses. Hence the tendency for deflation. It is only by eliminating this distortion that we can hope to reduce the risk of deflation.

About Michael G. Walter

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