Europe inches closer to a plan to fix its financial woes

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DONALD TRUMP and Theresa May have probably done more to push Europeans together, and open up an opportunity to reform their institutions, than any American president or British Prime Minister ever could. to have dreamed The “Commission’s reflection paper on the deepening of the Economic and Monetary Union”, published on May 31, points the way to a package deal that could be acceptable to the countries of the euro area North and South. But some key elements are still missing.

Encouragingly, the Commission is setting a tight timetable for completing the banking union, with the creation of a common deposit insurance scheme and a common back-up for European Resolution funds expected to be in place by 2019. These two elements are crucial if we are to stop the banks from being a permanent threat to the states where they operate.

But avoiding the “diabolic loop” between banks and states also requires cutting the other link – from state bankruptcy to banking failure. Currently, bank loan portfolios are even more concentrated on the sovereign debt of their own home countries than they were before the crisis. It is essential to ensure that banks have a diversified portfolio that would withstand a sharp decline in the solvency of their home country’s government.

To achieve this, the Commission proposes the creation of a new safe asset: “sovereign bond-backed securities”. The Commission argues that these new securities, together with a change in the regulatory treatment of sovereign bonds, could significantly reduce the vulnerability of the financial system. The lack of concrete on the design, however, makes this application dubious.

A group of economists led by Markus Brunnermeier, of which I was a part, proposed a two-tier design for such sovereign-backed securities in 2011. We called them European Safe Bonds or “ESBies”. A European debt group would buy euro zone sovereign bonds and issue two securities. First, it would issue European Safe Bonds, with a high claim on the payments from the bonds in the portfolio. In this way payment would be safe, as we calculated, even if Greece, Portugal and Ireland changed and haircuts on Italian and Spanish debt. Secondly, it would issue the youth share, backed by a portfolio of sovereign bonds, a security that would be risky, as it would absorb the first loss.

Such a two-tier system would make the European financial system safer, as banks would hold ESBies instead of their own government debt. It would avoid panic and ensure that any flight to safety would benefit all euro countries, not just Germany. And, crucially, he would do all this without introducing joint responsibility, thus increasing his political activity.

In banking and finance, the proposed package is therefore a positive step, albeit a rather vague one.

Where the package leaves much to be desired is in dealing with the abject political and economic failure of fiscal policy and the Stability and Growth Pact (SGP). This failure has been at the heart of the weakness of the European project over the past six years. Debt has continued to grow and a comprehensive fiscal policy has been possible. Recently, the SGP itself has become irrelevant, as shown by the “0 euro” fine imposed on Portugal and Spain for (correctly) avoiding it.

To correct this failure, the only thing that the Commission recommends to do before 2020 is to simplify the rules of the SGP.

Instead of simplifying the rules, the Commission should drop the SGP recommendation. It would be economically sensible to allow different, countercyclical fiscal policies in the member states to go against the uniform monetary policy required by a single currency. It is also politically necessary to end the SGP, as it involves excessive and unproductive involvement of the Commission in the main function of a democratic parliament: approving the national budget. As a result, it leaves the Commission, and by extension Europe, neutral in the South (“stop Europe getting involved!”) and in the North (“the commission is failing to back the waste of Southerners!”).

To replace the SGP we would need a new, decentralized control mechanism. Economists such as Jeromin Zettlemeyer and lawyers such as Lee Buchheit have developed a solution over the past decade: a sovereign bankruptcy procedure within the euro area that would allow for an orderly renegotiation of sovereign debt with private creditors . Such a mechanism would restore market control to the states, allow the necessary flexibility in fiscal policy without absurd regulations, and make the “no bailout” promise credible. Once the ESBies and European solvency and investment insurance funds are in place, the financial system should be strong enough to believe such a bankruptcy procedure.

Finally, there has been no sustainability or risk-sharing element in the European budget so far. The Commission very alarmingly proposes a “Decision on the design, preparation of implementation and start of operations” of “Central establishment activity” for the period 2020-2025, and breaks two ideas: an investment protection scheme, a type of insurance for investment, and an unemployment reinsurance fund that would support unemployment insurance schemes in member states.

Here the Commission is too technical and too scary. The current package deal must include a calendar for the implementation of the Euro budget with real European Unemployment Insurance with European regulations, based on flexible security principles. Not only would such a scheme be pre-cyclical, but it would make structural changes in the member states. This system should be financed through a (small) European charge on corporate tax. An additional benefit of such a system is the harmonization of corporate tax bases, which are currently being eroded by tax engineering.

To sum up, the Commission’s proposal is ambitious and timely in terms of banking and finance, but it falls short of giving European citizens a Europe they can love. Unemployment is where the difference made to citizens’ lives, both cyclically and structurally, can be greatest. A portfolio that does not include joint liability on bonds and sovereign bankruptcies should be confident enough towards the “North”; in exchange, the “South” should demand finance, a European unemployment insurance scheme, and single deposit insurance.

Destiny has given Europe a unique opportunity to put its house in order. If we do not take this opportunity, the rise of populism in the main countries of Europe will be inevitable. What would come next is too hard to imagine.

Luis Garicano is Professor of Economics and Strategy at the London School of Economics, and vice-president of the Alliance of Liberal Democratic parties in Europe (ALDE). This piece expresses his personal views, and not the views of ALDE.

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