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Symposium 2013

Proposal - The Kiel Policy Package to address the EMU crisis: Restoring prosperity based on fiscal federalism and monetary stability

The Challenge

Fourteen years after its foundation, the European Monetary Union (EMU) is facing the greatest challenge of its history thus far. High unemployment in a number of member countries, the need for substan ...

Fourteen years after its foundation, the European Monetary Union (EMU) is facing the greatest challenge of its history thus far. High unemployment in a number of member countries, the need for substantial consolidation of the budgets of numerous governments, and distressed banks are symptoms of economic misalignments and economic policy failure that threaten not only economic prosperity in Europe, but the European project as a whole. A series of interrelated fiscal and financial crises in the euro area have provoked a series of extraordinary policy measures. Some of these measures have undermined the fiscal sovereignty of affected countries, and they have circumvented market mechanisms. As social cohesion is called into question in various debtor countries, there is a danger that policy makers cannot or will not solve the existing problems in a way consistent with both monetary stability and the current political integration. The ECB’s announcement to possibly step in via its OMT-program has somewhat calmed down financial markets since mid-2012, but most of the fundamental questions for the future of Europe are either unanswered or answered quite differently by various parties. Policy makers have bought time, but the question remains what this time is used for and where the current policy stance leads to.

Guided by the principles of fiscal federalism (preserving national fiscal sovereignty) and monetary stability (narrow policy mandate for the central bank) the Kiel Policy Package focuses on bridging longer-term considerations for a workable policy framework and the short-term requirements of resolving European legacy problems by a set of ten integrated measures (addressing fiscal policy, financial market regulations, structural reforms and monetary policy) that come with a clear delegation of authority within the euro area.

Regaining sound public finances through national fiscal rules — Overcoming the confidence crisis in sovereign debt markets

In order to ensure adequate fiscal consolidation while retaining national fiscal sovereignty, we propose that:

(1) Each country shall individually implement a binding national fiscal rule that guarantees the long-term sustainability of government debt, while leaving room for countercyclical fiscal policy.

This fiscal rule should adhere to the following principles:

a) Design: The rule must specify a target for the long-term maximum level of debt relative to GDP. This target is constrained by the Stability and Growth Pact, which stipulates that national debt must not exceed 60 percent of GDP. In addition, the rule has to define the speed at which the long-term level of debt is to be reached and to what extent fiscal policy is allowed to engage in countercyclical policies.

b) Implementation: The rule should be subject to a strict enforcement mechanism, enshrined in the country’s constitution. Compliance with the rule has to be reviewed at the European level (i.e. external auditing). The extent of countercyclical fiscal policies consistent with the specific rule should be determined by an independent expert council. In order to ensure enforcement of the rule, automatic corrective fiscal policy measures (e.g. changes in VAT tax rates) should be legislated to be enacted by default, in case other measures to correct the fiscal stance are politically undertaken.

The fiscal rule would ensure that the public debt ratio reached its long-term target in a specified time frame, which would support confidence in bond markets. At the same time, national fiscal sovereignty remains intact, as the countries formulate their own rules and implement these rules through mechanisms embedded in their national legal systems. This allows countries to design their rules according to their national preferences.

European Interest Burden Equalization Scheme in the transition to national consolidation programs

Crisis countries, in spite of a commitment to fiscal consolidation, will presumably be confronted with substantially elevated risk premiums in the markets for their government bonds. In order to facilitate swift progress in fiscal adjustment we propose:

(2) The establishment of a European Interest Burden Equalization Scheme for a period of five years.

The average yield on government bonds for all euro area countries is the reference for the interest burden equalization scheme. Countries that can finance themselves in the capital markets at better-than-average conditions relinquish part of their interest rate advantages to the benefit of the countries which have to pay higher interest rates. To qualify for payments from the interest burden equalization scheme, countries must undergo a solvency test, adopt a national fiscal rule and implement structural reforms. The EU commission will evaluate whether a country fulfills these conditions.

