Econ 050: how to fix the Eurozone

Since the financial crisis in 2008, the notion of a “bail out” has become something of a household term. But what about a bail in? Assistant professor Christiaan van der Kwaak researches the Eurozone, the 19 EU states that use the euro, and he says that there are still some fundamental flaws in the system feeding calls for exiting the union.

Something has to give: either more nations will attempt to follow the UK’s lead and walk away from the EU, or reforms will have to be put in place to salvage the system. Van Der Kwaak says that a common EU budget could offer a way out of the current prisoner’s dilemma, but to what extent is the Dutch government prepared to get behind that idea?

What is a bail in?

Christiaan van der Kwaak: So in the immediate aftermath of the financial crisis in 2008, the banking system got into trouble and suffered big losses and all their equity net worth was wiped out in the crisis. We cannot just let banks go bankrupt because that’s so disruptive to the broader economy. And so you have a choice: so what you can do is you can either bail the banks out, and that means that the government raises funds and provides the banks with new equity that makes them better capitalized with more net worth relative to debt, so that they become solvent again. So that’s one way of solving a banking crisis, but that goes at the expense of the taxpayer. And that requires taxes to be raised on the common man, and that is not very popular. So what we have come up with is an alternative: a bail in, in which you say well we’re not going to demand the taxpayer to recapitalize the bank, but instead, we’re going to demand that the creditors of the bank, the people who own the debt of the bank, take a loss. Because if they take a loss, that means that the amount of debt in the bank goes down and then the amount of equity net worth increases. And so it’s good for the taxpayer. And in principle, it’s also good for financial stability, because it forces creditors to be more selective in which banks they provide credit with. And they will price in the fact that they will take a hit in case of a bankruptcy or in case of financial troubles. And that means that banks that are weaker will find it harder to obtain funding and that means that in general – or that’s the goal – that banks become less leveraged. And that financial crises become less likely.

What are the Netherlands’ options in the Eurozone?

Traci White:The Netherlands effectively has two options: to either stop using the euro, so to withdraw from the common currency, or to choose for a budgetary union with common issued debt securities also known as Eurobonds. Why are those the two options?
van der Kwaak: The moment a country defaults, the banking system will also default. And the only way for a country to avoid the banking system defaulting in an uncontrolled manner is to exit the euro, because then they get their monetary sovereignty back. They can introduce a central bank and they can provide the liquidity to the banking system, which will probably still go bankrupt because of this whole financial crisis, but then you can at least do it in a controlled manner. So if you have the no bail out clause, it means a sovereign debt crises will automatically lead to a euro exit. So in that sense, the monetary union is as prone to accidents because each time right now, you have to discuss with other governments, “please bail us out. please make sure that we don’t go bankrupt.” And each time that depends on a complicated process in which other countries are reluctant to provide funds because effectively, you provide it at lower interest rates down the markets interest rates because otherwise they would borrow from the markets. So the only way to break that is if you start to issue common debt, so that’s debt that is backed by tax revenues directly raised from all Eurozone countries. Because then that allows the banking system to replace the bonds of their own government by Eurozone bonds, so if a country defaults, the government defaults, then the banking system is still capable of going to the ECB and saying, “my sovereign has defaulted. I own these Eurozone bonds” and the ECB will say, “OK, sure we will still provide you financing”.

On the pros and cons of having a common European Union budget:

van der Kwaak:What a budget would do is that the taxes that go into the budget, they go down in a recession, and the expenditures, for example from an unemployment insurance, if that is financed from a common budget that goes up and that mitigates the impact of those shocks in either direction. And also I suppose that there would have been a use of Eurozone budgets. In Spain before the crisis, they would have to pay in more taxes so more money would flow out of the country and fewer funds would come in in the form of unemployment benefits. So that would kind of mitigate this inflationary expansion.
There are also significant cons. So from my story, you can deduce that such a budget has to be substantial. So there is currently a proposal on the table that is being discussed that’s 30 billion euros. That’s macroeconomically speaking, nothing. 0.03 percent of eurozone GDP. The French president is saying we need to have a budget of several hundred billions of euros, and that’s only 5 percent of Eurozone GDP. The most decentralised federations – America, Canada and Switzerland – most decentralised means they have the smallest budgets from the Federation that we know they have federal budgets of 15 to percent 20 percent of GDP. And so even the Macron proposal in the bigger picture is still quite small. But especially for the northern countries, there are disadvantages to this because it’s probably going to be very costly for them.

On how (un)likely a Nexit is:

van der Kwaak:I think ultimately not in the short run of course but in the long run, it is a binary choice: either full, fiscal and monetary integration and financial integration, or you have to exit the euro. I think that what it will come down to.
White: So it’s either staying the course which is maintaining a fragile union where something will need to fundamentally change in order to make it more appealing to remain a part of it, or countries will choose to leave and that will fundamentally change the EU anyway?
van der Kwaak: I don’t think it might be that countries leave. I think it’s more likely that a sovereign debt crisis that we suddenly are forced that we see how the current tools that we have are not going to work. If we want to solve this permanently then we do have to do those Eurobonds.