Recovery Pathways: The Difficult Italian Convergence in the Euro Area

By Marcello Messori

The book analyzes the different phases that have characterized the evolution of the policy framework and the economic governance of the European Union and the Euro Area since the end of the global financial crisis (2007-2009). This analysis, which is found-ed on a careful reconstruction of those "right" or "wrong" economic ideas that have "ruled" the European world until the pandemic shock (to paraphrase the final remarks of Keynes' General Theory), is crucial to appreciate the importance of the ground-breaking initiatives undertaken by the European policy makers and institutions in 2020: the ultra-expansionary monetary policy and the Next Generation EU. These initiatives are opening an unexpected scenario for the Italian economy, which is the main beneficiary of both initiatives. The aim of the book is to explain why Italy has wasted several chances over the first two decades of this century but cannot miss this new opportunity. To get ready for the post-pandemic world, the time is getting short. Italy must accept the challenge and start its difficult recovery pathway.

• Language: English
• Publisher: EGEA Spa - Bocconi University Press
• Release date: Jun 27, 2021
• ISBN: 9788831322317

Book preview

General Introduction

*

This book collects 16 of the Policy Briefs that I wrote during my directorship of the Luiss School of European Political Economy (SEP). SEP, which was established at the end of 2013 thanks to the initiative of the then-Rector of Luiss, Massimo Egidi, and a few other economists (Marcello De Cecco, Jean-Paul Fitoussi, Stefano Micossi, Gianni Toniolo, and myself),¹ has been a non-traditional place where top European scholars and policy-makers could analyze the economic and institutional problems of the European Union (EU) and the Euro Area (EA). SEP’s friendly atmosphere has fostered in-depth debate seminars and open-minded and penetrating discussions that get to the core of the various theoretical and policy issues. The number of SEP papers that I have co-authored (see www.sep.luiss/publications) demonstrates how deeply indebted my analyses are to the most active group of SEP fellows and to the SEP seminars’ contributors. The choice of including in this collection more than 40% of SEP’s co-authored Policy Briefs is also meant to testify to the importance of the collective work performed at SEP.

In the same period (2012–2021), I was fortunate to take part in another stimulating experience in the field of European economics: the co-coordination of two Working Groups at the Astrid Foundation.² The first group, centered on the Banking Union process (see Part II), produced a collective book on this topic (see Barucci and Messori, 2014). The second group, which guaranteed and continues to guarantee stimulating interactions with some of the top Italian members of the European Commission and the European Parliament, is offering profound discussions on the main European economic problems in the 2016–2021 period. Last but not least, my view of European issues has been strongly enriched by the involvement in an informal group of Italian friends, self-labeled Europeos and coordinated by Stefano Micossi. These friends work in different disciplinary fields that, nevertheless, are all focused on analyzing Europe’s institutional and economic problems.

This General Introduction is devoted neither to summing up the content of the book’s five parts nor to examining the phases in the evolution of the economic and policy framework of the EU and EA, which are specifically covered in different chapters of each part (three in Parts I – IV, and four in part V). These aspects are examined in the introductions to the book’s five parts. Here, the aim instead is to offer a unitary interpretation of the main changes in European economic governance and in the utilization of the monetary and fiscal policy tools that have characterized the EU and EA since the international financial crisis (2007–2009). Until the beginning of 2015 these changes, which have deeply influenced the content of the European directives and rules, had tried to find compromises between the main features of the market social economy approach (see Section 1) and the governance adaptations to the new economic problems in the EU and EA threatening the equilibria and – in a few cases – the survival of the monetary Union. From 2016 to the first pandemic shock (February 2020), this search for a compromise was abandoned and European economic governance regressed. Consequently, the monetary policy of the European Central Bank (ECB) became the only game in town. Conversely, since the pandemic shock, Europe’s response to the COVID-19 outbreak has opened a new scenario characterized by potentially groundbreaking innovations in the institutional and economic framework of the EU and EA. The challenge is the effective exploitation by the most fragile EA countries of the opportunities opened up by this new framework.

