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Journal ArticleDOI

Minimal Conditions for the Survival of the Euro

13 Feb 2016-Intereconomics (Springer Berlin Heidelberg)-Vol. 51, Iss: 1, pp 24-28

AbstractMost technocrats argue that creating the euro was a way of forcing the pace of political integration, since monetary union is not possible without political union. We disagree and instead put forward four minimal conditions for the survival of the euro. Political integration in Europe has its limits; the trick is to understand when less is more.

Topics: Political union (62%), European integration (57%), Politics (50%), Technocracy (50%), Social policy (50%)

Summary (2 min read)

Introduction

  • Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte.
  • You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public.
  • Economic theory similarly suggests limits to European political integration.

The European Central Bank

  • The fi rst of their four minimal conditions for the survival of the euro is a normal central bank that is able to pursue fl exible infl ation targeting and to backstop fi nancial markets in government bonds, thereby protecting the euro area from potentially self-fulfi lling crises.
  • Given the existence of a single monetary policy, there is little scope for governments to infl uence domestic infl ation rates.
  • Rather than adopting a symmetric infl ation target, it pursued a target of less than but close to two per cent, dangerously skirting defl ationary territory.
  • But deposit insurance is only confi denceinspiring if the funds standing behind it are adequate to meet potential claims, and the members of a monetary union, not being able to resort to central bank fi nance, may fi nd it diffi cult to come up with the necessary funds in extremis.
  • Some countries, notably Germany, worry that other members will be more prone to draw on the fund (German commentators regularly cite Greece as a case in point).

Centralization of fi scal functions

  • This of course begs the question of whether the wholesale centralization of fi scal functions is desirable – or whether monetary union without fi scal union will work.
  • Since the Maastricht Treaty and the Stability and Growth Pact, there have been repeated efforts to centralize EU fi scal policies.
  • The one thing these measures have in common is that they do not work.
  • EU member states have profoundly different preferences with regard to fi scal policy.
  • The framework in which taxes are raised and public spending is structured is intimately bound up with the details of each nation’s culture and history.

Europe’s banking union

  • A second minimal condition for the survival of the euro is completing Europe’s banking union.
  • An encompassing approach in which debt overhangs are reduced across the euro area, allowing fi scal control to be delegated to the governments of all participating member states, will help to restore the macroeconomic and fi nancial stability on which the euro’s survival depends.
  • A centrally coordinated approach can also help to surmount two further obstacles to restructuring.
  • If crossborder spillovers result from the bank-sovereign doom loop, then the solution is to prevent banks from holding concentrated positions in sovereign bonds, as the SSM seeks to do.
  • On the one hand, fi scal positions and thus preferences with regard to restructuring differ across member states.

Conclusions

  • The eurozone crisis has shown that monetary union entails more than just sharing monetary policies, and that the common central bank must aim at more than just price stability.
  • While completing the architecture is challenging, doing so does not require a forced march to political union.
  • That theory also sheds light on desirable ways of addressing the problems exposed by the crisis.
  • The authors have identifi ed four minimal conditions for solidifying the monetary union.
  • But irrespective of the details, some scheme must be adopted to restructure public debts comprehensively enough for eurozone countries to recover the use of their national fi scal policies.

