Ten Commandments to overcome the Eurozone’s many crisis
If the EMU is to succeed it must be developed based on rules

“If we don’t abide by the rules, the Eurozone is going to fall apart around us.“ (Wolfgang Schäuble)

Things have gone quiet with regard to the Euro. At the moment there are no acute crises. Hectic late-night meetings in Brussels, where bleary-eyed politicians scramble to save the EMU, no longer take place. Even Greece is currently neither a source of anxiety nor of dread. Even the impending Italian elections are thus far hardly disturbing financial markets. The Silvio Berlusconis and Beppe Grillos no longer seem so frightening. However, the Euro is far from being out of the woods. It is true that unemployment in the EMU is slowly declining, but it is still a concern. In particular, the future of the youth in the South still looks bleak. Government debt still isn’t looking good in many places. It is still far too high, with no improvement in sight. Structural reforms are delayed, a policy of austerity is on the blacklist, and redistribution is in fashion. And there is another cause for worry: the share of bad loans from banks is very high, with more in the South than in the North. The next recession could shake banks and mean trouble for their governments. The possibility of a vicious circle still can’t be ruled out. A good argument can be made for taking advantage of the currently calmer times to reform the EMU from top to bottom. The following catalogue of Ten Commandments outlines the major lines along which sustainable, truly rule-bound institutional reform should occur.

First Commandment: Going forward, the euro should continue to be “money without government“

For some, the denationalization of the EU can’t come fast enough. Martin Schulz, the failed chairman of the SPD, was hoping for a “United States of Europe“ by 2025. Those unwilling to play along were to leave the EU. Jean-Claude Juncker, President of the European Commission, wants to force all of the EU member states that meet the criteria for accession to the EMU to adopt the euro. Emmanuel Macron, the French president, is flirting with the ideas of a European finance minister, a euro zone budget and debt pooling. All of these proposals are steeped in the desire to renounce national sovereignty. Their ideological superstructure is a (relatively homogeneous) European community of values. This has always been an illusion. Now it appears grotesque. The cracks in the E(M)U are deepening. Europe is becoming more heterogeneous. It is less and less possible to talk of “harmony of interests“ while conflicts of interest are growing. They increasingly manifest as growing aversion and open hostility. Today, Europe is above all a community of convenience. In some fields it pays for countries to cooperate with one another, while in others they prefer to go their own way.  In short, the E(M)U will continue to be an area of heterogeneous nation states. In the future, the euro will continue to be “money without government“ (Padoa-Schioppa). And that’s a good thing.

Second Commandment: The ECB should remain politically independent

Monetary policy is one of the areas where the EMU countries believe(d) that gains are achieved through cooperation. The “Single Market Project of “˜92“ is another. In the Maastricht Treaty a common monetary policy was agreed upon. The ECB was installed as a politically independent institution modeled on the German Central Bank. National central banks of the EMU function as its shareholders. Each member country has only one vote, regardless of its economic strength. The ECB was committed to the objective of price stability. The economic policy task is clearly specified. Price stability is the single economic policy goal of the ECB. The participating countries and national collective bargaining partners are responsible for all other goals. The ECB’s independence is in jeopardy for two reasons: It was granted supervision of the banks following the existential euro crisis. And with its policy of “quantitative easing“, the ECB conducts monetary fiscal policy. In both cases it is dependent upon heavily indebted countries and their distressed banks. The member countries of the EMU need to outsource banking supervision to an independent institution. The ECB will remain independent only if it terminates its contract-breaching monetary fiscal policy as soon as possible.

