Political leaders meet for a two-day European Council this afternoon, one so full of big decision items that it has been billed the “mother of all summits”. The agenda includes migration and eurozone reform, with Brexit some way down the list of priorities.
The single currency reform push is of special interest for Free Lunch. While we wait to hear what may or may not be decided, let us take stock of the latest refinements in how experts understand the functioning — and sometimes dysfunction — of Europe’s monetary union.
The IMF and the Central Bank of Ireland have just completed a conference on “The euro at 20”, which brings intriguing new insights. Some of them, sadly, underline just how misguided the eurozone’s policy response to the debt crisis was. Here are those that particularly caught my attention.
On fiscal policy, the evidence continues to accumulate that the cost of austerity after 2010 was greater than leaders admitted at the time. Maria Coelho measures the local (subnational) “multiplier” on government spending — that is to say how much “bang for the buck” spending from the centre buys in terms of increased local economic activity. The numbers are big, larger than previously thought. This lends support to the push for investment budgets that are protected from cyclical swings.
Antonio Fatás, meanwhile, identifies a feedback loop between fiscal policy and potential output, the amount an economy can produce at full capacity (that is, when it is not in a recession). A downturn can permanently reduce the full-capacity potential (this is called hysteresis), and because of Europe’s fiscal rules, a reduced potential leads to calls for tougher fiscal tightening, worsening the damage further. He concludes: “This succession of contractionary fiscal policies was likely self-defeating for many European countries. The negative effects on GDP caused more damage to the sustainability of debt than the benefits of the budgetary adjustments.”
On financial integration, too, there is useful new knowledge. A study by Joseba Martinez, Thomas Philippon, and Markus Sihvonen finds that “a banking union is efficient at sharing demand shocks (deleveraging, fiscal consolidation), while a capital market union is necessary to share supply shocks (productivity/quality shocks, markup shocks)”. To disperse the effect of disruption on particular countries through private financial channels, banking integration and securities markets integration are not substitutes but should go hand in hand.
A similar lesson can be drawn from an analysis by Mathias Hoffmann, Egor Maslov, Bent Sorensen and Iryna Stewen, who examine the degree and quality of banking integration between eurozone countries. They note that while cross-border lending between banks grew strongly in the pre-crisis years, there was much less of what they call real or deep banking integration. That is when banks lend directly to end borrowers across borders, or when banking corporation themselves are structured as multi-country operations.
The problem is that the shallow type of banking integration is highly procyclical. (And this adds to another source of procyclicality in eurozone banking, identified by Harry Huizinga and Luc Laeven. Provisioning for losses tends to be done in such a way that lending has to be reined in just when it is most needed — which is usually when losses are likely to be acknowledged.) That is why deeper banking integration is needed to move to a truly pan-eurozone banking system where both ownership and customer relationships cross borders. The authors also argue that because capital markets and banking integration spread different sorts of risk, capital markets union can help banking union work better.
There is some good news to be taken from this. The types of policy actions and institutional design currently on the table in eurozone reform relate precisely to deepening the banking union and to allowing government spending — especially investment spending — to counteract downturns better. In other words, policymakers are focused on the right sorts of solutions, and not before time. Now they have to deliver them.