Policy proposals in Europe go in all directions

May 31, 2018 14:52
European leaders should acknowledge that national economic policies that worked in the pre-EMU times do not necessarily work now, and definitely not equally in all countries. Photo: Reuters

Ahead of the EU Summit in June, the discussion about the future structure and governance of the euro area is gaining traction. So far, policy proposals reflect the very heterogeneous views about the ills of the monetary union. None of these policy proposals have answers about how to deal with "OurNationFirst", or other populist policies, that do not comply or cooperate with European rules and procedures.

At least there is a discussion again about how to improve the stability of the European Monetary Union (EMU). Policy proposals, however, go in all directions as we have seen in recent days.

On May 21, more than 150 German economics professors published an appeal in the economically conservative daily Frankfurter Allgemeine Zeitung against mutualisation of risks in the euro area. Warning against policy proposals of Macron and Juncker, they reflect the view that moral hazard is the biggest risk for the euro area and structural reforms a cure for all.

It is noteworthy that the wake-up call does not present any other constructive policy proposals, in particular nothing about how German economic policies could contribute better to the stability of the euro area rather than following its own version of economic populism.

This is remarkable considering that for years Germany has been ignoring European rules about macroeconomic disequilibria by not addressing its outsized current account surplus with higher wage levels and more appropriate macro policies.

On May 24, the EU Commission published a new proposal for a framework for sovereign bond-backed securities (SBBS). Its basic idea is to abolish disincentives for the issuance of financial products that provide some diversification benefits when investing in a basket of euro area government bonds. This would allow banks to reduce the home bias in their portfolios.

There is nothing wrong with risk reduction by diversification and reducing home bias. But we wonder whether the existence of SBBS would make much of a difference.

First, banks could easily diversify their sovereign risk exposure in their hold-to-maturity books themselves. Second, it has been seen that national crises quickly become systemic in the euro area, which reduces the benefits of diversification as correlations between bond prices converge to one. Third, it is not clear whether a reduction of a home bias decreases or increases systemic risk in the euro area.

For years, investors were told not to worry too much about high debt to GDP levels in Italy as most bonds would be held by Italians themselves, lowering contagion effects in times of crisis. While Italian banks might reduce their risks by diversifying out of Italian government bonds and into SBBS, it would alter incentives for the Italian government.

In particular, it would decrease the economic costs of a sovereign default born domestically. All governments would usually avoid such a default, but what about populist ones like the new Italian one that lean to opposing the EU, the EMU and rules that intend to stabilize it?

In the current environment it needs to be acknowledged that non-cooperative net debtors are in better position to threaten European institutions and other governments than net creditors. In this respect, SBBS do not help at all.

We support new approaches to make the euro area more stable. These should start by recognizing that national economic policies that worked in the pre-EMU times do not necessarily work now, and definitely not equally in all countries. Technically smart rules and incentives in the EMU might be helpful, but only if the economic reality that voters face in their countries provides enough reason for a consensus to comply with European rules at all. The reality seems to be that this consensus is waning in Italy at least.

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RC

Chief Economist, Head Economic Research at Bank J Safra Sarasin