Ignazio Visco: The new EU economic governance and market discipline
Remarks by Mr Ignazio Visco, Deputy Director General and Member of the Governing Board
of the Bank of Italy, at the Brussels Economic Forum 2011, "Rethinking economic policy in
Europe - a new era of EU economic governance", Session II: "EU economic governance
framework in practice - ensuring its robustness", Brussels, 18 May 2011.
* * *
The Economic and Monetary Union has been a success in many respects. It has enhanced
internal trade and delivered a credible monetary policy that has anchored inflation
expectations and fostered a culture of price stability. The euro rapidly attained the status of a
strong international currency. However, the functioning of EMU has been hampered by some
very serious pitfalls in its institutional design. We now clearly see an asymmetry between the
strength of the "monetary" pillar and the weakness of the institutional framework. The
architects of EMU understood that fiscal discipline was necessary for the functioning of a
monetary union in which the single monetary authority would be confronted by multiple
national fiscal policy-makers. To achieve fiscal discipline they relied on a multilateral
surveillance mechanism based on fiscal rules.
The European sovereign debt crisis has shown that the surveillance mechanism has not
been effective. European rules were not sufficient to induce countries to adopt prudent fiscal
policies in good times. The result was that many euro area countries faced the crisis with
relatively high deficit ratios, still far from their medium term objectives; those objectives,
equal to a balanced budget for most member states, would have allowed countries to let
automatic stabilizers operate in unfavourable circumstances without exceeding the 3 per cent
threshold. In several countries the debt-to-GDP ratio was above the 60 per cent ceiling, in
some cases still by a large margin. Fiscal rules and procedures failed on more than one
occasion. In 2003 a trade-off of short-term interests within the European Council stopped the
rules from being applied to Germany and France. This reflected the lack of an independent
enforcer. The sustained fiscal profligacy in Greece was not timely reflected in official fiscal
data (the estimate for 2009 deficit, which in April of the same year was 5.1 per cent, was
progressively revised upwards to 15 per cent). This case exemplifies problems of the
statistical monitoring framework. There is a wide consensus that fiscal rules should be
broader (encompassing debt dynamics) and more effective (via new voting procedures).
The crisis has also highlighted that low public debts and deficits do not guarantee fiscal
sustainability. In a crisis, private liabilities can quickly turn into public debt. Before the crisis,
the fiscal performance of Ireland was considered extremely successful. From the launch of
EMU, it almost halved its debt-to-GDP ratio, reducing it to 25 per cent in 2007. The recession
more than doubled it. Furthermore, households and non-financial firms were highly indebted
(their debt burden was about two and a half times GDP); the major Irish banks had balance
sheet assets equal to five times GDP. The fall in real estate prices and the recession caused
them big credit losses; the political decision to use public funds to bail out reckless financial
institutions has pushed up the public debt by more than 20 percentage points of GDP so far,
to a level of about 95 per cent of GDP in 2010, with further disbursements anticipated for this
year following the results of the stress tests conducted on banks. Perhaps, the crisis would
have been less severe if a framework to detect and tackle macroeconomic imbalances and
systemic risks had been in place. This has prompted the introduction of a second pillar in EU
economic governance: macroeconomic surveillance.
But there is a need for a third pillar: market discipline. I will not focus on the temporary
arrangements devised to cope with the significant short-run challenges posed by the crisis.
Rather, I would like to offer some remarks on the long-term institutional set-up that is
currently taking shape in the European Union. During the early stages of the debate on the
new European architecture, there was relatively little emphasis on the role that markets can
play to induce fiscal discipline. The issue gained prominence in November 2010, when the
main characteristics of the European Stability Mechanism (ESM), the permanent mechanism
slated to replace the European Financial Stability Facility (EFSF) in June 2013, were spelled
out.
Scepticism on the effectiveness of market-based fiscal discipline was already present in the
early stages of the EMU project. The final report of the Delors Committee remarked in 1989
that: "the constraints imposed by market forces might either be too slow and weak or too
sudden and disruptive". The European Commission expressed similar concerns a year later.
And many years earlier, Luigi Einaudi, the great Italian economist and statesman, summed
up the common view by saying "i risparmiatori hanno cuore di coniglio, gambe di lepre..."
("investors have the heart of a rabbit, the legs of a hare ..."). I think it is fair to say that the
mistrust in market discipline finds support in the EMU experience. In the period from 1999 to
mid-2007 (just prior to the sub-prime crisis) markets almost did not differentiate among
European sovereigns. Sovereign yield spreads relative to the German 10-year benchmark
ranged from 5 basis points for Ireland to 50 basis points for Greece. The interest rate
differentials for Greece, Ireland and Portugal were still below 50 basis points in the spring of
2008. After a period of increased financial market tension, during which, however, the spread
on Greek and Irish bonds rarely exceeded 300 basis points, at the beginning of December
2009 10-year spreads were back below 200 basis points for all three countries. After that
they spiralled upwards, reaching 660, 380 and 330 basis points, respectively, between the
end of April and the beginning of May 2010. There were several more acute bouts of tension
on the euro area sovereign debt market in the second half of 2010 and the first few months
of 2011. The pressure eased temporarily after the decision, last March, to increase the
lending capacity of EFSF and to establish a permanent crisis resolution mechanism. But,
also reflecting the perception that in the transition from the EFSF to the ESM the burden on
private creditors may become extremely heavy, spreads have risen again to very high levels
and now stand above 650 basis points for Portugal, 750 for Ireland and 1250 for Greece.