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Eichengreen, Barry; Wyplosz, Charles
Article — Published Version
Minimal Conditions for the Survival of the Euro
Intereconomics
Suggested Citation: Eichengreen, Barry; Wyplosz, Charles (2016) : Minimal Conditions for the
Survival of the Euro, Intereconomics, ISSN 1613-964X, Springer, Heidelberg, Vol. 51, Iss. 1, pp.
24-28,
https://doi.org/10.1007/s10272-016-0569-z
This Version is available at:
http://hdl.handle.net/10419/141409
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Intereconomics 2016 | 1
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short way down that path. The euro’s existential crisis is
likely to be resolved one way or the other long before that
political destination is reached.
Economic theory similarly suggests limits to European
political integration. Public fi nance theory points to the
existence of economies of scale in the provision of public
goods (integration allows public goods like fi scal coinsur-
ance and a well-regulated banking system to be provided
more cheaply),
1
underscoring the advantages of political
integration and centralization. But it also highlights the
costs of centralized provision, since populations are heter-
ogeneous and preferences for public goods differ across
groups and regions – costs that create understandable re-
sistance to pooling responsibility for provision.
This tension is evident in how Europe has responded to
its crisis. In some areas where evidence of increasing re-
turns is overwhelming, Europe has moved toward central-
ized provision. Examples include centralized provision of
backstop facilities for sovereign debt markets (the Euro-
pean Central Bank’s Outright Monetary Transactions) and
creation of the Single Supervisor (with responsibility for
oversight of the banking system).
1 See e. g. W. Buchanan: An Economic Theory of Clubs, in: Econom-
ica, Vol. 32, No. 125, 1965, pp. 1-14.
Barry Eichengreen and Charles Wyplosz
Minimal Conditions for the Survival of the Euro
DOI: 10.1007/s10272-016-0569-z
Barry Eichengreen, University of California, Berke-
ley, USA.
Charles Wyplosz, Graduate Institute, Geneva, Swit-
zerland; and Centre for Economic Policy Research,
London, UK.
In this paper, we set out minimal conditions for the survival
of the euro. Typically, this issue is framed as whether Eu-
ropean monetary integration, which reached its apogee
with the euro, will now be complemented by the political
integration needed for the single currency to survive. This
is how the technocrats and political intelligentsia respon-
sible for the euro’s creation saw things: since monetary
union is not possible without political union, creating the
euro was a way of forcing the pace of political integration.
This is not how we see things. Over the time frame rel-
evant for the euro’s survival, political integration in Europe
has its limits. This is what historical comparisons suggest.
It took the United States more than a century, including
the experience of a devastating civil war, before it became
a true, irrevocable political union, and Europe is only a