Third Commandment: Monetary government financing should continue to be prohibited

The Maastricht Treaties are clear: public debt cannot be financed with the printing press. However, it is not all that easy to determine what monetary government financing is. The ECB is admittedly prohibited from becoming involved in the primary market for government securities. For reasons of “market maintenance“, however, it is allowed to intervene in the secondary market. The boundary between the two is sometimes hazy. It is undisputed that in times of existential crisis, such as that experienced by the euro in 2010, the ECB is under an obligation to do “whatever it takes“. This was recently pointed out by the Geneva economist Charles Wyplosz[1] in an interesting interview in “Perspectives of Economic Policy“. However, these times of existential crisis are now long past. It is high time for a change of direction. Meanwhile, another variety of monetary government financing tends to blossom in secret. Highly indebted EMU member states use the “Target 2 balances“ to grant themselves interest-free, unsecured loans at the expense of a few countries, at Germany’s expense above all. This is something that Hans-Werner Sinn[2] has long correctly pointed out. Valuable collateralization of Target 2 loans or their balancing during the year is necessary.

Fourth Commandment: National governments should have the say in matters of economic policy

The world doesn’t often experience the kind of existential crises, like the finance or euro crises, which could lead to a financial meltdown. In such times, economics functions very differently. However, “normal“ exogenous shocks, which occur frequently, are the rule. National economic policy is able to manage them on its own. Coordinated action by countries does more harm than good. The best defense against supply-side, symmetric, or asymmetric shocks is open goods and factor markets. National economic policy must support them. Constant structural reforms are indispensable. A European single market is helpful. In the case of supply-side shocks, wage and collective bargaining policy carries the main burden of adjustment in the EMU. Countries are also normally able to deal with demand-side shocks effectively on their own. In spite of fiscal indebtedness rules, with which, admittedly, none in the EMU concern themselves, there is still enough room for maneuver at the national level for countries to close any demand gaps which may arise. This is also necessary, as centralized monetary policy cannot respond to country-specific shocks. Countercyclical national fiscal policy is a great help: surpluses in good times help finance deficits in bad times. There is no reason to coordinate national fiscal policies across Europe – in avoiding doing so, national fiscal sovereignty is also preserved.

Fifth Commandment: The architecture of social security should remain nationally organized

The economic policy architecture of the EMU did not come about by accident. Monetary policy is centrally organized, while all other economic policy is decentralized. This institutional arrangement reflects the heterogeneous preferences in Europe. The “European miracle“ is unthinkable without the competition of heterogeneous institutions. This is also true for a central element, namely labor market and social policies. National welfare states reflect heterogeneous preferences. The “Anglo-Saxon“ world is more likely to rely on the market, the “Nordic“ more on the government, the “Continental“ more on corporatism, and the “Mediterranean“ more on the family. They all react differently to challenges. It would thus be a big mistake to pin hopes on a unified welfare state in Europe, as has been suggested by Emmanuel Macron. A European social union with uniform legal minimum wages, European collective agreements, uniform regulations for employment protection, a common European unemployment insurance, or harmonized basic social benefits comes into conflict with heterogeneous, national preferences.  And there is one more argument against a social union in Europe. Uniform European regulations clog an important valve used by countries (regions) to adapt to exogenous shocks. They would reduce the adaptive capacity of countries. This destabilizes the EMU. Europe should renounce the idea of a social union and continue to rely on heterogeneous, decentralized social security architecture.

Sixth Commandment: Hands off the four fundamental freedoms in the EU!

The European single market stabilizes the EMU. If (negative) exogenous shocks occur, economic agents (workers and firms) must adapt to the changed circumstances. If they do not manage to do so via relative prices (wages and wage structures), the (internal) adjustment will occur painfully through quantities (unemployment and mobility). The danger of quantitative adjustment increases if economic agents have the power to shift the burden of adjustment to third parties.  One such third party may be consumers if the ECB adopts a policy of stronger inflation (“monetary“ channel). It would be the government if it increasingly grants financial assistance (“fiscal“ channel). In most cases, however, it is the welfare state that must bear the brunt of the adjustments as employment burdens are shifted to pension, health, and unemployment insurance systems (“social“ channel). Tougher budget constraints imposed by economic agents clog these channels. Such action is most likely to succeed if competition in goods, services, and factor markets is intensified. The four fundamental freedoms, which also include the free movement of persons in the EU, ensure that this occurs. Competition intensifies, budget constraints become tougher, relative prices are more flexible, and labor and capital become more mobile. All of this contributes to the stability of the EU. Anyone who wants to protect the euro from severe crises in the future must therefore continue to develop the European single market in a competitive manner. Particularly in the services markets, there is still considerable need for (German) action.

