First-Hand Information on Economic Policy – The Dramaturgy of the Euro Crisis

Since 2009, Europe has been suffering from the euro crisis and its aftermath. Currently, there seems to be no political solution in sight. In order to tackle this issue and find a way out of the crisis, Professor Markus K. Brunnermeier from Princeton University proposes to introduce so-called European Safe Bonds (ESBies). In his speech, which he delivered as part of the lecture series "First-Hand Information on Economic Policy" at the Centre for European Economic Research (ZEW) on October 4, 2016, Markus K. Brunnmeier outlined his approach to saving the eurozone from the crisis that has gripped Europe since 2009.

The core problem of the euro crisis lies in the fundamentally different economic viewpoints taken by Germany and France. Significantly, the two countries have adopted completely opposing positions with regard to EU convergence criteria for price stability and inflation rates, established in the Maastricht Treaty of 1992. "The recent years have seen a considerable shift in power from Brussels to Berlin and Paris," explains Markus Brunnermeier at the beginning of his speech.

According to Brunnermeier, director of Princeton's Bendheim Center for Finance and advisor to the Deutsche Bundesbank and the International Monetary Fund, this power shift is down to a number of historic changes in the recent past: the introduction of the European Financial Stability Facility (EFSF) in 2010, ECB President Mario Draghi's speech in London, in which he pledged to do "whatever it takes" and thus paved the way for the bail-in regime during the Cypriot financial crisis, and finally, the decision of the British voters to leave the European Union.

Germany and France: Distorted picture due to national ideologies

"The picture we see when assessing our own, national interests is always distorted by national ideologies," explains Brunnermeier, "This is why we draw different conclusions." In the case of Germany and France, for example, there are four different dimensions that reflect the fundamental differences between the views prevailing in Berlin and Paris regarding monetary, fiscal and financial stability.

There is considerable disagreement when it comes to choosing a course of action in crisis management. While French politicians adopt a more active approach, their German counterparts prefer to stick by the rules as a means of crisis prevention. Brunnermeier further explained that while French decision-makers advocate a high level of self-regulation as well as strict guidelines regarding flexibility, German politicians prefer security measures such as debt cuts. Furthermore, French politicians promote the principle of solidarity, along with a fiscal union, liquidity, and reforms in periods of economic growth. By contrast, German policy makers advocate the principle of liability in terms of a "no bailout" clause, along with solvency, and reforms in times of crisis in order to build up political pressure. It is true that all of these dimensions have already existed during the Maastricht negotiations. "But at that time, policy makers were not yet aware of the great importance of financial stability," says Brunnermeier. The dire consequences are now being felt in the sovereign debt crisis.

ESBies: Risk weights for sovereign bonds

"If a state has euro-denominated debt, it is no longer in control of the currency and is therefore unable to devalue the currency itself. This leads to a high risk of default," concludes Brunnermeier, "This is the dramaturgy of the euro crisis." Since euro-denominated debt should be assessed according to same criteria as debt denominated in foreign currencies, the euro area needs a safe asset: ESBies. According to Brunnermeier's proposal, ESBies guarantee safety by pooling and tranching sovereign bonds according to their risk class, namely in risky junior bonds and safe senior bonds. "As a result, the flight of capital would no longer be across borders. It would be a flight across different financial instruments, namely in junior and senior tranches," adds Brunnermeier.

In the subsequent panel discussion, which was moderated by ZEW President Achim Wambach, Markus Brunnermeier discussed the ESBies concept with Professor Friedrich Heinemann, head of the ZEW Research Department "Corporate Taxation and Public Finance." Friedrich Heinemann pointed out that the introduction of ESBies would require a large, superior authority to risk-weight sovereign bonds. "Such an institution would have an enormous political and economic power," warns Heinemann, "a more moderate approach would be to eliminate the bulk risks associated with equity privileges of sovereign bonds by introducing proper regulation." One option would be to introduce Accountability Bonds, a concept developed at ZEW, which uses money flow instead of supply as a criterion.

The audience added more aspects after the panel discussion, asking: How can the eurozone be successful in cash-pooling, if there is only a relatively small number of borrowers? How can we solve the problem concerning the risk-weight of ESBies? And: Why should European government leaders heed these proposals in the foreseeable future, if the ECB currently makes up for all the damage? Both Friedrich Heinemann and Markus Brunnermeier provided detailed answers to these questions, the latter referring to his ideas explained in his recently published book, "The Euro and the Battle of Ideas".