Separation anxiety

EU is wrong to obsess about fiscal union Malcolm Barr & David Mackie

Amyth is stalking the euro area that, despite being nearly universally accepted, is almost certainly wrong. This myth is that a quick move to deeper fiscal, banking and political integration is needed to either prevent or resolve a future crisis.

The source of this myth is the most common interpretation of the causes of the 2011-12 EMU sovereign crisis: the region experienced a crisis because the house of EMU had only been partially built. It was a monetary union without a fiscal, banking or political union. At some level this is true. If the euro area had looked like the US in 2011-12, with a large federal tax and benefit system and a federal bond market, then the region would either not have had the crisis that it did or it would have had a very different one. But that particular federal destination is not on offer.

Although the federalists have more wind in their sails, further steps of integration are likely to be modest in the coming years.

IMF estimates make clear that payments into shared investment or unemployment insurance funds need to be of the order of 2pc GDP annually to begin to approximate the stabilising effects seen elsewhere. Nothing of this scale is on the table. We should not mistake possible intent for the real thing.

The focus on the absence of fiscal, banking and political union misses the more proximate causes of the 2011-12 crisis, where there is more political scope for relevant action. We would argue that there were three proximate causes. First, the explicit introduction at the Deauville summit of the idea that sovereign bonds in the region could be restructured, which led to the introduction of collective action clauses (CACS) from 2013 into government bond contracts. Second, an interpretation of debt sustainability in deficit and debt rules that led to aggressive fiscal austerity. And third, the reluctance of the ECB to fully use its balance sheets to ensure both price stability and financial stability.

These causes are of course linked. CACS, legislated in the ESM treaty, were intended to signal that debt restructuring would be part of any future crisis management. To some extent this came from the view that the appropriate measure of debt sustainability in the region was a balanced structural position and a debt to GDP ratio of 60pc. With such an aggressive view of debt sustainability, severe fiscal austerity was inevitable. And finally, the prospect of debt restructuring added to the ECB’S concerns about debt monetisation, making it reluctant to engage in QE.

This interpretation of the causes of the 2011-12 crisis leads to a very different view of what should happen next. Although the region is doing well, and the ECB’S attitude to its balance sheet has changed a lot, debt restructuring remains a possibility, the ECB is constrained in its bond purchases due to CACS, and the balanced structural position and 60pc debt to GDP objectives remain on the statute book.

The risk is that in the next crisis there will be renewed pressure to restructure sovereign debt, which would be a disaster. Even in the absence of such pressure, the existence of CACS means that the ECB could quickly become constrained in its QE purchases. And the pressure for fiscal austerity would return.

The two things that would be most valuable in tackling a new crisis are the removal of CACS from sovereign bonds and a rewriting of the deficit and debt rules to allow a more realistic path of adjustment for sovereigns under pressure.

These steps would allow the ECB and fiscal authorities to respond more flexibly in any future crisis. In our view, they would be much more valuable than a move to a small euro area budget, common deposit insurance and a renamed ESM.

Over the past few years we have learned three lessons. First, that uncertainty about the integrity of sovereign debt is very destabilising in a tightly knit region. Second, that overly aggressive fiscal rules can be very damaging.

And third, that a central bank that fully uses its balance sheet to achieve price and financial solidity is very stabilising. These messages are more useful than dreams of a fiscal union.

‘Federalists have wind in their sails but further integration is likely to be modest’

Malcolm Barr and David Mackie are economists at JP Morgan