Section 1 of this General Introduction examines the economic governance characterizing the EU and EA at the end of the international financial crisis (2009). According to the strategic view of the European institutions in the previous period, the efficient functioning of the EU and EA economy was guaranteed by only a few elements: in the long term, by the progress in the single market and in its institutional framework; in the medium term, by national fiscal policies subject to binding centralized constraints, and by national regulations and welfare systems; and in the short term, by a centralized monetary policy and market discipline. The international financial crisis and the consequent real crises emphasized the crucial role played by market and regulatory failures affecting the EU and EA member states in asymmetric ways. In particular, the EA sovereign debt crisis (end of 2009–spring 2011) and the doom loop between this crisis and that of the European banking sector (mid-2011–mid-2012) revealed the need for a more centralized regulatory and policy setting, based on the principle that asymmetric shocks require national adjustments but – in the meantime – European interventions. However, this new governance was characterized by structural weaknesses and its implementation was undermined by various policy shortcomings that fed an institutional uncertainty (see Section 2).

The risk was a stalemate in EU and EA economic governance. European institutions reacted to this risk by launching promising programs (in particular, the Banking Union process) framed in ambitious institutional designs (see Towards a genuine economic and monetary union, usually known as the Four Presidents’ Report). However, due to the divergences within the EA, the implementation of these programs created an opposition between risk sharing and risk reduction that, in turn, led to a lack of trust among various member states, and between European institutions and the most fragile countries. In this respect, the Greek case played a crucial role; however, Italy’s problems also had significant weight (see Section 3). The result was that the innovations in governance were not completed and the institutional uncertainty increased, so that it became difficult to progress in the construction of an effective European economic union.

Despite a few inconclusive attempts to relaunch strategic designs (see, for instance, Completing Europe’s Economic and Monetary Union, usually known as the Five Presidents’ Report), the 2015–2018 period was characterized by the recourse to an unconventional monetary policy, as a short- to medium-term absorbent of European disequilibria, and by a new emphasis on market discipline as a long-term adjustment mechanism at the national level. This framework put the principles of the market social economy under pressure. In any case, it could not represent an effective and efficient solution for an economic and institutional union among different member states. In particular, the recourse to market discipline as the long-term solution to European disequilibria determined a stalemate in European economic governance and an increase in political-institutional uncertainty, maximizing the long-term constraints and distorting the short-term benefits for the most fragile countries (see Section 4).

The symmetric shocks of the COVID-19 pandemic, which have asymmetrically affected the various EU and EA countries and productive sectors, have at least offered the opportunity to overcome this stalemate. Since spring 2020, the EU and EA have been characterized by innovative coordination between a strengthened unconventional monetary policy, and centralized and national expansionary fiscal policies; and in July 2020, the EU launched a groundbreaking initiative called Next Generation-EU (NG-EU) (see Section 5). This initiative is opening new perspectives for the evolution of the EU and EA. If the EU member states were able to exploit this opportunity, it would become possible to open a phase dominated by a centralized fiscal policy leading to a gradual process of institutional and political unification in the EU. Conversely, if some important EU countries were unable to successfully implement the main programs of NG-EU, it would become very difficult to design effective European economic governance (see Section 6). In a few concluding remarks, I will stress that the EU and EA are at a crossroads; and, in this case, it would be mistaken to maintain that the known devils are better than the unknown devils for Europeans.

1The Fragile European Construction

In this General Introduction it is impossible to examine the complex analytical structure of so-called ordo-liberalism (see Eucken, 1950; Peacock and Wilgerodt, 1989; and Bilger, 1964). It suffices to recall three aspects. First, one of the main features of ordo-liberalism is that the efficient functioning of competitive markets cannot be reduced to the economic choices and constrained actions of individual agents; the surveillance and the possible intervention of the state are required to ensure the institutional framework and the economic conditions for a non-distortionary regulation through prices. Second, this economic order is often defined as market social economy to emphasize that the market and the state should interact in a rich institutional setting combining the price-based allocation, the related market rules, state regulation and social protection toward the disequilibria induced by market functioning. Third, the principles of market social economy imply that governments as fiscal policy-makers do not aim at supporting aggregate demand but take full responsibility for the failures of the economic system in which they operate. Moreover, these principles suit the more recent approach according to which, having the monopoly of the seigniorage power, monetary authorities should act independently of governments’ preferences and of fiscal policies, and pursue pre-determined stability rules (see, for instance, Cukierman, 1992; Alesina and Summers, 1993).

