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How the Eurozone Can Be Strengthened After Brexit



Brexit raises fundamental questions, about the course of history, the nature of relations between European countries, the rise of populists, and the devalued status of politicians. These will be analyzed at length for months and years to come.

Meanwhile, Europe must continue to function. Both the European Union and eurozone projects have to be reexamined and made more resilient. It is in this context that a large number of prominent economists from different European countries, ranging from those who desire more political integration to those who are more skeptical, have written what they see as the essential next steps to reinforce the architecture of the eurozone.

Compared with the discussions on the big issues (“the course of history, the end of civilization as we know it….”), I will be the first to admit that the document we wrote makes for boring and narrow reading. “Don’t bother me with thee details” may well be the reaction. But, at ground level, the precise nature of the institutions affecting the behavior of financial actors and governments is what will make or break the eurozone project. And that discussion is badly needed and is needed now.

The purpose of the project, which started long before Brexit, was twofold. First, assess the nature of the challenges and the progress to date. (A previous document, published in November 2015 and also signed by a large number of economists, assessed the sources of the euro crisis and identified the problems.) Second, assess the degree of agreement among “experts” about the remaining challenges and solutions. If you look at the diversity of people on the list, the answer to the second question is that, in contrast to the often strident disagreements in the press, there is, indeed, surprisingly large agreement among experts.

What is this agreement? I shall let those interested read the original text. And I shall give here my own short summary, realizing that not everybody who signed would put it in the same terms. I would summarize my own take in three conclusions: The basic architecture is largely in place. Some strengthening is needed but does not require dramatic political steps. The most important set of measures to take is a strengthening of the European Stability Mechanism (ESM).

Let me develop these conclusions, focusing on two of the main sources of resilience: the ability of the banking system to withstand shocks and the sustainability of public finances.

Take the financial system first. The banking union is largely in place, and with it better tools to monitor and reduce financial risks. Stress tests are getting better; they will never be perfect. Rules governing default, such as bail-in rules, the role of states in recapitalization, have been defined. There are questions as to whether they are credible and will be implemented, but this must be seen as growing pains, common to new financial regulation rules in general. More progress can be made without requiring much more political integration.

Take public finances. This is where more needs to be done, along two lines: First, fiscal rules have become too many, too messy, with too many loopholes. They can and must be simplified. In many countries, the issue is not so much deficits than the high level of expenditure, which in turn makes it difficult to balance budgets without resorting to excessive taxation. Rules should focus more on expenditures and less on deficits per se. That can again be done without more political integration.

Even under the best fiscal rules, current levels of debt together with low growth imply that sovereign debt default is not impossible. Defining responsibilities and the process for sovereign default is essential. This should and can be the role of the ESM. This requires some increase in funding or in leverage and a more flexible decision making process: Unanimity makes it difficult to take decisions quickly enough; some form of qualified majority voting is needed. This is one place where I believe states have to be willing to give up some control. Otherwise the ESM will not be able to do its job.

These remarks have focused on solvency issues, both on how to reduce the risk in insolvency and how to deal with it were it to happen. We have learned, however, that liquidity runs can happen and be very destructive. The European Central Bank (ECB) now has the tools to provide liquidity to banks against good collateral. It would be good if it could do the same to states, through the Outright Monetary Transactions (OMT) program. At this stage, the OMT can be activated only in the context of an ESM program. Clarifying the respective roles of the OMT and the ESM as the two pillars of solvency and liquidity is essential, both practically and politically.

Many would like to see more ambitious steps taken, from a common fiscal policy, to euro bonds, to euro-level deposit insurance, etc. And indeed, the line taken by some US commentators today (e.g., Bradford DeLong and Paul Krugman) is that this is what our manifesto should have asked for. (They also argue for more aggressive monetary and fiscal policies. Our focus was on euro institutions, and we did not discuss those issues). Our goal was less ambitious and more realistic. It was to see if the eurozone could function and handle shocks without further political integration if political realities made it impossible for the time being. Our answer is a qualified yes, but it is surely not an endorsement of a do-nothing strategy. 

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