Read an excerpt from Luigi Zingales’ 2014 book Europe or Not.

On November 30, the Stigler Center hosted a panel discussion on the future of the euro between Nobel laureate Joseph Stiglitz and Markus Brunnermeier, both authors of recent books on the subject (watch the panel here). The event was moderated by Luigi Zingales, a professor at the University of Chicago Booth School of Business (also, one of the editors of this blog). Ahead of this event, we published the following excerpt from Zingales’ 2014 book about the euro crisis, Europe or Not (Europa o No, Rizzoli 2014; translated from Italian by Sarah Niemann). 

In designing the rules for the single currency, the not-too-hidden goal was to minimize the risk of inflation that could arise from a monetization of the budget deficit, i.e. a situation similar to that of Italy before the “divorce” between the Treasury and the Bank of Italy. This is why constraints on the deficit were imposed: the higher the deficit, the greater the risk of its monetization.

In truth, the problem in all the crises in the peripheral countries, except Greece, is not the budget deficit, but the perverse relationship between government solvency, solvency of banks, and monetary policy. In the case of Ireland and Spain, the lack of soundness of banks put the solvency of the state into doubt, in the Italian case it was vice versa. In all cases, however, the final result was a sharp contraction in the money supply.

The central bank “prints” only a small piece of the money supply. The majority is made up of bank deposits. When a bank makes a loan, it actually opens a bank account in favor of the debtor. Doing this increases the amount of means of payment available, or money supply. When it cancels a loan, however, the bank reduces the quantity of money available.((Michael McLeay, Amar Radia, Ryland Thomas, “Money Creation in the Modern Economy,” Bank of England Quarterly Bulletin, 1, 2014.)) We know that an ailing bank tends to cut credit. In doing so it reduces the volume of money and produces contractionary effects on the economy, worsening the budget deficit and making banks even more insolvent.

Although when the euro was created all of these mechanisms were known, the devastating effect of their interaction was not fully understood. In particular, they did not understand (or did not want to understand) that the single currency can only be sustained with greater political integration. In so far as the ECB does not intervene in support of governments (and banks) or both, each country risks that a crisis of confidence will trigger a vicious cycle from which they cannot escape on their own, as we have seen in Italy in 2011. 

In so far as the ECB intervenes instead, it presents the problem that arises whenever an individual does not pay for all of the consequences of their actions: that of moral hazard. A government that knows it will be helped by the ECB in the future, for example, tends not to respect its commitments, like Berlusconi, the Prime Minister in August 2011. And a bank that will be helped by the national government does not adequately worry about the amount of risk it assumes. Finally, the national government does not adequately worry about the amount of risk the bank assumes, because it knows that in the end the ECB or the European Union will save it.

This problem can be alleviated through ex ante control mechanisms. The banking union, agreed upon in the June 2012 European summit, goes in this direction. One of the most important advances achieved by this agreement is to transfer supervision of the major banks to the ECB, removing national supervisors. This reduces pressure on banks from national policy, but hardly eliminates the close link between solvency of the state and solvency of the banks. The other important advance is the creation of a European interbank Fund to ensure bank solvency. But the Fund will only be able to collect 55 billion euros, and only in ten years.((Rebecca Christie, Maud van Gaal, “EU Mulls Faster Pooling of Euro Bank-Failure Fund Money,” Bloomberg, 27 January 2014.)) In the meantime, European banks will continue to depend on national governments for aid in case of emergencies. So the problem is not solved. It requires a real banking union to make the monetary union effective and reduce the unfair competitive advantage that German companies have thanks to a reduced cost for and greater availability of credit. But to do that you must completely eliminate the possibility of the state saving the banks. As long as this possibility exists, as it does in the current proposal for the banking union, the more the financially stable countries provide an unfair competitive advantage to their domestic banks. Alternatively, a restriction of this kind is not credible (and it is hard to believe that the EU can impede Germany in saving its banks) a common European guarantee should be extended to all banks, independent of their nationality.

