Transcript of a Conference Call on the Presentation of the Staff Discussion Note “Toward A Fiscal Union For The Euro Area”

September 25, 2013

Washington, D.C.
September 25, 2013

MR. SYLVESTRE: Good morning. My name is Bruno Silvestre. I’m a senior officer of the communication’s department of the IMF and I would like to welcome you to this conference call for the presentation of the IMF staff discussion note entitled the Fiscal Union for the Euro area. With me this morning are two of the SDN authors, Celine Allard who is Deputy Division Chief in the IMF European Department, and Fabian Bornhorst who is a Senior Economist in the same department. Before I give the floor to Celine, let me remind you of a few items. Number one, the publication of this note and the survey story that was issued with it Monday at 5 p.m. Washington time is still embargoed for another hour, that is until 9 a.m. our time, Washington time. Number two, before asking your questions, I’d like you to introduce yourself and the media that you represent. Everything that you hear during this conference is on the record and you can quote both Celine and Fabian. And finally, a transcript of this conference call will be made available on the IMF website some time this afternoon. And with that, I give the floor to Celine.

MS. ALLARD: Good morning, or good afternoon for those who are in Europe. Before we open to questions, I’d like to introduce this work and summarize our main conclusions. First, I’d like to say this staff discussion note that you have in front of you is part of a broader agenda of research that we started last year with a reflection on the architecture of the EMU. As you may be aware, we had a similar publication earlier this year on Banking Union, in February, and this work compliments the reflection. It’s meant to engage a discussion on the policy issue of Fiscal integration for the Euro area and to promote the debate among policymakers. Let me add that it represents a collaborative reflection among staff here. And this work has involved our colleagues in the European department but also in the Fiscal, Research, Strategy and Policy Review and Legal departments. It’s also a continuation of a reflection that we have started in the context of the Euro area Article IV consultations last year and what we did here is flesh out more of the background analysis and the policy options pending our recommendation. We plan to roll out this paper with further discussions in Europe in the next few months.

So you have seen these documents and the accompanying background notes. I would like to acknowledge that this is a complex issue in Europe for which decisions will not be taken overnight. But it’s also a topic that is not going away and so we thought that it would be good to put forward a framework to understand the issue. So what I’d like to do now is clarify the background of the work and walk you through our main conclusions.

So what is the background of this work? The first element is that the crisis has exposed critical gaps in the functioning of the Monetary Union. Sovereigns have been priced out of the market and private borrowing costs have differed substantially within the Euro area despite the fact that we have a common monetary policy. Policymakers have discussed those issues and there have been several proposals to further integration, including last year the European Commission Blueprint and the Report from the Four Presidents. But wide differences on the contour of the Fiscal Union among Euro members remain. And so our contribution here is to outline a framework to assess the case for further fiscal integration in the Euro area and derive what we see as the essential elements to prevent further crises or at least minimize their severity.

To do that, we first identify the gaps that the crisis has exposed. Then, we derive the essential elements and finally we discuss the immediate priorities. So let me elaborate on those three elements. First on the gaps that have been exposed by the crisis: We see four of them. The first one is that country specific shocks have remained more prevalent than expected at the beginning of the EMU. The second is that effects of those shocks have been compounded by weak fiscal policies and by a governance framework that was too loosely implemented. And this has meant that there were not sufficient buffers built for crisis times. The third gap is that while those country shocks continue to prevail and policies at the fiscal level were not sufficiently sound, there were few market forces to prevent and correct imbalances. And in particular, one element that we pinpoint is that capital markets failed to differentiate properly between sound and unsound fiscal policy despite the existence of a no bailout clause. And the fourth gap that compounded all of those other gaps is that within the Euro area, the financial market grew increasingly interconnected in the 10 years of EMU and so that once shocks hit, financial stress in one area, in one country, spread very fast across the region. This is what unfolded in the crisis when you had limited fiscal buffers, and no circuit breaker to address in particular the bank sovereign links. The imbalances that had accumulated soon evolved into general financial stress and threatened the union itself.

So the next question is: how does further fiscal integration help address those gaps? The work we have done identifies four steps that we see as essential to prevent a replay of the crisis. The first line of defense is to strengthen fiscal governance in the Euro area. Here we have seen the most progress since the crisis with various reforms put in place, the Two-Pack, the Six-Pack, the Fiscal Compact. What they do is they improve the way fiscal policy is designed at the national level, and we welcome that, but enforcement of these new commonly agreed rules will be key. So that’s the first element.

Provided it’s put in place, we also see the need for increasing risk sharing. What we mean by that is that given the scope of shocks that we have seen, some insurance mechanisms would be beneficial. They can take different forms, and they all have their pros and cons, and we analyze those in the paper, but let me give you a few examples of the forms they can take. There’s a possibility of a rainy day fund where different countries would save in good times to help in times of crises. Some form of common unemployment insurance scheme is also an option that many federations use. And a dedicated Euro area budget is another option. So that’s the second element that we see as essential.

