Things that could be done, once the lesson is learned

This is the second of two posts on the current crisis by Professor Massimo Amato, of Bocconi University, Milan. The first, “Lessons to be learnt”, was posted on PRIME on 31st March

A new institutional architecture must be thought of. First of all for Europe. Europe has always thought of itself as an experiment and as a process. Now the time has come to experiment with new paths, in view of a new structure after the crisis.

In these days, people speak more and more insistently, and not always univocally, of "eurobonds" as means to face the fiscal expansions that the immediate response to the crisis will impose on all states. Just as there was talk of an intervention by the ESM [European Stability Mechanism].

As it is conceived today, the ESM does not uniquely either "save states" or "kill states": it is instead a mechanism that can generate opposite effects to those hoped for, because the conditionalities it poses for financing are such as to expose sovereign debts to uncontrolled depreciation on the markets. If the ESM renounced conditionalities, it would no longer be the ESM we know, but another thing. But what thing exactly? In view of what should we transform it? In view of the emergency alone or of a more solid and supportive European construction, less prone to self-harm?

Strictly speaking, Eurobonds will not exist until there is a European federal budget managed by a European Treasury able to borrow directly from its central bank, generating an asset that can be perceived as so "safe" as to become an international reserve asset, like the US T-Bills now. In the absence of a federal structure (if it was not built before the coronavirus, it will not be built during the coronavirus) if we look at the projects of European "safe assets" formulated so far, we see that they actually address directly the markets, and depend on markets for their dynamics, such as the ‘ESBies’ proposal [1].

In the current situation, "rebus sic stantibus", the ECB will be able to support the course of spurious "eurobonds", or it may renounce to fulfil its "capital key" obligations [2], supporting the debts of states under fire due to uncontrolled expectations generated on the markets. In any case, if it wants the euro not to collapse it will have to do one thing or the other, or both. This is the sense of the “whatever it takes” and of the "imperial guard" spirit (the guard who dies but never gives up) that must characterize the central banker at this time. But, once again, it would be a temporary solution, because if it renounced the purely proportional criterion of the "capital key", the ECB would find itself to deal with frankly unmanageable attributions, because they would generate those "moral hazard" dynamics that have hitherto prevented any serious mutualisation of the eurozone debt.  These dynamics have effectively prevented the construction of a pillar of integration, the unified management of public debts, as important as the banking union, and closely related to it, if we think about the role of banks as systemic buyers of sovereign debt.

But prospectively one can think of something else. For example, of a radical transformation of the ESM, with unchanged financial endowment. With, let us remember it, a capital endowment of 700 billion (80 paid and 620 of "callable shares"), the ESM can now make direct loans of up to 500 billion. But the ESM could be transformed from a Fund that lends in the short to medium term, with potentially vexatious conditionalities, into a "Debt Agency" capable to mobilize huge quantities of funds on the markets, at advantageous conditions, and to stabilize the returns of the public debt (structurally reducing spreads) as well as the markets and the balance sheet of financial operators, in so far as it could provide them with a genuine European safe asset even in the absence of improbable reforms of the EU structure.

Financing itself on the markets through the issue of bonds, and financing not the outstanding debt but only new debt (for example the "emergency" debt for crises like the one we are experiencing) and the previous debt at the time of its renewal, the new ESM, renamed the Debt Agency (DA), could gradually transform all the debts of the European states into perpetual debts, remove the volatility linked to the liquidity risk generated by the markets, and allow an orderly expansion of public budgets, in order both to consolidate the response to the crisis and to make infrastructure investments possible at the level of both individual countries and of the union as a whole.

In turn, the ECB freed from the role of "superbazooka", could indirectly support the activity of the reformed ESM, for example by using its tools to ensure the alignment of the returns of the new European "safe asset" with the current market "risk-free” interest rate.

In this renewed perspective, the markets would no longer have the impossible task of never-being-wrong, but the more modest and practical one of providing the liquidity necessary for the operation of the DA, receiving in exchange what they cannot produce on their own: a safe asset, or even better, an asset which is structurally safer than the best portfolio that market agents can build.

States could finance themselves through an agency that acts privately by interfacing with the markets, but which has the public mission of minimizing the financial burden for the states themselves. And the relationship of the states with the DA, not being spoiled by liquidity risks, would depend only on the "fundamental risks" of the single countries. This is not insignificant: for Italy this would mean gradually moving from an interest bill of around 70 billion, except for further increases in the spread, to an annual "instalment" of just over 25 billion, with the further effect of reducing the divergences between countries, often fuelled precisely by liquidity risk. Moreover: the instalments paid by individual countries to the DA could initially meet criteria of proportionality to the initial rating, in order to avoid any suspicion of moral hazard. The agency would charge instalments that reflect the fundamental risk of each country, but then evolve towards mutualistic, or even progressive criteria. This evolution, which seems impossible to us today, would sound less strange if we got used to the spirit of cooperation.

And it is not excluded, and at least we must hope, that the human, medical, social and economic tragedy of the coronavirus, could at least teach something in this direction. To everyone.

Professor Amato is the co-author (with Luca Fantacci) of “The End of Finance” (Polity) and “Saving the Market from Capitalism: Ideas for an Alternative Finance” (Palgrave). You can follow him on twitter at @MassimoAmato9

Editor’s notes:

[1] ESBies = European Safe Bonds, e.g. as proposed in this European Systemic Risk Board Working Paper of September 2016

[2] Re capital key and ECB bond purchases: See article in Financial Times by Elaine Moore, 7th September 2016, entitled “The ECB, bond buying and the capital key: a Q&A”, including this:

“The key determines how much capital each country should contribute towards the ECB — the calculation that roughly equates to the size of individual European economies. For Germany — both the largest economy and most populous country — the share is 18 per cent. For Cyprus it is 0.15 per cent. EU countries not in the eurozone also contribute — with the UK responsible for almost 14 per cent of the total. When the ECB launched QE in March 2015, it used the capital key to work out how much of each country’s bonds should be purchased, recalculating the total to exclude non-euro countries.”