January 5, 2018
Guest post by Luis Pablo, PhD student in Financial Economics.
The European Commission remains committed to undertaking an ambitious economic and fiscal reform for the European Monetary Union. The Commission recently released a roadmap where it puts forward a set of guidelines aimed at strengthening “the unity, efficiency and democratic accountability of Europe’s Economic and Monetary Union by 2025.” These guidelines include moving forward with the proposal for a banking union, reaching a new agreement on the necessity of undertaking structural reforms in the Member States or incorporating the Stability and Growth Pact, which imposes fiscal discipline on Euro countries, to the Eurozone’s legal framework.
In addition, two more proposals were introduced with the aim of consolidating the Union: the creation of a European Monetary Fund (EMF) and the appointment of a European Minister of Economy and Finance, a newly-created position that would strengthen the oversized European bureaucracy.
The creation of an EMF is an old longing of the Commission. In 2010, at the peak of the Eurozone crisis, two economists presented a plan to establish an EMF, which was shortly after endorsed by the European Commission. Although this reform proposal was never implemented, it paved the way for the establishment of the European Stability Mechanism (ESM), an institution designed ad-hoc to financially support those countries in need of economic aid.
At first sight, an EMF might seem like a good idea. After all, the European debt crisis that started in 2009 caught the Eurozone by surprise, unprepared to face a challenging situation that ended up jeopardizing the survival of the Monetary Union itself. Therefore, a supranational entity that deals with the consequences of financial crises should be the next step in the consolidation process of the Euro Area so that similar situations can be avoided in the future.
As reasonable as this may sound, the creation of an EMF could have potentially harmful consequences. First, it would expand the size and scope of the ESM, creating a new institution whose main purpose would be to bail out financially distressed countries. This would, in turn, reinforce the perverse incentives of certain nations to act irresponsibly when it comes to managing their finances.
In addition, the existence of an EMF would hamper the effectiveness of the Bank Recovery and Resolution Directive. This directive, which came into effect in January 2016, establishes a resolution mechanism (bail-in) whereby creditors are compelled to take a haircut on their debt instruments in case of bank restructuring. The adoption of this directive was aimed at preventing taxpayers from footing the bill for banks’ losses, thereby removing moral hazard from financial institutions, which tend to take more risks when they know that they will be bailed out by governments in case of bankruptcy.
While it is true that an EMF wouldn’t most likely be allowed to recapitalize financial institutions directly, the establishment of a supranational institution with the power of bailing out entire countries would eventually enhance the moral hazard of banks. In fact, we have an example of such a situation. In mid-2012, the Spanish government requested financial aid from the European Union to inject capital into several financial institutions that had suffered the impact of the housing crisis. The Eurogroup provided a line of credit of up to $117 billion, of which $66.5 billion were employed to bail out poorly-managed banks. The capital wasn’t injected directly into the financial institutions via the ESM. Instead, it was the Spanish government who was the legal beneficiary of the loan, which was later employed to recapitalize banks. Therefore, it doesn’t seem far-fetched to think that an EMF would find the way to bail out financial institutions, undermining the credibility of the bail-in directive passed in 2013.
Another key part of the Commission’s proposal is the creation of a European Minister of Economy and Finance and Budget. Earlier this year, Emmanuel Macron highlighted the importance of having a new European budget worth “several points of the Eurozone’s GDP”. This idea, which has been endorsed by German Prime Minister Angel Merkel, seeks to move forward with one of the oldest goals of the European institutions, namely: a common fiscal framework for the Union.
However, a shared fiscal policy has numerous drawbacks. First, the new European budget would be obviously funded via taxes. This would imply an increment in the already-heavy tax burden borne by European citizens. Furthermore, fiscal consolidation would do away with tax competition among countries, one of the most effective ways to attract foreign investments.
In theory, a shared fiscal framework isn’t necessarily negative. For instance, if corporate taxes in the Eurozone were levelled down to the level of Ireland’s corporate tax rate, the consolidation would certainly boost the economy. Yet, given the precedents, a process of tax harmonization would most likely result in a cross-country tax increase, depriving Member States of their capacity to manage their taxes and reinforcing the condition of EU countries as tax hells.
The 2008 Financial Crisis laid bare the weaknesses of the European Monetary Union. This led the European institutions to put forward plans to better cope with future crises. Although the creation of an EMF and a new European Ministry of Economy might reinforce the Union in the short term, the long-term consequences of adopting such measures are uncertain and could potentially cause more problems than they would solve.
Luis Pablo holds an MSc in Finance and a Master of Research in Business Economics. He’s currently doing a PhD in Financial Economics. He has been published by several media outlets, including The American Conservative, CapX and the Institute of Economic Affairs, among others.Guest contributor