A ‘what if’ approach to assessing proposals for euro area reform

A ‘what if’ approach to assessing proposals for euro area reform

Learning from mistakes: A ‘what if’ method of assessing proposals for euro area reform

George Papaconstantinou 21 June 2018

The policy discussion on euro area reform has entered a crucial phase. This column, portion of the VoxEU debate on euro area reform, attempts a ‘what if’ experiment predicated on the proposals in the recent CEPR Policy Insight. Concentrating on the Greek case, it talks about the counterfactual case of such proposals having recently been implemented first of the crisis and examines their potential role in avoiding the outbreak of the crisis or mitigating it once it had been underway.


This column is a lead commentary in the VoxEU Debate "Euro Area Reform"

The policy discussion on euro area reform has entered a crucial phase, and analytical contributions informing that discussion have grown to be particularly important. Among these, the recent CEPR Policy Insight (Bénassy-Quére et al. 2018) sticks out. It is a significant contribution to the discussion that your European Commission kicked off institutionally using its own ‘roadmap’ proposals. Reacting to the Policy Insight, as well as several other economists with diverse academic and policy backgrounds, I co-signed an impression piece on a “Blueprint for a democratic renewal of the Eurozone” (Andor et al. 2018).

Both of these contributions share several common views on the situation and just how forward. The starting place to both may be the built-in institutional weaknesses of the euro area and the recognition these have already been only partly addressed to date. And both believe not just that the status quo isn’t tenable but also that it will be a mistake to stay for marginal changes. Where they differ is within their scope and intent. Bénassy-Quére et al. explicitly try to influence the ongoing Franco-German debate on euro area reform by presenting what could constitute a satisfactory compromise. Andor et al. (2018) instead sketch out a bolder and broader direction that in today’s political climate appears to be to be beyond reach.

As a contribution to the debate engendered by Bénassy-Quére et al., I’d like to provide some thoughts in the context of a ‘what if’ counterfactual. This includes exploring ex post the impact of experiencing Bénassy-Quére et al.’s reform proposals already implemented prior to the euro area crisis on avoiding the crisis outbreak or mitigating it once it had been underway. I’ll take the Greek case as my starting place and as main focus, completely knowledge that the characteristics of the Greek crisis aren’t representative or fully replicated in the other euro area countries which had to depend on emergency loans. 1 Nevertheless, it really is by examining the outlier Greek case that one may best draw conclusions on the adequacy of preventive and stabilisation mechanisms set up.

Counterfactuals are naturally difficult to sketch out and especially difficult to interpret to be able to draw conclusions. As well as the influence of the inevitable hindsight, one difficulty is in separating the counterfactual setup from actual historical events which would arguably not need happened in an insurance plan environment vastly different due to having implemented certain policy proposals. Nevertheless, I’ll offer some reflections on the ‘what of’ question by looking at the potential impact of the various proposed reforms in Bénassy-Quére et al. (2018) on the factors which (i) triggered the crisis; (ii) managed to get worse than it might have already been; and (iii) allowed contagion to other euro area countries.

Starting with the original trigger,at the main of the Greek economic and financial meltdown was a triple deficit: a fiscal deficit, an external deficit, and among confidence. In ’09 2009, the united states was owning a public deficit more than 15% of GDP and a double-digit deficit in the external account. Simultaneously, the realisation that the deficit figures were severely underreported made markets cautious with corrective policy pronouncements by the brand new Greek government. The problem was further exacerbated by the long delay of EU countries and institutions in the first months of 2010 in knowing that regarding Greece, markets were effectively searching for a guarantee of no default. Market financing became gradually more costly, resulting in the in extremis creation of the bailout arrangements.

Would the crisis prevention proposals in Bénassy-Quére et al. (2018) have helped Greece avoid this outcome? A definitive response to this question is actually impossible. But carrying out a simple expenditure rule guided by a long-term debt reduction target could have avoided the sharp upsurge in expenditures of the 2005-8 period, that your rules of the preventive arm of the Stability and Growth Pact (SGP) didn’t properly monitor. This assumes effective monitoring, with the proposed independent national fiscal watchdog, supervised by an unbiased euro area-level institution, providing the early-warning signs which eluded Commission services used.

In that situation, the huge discrepancy between reported and actual deficit data which contributed to the increased loss of market financing might have been avoided. Separating the role of an unbiased fiscal watchdog at EU level from that of the political decision maker would likewise have put into the credibility of EU institutions vis-à-vis the markets when assessing the Greek situation.

Similarly, in a country which routinely used its domestic bank operating system in its public debt-financing exercise, the introduction of sovereign concentration costs for banks could have acted to effectively introduce a tighter market test when issuing debt and thereby reduced the large exposure of Greek banks to the sovereign, which undermined their position through the crisis. Simultaneously, a common deposit insurance could have at least tempered the continuous ‘bank jog’ of early 2010 which precipitated the necessity for financing from Greece’s EU partners and the IMF.

Within an unpublished companion note to Bénassy-Quére et al. (2018), Jeromin Zettelmeyer attempts such a ‘counterfactual’ for Greece, assuming all recommendations have been set up by 2001: the expenditure rule, banking union, sovereign concentration charges, the regime for debt restructuring, quick access to ESM liquidity, the rainy day fund. He runs simulations and concludes that if the federal government had followed the expenditure rule, Greece’s fiscal balance in ’09 2009 could have been positive, instead of a 15% deficit; hence the crisis could have been averted.

If, however, the federal government had ignored the expenditure rule but had still issued junior bonds, he believes you might have observed a youthful and less severe debt crisis, triggering an ESM programme with higher likelihood of success. Finally, if the Greek government had disregarded both expenditure rule and the junior bond issue, there may likely have already been a bailout this year 2010, but on condition of debt reprofiling, accompanied by debt restructuring in 2012, again with higher likelihood of success.

