Simon Wren-Lewis on Buti and Carnot

Simon Wren-Lewis has a typically thoughtful post on the European Commission’s approach to fiscal adjustment as set out by Buti and Carnot in a post linked to by Philip a couple of weeks back.   In the context of the zero lower bound constraint on monetary policy, it is hard to disagree with him on the inappropriate aggregate stance of eurozone fiscal policy.  

But I think his discussion neglects an important second dimension of the challenge faced by the Commission (and indeed the ECB).   In addition to being in recession, the fiscal lender of resort (LOLR) function is still a work in progress.   This function has come a considerable way since early 2011, when a hard line on official creditor seniority, and the threat of a low trigger for PSI in future bail out programmes, pushed Ireland  and Portugal – followed not far behind by Italy and Spain – deep into “bad equilibrium” territory.   (Some thoughts from the time here.)   In strengthening the lender of last function, the Commission is constrained by the concerns of stronger countries about the fiscal risks they are taking on, which they see as further aggravated by moral hazard.  

(Sometimes I do wonder if the reluctance on LOLR can be fully explained by conflicting interests.   Although it relates more to banking side, the recent comments – even if partially retracted – by the new Eurogroup head does give cause for concern about the appreciation for the importance of the LOLR for avoiding a serious escalation of the eurozone crisis.)   

The Fiscal Treaty, for example, must be seen as part of the quid pro quo for developing the LOLR.   The ESM – absent some of the more damaging elements of the original proposal – and the ECB’s OMT programme would be unlikely without the strengthening of the rules-based framework.    This must be balanced by the Commission against unwelcome implications of the rules for the aggregate fiscal stance.  

Given their advocacy for a strengthened LOLR, I do think the Commission sometimes gets a bum rap.

14 replies on “Simon Wren-Lewis on Buti and Carnot”

From the Orphanides interview that Philip links to below:

The second element of the decision taken by heads of states was to instruct the EBA to do a so- called capital exercise that marked to market sovereign debt and effectively raised abruptly capital requirements. The exercise required banks to have a core tier-1 ratio of 9%, and on top of that a buffer to make up for differences in market and book value of government debt. That famous capital exercise created the capital crunch in the euro area which is the cause of the recession we’ve had in the euro area for the last 2 years.

Even with ZLB, it’s not just about fiscal policy.

The jury is still out as to how this particular European drama is going to play out. What is certain is that the current mainstream economic theories are not going to be decisive in how it does.

The Commission is not a central player. To the extent that it might have been, a leader of the quality of Jacques Delors would have been required.

For a choice of the possible permutations cf. this ECB occasional paper.

As has been demonstrated by the former governor of the central bank of Cyprus in his interview with the Economist, it ultimately boils down to political choices. If the technical advice is to be listened to, it has to be couched in terms intelligble to the politicians making these choices. The record of success on this score is poor.

Just a quick response to Paul’s post.

Paul puts what he sees as the blind spot with regard to the optimal timing of fiscal adjustment in the context of a ZLB constraint on monetary policy down to the mandate of the ECB. But I think the more fundamental issue is the one raised by Simon on the lack of coordination in determining the aggregate eurozone fiscal stance. Even outside the zero bound, monetary policy is broadly exogenous for individual eurozone countries — and almost totally exogenous for small countries. I think this fact underlies the discussion of time-varying multipliers in the article by Gutram Wolff discussed in Paul’s post. Of course, this just brings us back to Simon’s question about the reasons for lack of institutional architecture for the coordination of fiscal policies in a way that takes into account the resulting aggregate fiscal stance. The point in my post is that the competing demands of minimising transfer risk in the context of developing fiscal LOLR arrangements has complicated the development of any such architecture during the crisis.

The work in progress on banking union as seen by IMF staff.

On the LOLR function, there is no proposal to change the current arrangment. As the ECB paper linked to above points out;

“In a monetary union, like the euro area, international arrangements are replaced by a common central bank that provides lender-of-last-resort lending to banks. In the institutional set-up of the euro area where national central banks are in charge of the actual conduct of central bank
operations with a country’s banking system, this provision of liquidity is reflected in the “TARGET2 balances”. At the same time, the comparison of a central bank of a euro area type monetary union with a country central bank operating under flexible exchange rates and a paper standard, like the US, shows that central banks under the former frameworks have a
similar capacity in managing dual liquidity crises as long as the integrity of
the monetary framework, i.e. the monetary union, is beyond any doubt.”

It is the last proviso which is under threat in Cyprus and it seems that the ECB is fully committed to seeing that it is fulfilled.

The IMF paper has this to say.

“32. Lender of last resort.