The third element is a common fiscal backstop for Euro area banks and this is to help sever the link between national sovereigns and banks that has been at the heart of the contagion of the crisis. And with a common backstop, you can help sever that link.

And finally, the fourth element that we see for the long term is common debt instruments. Those would be possible provided that you have sufficient central oversight and that those instruments are backed by common revenue. Those debt instruments could then help finance either greater risk sharing or the fiscal backstop that I just mentioned. So those are the four essential elements that we see for the long term of the Euro area fiscal union.

The last question that we assessed is what are the priorities for now? Let me stress that we do recognize that those elements will take time to put in place and that ultimately the scope and shape of the fiscal union will be a matter of social and political preferences. But there are two issues that are critical at this juncture. The first one is that the Single Supervisory Mechanism should be complimented by a commitment from policymakers to establish a Single Resolution Mechanism with the proper backstop to anchor confidence in the banking system. So that’s the common fiscal backstop that I mentioned as one of the essential elements and we see this as critical not only for the long term, but also for crisis resolution and crisis management efforts at this stage.

The second issue that we see as a priority for now is to define a roadmap for further fiscal integration and that this roadmap needs to emerge at the political level. The roadmap would both set the stage for implementation of these elements in the future, but it will also anchor as of today confidence in the viability of the Euro area.

So those are the main messages of the paper. Let me finish by saying that the note itself is accompanied by two background notes that you will have seen and they explore in more details the scope for risk sharing in the Euro area, and also the practice and the features of fiscal union in existing federations. Thank you. And now, I open the floor to questions.

MR. SYLVESTRE: Please, remember to identify yourself when asking your questions.

QUESTIONER: About European policies, what are the mistakes the European Union has made in the last few years?

MS. ALLARD: Let me elaborate on those four gaps I mentioned initially. As I said, countries have experienced more specific shocks than was expected at the beginning of the EMU, in the sense that there was less convergence across countries in terms of their cycles that we had expected initially. So that made countries more vulnerable to initial shocks. Now, those localized shocks are usually dealt with national fiscal policies and that’s what has been done to some extent in 2008. What we can see with the benefit of hindsight is that the European framework that was in place, the Stability and Growth Pact, did not provide enough incentives to build buffers to deal with those shocks. So one of the elements is to strengthen that framework by having fiscal rules that are both more ambitious in good times of the cycle, when you have sufficient growth, to allow for flexibility and buffers when the crisis hits a specific country. So that’s what we mean by strengthening fiscal governance, sufficient flexibility in the short run to help countries hit by a shock. But to be able to use that flexibility, you also need more credible medium term fiscal plans and corrective mechanisms when you have slippages on fiscal policy to bring you back to a credible path in the medium run. So those are the two elements that we would highlight.

QUESTIONER: You mentioned the possibility of establishing a common budget that could be up to 2, 2 1/2 percent of the block’s GNP. Is that roughly equivalent to two hundred billion? Would you say that’s accurate? And my second question if I may is on the financial backstop for the Single Resolution Mechanism, do you think it should be able to borrow money on markets, an idea that has recently come up here in Europe pushed for by ECB President Draghi and others?

MS. ALLARD: On your first question regarding the various forms of insurance mechanisms that could be put in place in the Euro area, what we do in the paper is try to get to an order of magnitude of what the transfers could be, what the mechanisms could be. So you’ve quoted that number of 2 1/2 percent. This is an exercise to show that those transfers, or those levels of common resources, do not need to be very large. So this is the main message that I would take from that exercise and if you compare this with the current crisis management approach where you’ve had some support from EFSF and ESM facilities and from support from the central bank. We also look at what the implicit cost of this approach has been and we find that this also has a substantial cost, which means that going to a further insurance mechanism at the Euro area level does not mean that you have to set aside an enormous amount of money.

On the financial backstop, let me say two things. First, it’s essential to move forward with a clear commitment to set this common backstop in place. On the issue of borrowing, our position is clear that common debt instruments could be put in place in the long run, once you have the proper central oversight, but also once you have identified the revenues that would back up that form of borrowing. So those two things would need to go hand in hand for a permanent solution.

QUESTIONER: I just have a really quick question. How do you respond to German concerns about moral hazard concerning common debt instruments?

MS. ALLARD: We do acknowledge that whenever you have insurance mechanisms, you have a potential risk of moral hazard. The existence of an insurance mechanism can modify the behavior of national governments. So that’s why we put a premium on putting in place the right fiscal safeguards initially and that’s why we say that the first element that needs to fall in place is to strengthen fiscal governance as euro area policymakers have started to do. The second thing I would say and we elaborate on that in the paper is that if properly designed, the insurance mechanisms can stay as pure insurance mechanisms. I would give you two examples.