These conclusions are reasonable; they point however to the inherent difficulty of such counterfactuals, especially with regards to how much of the original environment they assume to be altered by ‘full implementation’ of the proposals. And really should the other not also compare such a ‘what if’ with the choice of full implementation of the prevailing institutional framework at that time? This might be relevant in judging the potency of the expenditure rule versus simply following SGP rules in the decade resulting in the crisis. Had the federal government simply followed the SGP rules, with the EU institutions using the monitoring tools set up at the time better, it isn’t unreasonable to claim that the same crisis-aversion result may possibly also have been the results in Greece.

Passing from prevention to mitigation, it really is clear that once in the assistance programme, Greece suffered a massive economic and social cost. The drastic fiscal consolidation, alongside the internal devaluation to balance the external account, would under any circumstances result in a steep recession; however, the almost 30% cumulative drop in real GDP during this time period is far more than what must have been necessary, even considering the adverse initial conditions.

Simultaneously, both additional programmes following the initial 2010 bailout are testimony to some failures, both external and internal. The former stretch from a short programme design that was more a kid of political realities amongst euro area countries compared to the consequence of robust economic design, to the delay in taking action on debt restructuring. 2 The latter includes a significant implementation deficit, the consequence of the shortcoming or unwillingness of successive Greek governments and of the complete Greek political system to take ownership of the required reforms.

The proposals in Bénassy-Quére et al. (2018) usually do not address issues of programme design, or equally importantly the mandatory political economy discussion that ought to have accompanied the bailout arrangements to make certain the economic downturn isn’t changed into an economic and social collapse, with the associated political fallout and rise in populism. The next of both contributions referred to initially of the piece (Andor et al. 2018) comes nearer to recognising the need for these aspects. Proposals for a stronger macro stabilisation in case of extreme shocks, for instance a euro area-level unemployment insurance scheme, are essential in this respect. Equally important are proposals for a fresh type of cohesion and convergence policy for countries with competitiveness and institutional challenges. Greece is an ideal example where investments in education, legal systems and infrastructure could have made a notable difference.

Of the proposals in Bénassy-Quére et al. (2018), however, you have a higher relevance to mitigating a few of the adjustment costs. It’s the framework involvingsovereign-debt restructuring when solvency can’t be restored through conditional crisis lending. Reducing banks’ contact with a person sovereign (not merely Greek banks regarding government-guaranteed bonds, but also German and French ones), as well as better stabilisation tools and a euro area safe asset, had they experienced place at that time, could have helped euro area countries arrive faster at decisions on the inevitable debt restructuring of Greek official debt. The two-year delay in executing the private sector involvement – what Bénassy-Quére et al. call a “gamble of redemption”, but one driven by creditors instead of Greece – weighed on the adjustment effort by making market re-entry impossible and rendering the 2012 assistance programme unavoidable.

Turning to the ultimate issue of contagion, lots of the proposals in Bénassy-Quére et al. (2018) could have helped avoid the Greek crisis spreading and becoming systemic in nature. A euro area fund assisting countries to soak up large economic disruptions, or a euro area safe asset offering investors an alternative solution to national sovereign bonds, had they experienced place through the crisis, could have contributed to financial stability. Conversely, it really is harder to convey definitively the impact of the sovereign-debt restructuring proposals. ‘Fully implemented’, they might have indeed in principle rendered unnecessary the decisions taken at the October 2010 Deauville ‘walk on the beach’, which effectively precipitated Ireland and Portugal into assistance programmes. 3

Full implementation, however, isn’t necessarily the proper yardstick; we are always in a partial implementation environment, susceptible to the political and market pressures of as soon as. Even without Deauville, debt sustainability would in such crisis situations quite definitely be ‘in the attention of the beholder’. The mere existence of the mechanism could instead well have led markets to assume that Greece was basically the to begin many to fall. It really is difficult to gauge whether instead of acting as a stabilisation mechanism, the existence of the mechanism would actually force its broader than intended use.

To conclude, the proposals in Bénassy-Quére et al. (2018) certainly are a welcome contribution compared to that delicate dance between politics and economics which includes always characterised attempts to reform the euro area. Had they experienced place when the Greek woes triggered the broader euro area crisis, they might undoubtedly have designed for a far more robust system. It really is unclear, however, whether independently they could have avoided the outbreak of the crisis or seriously mitigated its impact. The policy tools set up at any given moment are obviously critical; but also for the eventual outcome, the defining difference may lie in the political economy of the problem.


Bénassy-Quéré, A, M Brunnermeier, H Enderlein, E Farhi, M Fratzscher, C Fuest, P-O Gourinchas, P Martin, J Pisani-Ferry, H Rey, I Schnabel, N Véron, B Weder di Mauro, and J Zettelmeyer (2018), “Reconciling risk sharing with market discipline: A constructive method of euro area reform”, CEPR Policy Insight No. 91.

Mody, A (2014), "The ghost of Deauville", VoxEU.org, 7 January.

Papaconstantinou, G. (2016), Game Over – THE WITHIN Story of the Greek Crisis, Papadopoulos Publishing.


[1] For an insider’s account of the Greek crisis, see Papaconstantinou (2016).

[2] While that is broadly recognised by academics and policy-makers alike, the IMF is probably the rare institutions which has attempted to offer an ex post analysis; see Independent Evaluation Office (2016).

[3] The “Deauville decision” preannounced that in future, sovereign bailouts would require that losses be imposed on private creditors, and for that reason drove spreads higher, arguably forcing the hand of Portugal and Ireland in requesting assistance programmes. For a far more skeptical take on this, see Mody (2014).

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