To Form a More Perfect Union

“In a monetary union with the consequent financial integration, there are features like centralised supervision, deposit insurance and resolution of banks…that are necessary for the whole framework to function effectively.” ECB Vice President Vítor Constâncio, 17 May 2018.

On 31 May 2018, Vítor Constâncio completes 18 years on the Governing Council of the European Central Bank (ECB)—8 as Vice President and 10 as Governor of the Bank of Portugal before that. Ahead of his departure, Vice President Constâncio delivered a valedictory address setting out his views on what needs to be done to make European Monetary Union (EMU) (and what people on the continent refer to as the “European Project”) robust.

Before we get to his proposals, we should emphasize that we continue to view political shifts as the biggest challenge facing EMU (see our earlier posts here and here). The rise of populism in recent euro-area member elections is not conducive to the risk-sharing needed to sustain EMU over the long run. Without democratic support, investor fears of redenomination risk—associated with widening bond yield spreads and, possibly, runs on the banking systems of some national jurisdictions—will continue to resurface whenever political risks spike or local economic fortunes ebb (see chart). This latent vulnerability—resembling that of a fixed-exchange rate regime with free movement of capital—diminishes the prospect for strong and stable economic growth in the region as a whole.

Euro Area: select long-term government bond yield spreads over Germany (basis points), 2008-29 May 2018

Note: The spreads are based on the harmonized EMU average monthly convergence criterion yields for government bonds close to a 10-year maturity. The final observations are as of May 29 for 10-year government bond yield spreads. Sources: Eurostat, Bloomberg,, and authors’ calculations.

Note: The spreads are based on the harmonized EMU average monthly convergence criterion yields for government bonds close to a 10-year maturity. The final observations are as of May 29 for 10-year government bond yield spreads. Sources: Eurostat, Bloomberg,, and authors’ calculations.

Turning to the need for change, the current framework has three significant shortcomings:

  1. The banking union—which typically consists of a common regulation and supervision authority, a common resolution mechanism (including common funding), and a common deposit insurance system—remains incomplete.
  2. Because euro-area sovereign debt is not free of default risk, and because some states are highly indebted, some sovereign bond markets remain susceptible to runs and to contagion, with interest rates spiking.
  3. There is no common fiscal mechanism for managing the inevitable asymmetries in business cycle fluctuations across the member states of the union.

On a number of occasions we have written about how these missing elements can lead to fragmentation of and strains in the European financial system. For example, when the banks in one country come under stress, depositors have incentive to flee to “safer” banks in member states viewed as more stable. This is what has happened at various times in Cyprus, Greece, Ireland, Italy, Portugal, and Spain (see our post on the operation of the Target2 system). Furthermore, the current system continues to tie banks so closely to their own sovereigns that loss of confidence in one means loss of confidence in the other. The reason is simple: banks hold their sovereign’s assets, while the ultimate responsibility for these banks (under current arrangements) still lies with their own sovereign. The result is a vicious feedback mechanism, sometimes called the doom loop: when banks come under stress, this creates problems for their government, which then leads to further difficulties for the banks.

In the original construct of EMU, the assumption was (and still is) that if a government maintains fiscal discipline, then economic and financial stability will follow. Unfortunately, this turns out not to be the case. Even where governments behave well—as Ireland and Spain did prior to the euro-area crisis—private credit and asset price booms can ultimately undermine both national banking systems and their fiscal backstops. As we have seen in many emerging market crises, both banks and governments face the threat of sudden stops (or even reversals) of foreign capital flows that amplify boom-bust cycles.

To secure the long-term viability of monetary union, Constâncio proposes a broad set of measures:

  1. Formation of a European Deposit Insurance Scheme (EDIS)
  2. Creation of a European safe asset
  3. Construction of a “genuine” capital market union
  4. Introduction of a significant fiscal capacity

The argument for shared fiscal capacity reflects the “optimal currency area” logic that many critics of EMU warned about before 1999. However, Constâncio’s recipe is far stronger. It also responds to the financial instability risks associated with a monetary union that lacks a complete banking union and an integrated capital market. Whether EMU also requires a closer political union (as we discussed several years ago) we leave for another day.

