Is cure better than prevention?
Prevention is better than cure, goes the adage. But history shows that economic and financial crises will inevitably happen, usually with unexpected causes. As a result, crisis management solutions are just as important as crisis prevention. The euro area was ill-prepared for the sovereign debt crisis in 2009. Since then, the region has set up several new institutions and mechanisms for managing and preventing crises.
To support a member state in difficulty, the euro area set up the European Stability Mechanism, which can grant loans of up to €500 billion. A member state under an ESM programme can also enjoy theoretically limitless support from the Outright Monetary Transactions (OMT) managed by the European Central Bank. For banks, the euro area has set up the single resolution mechanism as part of the new European banking union. In addition, the ECB now has several so-called “unconventional” measures at its disposal to stimulate economic recovery (long-term refinancing operations, asset purchase programme and negative deposit rates).
Although these new institutions and mechanisms represent a big step forward for the euro area, consensus is now building among European decision-makers that the current system is still inadequate to cope with a new major crisis, be it in terms of the size of the programmes or their governance. Several proposals have been made to share the risks: the creation of a euro area Ministry of Finance, a single budget for the euro area, a European Monetary Fund, a European deposit guarantee scheme and various types of eurobonds. These risk-sharing solutions would not only be useful in the event of a crisis, but they would also increase the euro area’s credibility in terms of its solidity, while contributing to economic growth and creating jobs. However, these proposals raise a fundamental question: what conditions need to be applied in exchange for this risk sharing? At a political level, setting clear conditions would reassure voters in so-called “stronger” member states by ensuring that the risk-sharing systems are not simply seen as allowing “transfers” to “weaker” member states.
Setting clear conditions would reassure voters in 'strong' member states.
Michala Marcussen, Group Chief Economist and Head of Economic and Sector Research, Societe Generale
Setting conditions also aims to prevent budget overruns and other excesses that could weaken the euro area. However, excessively strict conditions could prove counter-productive and cause risks at both a political and economic level.
To illustrate these difficulties, consider the proposal to transform the European Stability Mechanism into a European Monetary Fund(EMF). For the EMF to be credible, it would need substantial financial resources, which would considerably increase the level of risk-sharing between member states. Some have suggested that the EMF could take over the oversight of the stability programmes, which is currently the European Commission’s responsibility. The question is whether or not this would allow existing rules on fiscal discipline to be implemented more effectively. As doubts persist, some have suggested going even further and setting up a sovereign debt maturity extension mechanism that would be triggered automatically if a member state is granted support from the EMF. Although this idea is interesting in theory, it poses several problems in practice.
Regarding the management of a future crisis, it is often difficult to apply rules strictly when in the midst of a crisis situation. Imagine, for example, a situation in which a large amount of a crisis-stricken member state’s sovereign debt is held by the country’s banks. Restructuring the sovereign debt would risk adding a banking crisis to the sovereign crisis. The need to break the ties between member states and domestic banks is now widely understood, and this is what led to the creation of the European banking union. Applying strict conditions that are deemed to be credible by the financial markets could also, by impacting expectations, widen yield spreads and hinder economic recovery. To resolve this issue, there needs to be a fine balance between the sharing of risks and the application of conditionality. The fact that the euro area is currently enjoying an economic recovery should make this easier. However, at a political level, the situation is more complex. Although this is not the best solution, the euro area could, for want of political courage, decide that ultimately, “cure is easier than prevention.”