The unfolding crisis in Europe has focused policymakers’ attention on fiscal austerity and bailouts. We believe that this neglects a major dimension of the new political bargain – one that must be addressed if we are to deal with the severe problems facing the Eurozone and the EU.
Debt sustainability can only be founded on the sustained growth of our economies. Exclusive emphasis on restoring sound public finances will not suffice. A broader political deal on economic policies and economic governance is needed to lift growth and restore confidence in the future of the Eurozone and the EU. Such a deal must include, together with better-designed measures for fiscal discipline, a decisive drive to accelerate the completion of the single market and strong investment in cross-border infrastructures.
We make these points in a Policy Brief published by CEPS today (Gros et al. 2010) which we are also sending to the European Council as an open letter for consideration at their forthcoming meeting on December 16-17.
The Policy Brief recommends a comprehensive economic policy initiative which could help the European Council turn the corner on the lingering debt and bank crises in Europe. It would help governments match fiscal discipline with higher growth as well as restore a climate of cooperation between the member states. We summarise the gist of the Policy Brief in this Vox column.
We believe that a new political deal on sustainable growth needs to be built on four pillars:
- A reform of the Stability and Growth Pact;
- A reform of Eurozone crisis management;
- Growth enhancing structural reform; and
- Infrastructure investment for the internal market
On the reformed Stability and Growth Pact
The EU is right in seeking a sustainable correction of fiscal imbalances. A critical aspect that requires stronger tools in this context is the quality of consolidation programmes. These should be centred much more on permanently lower growth of current public expenditures, efficiency and growth-enhancing reform of entitlements (pensions), and unemployment support schemes (active labour market policies). A strengthening of relevant provisions in the Stability and Growth Pact legislative texts before Council and Parliament seems in order.
Furthermore, the public debate has placed too much emphasis on the “corrective” arm of the reformed Pact. Greater weight should instead be placed on strengthening the “preventive” arm, which is really where policy coordination within Ecofin and the European Council failed.
To this end, the European Commission’s powers to publish league tables of performance, launch early warnings, and make public its analyses and recommendations on divergent countries should not be subject to Council approval; and reverse voting in the Council on Commission recommendations should apply across the board.
The most important elements needed to underpin the reformed Pact are the envisaged changes in national fiscal institutions and procedures, which should be made legally binding at EU level. This includes the establishment in all member states of an independent fiscal authority that should be accountable to parliaments and entrusted with the task of publicly assessing the state of accounts, the quality of national consolidation programmes, and their consistency with Council recommendations.
The key to making a crisis manageable is a strong financial system able to withstand systemic shocks. Various measures are needed to strengthen market discipline. For one thing, banking supervisors should require intermediaries and institutional investors to pay adequate attention to the Commission’s warnings on the sustainability of sovereign obligations of Eurozone members. Rules limiting excessive credit expansion and risk-taking by financial intermediaries will also affect their willingness to finance risky sovereign debtors. Critical in this respect is a credible promise, in the event that one member state becomes insolvent, not to intervene to relieve its creditors.
The key issue then becomes how to lend sufficient credibility to the no-bail-out clause with respect to the member states and financial markets. Such a promise must be founded on two pillars.
- The first pillar is a new set of special procedures for bank crisis resolution that will make it possible for any bank, including large cross-border banks, to fail without fully reimbursing creditors and equity holders – with protection strictly limited only to retail depositors (and only up to a threshold). With such a system there would be strong incentives for bank managers and equity holders to limit risk-taking. (For design of a full bank crisis resolution mechanism within the EU, see Carmasi et al. 2010.)
- The second pillar is a European Monetary Fund – the permanent continuation of the present European Financial Stability Fund. The Fund should be endowed with sufficient capital and access to market financing to protect the euro and the EU’s financial system from the fall-out of a sovereign debt crisis. Its mandate should explicitly exclude covering losses of public and private insolvencies.