It is worth considering each of Constâncio’s proposed reforms briefly. First, the deposit insurance scheme (EDIS), when combined with common funding for the existing joint resolution authority, completes the banking union. Regulation and supervision already have migrated to the euro area (the Single Supervisory Mechanism) from the individual states. However, in a true banking union, the residents would be indifferent to where their bank deposits are located. In the euro area, so long as people prefer banks in Frankfurt, Amsterdam or Luxembourg over those in Athens, Lisbon or Rome, the banking system will be at risk of disruption. Countering this risk requires mutualizing it through a backstop that is jointly guaranteed by all euro-area countries.

Related to the need for deposit insurance is the need for a European safe asset. The debt of euro-area sovereign states is not free of default risk. Lacking such a safe asset, there is no basis for a risk-free term structure of interest rates that can used as a benchmark for pricing risky assets. Perhaps more importantly, banks are currently unable to purchase a euro-denominated debt instrument that is impervious to changes in the relative creditworthiness of the euro area’s sovereigns. Third, neither private banks nor the central bank have the ability to purchase bonds without the appearance of financing (and potentially favoring) a particular national government. Unlike the Fed, which can buy and sell federal-government backed debt, the ECB cannot achieve asset neutrality: its open-market interventions and collateral framework inevitably influence the relative prices of risky instruments.

Importantly, the construction of a safe euro-denominated debt instrument does not require the issuance of Eurobonds that mutualize sovereign risk. Instead, the most straightforward solution is to issue bonds that are backed by a diversified portfolio of euro-denominated government bonds. The safest tranche—which would be paid off before any riskier tranches—would become the safe benchmark. This tranche approach is the model for “ESBies” (see also Leandro and Zettlemeyer for a discussion of the options, and the report of the ESRB Task-Force), which can help impose debt discipline of the kind type originally envisioned in the Stability and Growth Pact. For example, a limit on the quantity of any particular sovereign’s debt included in ESBies would not prevent a government from borrowing more, but it would have to compensate investors adequately for the marginal risk of this additional debt.

The third reform on the list is the creation of a truly integrated, euro-area-wide capital market. A pan-European debt and equity market would have tremendous advantages. Capital would seamlessly flow to the firms that are the most productive, regardless of where they are located. Investors could easily diversify their holding across the member states, without having to go separately to the exchanges and markets in individual countries. And, a capital market union would promote risk-sharing that would help individuals to smooth their consumption across the entirety of Europe. Taken together, this would surely support economic growth.

As we will discuss below, the introduction of deposit insurance and a safe asset are politically difficult, but not technically challenging. A capital market union faces both issues. A key obstacle is differences in legal frameworks. Can equity and debt finance both really be pan-European so long as member states have different bankruptcy laws and different court systems? Perhaps, if one of the states (like Delaware in the United States) becomes the natural home for new issues. At best, that remains a long way off.

Finally, there is the fiscal stabilization function. As mentioned above, the notion of fiscal burden-sharing  was identified in the original discussions of optimal-currency areas in the 1960s. Importantly, fiscal burden-sharing allows for countries to participate in a monetary union even when their structural economic differences make them vulnerable to asymmetric shocks. From this perspective, risk-sharing allows countries to specialize in their area of comparative advantage, consistent with the efficiency benefits of a large, common market and unified currency area.

The point is that monetary policy can only address common movements, not idiosyncratic ones. So, if half the euro area is booming while the other half is experiencing a recession, traditional monetary policy would be helpless to redress the imbalance. Fiscal policy would be the appropriate tool, but it can only do the job if it has sufficient resources. Placing the entire burden of such fiscal adjustment on the individual states may provide an incentive for fiscal discipline, but—in light of the doom loop—can become a source of both economic and financial instability.

