Impossible Trinity of European crisis

Jean Pisani-Ferry of Bruegel takes us through another impossible trinity. Impossible trinity says you cannot have all the three things working together. You have to give up one of the things in order for the system to work.

Robert Mundell gave us the first impossible trinity in economics which was related to price stability, capital flows and currency movement. Dani Rodrik gave us another trilemma/trinity in the international political economy field between nation states, economic integration and domestic policies.

Pisani-Ferry gives yet another trinity related to European crisis. This one is related to absence of co-responsibility for public debt, the strict no-monetary financing rule and bank-sovereign interdependence. Currently we have all three playing which is creating a stress.

  • In current  crisis, as public debt has increased,  responsiblity has fallen on countries to resolve the issue.  There is no fsical union which can transfer funds to the needy state
  • The wide debt has led to widening of spreads on bonds and has hurt the banks which hold the debt.
  • In absence of any major help from ECB, the crisis just keeps worsening.

Hence you have the name impossible trinity. You need to resolve one of these issues to get Euro working.

His main idea is lack of fiscal union is not the only reason for this crisis. The other two issues of having a central bank which is not really responsible for financial stability and relation between government and debt is as problematic. So the reform has to look at all three over a period of time.

The euro area is fighting for survival and its leaders have given every possible indication that they intend to do ‘whatever it takes’ to save it. Yet their discussions and the search for solutions are based on a partial diagnosis that puts excessive emphasis on the lack of enforcement of the existing fiscal rules. True, poor enforcement has been one of the causes of the current difficulties. True, ambitious budgetary consolidation is required. But the budgetary dimension is by no means the only one, not even the most important one18. Europe’s fiscal obsession has deep roots in the history of EMU, but to look at the problems through the fiscal lens only is a recipe for  disappointment.

In this paper I have emphasised that an impossible trinity of no-coresponsibility over public debt, strict no-monetary financing and bank-sovereign interdependence is at the core of euro-area vulnerability. I have assessed the corresponding three options for reform – a broader  mandate for the ECB, the building of a banking federation, and fiscal union with common bonds – and I have argued that none is easy. Economic, legal and political obstacles make all three difficult. This explains why Europe is agonising over reform choices.

He gives  reasons why each of these three are difficult to resolve.  But to atleast get the zone going for now, having a limited fiscal union with an experimental issue of Eurobonds looks most likely.

  • Turning to the feasibility of the three options, the least feasible is probably to change the mandate of the ECB in a way that would lastingly affect the rules of the game and their perception by markets.  It is one thing for the ECB to possibly step up its intervention in response to an escalation of financial tensions, and it is another to let markets understand that it would permanently behave in a way that ensures continued access to liquidity for solvent sovereigns. Even a change in the mandate, to include financial stability, would not be enough to quell impediments to future action resulting from strong reservations in important parts of the Eurosystem, and tensions between the governance structure and the nature of the decisions to be taken.
  • The building of a banking federation involves more than one reform. The setting of regulatory limits on bank exposure to any single borrower, euroarea or EU supervision of large banks, the creation of a common deposit insurance scheme backstopped by a common fiscal resource, and, in the medium run, support for national insurance schemes by the EFSF/ESM, are important aspects. 
  • This leaves fiscal union as the field in which decisions by European leaders could change the game and create the basis for a return to stability. True, there are major political obstacles on the road, not least because, as indicated in this paper, the issuance of Eurobonds implies ex-ante approval of national budgets, which in turn implies a form of political union. By the same token, however, a decision to move in this direction would portend a stronger EMU and would be regarded in this way by markets and the ECB. One possibility would be to introduce a limited, experimental scheme that would rebuild trust. This would also leave time for negotiations on political union.

    There is not only one way out of the euro crisis. There are several possible choices, or at least several possible short-term priorities. But one at least has to be selected for implementation, because to not choose any would amount to keeping the euro area in a state of dangerous fragility.

Very interesting perspective from the author. I just pointed to a paper on US fiscal union history which shows  how difficult it is to get the fiscal union going. It takes number of years to work out a solution..Europe just does not have the time and has made a basis mistake of getting so many countries in the union in very short time. It should have first experimented with core countries (core has shrunk to just Germany right now) and then expanded to others. But this cannot be undone now..real tough choices for EMU…

2 Responses to “Impossible Trinity of European crisis”

  1. Mit Mehta Says:

    Your blog is superb.It always contains worth reading articles.Keep up the good job.

  2. From impossible trinity to holy trinity « Mostly Economics Says:

    […] I had just written on the impossible trinitytrilemma of the European crisis. […]

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