Vive l’Euro?

Lucrezia Reichlin

LONDON – Emmanuel Macron’s victory in the French presidential election on May 7 triggered a surge of optimism about the future of the European Union, and the eurozone in particular. This is partly because Macron ran an unambiguously pro-EU campaign, and was rewarded for it. But it is also because the threat of a populist government in one of the EU’s founding states is, for the moment at least, a thing of the past.

Yet renewed EU enthusiasm should not be mistaken for unwavering confidence. As Macron himself surely understands, the EU’s long-term viability requires that the “European project” appeal to its citizens more than its leadership. EU leaders therefore must – and probably will – take this opportunity to revitalize efforts to address security, migration, and growth challenges.

There is, however, an elephant in the room: the need for eurozone governance reform. At the moment, eurozone reform talks are not a priority for leaders in France, Germany, or anywhere else. That partly reflects a decrease in the risk of financial instability; but “reform fatigue” among members is a factor as well. The EU’s institution-building efforts pursued over the last few years have stalled. Further progress will require accepting a degree of risk-sharing throughout the bloc, and that will be possible only with more campaigning and possible national referenda. For now, political expedience favors the status quo.

But Macron’s victory gives the EU only a momentary reprieve. The fact remains that a strong EU depends on a credible and stable euro, and much work remains to be done to ensure the euro’s long-term viability. If the eurozone economy were to face a severe shock today, it would be unprepared. A new grand bargain between the eurozone’s two largest economies, France and Germany, will be needed sooner rather than later. In the meantime, the search for technical solutions to the euro’s woes must be pursued.

A few key principles should guide these efforts. For starters, the eurozone’s reformed fiscal and financial frameworks should be based less on rules and more on discretion. The eurozone’s experience during the recent financial crisis – especially when contrasted with that of the United States – highlighted the need for rapid, flexible decision-making by governments, not just monetary authorities.

If the public is to support such a shift toward discretion over rules, however, the system of fiscal governance for the eurozone members must be subject to real market discipline. A debt-restructuring framework should therefore be a pillar of a reformed eurozone governance structure. Such a framework could be administered under the auspices of the European Stability Mechanism, complementing the ESM’s crisis-lending facility.

Given the legacy of high indebtedness in many member states, the transition to such a framework could be dangerously destabilizing. To avoid problems, a kind of debt-management agency should be established as well – possibly also under the auspices of the ESM – with a mandate to buy back member states’ debt above a certain threshold. There are proposals on the table for such a scheme, though any that is adopted would have to incorporate some limited joint guarantee by member states.

And herein lies the most important principle that must guide eurozone governance reform: changes must be pursued alongside political reforms that strengthen the legitimacy of decisions involving risk sharing among countries. Only then can the eurozone achieve a stabilizing compromise between market discipline and any move toward even limited risk sharing.

A similar compromise could also be reached for the eurozone’s financial framework, and in particular the treatment of sovereign risk on banks’ balance sheets. This would move the EU away from the current situation, in which all sovereign bonds denominated in euros are treated equally, regardless of the issuer’s debt position.

A new set of rules – with the goal of strengthening market discipline – would also provide incentives for diversification. One such idea also envisages the creation of sovereign-debt backed collateralized debt obligations While CDOs would not require any joint guarantees, they would help to enforce market discipline, while making it easier for the European Central Bank to implement monetary policy. A recent EU proposal is a welcome step in this direction.

Two additional issues must be addressed. The first is the completion of the eurozone banking union, which would feature shared bank regulation, including a credible resolution fund. Given the lack of political will to make progress on this front, however, it may be sensible to begin by focusing on national-level solutions that, if successful, could pave the way for eurozone-level arrangements.

The second remaining issue is the creation of a centralized capacity to ensure adequate fiscal stimulus at the eurozone level. Here, too, there is a lack of political will. But, with a real debt-management agency and a regime for managing legacy debt, member states’ newly liberated fiscal capacity might relieve the need for such a centralized solution.

If the relatively conservative compromises outlined above are to be adopted, EU citizens must be involved in the decision-making process. This is particularly true for proposals involving a larger role for the ESM and joint guarantees for sovereign bond holdings. Moreover, changes of this scale would require giving more responsibility to the subset of the European Parliament that represents eurozone countries.

As we saw with the Brexit referendum in the United Kingdom, giving voters too much power to regulate the European project can backfire. But as France has just demonstrated, selling EU integration to the electorate might be the easy part. Fiscal governance will be the true test of the euro’s staying power. /project-syndicate