The Economic and Monetary Union:
Time to Break the Deadlock
Keynote address by Ignazio Visco
Governor of the Bank of Italy
OMFIF-Banca d'Italia seminar
"The future of the Euro area"
Rome, 15 November 2019
This seminar comes at a difficult juncture for Europe. The tide of the global
financial crisis and the sovereign debt crisis has long fallen, but its poisonous legacy and
geopolitical tensions are fuelling distrust, fears and even prejudices once thought long
buried. The European construction is at a standstill while progress is badly needed in the
key areas, where the Union is better at prohibiting things than at getting them done.
Although the single currency was a vital step on the path to European integration, the
Economic and Monetary Union remains an unfinished construction. Europe's architects
knew this, and wanted and anticipated greater progress in the future. Even before the
introduction of the euro, the unusual status of a Stateless currency had been underlined,
as had the institutional solitude of the European Central Bank (ECB) and the problems
posed by the imperfect mobility of capital and labour.
The risks inherent in this situation materialised with unanticipated violence during
the sovereign debt crisis. The inadequacy of the euro area's economic governance was laid
bare. Hesitancy in defining the procedures to support countries in difficulty fuelled fears
of a break-up of the euro. Spreads on government bond yields widened dramatically, in
some cases by far beyond what would have been justified by the economic and financial
conditions of the countries affected, making these conditions all the more difficult to
overcome.
The proposals for reform drawn up after the peak of the crisis envisaged the gradual
strengthening of integration, first in the financial area and then for public finances. Yet,
seven years later, only partial progress has been made. The banking union is incomplete
and not without flaws, the foundations for the capital union are still being laid, and fiscal
union has been postponed to an unspecified future date.
Concerns about the public and private financial vulnerabilities accumulated during
the crisis and mutual distrust keep progress on hold. While risk reduction and sharing
should go hand in hand and mutually reinforce one another, uncertainty around how
to proceed, disagreement on the sequence and effects of interventions, and fears of
negative spillovers produce a standstill in the reform process. As a consequence, the
euro area's economic integration is being held back and the area itself continues to be
exposed to financial risks.
This deadlock must be broken and the conditions must be created to allow for steps
to be taken in the future that appear impossible today. Against this background, I would
like to share some reflections with you, first, on how sovereign and banking risks are being
dealt with in Europe, and second, on the state of play of fiscal and capital markets unions.
Sovereign and banking risks
The widespread concern over high public debts is justified. They are a source
of systemic risk. Even if fundamentally solvent, highly indebted countries are more
vulnerable to liquidity shocks and negative markets' assessment of national authorities'
commitment to financial stability. In addition, in a currency area, a sovereign debt crisis
can have strong repercussions for neighbouring countries, given the close economic and
financial links.
A reform of the Treaty on the European Stability Mechanism (ESM) to reinforce
its role in preventing and managing sovereign crises in euro-area member states is
currently being finalised. It is part of an effort aimed at reducing uncertainty as to how
and when a sovereign debt can be restructured. Clarifying the conditions and procedures
for restructuring would certainly reduce the part of the cost of a sovereign default which
can be attributed to uncertainty over the manner and timing of its solution.
But this is only a small part of the cost of sovereign insolvency. Moreover, this is a
matter to be handled with care. The small and uncertain benefits of a debt restructuring
mechanism must be weighed against the huge risk that the mere announcement of its
introduction may trigger a perverse spiral of expectations of default, which may prove to
be self-fulfilling. We should all keep in mind the dire consequences of the announcement
of private sector involvement in the resolution of the Greek crisis after the Deauville
meeting in late 2010.
The importance of rigorous budgetary policies at a national level cannot be
overestimated. But reducing the debt-to-GDP ratio requires time and there is the risk
that a crisis might interrupt the process, without this being the direct consequence of a
policy decision. Europe should seek ways to support and protect the efforts that must
be made by member states to reduce their debt. This is why some form of supranational
insurance is needed, for example through the creation of a European debt redemption
fund (ERF) financed by dedicated resources of the participating countries.
The mechanism can be designed in a way that prevents systematic transfers across
countries while reducing the risk of financial instability for the area as a whole. The
introduction of an ERF would strengthen national commitment to debt reduction (as the
share of national debt transferred to the fund would be backed by a dedicated revenue
stream) and reduce the systemic relevance of (residual) national debt. This would be
instrumental in enhancing the credibility of the no-bailout clause and the enforceability
of European fiscal rules.
