A European Monetary Fund

Sapir and Schoenmaker at Bruegel have a discussion of what a European version of the IMF might look like and do. Here are my thoughts on the sovereign debt (not banking) side, which I am sure will be regarded once again as radical and will therefore be ignored.

I think some new Eurozone institution is necessary, but not for the reason that most people might think. The idea that the Eurozone might have a common fund that lends to Eurozone countries in fiscal difficulties with associated conditionality, as the IMF does, is a terrible idea. We know it is a terrible idea because of Greece.

Think of the following scenario. A country getting into difficulties is lent some money by the EMF. That sum increases as existing private investors take fright. For whatever reason the ‘recovery plan’ imposed by the EMF goes wrong, and it becomes clear to all neutral observers that the country needs to default on its debts, including those to the EMF. As the EMF loan is regarded as ‘our money’ by a good part of the EZ electorate, this default is resisted and punitive austerity is imposed on the country so that the EMF can get its money back. This does not happen to the IMF because the electorate in any individual country do not think of their loans as ‘their money’, but it is naive to believe that wouldn’t happen with an EMF. It is exactly what happened in Greece, and it is also why moves to a political union are far too premature..

This raises an obvious question: why have an EMF, when we have an IMF? The wrong way of thinking about that question is that the Eurozone needed to supplement the IMF during the last crisis. The last crisis is not a good example because the ECB did not operate OMT until September 2012. The right way to think about the past is what would have happened if OMT had been operating from the start.

The ECB is (rightly) only prepared to operate OMT for a country that is returning its financing to some sustainable level. For some countries that may not be possible, or desirable, without default. That was the case for Greece. For others that will be possible without default, as Ireland and Portugal have shown. You need somebody, or some institution, to decide which category a country finds itself in. But whether default is needed or not, a recovery plan (austerity) has to be put in place to return the public finances to sustainability and once that plan is in place OMT then operates.

Once that happens, I think any lending should be done by the IMF for the reason I have already given [1]. However it may well be that as long as the austerity is sensibly mild and drawn out [2], private sector lending will resume because of OMT.

I think a new institution to do both the job of initially deciding about default and to create the recovery plan would be a good idea. But both decisions have to be kept as far away from politicians as possible. The reason again comes from history: the loans to the government that may require default are likely to be from banks or institutions in other EZ countries. That creates a serious bias towards ‘lend and pretend’, as we saw with Greece. 

How can you achieve such independence in the EMF? In addition, how do you justify giving an institution staff and resources when it hopefully will be hardly ever needed? One answer could be to use the IMF, although at the moment the IMF is not sufficiently independent of EZ politicians. Another is to utilise the network of independent fiscal institutions or fiscal councils that every EZ country now has. If those institutions live up to their name, they should be independent of politicians. In addition, they have exactly the expertise to decide on any default and to put together a recovery plan.

Now the great thing about this set-up is that it allows fiscal autonomy in countries that have not got into fiscal difficulties. Fiscal discipline through the market is restored, because there is a clear default risk (but not the self-fulfilling default risk that operated before OMT). There would be less of a feeling in countries like Germany that they had to worry about fiscal policy in other EZ countries because they will pick up the tab because there will not be any tab to pick up. In that sense the no bail out rule is restored. 

What would the Brussels machinery that currently monitors each EZ country do? Am I proposing to put some Brussels bureaucrats out of a job? Not necessarily. A potential problem with the system I suggest is that fiscal councils will be captured by their governments. Brussels could ensure that the fiscal councils are independent, which would involve checking their assessments and forecasts (or even supplying them with forecasts).

I can predict with almost certainty that some comments will be that I am taking crucial decisions away from democratically elected politicians and giving them to technocrats. We have enough of that in the Eurozone as it is they will say. There are two simple responses. First, in the absence of the Eurozone, governments that were no longer able to borrow would face the technocrats at the IMF. Second, we have tried the democratic route and it has failed spectacularly for reasons that will not go away in a hurry. 

There you have it. A feasible plan to increase sovereignty in the Eurozone and mitigate another Eurozone crisis and avoid another Greece. Now tell me why we have to move to fiscal and political union.

[1] Obviously in that case the IMF would also have to approve the recovery plan.

[2] A short sharp shock will almost inevitably lead to damaging negative feedback on output, perhaps creating another Greece.