Restoring Euro Area confidence

Adam Bennett (Senior Member, St Antony's College, Oxford)

In the second session of PEFM’s Michaelmas seminar series, on Monday, October 21, the spotlight shifted from UK banking reform to the problems of the Euro Area. Klaus Regling, Managing Director of the European Stability Mechanism (ESM), gave a comprehensive presentation of how he saw progress towards restoring confidence in the Euro since the onset of the Euro Area crisis in 2009. Regling conceded that the various European authorities had perhaps not done the best job in reacting to the crisis—that many measures had been ad hoc and too late—but he insisted that there was and remains a coherent strategy. Moreover, he believed that this strategy was working.

The Euro Area strategy, as Regling saw it, had four principal elements: (i) fiscal consolidation and structural reform in the periphery countries, (ii) improved policy coordination in the Euro Area, (iii) establishment of financial backstops, and (iv) reinforcement of the banking system. The first element was a key part of the process of stabilizing the situation, and the conditionality enforced by the Troika (EC, ECB and IMF) was delivering the desired results – fiscal deficits were declining across the Euro Area, unit labour costs in Southern Europe were converging back towards those of Germany (except perhaps in Italy), and current account deficits were moving into balance, or even surplus. He also saw considerable progress in advancing structural reform in these countries. The second element - policy coordination - was being strengthened by the adoption of more comprehensive and binding rules for national economic policy, inter alia with much stricter rules on fiscal deficits and public debt levels. An important part of the stabilization process has been the establishment of financial backstops, especially the (temporary) European Financial Stability Facility (EFSF) and its permanent successor the ESM, of which Regling is the first Managing Director. These lending arrangements had already been activated for a number of countries, all (apart from Spain) in conjunction with the Troika. Unlike the IMF (the other main source of Troika funds) whose resources come by member subscription, the EFSF and ESM must raise money from the markets. The ECB has meanwhile introduced (in place of its old Securities Market Program) a separate means of financial support (subject to conditionality via a country’s use of the ESM) of Outright Monetary Transactions (OMT) which enable it to buy government bonds in the secondary market in potentially unlimited amounts. Finally, the banking system itself is being strengthened by the endorsement of Basle III capital adequacy ratios (enhanced by a higher European Core Tier 1 capital ratio of 9 percent), and more importantly by the much vaunted and overarching Euro Area wide “banking union”.

Regling described the main objectives of the envisaged Euro Area banking union as being to limit banking fragmentation, break the link between banks and their sovereign host, and protect taxpayers from bailout costs. Banking union is to be supported by three new institutions: (i) a Single Supervisory Mechanism (SSM) for large financial institutions, comprising the ECB and the national supervisory authorities; (ii) a Single Resolution Mechanism (SRM), tasked with resolving non-viable banks (which Regling hoped could be introduced without a treaty change), and (iii) the Direct Recapitalization Instrument (DRI) to help remove the risk of contagion from the financial sector to the sovereign. This strategy has been bolstered by the creation of three new supervisory authorities, the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA), and the European Securities and Markets Authority (ESMA), and supplemented by the European Systemic Risk Board (ESRB), charged with providing authorities with an early warning system.

Armed with these various initiatives and reforms, with their bewildering array of acronyms, and encouraged by signs of Euro Area economic stabilization (if not outright recovery), Regling believed that the European Commission had been strengthened by the crisis, and that it was regaining its proper role as guardian of the EU and its destiny.

In this confident vision of the role of the EC, it is fair to say that Regling has been joined (not surprisingly) by other top Eurocrats, including Olli Rehn, and Manuel Barroso, while his optimism regarding the future of the Euro is shared by many heads of key European institutions such as Mario Draghi (at least as reflected in their public statements). Many commentators have, however, interpreted events differently, seeing member government (particularly German) dialogue having largely usurped the EC as the decision making forum, and noting the possibility that the European Parliament, hitherto an ally of the EC, could swing Eurosceptic in the 2014 elections. And as for the fate of the Euro, there is no shortage of doomsayers, who see the progress to date as a “sticking plaster” solution that may work for a while, but is unlikely to solve the underlying deep-seated structural problems that are undermining the viability of monetary union in Europe.

Notwithstanding this climate of doubt, Regling fielded a volley of questions from his discussant and the audience with feisty determination. There were few dissenters from the view that the Euro Area had stabilized economically, but how much did this depend on interest rates remaining as low as they are now? Are such narrow spreads really justified, and how much do they depend on the ECB’s as yet unrealized promise of OMT? Is there a moral hazard risk in this “Draghi Put”, as there arguably was with the so called “Greenspan Put” (low interest rates and ample liquidity) in the run up to the crisis? On institutional arrangements, several queried the wisdom of forcing the ESM (when activated) to borrow from markets (unlike the IMF) when one or more guarantor member states was (by presumption) in financial difficulty. A question was also raised about the fact that ESM activation required unanimity amongst its members (unlike the simple majority required for IMF assistance). Would this hinder its effectiveness? Regarding other institutional reforms, several questions focussed on the provisions for banking union, including on the plan for a union-wide system of supervision. How practical was it to seat this role (albeit as overseer) in the ECB, given the ECB’s limited experience in banking supervision so far and the large number and complex nature of European banks? Another concern was expressed over the tightening of fiscal rules (in a revamped Stability and Growth Pact) and whether this necessarily made sense in a monetary union. Such rules might address the fiscal symptoms of stress, but as configured they risked removing one of the few remaining national policy instruments available to better manage domestic demand and competitiveness consistent with staying in the union. If the rules became too rigid, they could paradoxically become a source of renewed instability. Finally, from those with a broader perspective, frustration was voiced that these EU initiatives seemed overly focussed on technical economic issues, and ignored the underlying political problems that the crisis had created—including the effects of high levels of long term unemployed and the dangers of extremism. Where, for example, was the growth strategy? Where indeed. Well, hope springs eternal, and we shall certainly be relying on it for some time to come before we can truly declare the Euro Area crisis over.