In the academic and political debate, the introduction of a sovereign debt
restructuring mechanism is often linked to proposals to introduce prudential
requirements limiting banks' sovereign exposures. Here, it is important to bear in mind
that the sovereign-bank nexus does not operate exclusively through banks' direct
exposures: a sovereign crisis would also affect banks through an increase in their cost
of funding (particularly in the event of rating downgrades) and, above all, through its
effects on the overall economy. A sharp rise in the perceived risk of one State's debt
can quickly trigger a recessive spiral, kindling social tensions with unpredictable results.
The blow to the banking system would be severe, irrespective of its capitalisation and
direct exposure. Thus, if we really want to break the sovereign-bank nexus, we need
to reduce the risk embedded in sovereign bonds, not just the amounts held by banks.
Moreover, simply shifting risky bonds from the balance sheet of banks to those of
other sectors would not reduce the overall risk. Finally, since prudential requirements on
sovereign exposures are not imposed in any other jurisdiction, if we were to introduce
them in the European Union or in the euro area, we would need to provide financial
markets with an alternative "risk-free asset", such as a Eurobond of some sort - and the
debt redemption fund I mentioned before would be instrumental.
Reducing banks' sovereign exposures and the ratio of non-performing loans (NPLs)
to total outstanding loans are often considered as preconditions for the completion of
the banking union. Other important sources of risk have, however, not been sufficiently
considered. Recent initiatives by the Single Supervisory Mechanism to determine the
most appropriate treatment of illiquid and opaque assets on banks' balance sheets are
meant to respond to these concerns.
Even worse, the vulnerability produced by an incomplete framework for the effective
and orderly management of banking crises has also been, and still is, overlooked. On
the one hand, consensus has grown around the idea to postpone the implementation
of the ESM backstop to the Single Resolution Fund until 2024 unless further progress
has been achieved in risk reduction measured solely in relation to NPL volumes (and in
building up buffers of liabilities to be used in a crisis). On the other hand, a situation is
accepted whereby a disorderly liquidation is the only possible outcome for the crises of
small and medium-sized intermediaries which, like most European banks, are not subject
to resolution (albeit - it must be noted - they are required to contribute to the Single
Resolution Fund).
The recent suggestions from Germany on the completion of the banking union is a
welcome development in that it shows willingness to keep the dialogue open. However,
they fail to address some of the issues I just mentioned. Banking risks are once more
exclusively identified with NPLs and sovereign exposures. Moreover, when considering
a revision of the prudential treatment of the latter, there is no mention of the need to
introduce a European safe asset, which is particularly at odds with the frequent references
made to the US model, where the role of federal debt as a safe asset is paramount.
An adequate fiscal capacity and the implementation of the capital markets union
If sovereign and bank risks management is a source of concern, turning to the
state of play of discussions about the fiscal union and the implementation of the capital
markets union will provide little consolation. Monetary policy was the sole line of
defence against the risk of euro area financial fragmentation during the sovereign debt
crisis and against the risks of deflation that emerged in the years thereafter. The ECB's
Governing Council demonstrated its readiness to use all of the instruments available and,
if necessary, to introduce new ones to pursue the objective of price stability. It has been
largely successful, but its actions could have been even more effective had they been
accompanied by other economic policies.
Inflation in the euro area remains at levels that are still too low, and these low
levels are pushing down short-term inflation expectations once again. The risk of a
de-anchoring of medium- to long-term expectations has re-emerged. The Governing
Council response has been timely, appropriate and proportionate. But once again we are
seeing that to make the fullest possible use of the expansionary potential of monetary
policy measures, other policies should move in the same direction.
Fiscal policies that support economic activity in the euro area can deliver a faster
return to price stability. To ensure sustained higher growth, reforms are needed to remove
any obstacles to development, foster innovation and help modernise the productive
system. Acting in isolation, monetary policy can do nothing but continue along the path
of "non-standard" measures. This increases the risk of adverse side effects, which, in turn,
need to be kept under control using instruments of an increasingly administrative nature.
As the former President of the ECB recently recalled, "we need a euro area fiscal
capacity of adequate size and design: large enough to stabilize the monetary union". This
is no subversive statement. Economic theory as well as the concrete experience of other
successful monetary unions, most notably the United States, suggest that the euro area
would greatly benefit from the establishment of a supranational fiscal capacity. Indeed, a
report on the appeal of a fiscal union - the MacDougall Report - was published as early
as 1977 on behalf of the European Commission, and even the 1970 Werner Report makes
reference to it. Later on, the technical papers accompanying the 1989 Delors Report
discussed the topic in depth.
