Graham Bishop: Three proposals to ensure fiscal sustainability in the eurozone
Summary: Three Proposals for Action
I. Build on the emerging political union between eurozone Member States* and modify the EFSF (and its successor) to make it the preferred borrowing route for most Members. That would be a huge carrot, but there must also be a genuine stick that would be virtually automatic. The latter can be achieved by the following two steps:
II. Insert into the Definitions Article of the relevant Commission economic governance proposals: “Special access to financial institutions” means special treatment for the borrowings of a Member State held by any financial institution subject to EU regulations. This treatment is in respect of capital requirements, eligibility as liquid assets and absence of prohibition on concentration of asset holdings. Such special access shall only be available to Member States that are permitted to borrow from the European Financial Stability Facility (and its successor), or would be so permitted if they applied.
III. Add an Article to the sanctions sections of the relevant enforcement Regulations: Any Eurozone Member State subject to sanctions is ineligible to borrow from the European Financial Stability Facility (and its successor) and therefore loses its special access to financial institutions.
* These proposals build on Scenario III in my recent book, “The EU Fiscal Crisis: Forcing Eurozone Political Union in 2011?” (details). Under this scenario, eurozone would emerge in 2011 from the financial crisis as a political federation – loose in some respects, but with tightly centralised economic governance at its heart.
28 November, 2010: The separation between the eurozone and ‘other EU members’ surfaced even more pointedly in the agreements that day relating to Ireland. The Eurogroup, rather than ECOFIN, announced that “Rules will be adapted … to send a clear signal to private creditors that their claims are subordinated to those of the official sector”. Moreover, “Eurogroup Ministers will make a unanimous decision on providing assistance.” They also decided that identical collective actions clauses (CAC) will be included in “all new euro area government bonds starting in June 2013” to enable creditors to accept a legally binding change in terms – including haircuts.
That was a momentous decision – both politically and for the nature of Europe’s financial system. Ireland’s economic misfortunes have precipitated far-reaching changes that must cause a major rethink of many core elements of the EU’s regulatory framework for eurozone members. The driving force is the belated recognition by eurozone political leaders that the nature of their debts was fundamentally altered when they gave up the power to print money to repay such debts. That actually occurred at the instant they joined the monetary union, but it has taken a decade of mismanagement for the natural results to surface.
Is it now right that the regulatory framework governing all types of financial institution in the EU should continue with the fiction that debts of EU-penalised governments are risk free and that they are suitable, readily-marketable assets in which banks should hold their liquidity? In Basel III, the global banking supervisors continue to permit this now self-evident fiction. The Irish have just sent a torpedo into the middle of the Basel III concepts. At the very least, the Eurogroup must act together to change EU regulations to take proper account of the new reality they are imposing.
So the framework of prudential regulations governing all EU-based financial institutions that lend savers’ funds to public authorities should now be reviewed to test their consistency with the new reality. That should cover all types of credit institutes – banks and investment firms – insurers, pension funds, UCITS and Alternative Investment Funds. But that should not preclude savers making a conscious and informed decision to invest in the debts of governments deemed risky because such actions can be a vital stabilising mechanism.
Looking ahead, the next decade will witness an upsurge in age-related public spending and potential retirees will be encouraged to raise their savings to pay for their retirement. What assets should they purchase? It would be a particularly callous policy if governments defaulted on part of the loans made to them by elderly citizens to fund their retirement.
Evolving principles of policy
December 17: The Heads of Government “reiterated our commitment to reach agreement on the legislative proposals on economic governance by end June 2011 with the aim of strengthening the economic pillar of the Economic and Monetary Union…”
The Heads of Government also decided to add an extra clause to Article 136: "3. The Member States whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole. The granting of any required financial assistance under the mechanism will be made subject to strict conditionality." So the eurozone, rather than the whole EU, was to be responsible for dealing with all future ramifications of this crisis. But the Heads of Government of the eurozone also made important commitments to preserve the euro – see box below.
Statement by the Heads of State or Government of the euro area and the EU institutions:
The Heads of State or Government of the euro area and the EU institutions have made it clear, as set out below, that they stand ready to do whatever is required to ensure the stability of the euro area as a whole. The euro is and will remain a central part of European integration [Editor’s emphasis]. In particular, the Heads called for determined action in the following areas:
a) Fully implementing existing programmes: we welcome the impressive progress made in implementing the Greek programme and the agreed adjustment programme for Ireland, including the adoption of the 2011 budget.
b) Keeping up fiscal responsibility: we are all committed to strictly implementing the budgetary policy recommendations, fully respecting the fiscal targets for 2010 and 2011 and to correcting excessive deficits within the agreed deadlines.
c) Stepping up growth enhancing structural reforms: we are determined to accelerate structural reforms to enhance growth.
d) Strengthening the Stability and Growth Pact and implementing a new macro-surveillance framework from summer 2011.
e) Ensuring the availability of adequate financial support through the EFSF pending the entry into force of the permanent mechanism: we note that only a very limited amount has been committed from the EFSF to support the Irish programme.
f) Further strengthening of the financial system both as regards the regulatory and supervisory frameworks and conducting new stress tests in the banking sector.
g) Expressing full support to ECB action: we support the ECB in its independent responsibility to ensure price stability, solidly anchor inflation expectations and thereby contribute to financial stability of the euro area. We are committed to ensuring the financial independence of the central banks of the Eurosystem. Elements of this strategy will be further developed in the coming months as a comprehensive response to any challenges, as part of our new economic governance.