With the interest burden equalization scheme, the Kiel Policy Package contains a temporary element of international redistribution which helps to smooth adjustment in the early phase of consolidation without mutualizing the underlying national government debts.

Overcoming the national segmentation of banking—Preventing the Eurosystem from balance-of-payments financing

In order to contain the massive balance-of-payments financing through the Eurosystem, we propose the following two measures:

(3) Bank regulation and supervision must follow a unified set of standards in the whole currency area.

The setting and monitoring of banking standards will be assigned to a European body independent from the central bank, in order to avoid a conflict of objectives for the ECB. Banking supervision operations should remain with the established national authorities as they command the necessary country-specific knowledge. The work of the national authorities is, however, subject to oversight by the European body.

(4) The Eurosystem applies strict, uniform, and transparent standards to the collateral used in refinancing operations with commercial banks.

The risk management teams of each central bank of the Eurosystem shall keep the risk of non-payment at minimal levels. Uniform risk criteria guarantee that access to central bank money is governed by economic criteria and not by other considerations. Credibility and monitoring of the central banks is strengthened by comprehensive transparency regulations.

With the combination of measures (3) and (4) in place, all commercial banks have access to central bank money at the same conditions irrespective of the country involved. These measures would overcome the national segmentation of bank markets with respect to monetary policy and regulation policy.

Allowing bank failures through an orderly resolution scheme

Bank insolvencies can be destabilizing if the failure (or the expectation of the failure) of one bank leads to runs on other banks, triggering a liquidity crisis. This can be addressed by the following measure:

(5) A European Bank Resolution Agency (EBRA) is established at the European level.

The EBRA resolves distressed banks and recapitalizes them if appropriate. Remaining ESM funds should be exclusively used for this purpose, and lenders would participate in the losses incurred by failing banks.

Strengthening the capacity of banks to absorb losses

To make sure that the recapitalization of banks through the EBRA remains an exceptional emergency measure, the capacity of the banking industry to absorb losses has to be increased substantially. To this end, we propose:

(6) Contingent Convertible Bonds (CoCo Bonds) which stipulate that bank debt is automatically converted into equity if the equity ratio falls below a certain threshold.

This provision is at the core of the proposed reform of bank regulation and re-establishes the principle of liability in the banking sector in a comprehensive way. The convertibility clause would be obligatory for all future external financing of commercial banks, except for deposits from non-banks.

Debt sustainability vs. orderly sovereign default in the long term

In the case that the current crisis countries comply with their national fiscal rules, debt-to-GDP ratios will persistently fall, leading to improved debt sustainability and an increase in investor confidence. In the long term, gauging the credit standing of each and every member country remains completely up to the capital markets.

(7) If a country cannot convince investors of its debt sustainability in the longer term, it will have to come to a debt restructuring agreement with its creditors in an orderly process.

In the future, sovereign default could not endanger the stability of the financial system, since the capability of banks to absorb losses will be massively increased. With the stability of the whole financial system no longer at risk, the no-bailout clause would regain credibility.

Clear limits for monetary policy

The monetary mandate of the central bank is strengthened by the clear signal that neither in the long term nor in the short term will it finance governments through the printing press:

(8) The ban on monetizing government debt through the Eurosystem remains in place.

A credible guarantee that the ECB will not engage in government financing through the Eurosystem is a prerequisite for financial and monetary stability, and it will encourage governments to implement serious reforms. At the same time, the implementation of such reforms will reduce pressures on the ECB to engage in government financing. The ECB could then focus on its main objective of price stability.

A structural policy reform agenda to raise potential output

The current severe situation in the crisis countries is to a large extent rooted in structural problems. By prudently cutting down on regulations and reforming institutions that reduce flexibility, the government can tap the growth potential of the economy. Therefore we propose that:

(9) Crisis countries engage in structural reforms, most notably in the following areas: Increasing flexibility in the labor market, fostering competition in product markets, cutting red tape for businesses, privatizing noncore state assets.

(10) At the request of the crisis countries, international organizations give advice on the implementation of reforms.

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