And so the euro crisis rumbles on from summit to summit. An avoidable crisis and at its heart the consequence of systemic policy failures in the way European Monetary Union (EMU) was designed, constructed and implemented. The severity of the crisis has been greatly deepened by the profound mismanagement of Eurozone leaders and by crisis misdiagnosis as one of fiscal discipline, where, Greece apart, it is really a system crisis with its roots in the design flaws of EMU itself. Policymakers have failed to learn the lessons of the Great Depression and of the long Japanese stagnation of the 1990s. Current responses are insufficient and in some cases even counterproductive. In the TASC discussion paper [The Euro Crisis: Causes and Solutions] I suggest a path out of the euro crisis.
An essential component of the crisis resolution package is the establishment of a ‘conditional’ Lender of Last Resort (LOLR). With an LOLR in place we can eliminate the possibility of sovereign default by member states exhibiting demonstrated willingness to pursue sustainable fiscal policies. The failure to establish a conditional LOLR was perhaps the most important policy mistake in EMU design. Unfortunately the European Stability Mechanism (ESM), as currently designed, is not an LOLR and has an inherently fragile structure. It is not the solution. Mutual debt issuance schemes such as the various Eurobond proposals come attached with substantial moral hazard risks. Yet we can establish a conditional LOLR model for sovereign borrowers to minimise moral hazard risks and reward fiscally sustainable policies. By giving the ESM a banking licence it could borrow from the European Central Bank (ECB). The ESM could then engage in purchases of government bonds in the primary market using its first tranche of paid-in capital and place these bonds as collateral with the ECB to maintain its own capital base. By providing conditional liquidity for sovereigns, and then obtaining its own liquidity from the ECB, the ESM would de facto function as an LOLR for sovereign borrowers. Crucially, the backstop interest rate offered as a ceiling by the ESM could be set to vary from member state to member state and calculated automatically using an agreed mathematical formula set annually by European policymakers. By incorporating member states’ discretionary fiscal actions into the formula we can incentivise fiscal prudence while accommodating moral hazard concerns.
The sovereign debt crisis cannot be detached from the banking crisis. A European Deposit Insurance Corporation (EDIC) funded primarily by the banks should be established in the medium-term to supervise and regulate all Eurozone credit institutions. In the short-term these functions should be assigned to the ECB. The ECB, and once established the EDIC, could underwrite the deposits of all Eurozone banks and be assigned the power to close down insolvent banks, resolve their winding-up, and transfer deposits to a solvent institution. At the same time, the ECB should be mandated to provide guaranteed liquidity support for solvent credit institutions. The purpose is to end the prospect of bank runs, break the link between member state governments and their domestic banks, improve the quality of financial sector surveillance and regulation, and protect Eurozone taxpayers from having to fund future bank bailouts. The socialisation of private debt was a vast transfer of wealth from ordinary people to the financial sector and should not be repeated. Where found insolvent by ECB or EDIC stress tests, banks should either be wound-up or their ownership transferred to creditors as part of a debt for equity process.
Austerity is exacerbating the economic crisis in the Eurozone periphery. The inability of Eurozone member states to restore competitiveness through currency devaluation should be addressed through differentiated inflation targets for different regions. Forcing all the burden of the competitiveness adjustment on the debtor countries makes it more difficult to achieve nominal GDP growth and therefore debt sustainability. Higher levels of inflation and wage growth in the more competitive core is the only way, at least in the short-run, to successfully reconcile the twin goals of rebalanced competitiveness and reasonable nominal GDP growth in the periphery. Full fiscal federalism is not necessary. However, the Eurozone does need a mechanism to soften the impact of recessions and asymmetric shocks. A centralised inter-regional insurance fund to provide direct financial support to troubled economies under strict guidelines would fill this role. The fund could be required to run a surplus over the course of the economic cycle and could be funded from a common Eurozone consumption tax. We must restore the social element to economic policy making. The new six-pack rules should be expanded to monitor indicators such as poverty rates and income distribution, while the rules of the fiscal treaty should be expanded to incorporate growth, development and social justice considerations. We can solve the design flaws but it is not sufficient simply to preserve the euro. The type of Eurozone that survives is crucial.