I have drawn together this anthology of my earlier works on the possible role of “market discipline” in ensuring financial stability in the Economic and Monetary Union (EMU). My first paper was published by Salomon Brothers in 1989 during the Maastricht Treaty negotiations and the final paper in the series was published in 1993.
My central point was that public debts denominated in a currency that a government could not order to be “printed” – the euro – had a fundamentally different credit quality than paper money that could be printed at will – in extremis. That different quality should be reflected properly in the newly developed system of risk weightings for banks holding public debt as a core asset. This argument was seen as an `inconvenient truth’ at the time, and the Basel Committee on Banking Standards (BCBS) continues to obfuscate on this point - despite my submission to its consultation in 2019.
The European Union is engaged - yet again – in a debate about “fiscal rules” intended to prevent an unsustainable build-up of public debts that might threaten the integrity of the common currency – the euro. The debate seems to just be a continuation of the arguments in the run-up to agreement on the Maastricht Treaty when the concept of “market discipline” was rejected in favour of “rules” to be enforced by finance ministers.
In the ensuing decades, ministers have never enforced these rules – until the financial markets (acting as so-called `bond market vigilantes’ ) refused to fund what financial market participants regarded as unsustainable debts in several EU states. In response, Euro area states were forced to create the European Stability Mechanism (ESM) and the European Central Bank (ECB) had to create a series of new facilities that approached the very edge of Treaty prohibitions on `bail outs’ and `monetary financing’.
Remarkably, the new proposals for fiscal rules target “net expenditure” that excludes debt interest on the basis that it is not directly controllable by the Member State. However, market analysts are perfectly capable of plugging in actual/feared interest rates into their models of public debts – just as they did in 2010/12 – and drawing unpleasant conclusions about sustainability as debts are rolled over at higher spreads. Such calculations will quickly re-awaken discussions of the `doom loop’ between the leading banks in a state holding excessive quantities of their home government’s then-unsustainable debts.
Italy’s blocking of revision to the ESM Treaty and Germany’s unwillingness to complete the European Deposit Insurance Scheme (EDIS) illustrate that risks to financial stability remain significant – if merely latent.