How to fix the eurozone

PARIS — The time to repair the roof is when the sun is shining. When it comes to the eurozone, European leaders long ignored these sage words by John F. Kennedy.

And as a result, they were left making desperate last-minute fixes in the teeth of a financial hurricane that nearly blew the house down. German Chancellor Angela Merkel felt she could only persuade parliament to accept bailouts for Greece, Ireland and Portugal as a “last resort” when the very survival of the euro was at risk.

With economic growth returning and the prospect of a couple of years of political stability in key euro countries, leaders of the 19-nation monetary union have a period of sunshine in which to rectify their earlier mistake.

They should move quickly to correct the eurozone’s design flaws and build a stronger structure before the next storm strikes, as it inevitably will. The trouble is they don’t agree on what needs fixing — and some no longer feel any sense of urgency.

That’s a dangerous sentiment. The eurozone needs more than just a few new roof tiles.

Beyond a quick fix of the most gaping holes, leaders should agree next year on the long-term goal of building a new roof: issuing common bonds linked to fiscal and economic policy conditions once they have reduced legacy risks to sovereigns and banks.

“We don’t really know what France wants while the Germans have been busy drawing red lines” — Eurozone official

European Central Bank President Mario Draghi’s pledge in 2012 to do “whatever it takes” to preserve the euro ultimately halted the first eurozone crisis. But the ECB does not have unlimited firepower or a complete legal mandate. Nor does it have unlimited public support in Germany, the EU’s biggest economy.

If heavily indebted governments or banks hit trouble in the next downturn, bond traders and investors such as the Chinese may question again whether Europe really stands firmly behind the euro, given Northern creditor nations’ enduring reluctance to share risks with Southern debtor countries.

“Eurobonds” would remove such doubts.

Next month, at the first euro summit since July 2015, heads of state and government are due to set an agenda and a timetable to try to repair the currency framework.

There’s little agreement about what needs to be done. While French President Emmanuel Macron has made the running with ambitious speeches urging closer integration of the eurozone, EU officials say Paris has yet to circulate any proposals. “We don’t really know what France wants while the Germans have been busy drawing red lines,” one eurozone official said.

Macron addresses the press after discussing eurozone reforms with Chancellor Merkel | Odd Andersen/AFP via Getty Images

What Macron has done is call for a finance minister, a large common budget to fund investment and a parliament for the single currency area. But those ideas are unlikely to find much purchase in the near term.

Berlin wants instead to give more power to the eurozone’s German-dominated bailout fund, including the right to supervise national budgets and to force mandatory debt restructuring on countries that turn to it for help.

There is an emerging consensus that the eurozone needs to give its inter-governmental bailout fund known as the European Stability Mechanism a new, more flexible tool to support governments before they lose bond market access — a standby loan on condition of EU-supervised reforms.

Former German Finance Minister Wolfgang Schäuble insisted in a paper circulated to Eurogroup colleagues at his last meeting in October that in return, the ESM be empowered to order a restructuring of a country’s unsustainable debt and force private bondholders to take losses.

Schäuble’s paper was a “greatest hits” of old German demands for stricter enforcement of EU budget deficit rules and rejection of fiscal transfers, any form of debt mutualization or the creation of a common safe asset in the euro area.

If, as some EU officials fear, it represents the consensus of Berlin policymakers past and future, it could kill off any wider reform of the eurozone before negotiations even begin. There’s a serious risk that Europe stops permanently short of the major overhaul that many economists say is essential for the euro to survive and prosper.

As with other European projects, any refit of the eurozone will be a compromise between the French and German visions and will have to proceed in stages, starting next year with measures that don’t require changing the European Union treaty — a lengthy and politically perilous exercise.

The most pressing task is to complete the banking union, launched at the peak of the crisis in 2012, under which the European Central Bank became the single supervisor for more than 130 large banks across the euro area.

Ideally, European leaders would strengthen the €55 billion fund levied from the financial sector to help resolve troubled banks. The fund, which will take a decade to build up, is too small and may be too late to cope with a serious crash. It also has no state-underwritten backstop and no common deposit insurance to guarantee savers’ money.

Merkel would be wise to respond more positively to Macron now that she finally has a partner in Paris committed to sound public finances and economic reform.

Berlin has balked at rectifying any of those problems until Southern countries, especially Italy, make their banks purge bad loans from their balance sheets, even if that means burning bank shareholders. The Germans also want banks’ holdings of government debt to be risk-weighted instead of treated as safe assets — a move that would deal a severe blow to Rome and other highly indebted nations.

Merkel is not in a strong position domestically. It’s doubtful that Germany will have a new government in place by the time of the summit, and the liberal Free Democrats, one of the German chancellor’s likely future coalition partners, are opposed to France’s bold ideas for sweeping eurozone reform. She may have little room to make commitments.

However, Merkel would be wise to respond more positively to Macron now that she finally has a partner in Paris committed to sound public finances and economic reform.

Berlin is also reportedly pushing for Bundesbank President Jens Weidmann, a hawkish critic of ECB bond-buying who has made few friends among Southern European countries, to succeed Draghi when his nine-year term at the helm of the central bank expires in 2019. That would require strong French backing.

So, beyond a quick completion of the banking union and extra tools to support countries under stress before they run out of road, Merkel should be open to exploring bolder ways to deal with the sovereign debt overhang in the eurozone, boost public investment, promote economic convergence and increase the growth potential of the eurozone.

As with other European projects, any refit of the eurozone will be a compromise between the French and German visions | Dan Kitwood/Getty Images

She has signaled openness to creating a small central fund to reward euro countries embarking on difficult reforms of pensions or labor markets which may entail initial costs. That would be a positive step if done on a sufficient scale to make the political pain worthwhile.

Germany must go further and overcome its aversion to some form of joint borrowing and the creation a safe financial asset for the eurozone equivalent to U.S. Treasury bonds. Breaking the taboo over “eurobonds” — especially since such securities are already issued in small volumes by the European Investment Bank, the European Commission and the ESM — would be a game-changer.

If properly constructed, jointly underwritten or jointly insured debt issuance up to an authorized limit for each country could be a powerful tool to reinforce fiscal discipline and underpin market confidence in the permanence of the euro.

It would be a way of Berlin sharing its AAA rating with weaker eurozone partners — without large fiscal transfers — to help them reduce their legacy debt without an insolvency crisis. That is in Germany’s interest too.

It won’t happen in the next six months, but it should be the eurozone’s destination in the coming years.

Paul Taylor, contributing editor at POLITICO, writes the Europe At Large column.

Original Article