The lender of last resort makes liquidity support available to solvent
yet illiquid banks. Centralizing all LOLR functions at the ECB would in the steady state eliminate bank-sovereign linkages present in the current ELA scheme (see Box 1). This would require changes to the ECB’s collateral policy, as by definition euro area banks that tap ELA cannot access
Eurosystem liquidity owing to collateral constraints. Until such time as all banks are brought under the ECB’s supervisory oversight, ELA would be sourced through both the ECB (for banks brought under its purview) as well as national central banks (for banks that remain under national
supervision, albeit with adjustments made to the national ELA limits).”

This recent FT article on the 60% drop in so-called safe assets is also of interest in underlining the “dual liquidity” aspect of the problem, not to say its chicken and egg nature. Continued fiscal consolidation may not be a bed of roses but it is hard to see what the alternative could be.

The two-stage nature of the banking union rocket also now seems to be firmly fixed.


Thanks for those links. The IMF paper has a fascinating TARGET 2 graphic, which shows Germany increasingly “financing” most of the rest. Maybe Prof Sinn is write to be alarmed.

@ Brian Woods

This graphic is the most telling that I have seen. Incidentally, the idea given some credence that the Target 2 balances are just the reflection of the EA ship listing in heavy seas and that it will right itself once calmer waters return seems to me to be fanciful.

I think that the issues raised on this thread are quite fundamental but that the basis of the debate may not be in tune with the political tug-of-war that is going on between the main protagonists. In short, I do no think that the idea of an “aggregate fiscal stance” has much meaning in the current European context.

The German position is clearly being subordinated to the electoral cycle. Nothing wrong with that! It is the job of politicians to get re-elected. However, it seems to be a very high risk strategy given the collapse of the domestic popularity of Hollande and the uncertainty with regard to Italy. It seems, however, that all parties in Germany are happy to see the squeeze on recalcitrant leaders in other countries continue.

There is also the oddity of what was agreed at the European Council in December “leap-frogging” over the last meeting, no doubt because of the developing situation in relation to Cyprus.


“12. To this end, the President of the European Council, in close cooperation with the President of the Commission, after a process of consultations with the Member States, will present to the June 2013 European Council possible measures and a time-bound roadmap on the following issues:

“c) the feasibility and modalities of mutually agreed contracts for competitiveness and growth: individual arrangements of a contractual nature with EU institutions could enhance ownership and effectiveness. Such arrangements should be differentiated depending on Member States’ specific situations. This would engage all euro area Member States, but non
euro Member States may also choose to enter into similar arrangements;”

What these “mutually agreed contracts for competitiveness and growth” will constitute remains a bit of a mystery. They would not, of course, impact on Ireland as we already have our own version i.e. the MOU(s) agreed with the troika.

“I think that the issues raised on this thread are quite fundamental but that the basis of the debate may not be in tune with the political tug-of-war that is going on between the main protagonists. In short, I do no think that the idea of an “aggregate fiscal stance” has much meaning in the current European context.”
The rationale set out by JMcH above would have merit if the real world would follow more traditional economic dogma. However, proponents of the Fiscal Treaty et al have fundamentally mis-diagnosed what’s really happening, which all along has been little more than the usual tussle between creditor and debtor. The Euro Project will very likely fracture along those lines, ultimately. Certainly will happen if it continues along the present lines – with a wider gap between North and South, and less and less likelihood of banking union & related. John and many others like him have mis-diagnosed the problem(s), in apparent belief that Europe was firmly on the road to being like a USA. Interesting to see a certain ‘defensiveness’ in his narrative above….now his support seems more ‘qualified’.

@ Paul W

I do not think the situation is as black and white as you suggest. The debtor creditor struggle arises because of the existence of the euro. It would have been decided long ago in an era of independent currencies with devaluations (or a revaluation of the Dm to save French blushes).

The slides presented by Draghi at the recent European Council say it all.

The current budgetary stance of Germany is nothing short of extraordinary cf. slide 14. In the eyes of some, it is the equivalent of pouring petrol on a blazing fire. Another more nuanced view would be that the overall debt situation of Germany is not the best (slide 6). The real question, however, is whether a fiscal stimulus there would fix the real problem viz. a lack of competitiveness in the other major economies. For anyone with a reasonable grasp of economic reality – a talent not confined to professional economists – the answer must be no as higher levels of inflation in the lagging economies are clearly a product of this very lack of competitiveness.

To this must be added the fact that German “competitiveness” is of a very doubtful character and to an extent a product of restrictive administrative practices. As Lagarde said in her previous existence as French economy minister “it takes two to tango”.

The issue in a European context, however, is one of political rather than economic dexterity. Merkel’s incapacity in this area is by now well known. What direction she is going to take in the months ahead remains to be seen. Her predecessor but one, Kohl, would long ago have taken control of the situation. Her immediate predecessor, Schroeder, played a major role in creating it.

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