Commission Proposals for economic governance
September 29: The legislative texts were published. The politics of these proposals are a huge step towards a more collective form of economic governance that will amount to a loose federation once fully operational. The highlighted points in the box below make it very clear that the collective examination run by the Commission will be highly detailed and flow into virtually every aspect of a state’s economic life if ‘imbalances’ begin to appear. Competitiveness covers wide swathe of a nation’s economic activity because it goes to the heart of the performance of the entire private sector.
Proposal for a Regulation on enforcement measures to correct excessive macroeconomic imbalances in the Euro Area [COM (2010) 525]
… The monitoring of internal indicators can also be justified on its own sake on the ground that internal imbalances can have repercussions on other Member States, particularly via financial contagion…
If the in-depth review points to severe imbalances or imbalances that jeopardise the proper functioning of the Economic and Monetary Union in a specific Member State, the Council may, on a recommendation from the Commission, adopt recommendations in accordance with Article 121(4) of the Treaty declaring the existence of an excessive imbalance and recommending the Member State concerned to take corrective action within a specified deadline and to present its policy intentions in a corrective action plan. Member States with excessive imbalances within the meaning of the EIP would be subjected to stepped-up peer pressure. These ‘EIP recommendations’ should be made public; they should be more detailed and prescriptive than the ‘preventive’ recommendations provided for in Article 6. Depending on the nature of the imbalance, the policy prescriptions could potentially address fiscal, wage, macro-structural and macro-prudential policy aspects under the control of government authorities.
Proposals for Action
I) Modify the EFSF to make it the preferred method of borrowing for most eurozone members.
II) Insert into the Definitions Article of the relevant Commission proposals:
“Special access to financial institutions” means special treatment for the borrowings of a Member State held by any financial institution subject to EU regulations. This treatment is in respect of capital requirements, eligibility as liquid assets and absence of prohibition on concentration of asset holdings. Such special access shall only be available to Member States that are permitted to borrow from the European Financial Stability Facility (and its successor), or would be so permitted if they applied.
III) Add an Article to the sanctions sections of the relevant enforcement Regulations:
Any eurozone Member State subject to sanctions is ineligible to borrow from the European Financial Stability Facility (and its successor) and therefore loses its special access to financial institutions.
Rationale for proposals
The eurozone Heads of Government have announced their determination to agree a package of measures that will enforce collective economic discipline. In practice, they now have no alternative as the failure to complete this process will send markets a clear message to avoid purchasing the debts of risky states, thus deepening the crisis. The assumption must be that these economic proposals will be develop strictly in parallel with any financial measures about the expansion of the EFSF - “Nothing is agreed until everything is agreed”.
A critical flaw in the current discipline process is the market’s recognition that the EU’s political class has failed to impose, let alone enforce, any sanctions during the first decade of the monetary union. Why will it be any different in the future? The crisis has now delivered a powerful stick and carrot that – if properly applied – could provide that certainty of genuine sanctions that will restore confidence.
Proposal I Reform the EFSF (and correspondingly of its successor) so that the IMF no longer needs to be involved in the oversight of EU economic governance after this initial emergency period. If it is only IMF involvement that is the guarantor of proper economic policies in the eurozone, then investors would do well to avoid the whole zone. But that also removes any reason for the EFSF not to on-lend to members at its own cost of funds as its loans would then be the most senior.
The phrase in the new Art 136 paragraph (“indispensable to safeguard the stability of the euro area as a whole”) may need to be modified to something like “enormously beneficial to safeguarding…” because the strategy of the political union would be to encourage members in good economic standing to borrow by this route.
If the EFSF does indeed take over the funding of several Eurozone members during 2011, it will become a major global issuer. As the years roll past and the benefits of improved policies become fully visible, then the credit rating of EFSF borrowers should improve and the rating of the fund’s issues would itself become much simpler. Surely the medium term goal must be that all eurozone members would be rated close to AAA? At that stage, the EFSF would only have loans to exceptionally highly rated states and the scale of its own borrowing would make it a globally liquid player. Its own cost of funds would reflect both liquidity and the strength of its mutual guarantees – taking it very close to a “joint and several guarantee”. Its bonds would then be all but “E-bonds”.