But the biggest problem is in monitoring the solvency of governments. This would mean an EU commission supervising and approving all of the member states’ budgets. The transfer of this level of sovereignty to Brussels would be hard to stomach for most member countries. From my point of view, the only possible solution is to leave the task of monitoring national governments to the governments. But if the ECB is forced to intervene, what discipline is left to the market?    

Two economists from the think tank Bruegel suggested a reasonable compromise.((Jacques Delpla, Jakob von Weizsäcker, “Eurobonds: The Blue Bond Concept and its Implications,” Bruegel Policy Contribution, 21 March 2011.)) Euro countries’ debt should be divided into two categories: blue bonds, with an upper limit of 60 percent of GDP, guaranteed by the EU; and red bonds backed only by the issuing nation state that will be repaid only after the payment in full of the blue bonds. While the blue bonds would be risk-free, the red bonds would remain subject to market discipline.

With this distinction, even the most heavily indebted countries would have a percentage of safe debt that banks could invest in without the risk of heavy losses. Limiting regulation of the national banking system’s investments to red bonds would break the perverse relationship between the state and banks.

There is an additional advantage to the introduction of these two types of debt: it would allow a reduction in the weight of Italian public debt without default. Often companies that are too indebted solve their prob
lems through a public exchange offer. The problem is how to induce creditors to hand over their bonds for bonds with a lower face value. The secret is to offer bonds with shorter maturity of priority in repayment of capital. Because of this, a joint offer of a packet of blue and red bonds with a combined face value lower than the initial debt can achieve the goal. My estimates suggest that doing this could easily reduce the debt burden of Italian GDP by 15 percentage points.((Luigi Zingales, “How a Debt Exchange Could Ease Europe’s Crisis,” Bloomberg, 8 September 2011.))
 With a solid plan for the disposal of state-owned businesses and property, it’s not unreasonable to conceive of reducing the debt burden by an additional 15 points. So this would bring it to around 100 percent debt to GDP: a much more manageable figure.

This is how we can solve the major financial problems, but not those of the real economy. For the latter, we must think again about the theory of optimum currency areas.

An area with a common currency must have automatic stabilization mechanisms to compensate for regional shocks with European funds. The automatic stabilizing mechanism that we know best is unemployment benefits. The advantage is that this is not a permanent transfer from North to South. Remember, for example, that in 2005 Germany had higher unemployment than Italy, Spain, and Greece, therefore the transfer would have gone from Southern Europe to Germany and not vice versa. In addition, stabilizing mechanisms don’t just work to help countries in difficulty, but also serve to reduce overheating of economies in the expansion phase. During the first half of the 2000s, Spain was in a housing bubble with unsustainable growth rates that were causing strong inflation of prices at the local level. If somehow there was a European taxation for this excess growth, it would have slowed Spanish expansion a bit in that moment, with the advantage that local prices would not have risen too much, and therefore would have been more easily absorbed in recent years. Because unfortunately what we are seeing, especially in Spain, is need for deflation to compensate for local inflation that developed ten years ago.

The real battle that we must wage at the fiscal level is for an unemployment insurance mechanism at the European level. The risk of this type of subsidy is that it increases incentives to not work. But it is precisely here that the European dimension can help. Germany has absolutely no interest in subsidizing falsely unemployed Italians, just as Italy has no interest in subsidizing falsely unemployed Germans. So the only possible agreement is one that minimizes waste and inefficiencies. The best thing would be for German inspectors to monitor disbursement of subsidies to unemployed Italians and vice versa, thereby making it more difficult to abuse. Finally, the big advantage of this kind of initiative would also be political. Today, Europe is suffering from a crisis of general support; if the unemployed get a check printed with the symbol of the union, a stronger attachment to Europe than exists today would develop.

The third reform to make the euro sustainable relates to the ECB’s objectives. If the ECB wants to achieve inflation averaging at 2 percent, it must have symmetrical costs when it exceeds or misses the 2 percent objective. Today, the costs are asymmetric: high if it exceeds, zero if it misses. Hence the tendency towards deflation. Only by eliminating this distortion can we hope to reduce the risk of deflation.