ZBW – Leibniz Information Centre for Economics
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dency of Jean-Claude Trichet, it concentrated on headline
rather than core infl ation, leading it to raise interest rates
in 2008 and 2011, when de ation was the fundamental un-
derlying danger. It threatened to terminate ELA for Ireland
in 2010 unless its government applied for a bailout and
agreed to a program of austerity and bank recapitalization.
3
It stopped ELA for Greece in 2015 until the government
agreed to a program rejected by voters in a referendum. It
hesitated to adopt unconventional monetary policies when
interest rates fell to the zero lower bound. It was reluctant
to intervene with purchases of government bonds when in-
vestors doubted the “essential cohesion” of the euro area,
4
fearing that the German Constitutional Court would rule
such action incompatible with that country’s Basic Law.
Hearteningly, the ECB has now moved some distance
in the direction of becoming a normal central bank. The
commencement of quantitative easing operations in
March 2015 demonstrated that the members of its Gov-
erning Council understood the special, and especially
dangerous, nature of defl ation. In its day-to-day opera-
tions, the ECB has effectively shelved the monetary pillar
and now more carefully and systematically distinguishes
core from headline infl ation. While a symmetric infl ation
target and a smaller, nimbler monetary policy committee
are still required, these are steps in the requisite direction.
What is now required to cement this progress? First, the
ECB needs to heighten its transparency to correspond
with its greater discretion and the breadth of powers in-
vested in a normal central bank. Transparency is a mech-
anism for holding an independent central bank account-
able in the court of public opinion. It is a way of communi-
cating to constituents that policies are being implement-
ed with the common good and not particular national
interests in mind. If the presence of national representa-
tives on the Governing Council is an obstacle to taking
and publishing formal votes, then this is an argument for
reorganizing the Council to reduce the presence of those
national representatives. Doing so would be a very limited
step in the direction of greater political integration but, in
our view, a necessary one for the survival of the euro.
Second, the ECB, when undertaking purchases of gov-
ernment bonds in the context of quantitative easing, or
conventional open market operations, needs assurance
that its decisions will not be disallowed by the German
Constitutional Court. This may require a change in Ger-
many’s Basic Law or an unambiguous statement by its
Constitutional Court that it will accept the judgment of
3 European Central Bank: Irish Letters, 6 November 2014.
4 M. Draghi: Stability and Prosperity in Monetary Union, Speech at the
University of Helsinki, 27 November 2014.
I
n other areas, however, the benefi ts of centralized pro-
vision are dominated by the costs of uniformity, creat-
ing resistance to further centralization. This is true most
obviously of fi scal policy, where different countries have
different tastes (insofar as countries, as distinct from indi-
viduals, have tastes) for fi scal rectitude and stabilization,
and different degrees of tolerance of debt and defi cits.
This heterogeneity in turn creates a problem of trust. Can
those formulating and executing the common policy be
trusted to do so in a manner consistent with a group’s
tastes? This is analogous to the problem that results in an
undersupply of public goods like policing and schools in
localities where the population is heterogeneous, wherein
each group is reluctant to pay additional taxes for fear
that the resources so mobilized will go to pay for public
goods valued by other groups but not by their own.
2
In what follows we use these insights from theory and
history to guide our discussion of the minimal conditions
for the survival of the euro. The conclusion we reach is
that for the single currency to survive, Europe needs both
more political integration and less political integration.
The trick is to understand when less is more.
The European Central Bank
The fi rst of our four minimal conditions for the survival of
the euro is a normal central bank that is able to pursue
exible infl ation targeting and to backstop fi nancial mar-
kets in government bonds, thereby protecting the euro
area from potentially self-fulfi lling crises. These are func-
tions in a monetary union that must be provided at a cen-
tralized level if they are to be provided at all. Given the
existence of a single monetary policy, there is little scope
for governments to infl uence domestic infl ation rates. Na-
tional central banks (which partner with the ECB in the
European System of Central Banks) can advance credit
to domestic banks requiring liquidity only against eligi-
ble collateral and with the approval of the ECB to provide
emergency liquidity assistance (ELA). Sovereigns, not
having recourse to a national central bank, have limited
ability to backstop their fi nancial markets unilaterally.
As conceived initially, the ECB did not provide these func-
tions. The bank’s two-pillar strategy focused not just on
infl ation but also on growth of a talismanic monetary ag-
gregate that bore no stable relationship to infl ationary out-
comes. Rather than adopting a symmetric infl ation target,
it pursued a target of less than but close to two per cent,
dangerously skirting defl ationary territory. Under the presi-
2 A. Alesina, R. Baqir, W. Easterly: Public Goods and Ethnic Di-
visions, in: Quarterly Journal of Economics, Vol. 114, No. 4, 1999,
pp. 1243-1284.