Growth enhancing structural reform
Two main features stand out in Europe’s economic performance: low productivity growth and low growth of domestic demand. Policies for public sector consolidation will strengthen financial stability and improve incentives for private investment but in the short term will have a negative impact on demand. Europe cannot return to sustained growth without raising the rate of growth of domestic incomes and domestic demand – and keeping it there.
To this effect a much stronger role must be played by structural reforms. There is a need for labour-market reforms aimed at increasing flexibility that would allow real wages to respond more efficiently to competitive pressures. Increasing employment rates among women and young people can add significantly to the labour force and strengthen potential output.
Moreover, services liberalisation can boost investment including in countries where current-account surpluses reflect a low level of investment with respect to savings, thus addressing the structural determinants of external payment imbalances. By opening the services sector to competition we would create enormous opportunities for domestic investment and productivity increases, which would translate into higher domestic incomes, as well as strengthen our industry with lower-cost and higher-quality services. Critical in this context is the liberalisation and full integration of energy markets, still fragmented into closed national gardens and controlled by national monopolists reaping hefty rents by imposing very high costs on industry and consumers.
Infrastructure investment for the internal market
A substantial increase in investments for the single market infrastructures would bring great benefits for growth by boosting demand in the short term and by raising the EU’s potential output in the long term. The obstacles to overcome are two-fold: the planning and selection process, and the financing.
As to the planning and selection process, notably within the TENs (trans-European networks) framework, the member states have displayed great dexterity in gaining support for national priorities, much less in agreeing on the required concentration of efforts in cross-border projects effective for removing cross-border bottlenecks in energy, transport, and communications and creating the integrated open playing field that is needed for the internal market to function.
A fresh start is needed, able to identify a new list of priorities and projects, strictly and rigorously aimed at removing obstacles and laying the groundwork to a functioning single market. All projects should be validated by the European Investment Bank and the European Bank for Reconstruction and Development, which should also be entrusted with overseeing their implementation – thus barring all national interference and ensuring maximum value for money.
As to financing, there is a need to mobilise major resources, to a scale unseen so far. As suggested by the Monti report (2010), this requires exploring new combinations of public and private funding, based on innovative techniques for awarding contracts that are able to offer long-term private investors appropriate rewards. Structural funds may be mobilised in this context to reduce risks to private investors and to pay a fair share for public benefits that cannot be monetised.
A substantial contribution may come from issuance of EU bonds by the European Investment Bank and the European Bank for Reconstruction and Development – which over time may usefully merge into one large infrastructure and development bank, adequately capitalised to be a credible and attractive counterpart to sovereign and institutional investors worldwide. Issuance of Union bonds would not be a way to redistribute resources between the member states, but only a way to ensure ample finance at the lowest possible cost for critical infrastructures. These bonds would be backed by real guarantees, namely the returns from the projects to be financed, thus effectively transforming them into some sort of covered bonds with a double guarantee.
Europe’s debt sustainability challenge is basically a problem of getting debt-to-GDP ratios down. Most of the focus to date has been on the top part of that fraction – i.e. reduction in the growth of public debt. While important, the most critical factor in the long run is the restoration of GDP growth. Kick-starting the EU economy requires a new political deal on economic policies and economic governance. The key elements are better economic governance at the national and EU levels, including sounder public finances, more forward-looking crisis management, structural reforms that can restore European growth and confidence, and strong investment in infrastructure for the internal market.
Carmassi, J, E Luchetti and S Micossi (2010), “Overcoming too big to fail: A regulatory framework to limit moral hazard and free riding in the financial sector”, CEPS, Brussels, March.
Gros, Daniel et al (2010), "A Renewed Political Deal for Sustainable Growth within the Eurozone and the EU: An Open Letter to the President of the European Council," CEPS Policy Briefs
Monti, Mario (2010),“A new strategy for the Single Market – at the service of Europe’s economy and society”, Report to the President of the European Commission José Manuel Barroso, May.