Formal statistical exercises also find a relatively weak correlation between spreads and fiscal
fundamentals (i.e. the debt level, present and projected primary deficits) in the pre-crisis
period. The correlation became stronger later, when it was already too late to avoid a major
area-wide turmoil. The issue, then, is how markets can exercise a more prominent role,
working properly - which means gradually - to complement rule-based fiscal surveillance. A
deterioration of the cost and availability of funds to both private and sovereign issuers
provides a strong incentive to correct irresponsible behaviour, tracking closely both the
country's fiscal fundamentals and private sector's weaknesses (that may prompt the
government to step in). Thus, the key question is when and under what conditions credit
markets provide sufficient incentives to restrain irresponsible borrowing.
The recent experience suggests that investors will be more effective in disciplining euro area
governments if certain institutional prerequisites are met. First, borrowers must adequately
and promptly respond to market signals. Second, transparent and timely information
concerning the actions and the budgetary position of sovereign lenders should be available
to all agents (and a reform designed to improve the quality and reliability of fiscal statistics by
strengthening Eurostat's powers has been recently adopted). Third, full bail-out of troubled
governments should be credibly ruled out. A no-bail-out clause is already enshrined in the
European treaties, but many investors were inclined to believe that the clause would not be
applied in an emergency. This implied that, ex ante, investors did not demand sufficiently
higher premia for holding government bonds with higher default risk. By contrast, if the threat
of a default is credible, this will foster stricter market oversight and induce less fiscal
profligacy ex ante. In equilibrium, default will be less, not more, likely.
But how can a no-bail-out clause be made credible? The answer, of course, is by making, ex
post, the bail-out more costly than a bail-in for official lenders; that is, by reducing the
spillover of a sovereign default so that the economic and political costs of a default fall mainly on
the defaulting country. It is paramount to weaken the link between sovereign risk and bank
risk. This will require a careful analysis of the many different channels through which a
deterioration in fiscal conditions affects the cost and availability of bank funding. For
example, regulators might want to carefully assess the (regulatory) incentives banks have to
hold excessive amounts of risky sovereign bonds, and the collateral rules that are used by
central banks and in wholesale markets could be reconsidered. The link between sovereign
and bank credit ratings should also be carefully examined.
Rules and markets should not be seen as mutually exclusive, but as mechanisms that
complement and reinforce each other. The challenge would be not only to limit the
intermediary's exposure to a given sovereign borrower considered in isolation, but also to
guarantee that intermediaries can survive even if debt restructuring in one country triggers
restructuring in others. It should also be taken into account that a default can threaten
financial stability through its impact on derivative markets (e.g. the market for credit default
swaps). All this clearly requires regular stress testing of financial intermediaries and the
availability of timely and objective assessments of sovereign risk. Such assessments should
evaluate fiscal conditions and prospects, consider the level and trend of private sector
indebtedness, and take a country's prospects of growth into account. Clearly, this is a
formidable challenge, and we know too well that it has not been satisfactorily addressed by
credit rating agencies. But we have to find ways for such institutions to develop proper
standards and operate in a transparent relationship with national agencies such as
independent national fiscal councils, supranational (in Europe, Community) institutions and
international financial organisations.
Ex-ante procedures that facilitate an orderly default should be considered. The European
Council's proposal to introduce collective-action clauses (CACs) would help to make debt
restructuring more likely and quicker, credibly reinforcing the threat of a default. If approved,
however, the innovation will apply only to new debt issues, potentially raising a problem of
market segmentation and indirectly providing a senior status to current bonds. As Axel
Weber and his Bundesbank colleagues have recently suggested, a clause that automatically
extends debt maturity when a country gets the ESM assistance could also be included. This
would put some of the burden of restructuring on short-term borrowers, who otherwise would
benefit disproportionately from ESM intervention. It would make private sector involvement
possible as soon as the crisis manifests itself, whereas CACs can only play a role in the later
phases of a crisis, when ESM help has already proven ineffective.
The introduction of the ESM rightly envisages the involvement of the private sector in all
cases where the sovereign borrower is deemed insolvent (short-term illiquidity problems are
instead properly addressed with ad hoc and conditional financial help). Of course, the devil is
in the details. There is no foolproof way to distinguish short-term illiquidity from fundamental
insolvency (the quest for a clear-cut answer probably started with Bagehot around 1870). So
the ESM (like any other lender of last resort) is exposed to two kinds of risk: bailing out an
insolvent borrower and allowing the bankruptcy of an illiquid one. Furthermore, unlike private
borrowers, sovereigns usually can choose whether or not to honour their debts, so that the
issue is not really insolvency in the strict sense (i.e. inability to repay) as unwillingness to
repay owing to exceedingly high social or political costs, which are even less straightforward
to judge and to measure. Still, this issue cannot be avoided. We need to think about what
institution should be in charge of such evaluations, and acknowledge that it should
comprehensively consider the evidence and assessments provided by credit rating agencies,
national fiscal councils, international financial institutions and organizations. A tough
assignment, indeed.
To conclude, I have to confess that, in a sense, I have cheated you. My Einaudi's quotation
was actually incomplete. He not only said that "investors have the heart of a rabbit, the legs
of a hare..."; he continued and said that they have "...la memoria di un elefante" ("the
memory of an elephant"). This should be a reminder of the disruptive consequences of a
default, which often permanently stains a government's reputation. Governments that default
are excluded for potentially long periods from international capital markets, especially when
markets consider the default opportunistic. They also face an increased cost of borrowing
thereafter. Finally, and perhaps most importantly, default also signals an overall lack of
reliability of the country. A proper design of the conditions for the ex-ante involvement of
creditors in an orderly restructuring of the debt of a sovereign borrower and the definition of
appropriate incentives for a more gradual, timely and responsible market assessment would
significantly reduce the probability of sovereign default and the risk of extremely harmful
financial stress associated with such an event.