Intereconomics 2016 | 1
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establish conforming insurance schemes for accounts up
to this ceiling – the crisis having shown that non-uniformity
and, in some cases, the absence of deposit insurance can
threaten confi dence and fi nancial stability throughout the
monetary union. But deposit insurance is only con dence-
inspiring if the funds standing behind it are adequate to
meet potential claims, and the members of a monetary un-
ion, not being able to resort to central bank fi nance, may
nd it diffi cult to come up with the necessary funds in ex-
tremis. This is why deposits in the United States, follow-
ing experience with state bank holidays in the 1930s, are
federally rather than state-insured.
Some countries, notably Germany, worry that other mem-
bers will be more prone to draw on the fund (German
commentators regularly cite Greece as a case in point).
They reject mutualization of deposit insurance as a de
facto fi scal transfer. The response comes in three parts.
First, banking stability is a valuable public good which
generates suffi ciently increasing returns so as to warrant
centralization of the deposit insurance function. Second,
all member states, not least Greece, are required to im-
plement the banking union’s new resolution rules to limit
taxpayer liability. Third, this is a limited and specifi c mu-
tualization of fi scal powers targeted at a specifi c nancial
problem intimately associated with monetary union, not
the wholesale centralization of fi scal control at the level of
the European Union or the euro area.
Centralization of scal functions
This of course begs the question of whether the whole-
sale centralization of scal functions is desirable – or
whether monetary union without scal union will work.
Since the Maastricht Treaty and the Stability and Growth
Pact, there have been repeated efforts to centralize EU
scal policies. These early attempts have now been sup-
plemented by further initiatives by the European Commis-
sion, including the Six Pack, the Two Pack, the European
Semester, and a new treaty (the Treaty on Stability, Coor-
dination and Governance in Europe).
The one thing these measures have in common is that they
do not work. EU member states have profoundly different
preferences with regard to fi scal policy. They are reluctant
to mutualize fi scal resources or delegate decisions over
national fi scal policies to the Commission and the Europe-
an Parliament, since the consequent decisions would dif-
fer markedly from the preferences of some members. The
framework in which taxes are raised and public spending
is structured is intimately bound up with the details of each
nations culture and history. Fiscal policy is fundamentally
political and distributive, limiting delegation even at the na-
tional level. From the start, it was evident that EU members
the European Court of Justice on ECB-related matters.
Changing this aspect of the Basic Law to conform to EU
jurisprudence would be a limited step in the direction of
political integration.
Europe’s banking union
A second minimal condition for the survival of the euro is
completing Europes banking union. The crisis has under-
scored how banking system stability is a euro-area-wide
public good which provides strongly increasing returns.
One need only recall how lax regulation of French and
German banks allowed these institutions to lend hand
over st to Southern European countries, which helped to
set the stage for the crisis, or how the subsequent prob-
lems of some banks then threatened to destabilize oth-
ers via the interbank market and related mechanisms. For
good and bad reasons, member states harbor somewhat
different tastes about precisely how they prefer to super-
vise and resolve their banks. But experience has shown
that this is an area where the strongly increasing returns
from centralized provision dominate the costs of uniform-
ity. As the point is sometimes put, monetary union without
banking union will not work.
To this end, euro area member states (and other EU mem-
ber states that choose to opt in) have created a single su-
pervisor of fi nancial institutions, locating the Supervisory
Board within the ECB. The Single Supervisory Mecha-
nism (SSM) oversees large fi nancial institutions and works
closely with national supervisors overseeing other inter-
mediaries. The SSM has already intervened to enhance
the public good of nancial stability, for example by limit-
ing the exposure of Greek banks to the Greek government
and more generally by pressing the banks it supervises to
reduce home bias in their sovereign bond portfolios.
5
In addition, the European Parliament and Council have
adopted a common mechanism for resolving failed fi nan-
cial institutions, the Bank Recovery and Resolution Direc-
tive. This obliges all EU governments to bail in unsecured
creditors before tapping taxpayer funds, requiring mem-
bers to implement these rules through national legislation.
Again, these are limited but necessary steps in the direc-
tion of fi nancial and political centralization.
A political “bridge too far” has been the creation of a com-
mon bank deposit guarantee fund in which money from all
euro area members will be pooled to guarantee that bank
accounts up to €100,000 are fully insured. Under the terms
of the banking union, member states are now required to
5 N. V é r o n : Europe’s Radical Banking Union, Bruegel Essay and Lec-
ture Series, 2015.