On 3 May 1998, when Europe was completing the last steps before the adoption
of the single currency, Tommaso Padoa Schioppa wrote in a column in Corriere della
Sera: "the Union has full competence for microeconomic policy [...], but its capability
for macroeconomic policy is, with the exception of the monetary field, embryonic and
unbalanced: it can avoid harm (excessive deficits) but it cannot do good (a proper fiscal
policy). [...] It is thus right not only to applaud yesterday's step but also to underline its
unfinished nature, the risks and the rashness".
Nevertheless, little progress has been made in the way of remedying the asymmetry
of having a single monetary policy and yet multiple national budgets, perhaps out of
fear of sharing the debts that could result from the operation of a fiscal union. Yet, as
I have observed, a common fiscal capacity can be structured in such a way as to avoid
systematic cross-country transfers, thus reconciling the full exercise of macroeconomic
stabilization with the balancing of public accounts in each country. Fiscal union would
make it possible to implement policies consistent with the cyclical conditions in the
various member states and in the euro area as a whole, promptly and with no doubts as
to their legitimacy. The single currency needs to interact with a single fiscal policy.
It has been argued that national fiscal policies could absorb the effects of cyclical
fluctuations in member states and that financial markets could provide an insurance
analogous to the one that would be provided by a fiscal union. However, cross-country
spillovers may reduce the effectiveness of national initiatives and, in the current situation,
several national budgets have little room for manoeuvre due to high public debts. In
addition, European financial markets are far from being perfectly integrated, which clearly
limits their viability as shock absorbers.
In the United States, in Canada and in other federal countries, a significant share of
individual states' income variability is offset by the federal fiscal system (estimates based on
different methods average at 10-15 per cent for both the US and Canada). The difference
between the euro area and fully-fledged federations in terms of shock- absorption capacity
is even higher when we look at capital markets.
The smooth functioning of a currency area requires a single capital market that
facilitates access to financing for businesses. In addition, an integrated market helps to
absorb local macroeconomic shocks, increases the robustness of the economic system,
and strengthens financial stability. It would also obviously aid the effective and speedy
transmission of fiscal and monetary policy measures.
But it is a complex endeavour. It entails decisive action towards the harmonisation
of company, securities, bankruptcy and tax laws, as well as of supervisory procedures.
While such a harmonisation may begin with changes in relevant national legislation and
focus on those areas which may produce broader effects, the ultimate goal must be one
of achieving a single rulebook. Above all, a single capital market requires a common safe
asset. Addressing this gap would support the banking and capital markets by creating
a homogeneous product of a high quality and significant size that could become a
benchmark for investors and improve financial integration.
* * *
I do not think that I have to struggle to convince you of the lack of significant
progress with the European construction. There has been a substantial transfer of
sovereignty on economic and financial matters, especially in recent years. It is indeed
illusory to believe that we can direct the course of the economy and finance, patently
global phenomena, from within the narrow confines of individual European countries.
The construction, however, is lopsided and incomplete; its very sustainability requires
that the missing elements be incorporated soon.
Today, proceeding by means of compromise is becoming increasingly difficult.
Distrust leads to disaccord, and in the exasperated pursuit of mutual reassurance and
short-term gains, the necessary steps are hard to take. The concrete achievement of
monetary union, banking union, capital markets union, and even the prospect of a
common fiscal policy, all call for a leap in quality. Europe must remain an anchor of
stability in a world that appears ever more unstable and politically unpredictable.
The introduction of a safe asset in the euro area is a clear and immediate objective.
It is a technical endeavour, but it is also the common denominator to the three unions
(banking, capital markets, fiscal) that must flank monetary union. By partly replacing national
government bonds, a European debt instrument could help to diversify the sovereign
exposures of financial institutions. It could reduce the risk of flights to safety by investors
in times of market tension and enable the financial market to play an effective role as
shock absorber, thereby also enhancing the effectiveness of monetary policy. It could be
an instrument for funding shared automatic stabilisers within a common fiscal capacity.
As I have said, it is possible to design mechanisms that enable a safe asset to be
introduced with the necessary safeguards against the risk of opportunistic behaviour. But
aside from the rules, the essential requirement for the viability of this solution lies in a
renewed and convinced commitment by all to the European project and a willingness to
pursue common solutions for common problems.
Grafica a cura della Divisione Editoria e stampa della Banca d'Italia