Correspondingly, most Members States would find EFSF borrowings significantly cheaper than borrowing from banks so the systemic vulnerability to banking fragility should be reduced as central governments fund directly from a much wider range of unleveraged financial institutions, and even the public directly.
This happy set of circumstances should be the natural outcome of the policies that Eurozone has declared it will operate – from June 2011.
That is a huge carrot for eurozone members. But there is an equally huge stick as well.
Proposal II would catch all the methods that Member States have devised over the decades to privilege their debt versus the private sector to access the savings of citizens. This may well have been appropriate when states printed the money which they used to repay their debts. It is not now. But this privilege also permeates international regulatory agreements. For example, the new Basel proposal for re-inforcing the liquidity of banks to minimise the risk of a run includes the definition below.
BCBS: International framework for liquidity risk measurement, standards and monitoring - consultative document, December 2009: Definition of liquid assets
34. The stock of high quality liquid assets should be comprised of assets which meet the characteristics outlined above. The following list describes the assets which meet these characteristics and can therefore be used as the stock of liquid assets:
… (c) Marketable securities representing claims on or claims guaranteed by sovereigns, …. as long as all the following criteria are met:
(i) they are assigned a 0% risk-weight under the Basel II standardised approach, and…
So the full implications of the removal of this privilege would be profound – across the full spectrum of prudential regulation of all EU financial institutions. But this debate is no longer just an intellectual debate because the Eurozone has declared – publicly and irreversibly – that borrowings by it members have the potential to incur significant credit risk. As that risk rises in a particular case, it would be wholly inappropriate for such claims to be treated as liquid (in the example above) or risk-free.
Proposal III is the enforcement mechanism. If a State can borrow at will from the EFSF, then (a) it has no need for market borrowings in its own name; and (b) with the exception of a handful of members States, the cheapest source of funds is likely to be via the EFSF. That would be a major carrot to a Member State.
Presumably, agreement by the eurozone to the policy mix proposed by a state during the European Semester will be the equivalent of agreeing the “strict conditionality” for the granting of EFSF loans – as specified in the proposed new paragraph of Article 136. If a Member State does not abide by its policy commitments under the Commission’s September governance proposals, then it would have “automatically” fallen outside such conditionality.
If the situation persisted and the state is subjected to sanctions, then it is abundantly clear that it would not be permitted to borrow from the EFSF and indeed would be at imminent and grave risk of crystallising credit risk for the private sector holders of its debt. There would be no case for permitting its borrowings to benefit from privileged access to the EU’s financial institutions and risking the spread of contagion. If eurozone Member States are unwilling to lend because they believe the loans would be risky, then it follows logically that they should not encourage the financial institutions that they regulate (and perhaps implicitly guarantee) to lend instead.
So the first “lock” on a state to ensure its continued good economic policies is the judgement of the European Commission about those policies. If the Commission judges them not to be compliant, then the proposal is that this judgement can only be overridden by a QMV of states voting against the Commission.
But there is a second “lock”: “Eurogroup Ministers will make a unanimous decision…” about borrowings from the EFSF. So any single eurozone member could veto new loans to a state where it did not feel comfortable with the proposed borrower’s policy. (This may need to be modified to guard against sophisticated blackmail attempts).
So the stick that is applied if either lock is put into operation is:
The risky state faces a public statement of great force about its policies
It will almost certainly face a major uplift in the market cost of any new borrowings in its own name
The automatic removal of its “special access to financial institutions” may make it very difficult to borrow at all
This all amounts to a financial cliff that any eurozone Member State would be extremely reluctant to be pushed over.
As a footnote, the economic crisis has highlighted governance failings in many institutions – banks, regulators etc. The De Larosière Group Report was scathing about the inability of bank directors to understand the products and thus the risk their banks were actually running. Codes have been drawn up to improve matters and many of them feature increased accountability of the board of directors. There is a clear analogy to be drawn with the Board of Directors of the euro project and the euro zone sub-group – Eurogroup. As the DLG put it “There was little impact of early warnings in terms of action – and most early warnings were feeble anyway.”
At the top of the EU’s economic governance system sits ECOFIN – a body which presided over a decade of lost opportunities. Indeed at vital moments, it actively undermined the system which did exist. How accountable now are those who sat on this “board” at the time? Indeed who were they?
Perhaps the EU should take a leaf out of the corporate governance codes and require Ministers to take personal accountability. At the end of the new European semester of public finance reviews, there will be a decision by ECOFIN that all (presumably) Member States are compliant with policies that should produce a good outcome of competitiveness and fiscal policy.
ALL ministers who are a signatory to that decision should sign an open letter to their national Parliament to attest that they have reviewed the situation personally, and in detail. Accordingly, the Minister can personally recommend to their Parliament that the agreement is satisfactory. That individual is then on the record of history. This does not require a Treaty change - or any legislative action. Merely each national parliament will hold its representative to account in the same way that the Parliaments are planning to hold the private sector to account.