11 November 2013

Bundesbank/Weidmann: The euro area caught between individual responsibility and joint liability

Weidmann looked at whether the eurozone might take inspiration from the Swiss model of balancing control and liability. He stressed that over the medium term, government bonds should be treated like other bonds or loans to companies.

Although Switzerland is not part of the European Union, it has has often proved a catalyst for European ideas. If one compares Switzerland and the euro area, it quickly becomes apparent that it can continue to play this role. The debt crisis has exposed weaknesses in the architecture of monetary union. By contrast, Switzerland has proved to be remarkably stable - despite the fact that Swiss fiscal policy structures resemble those in the euro area in many respects. This is the case, for instance, with regard to the high degree of autonomy the Swiss cantons enjoy in defining their fiscal policy.

The flaws in European Monetary Union

The introduction of the euro was the biggest economic integration step in the history of the European Union. The combination of a single monetary policy and decentralised fiscal policy can further compound the tendency of governments to finance their spending through debt, thereby undermining the stability of monetary union. To keep monetary union on track in spite of these dangers, the founders of European Monetary Union drew up the fiscal rules enshrined in the Stability and Growth Pact, which cap deficits at 3 per cent and total debt at 60 per cent of GDP. The effect of these rules was, however, limited. Also the disciplining by the markets which, it was hoped, would result from the no bail-out clause failed to materialise. For many years, Greece was highly indebted, but paid little more for its debt than Germany or France.

Might Switzerland point the way?

So what can the eurozone learn from Switzerland in order to improve the balance of control and liability? First of all, it should be noted that in addition to structural similarities, there are also significant differences between the two currency areas, also with regard to fiscal policy. A key component of Swiss fiscal policy – albeit one which cannot be readily transposed to the euro area – is the principle of direct democracy which gives the general public a say in fiscal decisions, especially at the cantonal and local government level. This form of balance of control and liability cannot be transferred to the euro area in my opinion. But the underlying principle can be valuable to point in the right direction.

A key building block of the Swiss fiscal framework is a clause that excludes mutual assistance for municipalities. But how can the principle of financial responsibility of the euro area countries be strengthened again? Basel is the starting point, more precisely the regulatory preferential treatment of government bonds, as this preferential treatment sends out conflicting signals about whether a sovereign insolvency is even a permissible concept for legislators. It also makes such a scenario appear unrealistic not least because a sovereign default without appropriate capital buffers at banks would quite likely trigger a financial crisis. So first, government bonds should be adequately backed with capital, and second, banks should hold loans to individual sovereign debtors only up to a certain level. In a nutshell, over a medium-term horizon, government bonds need to be treated just like other bonds or loans to enterprises.

The bottom line of national responsibility is that sovereign insolvencies and insolvencies of large banks should also be possible without jeopardising the stability of the European financial system as a whole. The tightened capital rules for banks, which are designed to enhance financial sector resilience, naturally also contribute to achieving this goal. So this is another area in which Basel plays a crucial role. But this time, it is Basel III which I am talking about. No less important is a stricter supervisory regime like the one which Europe is looking to achieve by establishing the Banking Union. Switzerland has a wealth of experience in applying fiscal rules. Its national debt brake has been up and running since 2003, since which time debt has roughly levelled off, and the debt ratio has been on the decline.

Bearing this in mind, a rule allowing potential sinners to pass judgement on actual sinners would have little prospect of success. The euro-area member states have already tightened the groundrules by rolling out the revised Stability and Growth Pact and the Fiscal Compact, making it much more difficult now for finance ministers to turn down the Commission’s recommendations. So it remains to be seen how, and to what extent, the new Stability and Growth Pact will actually reinforce fiscal discipline. Perhaps enshrining debt brakes in national legislation, as envisaged by the Fiscal Compact, can provide a further impetus in that direction.

Full speech

Further reporting © Market News International

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Separately this week, Weidmann called for an earlier introduction of bail-in rules, ensuring that banks' bondholders and big depositors share the costs of any lender failing should be introduced earlier than currently planned. The bail-in rules should if possible be in place by the time the planned mechanism to wind down banks starts, he said. That is currently expected in 2015, shortly after the ECB takes up its new role as the single supervisor for eurozone banks.

Further reporting © Reuters

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