Seventh Commandment: Fiscal free riding should be prevented

If it becomes possible to shift burdens onto others, one’s own behavior changes. This does not just apply to individuals. The architects of the EMU have recognized this risk (“moral hazard“). They attempted to contain it using fiscal guardrails, but this proved unsuccessful. Nevertheless, the EMU will only be stable if it succeeds in avoiding as many risks as it can and in sharing as few risks as possible. The first is only possible if the EMU countries engage in constant structural reforms and governments ensure that state budgets are sound. Northerners in particular are open to this path. Failure to address the second requirement inevitably leads to a transfer union, destabilizing the EMU and eventually destroying it. Above all it is the southern countries of the EMU who prefer the transfer union model. It’s beyond me why 14 German and French economists would bet more strongly on risk sharing, i.e. on a transfer union[3]. The EMU will in fact only be stable if it succeeds in installing fiscal guardrails that really work. An effective non-liability clause, the keystone of the EMU (Charles Wyplosz), is ultimately unavoidable. The “Fall of Greece“ must not be repeated. However, Germany, with its outdated “principle of mutual help“, does not offer a good example of effective exclusion of liability for the EMU. For it to function there, it must be shielded by a “fiscal cordon sanitaire“: a bankruptcy code for countries, no issuance of common bonds (Eurobonds, subordinated bonds, etc.), limited, incentive compatible Target 2 balances, and no European deposit insurance or European unemployment insurance.

Eighth Commandment:  Banks and governments should be separated by a firewall

In the EMU, banks and governments live in a fatal symbiosis. When one catches fire, it also sets the other ablaze. Therefore, the firewall between banks and governments must be strengthened. An initial option is to limit banks’ investments in government securities. If countries get into trouble, their negative influence on the soundness of banks is limited. The vicious circle cannot even begin. As a second element, government securities in bank balances must be deprivileged. Government securities are not without risk. They must be backed by equity dependent on the level of risk. If this is done, the incentives of banks to hold risky government securities will be permanently reduced. A third step is to appreciably increase the banks’ equity ratios. Proposals allow for shares equivalent to 25-30%. A fourth element should prevent governments from rescuing banks over and over again. Bank collapses must again become possible, regardless of their specious systemic relevance or that claimed by interest groups. The owners and creditors of banks must bear the costs incurred. Bail-ins should replace bail-outs. The cornerstone of the stronger firewall must be an insolvency code for governments. In the event of bankruptcy they need to restructure their debts instead of resorting to fiscal and monetary bailouts that are funded by other EMU members.

Ninth Commandment: The EMU should not implement a permanent EMF

In the euro crisis, the EMU was threatened by the financial meltdown. This was especially frightening for the countries that found themselves looking into the financial abyss. They are calling for a permanent financial fire department to extinguish fires in distressed countries. The European Stability Mechanism (ESM), which rests on intergovernmental agreements, is to follow the example of the IMF and be transformed into an EMF. This proposal is favored by some in the EMU. They want it to be organized according to European Union law, managed by the EU Commission, and jointly financed. This is rash. A European “professional fire brigade“ is superfluous in the EMU. The majority of the fires that countries struggle with are rather small. They can be effectively extinguished by the local (national) fire departments. In spite of the financial and euro crises, large fires are the rare exception to the rule. However, in emergencies, assistance from the larger community may be necessary. Fire departments from the surrounding area (EMU) are then needed to bring such major fires under control. Nevertheless, the creation of a jointly financed “professional fire brigade“ is inadvisable. Constant readiness comes with a hefty price tag. The long “idle state“ between fires will lead such a “professional fire brigade“ to “foolish“ ideas. It will seek out new tasks. In this context the IMF serves as a cautionary tale. The constant presence of a European “professional fire brigade“ and its joint financing contribute to the neglect of local fire prevention measures. An EMF will increase the “fire risks“ in the EMU[4].

