The proposal for European Monetary Fund

I had blogged earlier about the crisis facing the Euroland and the fundamental structural problems associated with monetary integration which is not accompanied by political union. The PIIGS governments, constrained by the rigid conditions of the Stability Pact, also do not have access to the conventional policy instruments - interest rate policy, currency devaluation, running up fiscal deficits etc - to fight the depth of recession and unemployment facing them. And in the absence of a political union, labor mobility and fiscal transfers from the center to the affected periphery members becomes difficult.

Desmond Lachman draws attention to Willem Buiter's characterization of Greece being five minutes to midnight to put the crisis in perspective. Since adopting, the Euro, Greece has lost more than 25 percent in competitiveness, which has contributed to a widening in Greece's external current account deficit to more than 10 percent of GDP. At the same time, Greece's budget deficit has ballooned to 12 percent of GDP, while its public debt to GDP ratio is approaching 120 percent, or double the Maastricht criteria.

A Roundtable in the Economist draws attention to the twin-failure of EMU to encourage member governments to maintain control of their finances and to allow for an orderly sovereign default, and advocates setting up a European Monetary Fund (EMF) to address this challenge. It proposes that The EMF could be run along similar governance lines to the IMF, by having a professional staff remote from direct political influence and a board with representatives from euro-area countries. Though it would conduct regular and broad economic surveillance of member countries, its main role would be to design, monitor and fund assistance programmes for euro-area countries in difficulties, just as the IMF does on a global scale.

Daniel Gros and Thomas Mayer suggest that the EMF raise its initial funding by borrowing from the market with the full and joint backing of all its member countries. Subsequently, in order to limit moral hazard associated with bailouts, "only those countries in breach of set limits on governments’ debt stocks and annual deficits would have to contribute, giving them an incentive to keep their finances in order".

They estimate that an annual contribution of 1% of the "excess debt" (over and above the Maastricht limit of 60% of GDP) and "excess deficits" (over the limit of 3% of GDP) would have accumulated about €120 billion ($163 billion) over the past decade, enough to cover the likely costs of rescuing Greece. About the mechanism to enable members to access funds to address their fiscal balance, they write,

"Any member country could call on the funds of the EMF up to the amount it has deposited in the past (including interest), provided its fiscal-adjustment programme has been approved by the Eurogroup of euro-area finance ministers. Any call on EMF funds above this amount would be possible only if the country agreed to a tailor-made adjustment programme supervised jointly by the European Commission and the Eurogroup, and on condition that the EMF ranked ahead of all other creditors."

About the EMF's role in managing a sovereign default in the aftermath of a sudden withdrawal of market funding from a euro-zone government, without creating much moral hazard among profligate governments and reckless investors, they write,

"If a euro-area country loses access to market financing, the EMF could step in and offer all holders of debt issued by the defaulting country an exchange against new bonds issued by the EMF. The fund would require creditors to take a uniform 'haircut', or loss, on their existing debt in order to protect taxpayers. The EMF could, for example, tie its guarantees to the 60%-of-GDP Maastricht limit on debt, so that creditors of a country with a debt stock of 120% of GDP would face a 50% haircut. The losses to financial institutions would be limited and certain, reducing the risk of contagion...

Having acquired bondholders’ claims against the defaulting country, the EMF would allow the country to receive additional funds only for specific purposes that the EMF approved. The new institution would provide a framework for sovereign bankruptcy comparable to the Chapter 11 procedure for bankrupt companies in America."

This presumes that in case of an insolvency, the EMF will both be able to mobilize sufficient resources quickly enough for the failing member and also push through the required structural and fiscal adjustment measures, to both prevent other countries being dragged into crises through market contagion. Desmond Lachman and Edwin Truman doubts this and therefore describes the Gros-Meyer plan as a non-starter. In particular, Truman feels that the financing by fines based on deviation from the Maastricht conditions, presence of the IMF to fall back if the EMF imposes unpalatable conditions, the difficulty of structuring haircuts on sovereign debts etc makes it politically difficult to implement. Lachman also feels that since sovereign borrowing is now done preponderantly in the securitization market rather than in the form of bank loans, any debt restructuring, a la Brady Bonds, is very difficult.

Mark Thoma makes the important point that without monetary policy autonomy, individual members are denied one of the most critical macroeconomic policy levers in attentuating the economic cycle. He therefore advocates a strong fiscal policy to make up for the absence of monetary policy in economic stabilization, and feels that there should be fiscal federalism to effectively manage resource transfers from a centralised authority in an attempt to stabilise economic activity (like that exists between states and the federal government in all countries). He therefore argues for a European Fiscal Fund with a centralised authority can more effectively coordinate policy across countries and avoid the free-riding incentives that exist for individual countries.

In view of the pro-cyclical rather than counter-cyclical nature of ECB policies towards Europe’s periphery (ECB drove up the Euro just as the periphery started to collpase and now ECB want the PIIGS to cut wages and deficits when they are gasping for breath), Peter Boone feels that an EMF is bound to fail and titl the balance even mroe towards the core countries. Under the proposed EMF, the core European countries, which control monetary policy in a manner that serves them best, would also effectively control procedures for bailing out or ejecting the periphery.

Tyler Cowen suggests that instead of an ambitious and politically difficult to implement EMF, the ECB should be reformed to expand its mandate beyond price stability and include more co-ordination in fiscal policies with individual governments, as was the case with the Fed-Treasury co-ordination in the US. He is right on target in claiming that the "essence of the European dilemma is the divergence between monetary union and fiscal separation, layered on top of some low-trust, dysfunctional cross-national governance. Multiplying intermediate institutions won't make those problems go away."

Roberto Perotti feels that the fiscal transfers possible under the EMF (by drawing on forced savings and fines) would be too small to address the problems like that facing Greece today. He also feels that the conditionalities under any fiscal restructuring program to prevent sovereign default are too political to be so easily implemented.

Update 1 (23/3/2010)
Daniel Gros sums up the EMF proposal here.