If it is so important for stability, why have euro area countries not yet created a common deposit insurance scheme or ensured adequate common funding for bank resolution (let alone shared countercyclical fiscal responsibilities)? The answer is that the member states have differing political interests.

We see two enormous stumbling blocks in what amounts to a further mutualization of risk in the banking system. First, today, the quality of assets is clearly higher in some countries’ banking systems than in others. If all banks were to receive deposit insurance and backing by a common resolution authority before meeting the same solvency standards, the result would be a transfer from countries with strong banks to countries with weaker ones. The recent call by some German economists to prevent EMU from becoming a “liability union” partly reflects such concerns.

Second, there is the related problem of moral hazard. Public safety nets—either in the form of deposit insurance or implicit public bailouts—lead bank managers and owners to take on more risk than is socially desirable. The solution to this is two-fold, but it is not very popular. First, require sufficient bank capital. That is, make sure that the first loss belongs to the owners of the bank, and that first loss can in fact be relatively large. In practice, capitalization of euro-area banks has improved since the crisis, but substantially less than it has in the United States. And second, it is essential that there be a common and consistent application of regulations across all banks in the euro area. In that context, regulators can no longer afford to allow large banks to be national banks; they must be euro-area banks that are not unduly exposed to the risks of any particular sovereign. Yet, as Constâncio notes, in a context of high debts and sovereign default risk, the addition of risk-reducing diversification incentives for banks could trigger short-run instability in the sovereign debt markets.

It should come as no surprise that creating an economic and financial union of sovereign states is extraordinarily difficult (see, for example, here). People often look at the United States as a successful example. But sharing risk and power among the American states went through a long evolution. The 1789 Constitution began the process of forming “a more perfect union,” but unlike the euro area, political union preceded monetary and banking union in the United States. The federal government issued a common currency in 1863, during the Civil War. The United States achieved a modern banking union with the creation of federal deposit insurance in 1934, more than 150 years after the Constitution. And, fiscal burden sharing through the federal government is largely a phenomenon of the post-World-War-II economy. Arguably, it became feasible only because of state-level fiscal discipline that resulted from earlier episodes when states went bankrupt (see, for example, Thomas Sargent’s 2011 Nobel Prize address “United States Then, Europe Now”).

Prior to the creation of the euro, even the optimists understood that, from time to time, there would be tensions. They hoped that when strains arose, it would push European leaders, cognizant of the historical dangers of nationalism, to further cooperate and coordinate. If that was supposed to be an automatic mechanism, it has not worked. For example, there is little evidence that euro-area countries with fiscal capacity used it to counter the region’s downturn when peripheral countries were compelled to tighten aggressively. More recently, the advance of populism suggests an even greater loss of appetite for sharing of risk and power.

Euro pessimists also have been wrong. Had anyone known in 2001 of the Great Depression that awaited Greece as a member of EMU, who would have expected that the people of Greece would remain as committed to the euro as they seem to be? More broadly, had they known in 1999 about the euro-area crisis and its aftermath, pessimists who viewed EMU as a trigger for political conflict probably would have expected at least one country to have exited by now. We haven’t seen that either.

Perhaps Constancio’s most-important message is to warn against complacency. With all of the peripheral countries growing again, and with a range of recent reforms (like the creation of the common supervisory mechanism) helping to strengthen the system, it is unsurprising that the latent structural risks temporarily lose salience. Yet, without the completion of the banking union, a future recession, with its inevitable regional asymmetries, is almost certain to revive strains in the monetary union. And, the day may yet come when populist leaders in one country or another, with the support of their citizens, opt to exit the euro rather than adopt the painful reforms needed to make a common currency sustainable.

No euro-area country’s long-run interests are served by even the risk of such a collapse, much less the reality.