Tenth Commandment: National parliaments should have the last word

It is illusory to believe that the members of the E(M)U will develop into a “United States of Europe“ in the foreseeable future. Countries pursue divergent interests. They find it difficult to relinquish national sovereignty. The most substantial relinquishment has been made by the EMU countries in the area of monetary policy. Not all agree with this course of action. The resistance to the ECB’s unconventional monetary policy is growing. However, particularly in financial policy, the member states insist on maintaining their national sovereignty. The proposal of some, such as the French President, to install a European Finance Minister is neither serious nor expedient. This Finance Minister would lack political legitimacy. National parliaments should still have the say in matters of financial policy, not the European Parliament. This would only change if genuine joint tasks were created in the E(M)U and supranationally financed. Parliamentary control would then need to take place at the E(M)U level. The European Parliament would then come into play. The influence of national governments would decline. As long as this is not the case, the decision-making rights of the European Parliament (“he who pays the piper calls the tune“) and the scope for action of the European Commission are both limited. The E(M)U remains the boarder of the national governments. For the foreseeable future, it will remain an area of heterogeneous nation states that have little desire to relinquish their sovereign rights.

Conclusion

The current mood of calm in the EMU is deceptive. It still rests on shaky foundations. Many “reforms“ of recent years were merely stopgap measures. A consistent plan is still missing. The statics of the EMU continue to be unstable. Glaring structural defects remain unresolved. It will not be possible to patch up the next crisis using the money of others. What the EU needs is institutional reforms. The erratic, discretionary behavior of politics during long nights in Brussels, which only accomplishes hectic, makeshift repairs, is counterproductive. The EMU is never going to get anywhere without clear, credible rules which are also adhered to. Meanwhile, the euro is going to remain “money without government“ for the foreseeable future. This is the reality. The “United States of Europe“ is one of the political smoke grenades of the Jean-Claude Junckers in Europe, providing a smokescreen behind which the EU Commission and the European Parliament can engage in their centralist mischief. In the future as well, it should be national governments that have the primary say in matters of economic policy in the EMU. This is the right response to heterogeneous preferences of citizens in Europe. The E(M)U can only be stabilized if action and liability once more go hand in hand. The EMU cannot get back on its feet economically without real exclusion of liability. A joint liability scheme is politically disastrous as well. The Maastricht Treaty was absolutely right about this. However, it left a systemically important spot blank: the ominous symbiosis of banks and governments. This is a constant source of danger to the stability of the EMU and the two must be separated as soon as possible. If the member states of the EMU orient themselves according to this rule-based Magna Carta, the euro will be successful as well. If they do not, Europeans will see the euro blow up in their faces as soon as another crisis strikes.

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[1] Charles Wyplosz, Wir erleben eine historische Transformation Frankreichs. Ein Gespräch mit Charles Wyplosz über die Reformen von Präsident Emmanuel Macron, das notwendige Großreinemachen in der Europäischen Union und das Drama Griechenlands, in: Perspektiven der Wirtschaftspolitik, 2017, 18 (4)

[2] Hans-Werner Sinn, The Euro Trap. On Bursting Bubbles, Budgets and Beliefs, Oxford University Press: Oxford 2014

[3] Agnès Bénassy-Quéré et al., How to reconcile risk sharing and market discipline in the euro area, in: VOX, 17. January 2018

[4] Roland Vaubel, Das Ende der Euromantik. Neustart jetzt. Springer: Wiesbaden 2018