Uniform monetary policy and inflexible exchange rates will create conflicts whenever cyclical conditions differ among the member countries\" warned Martin Feldstein (Feldstein, 1997, p. 41). Indeed, the Eurozone stability was severely tested during the sovereign debt crisis as some members could not cope with the impact of the 2008 Great Financial Crisis (GFC). The European Monetary Union (EMU) inadequacies to deal with such a large economic shock was a revealing moment for policymakers and led them to adopt some emergency measures to save the Euro.
Despite progress towards economic integration, regional divergences remain, making the zone vulnerable to instability. Hence, the EMU governance framework put in place post-2008 must be developed further to deal with unexpected shocks and improve the Eurozone sustainability. But the Eurozone remains an incomplete institutional construct and must progress towards further fiscal and political integration to ensure its long-run sustainability.
The Maastricht Treaty centralised the monetary policy while leaving the fiscal responsibilities at national level. It forbade monetary financing by the ECB and country bail-out between members and by the European Central Bank (ECB).
It also imposed a ‘German’ preference for fiscal discipline through the Stability and Growth Pact (SGP) limiting government deficit and debt respectively to 3% and 60% of GDP. During the GFC, these foundations left the national governments with a limited policy toolbox, mainly tax revenues, to address the consequences of the demand shock. Sovereign bond yields rose sharply as bondholders questioned the governments’ ability to service their debt. This fuelled a doom loop as domestic banks impaired the value of their sovereign bond portfolio, restricted their lending to satisfy the solvency ratios, accelerating the economic recession and the fear of sovereign default, finally forcing governments to bail out banks.
Faced with “a tail-risk in the euro area and self-perpetuating dynamics in the economy” (Cœuré, 2013), the ECB reluctantly decided to bend the Maastricht Treaty rules and launched the Outright Monetary Transactions (OMT), a limitless buy-back programme of sovereign bonds on the secondary markets.
The OMT along with Draghi’s stance to do “whatever it takes to preserve the euro” broke the ‘no bail-out’ clause and placed the ECB in a temporary position of lender of last resort (LOLR), alleviating fear on the bond markets and lowering the cost of debt for the Eurozone members. The Fiscal Compact, introduced in 2013 as a condition of the OMT, committed bailed-out members to drastic austerity measures in return for the financial assistance of the European Financial Stability Facility, diverting surpluses to achieve debt reduction and to balance budgets. The process was particularly painful for countries where the real exchange rate (RER) channel did not function efficiently. Indeed, the Eurozone has seen little RER convergence but rather an increased German competitiveness since 2009 (Giusti & Zoppè, 2017), which, in the context of low labour mobility (Fries-Tersch, et al., 2018) prevents the levelling of regional imbalances. Greece did not return to prosperity and its 2019 real GDP remains 22% lower than in 2008 (OECD, 2019).
The potential for a ‘doom loop’ still exists despite improvements to the EMU governance post-2008. The EMU still falls short on some Optimum Currency Area criteria . If economic synchronisation progressed before 2008, there has been a divergence between the core and the periphery through the 2008-2015 period, as well as a deviation within the periphery and differences in amplitude of the cycle within the core (Belke, et al., 2017), weakening the argument of the endogeneity of the Eurozone. Indeed, in 2019, GDP growth ranged from 0.3% in Italy to 5.5% Ireland and was 1.2% for the Euro area (Eurostat, 2020). The heterogeneity limits the ECB’s ability to act as an efficient stabilization mechanism as a common monetary policy relies on business cycle synchronisation. Also, the GFC led to significant fiscal imbalances – government debt to GDP ratios range from 22% in Luxembourg to 176% in Greece and half of the EMU members are above the SGP target of 60% (Eurostat, 2019). In addition, bank liabilities are many times larger than the government liabilities (9 of the 19 EMU members shows banks liabilities to GDP in excess of 200%) (European Central Bank, 2019) and the household debt to GDP (100% in Germany but 241% in the Netherlands) highlights some significant divergence in banking prudential norms. In this context, the EMU remains fragile and, to avoid the repetition of 2008 scenario, the Eurozone should embed government bailouts and ECB’s role as a LOLR into European legislation to ensure the right level of credibility. There is debate to decide whether the role of liquidity provision by the ECB should also be split from the supervisory role (De Grauwe, 2011), that is the governance of moral hazard, or whether both should fall under the ECB’s remit (Goodhart & Schoenmaker, 2014). Whichever choice, the institutions in charge should have limitless firepower and be independent from government intervention.
The European Stability Mechanism lacks both characteristics. The Eurozone should further promote a fully-fledged banking union to ensure that Eurozone members are jointly responsible for the solvency of European banks. The banking union is currently articulated around two pillars, first the Single Supervisory Mechanism, which strengthens supervision of banks, and second the Single Resolution Mechanism, which ensures joint responsibility for bank solvency across the Eurozone. A common euro area deposit protection system should also be set up, but the Eurozone finance ministers recently failed to agree to the completion of a bloc-wide banking union. Not only would a complete banking union have beneficial macroeconomic effects, but it would also support the ECB’s role as LOLR (Praet, 2016), and thus participate to the long-run sustainability of the Eurozone.
Finally, the Eurozone must progress towards fiscal and political integration to ensure its long-run sustainability. The absence of a large federal budget prevents large scale transfers to stabilise asymmetric shocks and provide pan-European solidarity. In 2019, the EU budget was €148 billion, that is 2% of the combined national budgets of all 28 EU countries (European Commission, 2019). A mutualised budget should be financed by mutualised debt through the creation of Eurobonds, making EMU members collectively responsible not only for each other’s sovereign debt but also for the common European debt. Such a mechanism would finally break the interconnectedness between states and their banks, removing the risk of a ‘doom loop’. The issue of Eurobonds should not be mistaken with the recent proposals for the creation of sovereign bond-backed securities (SBBS), whose objective is to help banks diversify their sovereign exposures and weaken the link with their home governments (European Commission, 2018).
SBBS would not involve mutualisation of risks and losses among Eurozone countries and as such cannot replace a proper mutualised financing mechanism. Eurobonds are a highly politically charged issue. The most recent suggestions by some EU countries to create joint financial instruments to deal with the macroeconomic impact of Covid-19 epidemic were rebuked by northern European countries, who fear Eurobonds would raise their borrowing costs to the sole benefit of the less fiscally sound southern countries. Given the strong resistance to debt mutualisation, the ECB could be authorised to buy sovereign debt at issuance on the primary market. National governments would remain responsible for the debt, but the ECB backstop would alleviate potential fear on the market. The Eurozone should progress towards further political integration in order to replicate the structure of a nation state and promote the acceptance of a common governance. \n In conclusion, the Eurozone has currently only improved its long-run sustainability. Ensuring it requires the progressive retreat of the nation states, a scenario that is at odds with the current mindset of the European population.