The first one is when we look at unemployment insurance. We do acknowledge that long-term unemployment insurance would lead to more permanent transfers and that’s why we say that the part of insurance mechanism that could move to a common scheme should be short-term unemployment insurance, which is clearly related to cyclical developments,.

The second element that I would like to highlight is that we have conducted in the paper a thought experiment where we look at what would have happened if such mechanism had been in place over the last 30 years. Of course, this is a complete thought experiment, but it’s useful in the sense that it shows that during that longer period where shocks would have been more spread across countries, every single country in the Euro area would have benefited. So that’s one thing. The second thing is that even if in that system your neighbor gets a transfer, you’re better off because that minimizes the negative effect that would come from contagion of problems from one country to another. So that provides benefit not only directly to the countries that are affected by a shock in the Euro area, but also to neighboring countries. And that’s why we say that with the appropriate safeguards, it will be beneficial for the entire membership of the Euro area.

QUESTIONER: I’m wondering what’s your assessment of how the Euro zone policies are progressing with regards to the solutions that you suggest.

MS. ALLARD: We have seen some progress as I mentioned earlier, especially in the area of strengthening the fiscal governance. That should be the first element to be put in place. What we see now as needed is to continue the debate that was started with the Four Presidents Report, and come up to an agreement on the contours of a fiscal union. We do recognize that this implies further discussion. The discussion is ongoing, and that will take time to come to maturity. Now on the elements that I mentioned as a priority, which is the fiscal backstop for the Banking Union, we have seen a debate. The debate is ongoing. The Commission has put forward a proposal and we now look forward to the debate at the Council level on those issues.

QUESTIONER: And just one other question. You mentioned for the rainy day fund, annual contributions on the order or 1 1/2 to 2 1/2 percent of GNP. Would those be annual contributions each and every year?

MS. ALLARD: This is correct.

QUESTIONER: So you seem to compare that to the total resources of instruments like the ESM or EFSF, but over a number of years, that would build up to be significantly larger than that?

MS. ALLARD: Your question is about whether this fund would accumulate resources over time : this is correct. This is the concept of a rainy day fund. But the idea is that those funds can be drawn at times of crises. We have done some background analysis and I would refer to the background note where we look at the amount that would have accumulated over time in such a rainy day fund if it had been in place since the beginning of the EMU. And we find that basically the amount that would have accumulated at the maximum is close to the amounts that are planned to be in the ESM, about 7 percent of GDP.

So this is a similar order of magnitude.

QUESTIONER: Hello. Just one simple question. The price that you pay for moving toward the fiscal union, obviously that’s a huge issue, a huge decision to be taken by the politicians, but is there any economic downside to moving toward the fiscal union from your research?

MS. ALLARD: I’ve mostly highlighted the benefits, which we see as overwhelming, but you’re right and I think your colleague hinted at the question of moral hazard and the fact that some behaviors of national policies could be affected by that. So we do recognize that it is a risk and that having in mind those risks, you need to put in place the appropriate safeguards. But as any insurance mechanisms properly designed, they are beneficial for the entire membership. So those economic benefits are positive on a net basis.

QUESTIONER: In scanning the document and listening to your comment, can’t we say that the policies that have been in effect, the austerity policies that have been in effect in the problem peripheral countries, there was no choice but to do that in order to make monetary union work. Am I right?

MS. ALLARD: What we’re saying is that you need to improve the way policymaking on the fiscal side is made so that in the long run, you have enough buffers during the good times to be able to draw from those buffers in the bad times. Looking back at what happened during the crisis, and as I said, during the good times countries did not accumulate enough buffers. Countries did not put their fiscal houses in order sufficiently, which meant that in the bad times there was not enough buffers to draw from.

QUESTIONER: Fair enough. So as a result of the absence of buffers, there was no alternative but the policies that the Fund and ECB and the European Union have now promoted. Doesn’t that follow?

MS. ALLARD: It was a consequence that had to be drawn at that time, and the broader consequence of that is that, in the long term, to prevent this situation from happening again in the future, you would want to improve the way things are done, yes.

I also want to reiterate and clarify the discussion we had about specific numbers that this exercise was illustrative to show the various orders of magnitude, and that moving to further insurance mechanisms isn’t large relative to what it has already cost. But again to reiterate that, the numbers are not to be taken at face value, but that they are illustrative.

QUESTIONER: You said that you have to improve the way that we do things in the future. I would like to ask you if one of the problems isn’t the political conflict that exists inside the Euro area between the European Union and the IMF itself. And if you recognize that there is a different opinion in the IMF and in the European Union, could you describe how it is affecting Europe? Thank you.

MS. ALLARD: I just want to say that this work is focused on the economic arguments in favor of moving towards further fiscal integration and I will not comment on any political dimension of the issue.

MR. SILVESTRE: Okay. This concludes our conference call on the SDN on a Fiscal Union for the Euro Area. I want to thank all the participants for being with us this morning and I thank Celine and Fabian for being here as well. Thank you very much.
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