ZBW – Leibniz Information Centre for Economics
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see them restructured, whereas more lightly indebted coun-
tries will fear losses and reputational consequences. Public
choice theory points to the existence of costs of uniformity
and centralization in the presence of such heterogeneity.
On the other hand, the benefi ts of a centrally coordinated,
encompassing approach are compelling when the surviv-
al of a public good, the euro itself, hinges on the outcome.
A piecemeal approach in which a few countries regain
scal exibility but others do not is unlikely to permit the
repatriation of fi scal policy to the national level, violating
another of our key conditions for the survival of the euro.
Individual countries may be discouraged by the stigma
attached to restructuring and by the associated poor
credit ratings and risk premia, with the predictable result
that no country will want to go it alone, or even to go fi rst.
An encompassing approach in which debt overhangs are
reduced across the euro area, allowing fi scal control to be
delegated to the governments of all participating member
states, will help to restore the macroeconomic and fi nan-
cial stability on which the euro’s survival depends.
A centrally coordinated approach can also help to sur-
mount two further obstacles to restructuring. First, it
may be better able to overcome resistance from debtors.
Banks in one eurozone country will typically hold bonds
issued by the government of another, and European in-
stitutions like the ECB hold national debts. If one country
restructures its debts, it will impair the balance sheets of
its own banks but also of banks in other countries. Iso-
lated debt restructurings do not take this externality into
account, whereas a collective approach can do so. It can
distribute losses due to these externalities in many ways,
including assigning them entirely to the country doing the
restructuring. Whatever the solution chosen, the point is
that under the collective approach there will be an agree-
ment on burden-sharing. If the agreed solution involves
transfers – which is not necessarily the case, as shown
below – then it will have to be agreed by offi cials of each
country on behalf of its taxpayers rather than being im-
posed by a foreign authority.
The second obstacle is that debt restructuring may be
seen as an encouragement to accumulate large debts in
the future in the expectation that they will be restructured
again. Weakening the bonding role of debt is therefore a
source of moral hazard. Collective action may help to re-
move these objections. Member states will be aware of
the risk and will demand incentives or require guarantees
that countries will not act unilaterally and opportunisti-
cally in the future. The guarantees, which may take vari-
ous forms – an example is provided below – may not be
ironclad, but they should be compared to how the issue is
dealt with under the unilateral approach.
were reluctant to allow interference in such matters.
6
It is
unclear why the future should be different from the past.
To be sure, fi scal policy has some of the characteristics
of a public good. Its macroeconomic effects spill across
borders, and fi scal instability in one country can create in-
stability in other countries insofar as one country’s banks
invest heavily in other countries’ bonds and fi scal crises
are met with multilateral bailouts. But the notion that there
are strongly increasing returns from centralization can be
questioned. The magnitude of direct cross-border spillo-
vers is limited: more de cit spending by Germany raises
the demand for Italian exports but also drives up interest
rates in Italy, partially offsetting the fi rst effect. If cross-
border spillovers result from the bank-sovereign doom
loop, then the solution is to prevent banks from holding
concentrated positions in sovereign bonds, as the SSM
seeks to do. If spillovers result from pressure for multilat-
eral bailouts, then the solution is a no-bailout rule.
Is there an alternative to this doomed effort to centralize
scal policy at the level of the Union? We would answer
yes: it is to renationalize scal policy. This is our third mini-
mal condition for the survival of the euro. The fi ction that
scal policy can be centralized should be abandoned,
and the euro area should acknowledge that, having for-
saken national monetary policies, national control of
scal policy is all the more important for stabilization. If
reckless national fi scal policies endanger the banks, then
the banks should be prohibited from holding sovereign
bonds. There is no reason why a no-bailout rule of the sort
enforced for U.S. state governments since the mid-19th
century would not then be credible. Absent expectations
of a bailout, investors will pay better attention, and market
discipline will be more intense. Governments in turn will
have more incentive to strengthen their fi scal institutions
and procedures so as to deliver better outcomes.
Removing inherited debt overhangs
Making effective use of fi scal policy for stabilization pre-
supposes removing inherited debt overhangs in whose
presence fi scal policy is unavailable. Removing those
overhangs is thus our fourth precondition for the survival
of the euro.
The question is whether this process is best organized at
the national or EU level. Arguments can be made for both
approaches. On the one hand, fi scal positions and thus
preferences with regard to restructuring differ across mem-
ber states. Countries with unsustainable debts will prefer to
6 B. Eichengreen, C. Wyplosz: The Stability Pact: More than a Mi-
nor Nuisance?, in: Economic Policy, Vol. 13, No. 26, 1998, pp. 67-113.

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Abstract: We present a model that links heterogeneity of preferences across ethnic groups in a city to the amount and type of public good the city supplies. We test the implications of the model with three related datasets: US cities, US metropolitan areas, and US urban counties. Results show that productive public goods -- education, roads, libraries, sewers and trash pickup -- in US cities (metro areas/urban counties) are inversely related to the city's (metro area's/county's) ethnic fragmentation, even after controlling for other socioeconomic and demographic determinants. Ethnic fragmentation is negatively related to the share of local spending on welfare. The results are mainly driven by observations in which majority whites are reacting to varying sizes of minority groups. We conclude that ethnic conflict is an important determinant of local public finances.

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Frequently Asked Questions (1)
Q1. What are the contributions mentioned in the paper "Minimal conditions for the survival of the euro" ?

Pâris and Wyplosz this paper proposed a solution that involves centrally restructuring debts while allocating costs at national level.