The economic governance and the institutional framework of the EU and EA at the beginning of the international financial crisis (2007) were largely compliant with the market social economy approach.³ Germany supported the monetary union under the non-negotiable condition that the ECB would enjoy full independence from national governments and would not be involved in fiscal issues (so-called monetary dominance). The construction of the single market, centered on the four freedoms (free circulation of goods, services and capital, and free mobility of persons/workers), was mainly based on prices’ allocative functions. Nevertheless, the European Commission held strong powers in competitive market regulation through the broad tasks assigned to the Directorate-General (DG) Competition. By monitoring and managing market failures, this regulation justified the crucial role attributed to market discipline: any (direct or indirect) form of bailout toward government debts was prohibited, to such an extent that the ECB cannot even influence the relative levels of interest rates on public bonds issued by different EA member states (the so-called spreads). Moreover, fiscal policy remained the responsibility of national governments, which were subject only to the constraints fixed by European institutions. However, these constraints should be rigorously met to dis-incentivize opportunistic actions which could generate instability and threaten the ECB’s independence in a decentralized fiscal setting. If binding, these constraints could require national recourse to various forms of fiscal repression.⁴

The EU and EA lacked centralized mechanisms to manage economic crises and centralized financial regulation and supervision, because regulated competition should be sufficient to avoid systemic market failures; and local failures would have to be handled by national regulatory mechanisms and by national fiscal authorities. The same principles explained the lack of monetary policy guidance during emergencies, because the latter should be solved through pre-determined conventional tools, given the main local responsibility of the national fiscal policy-makers.

It is controversial if the combination of these different factors inevitably leads to the inconsistent quartet defined by Padoa Schioppa (1982, 2004a). In any case, the international financial crisis was characterized by widespread market and institutional failures, the collapse of the international financial markets, and a high risk of systemic bankruptcy of the most important European banking sectors. Moreover, it caused the great recession of the real economy in the most advanced areas (the United States and the EU). Europe’s response to this situation was, in the first phase, entrusted to the ECB and the national banking supervisors. The ECB eased the access conditions to its conventional open-market operations and decreased its policy interest rates.⁵ The national governments, acting in agreement with the banking supervisors, implemented discretionary bailouts of banking groups on the brink of failure in order to contrast possible local contagions (see Messori, 2009, pp. 26–35). Then, after the bankruptcy of one of the most important US investment banks (Lehman Brothers in mid-September 2008) and the rescue of one of the biggest insurance companies (AIG) by the US Treasury Department and Federal Reserve,⁶ a number of EU member states (mainly Germany, the UK, the Netherlands, Belgium and France) launched public interventions to socialize the private losses of their banking sectors and to avoid national systemic financial collapse. Moreover, the large majority of EA countries further increased public spending to handle the recessionary phase and, especially, to meet the automatic activation of national social stabilizers (such as unemployment benefits).

These national initiatives were not based on efficient European coordination.⁷ The EU’s interventions were limited to suspending the rules on state aid relative to the financial sector and to de facto easing the fiscal constraints imposed by the Stability and Growth Pact. However, since April 2009, it became evident that the lack of centralized coordination in the national aid programs in favor of the various European banking sectors contributed to the limited effectiveness of these interventions compared to those implemented in the United States. Moreover, especially since 2011, the economic recession implied a dramatic surge of Non-Performing Loans (NPL) in the national banking sectors less affected by the international financial crisis due to their traditional business models.⁸ On the other hand, the combination of the increase in national public spending and the severe fall in national GDPs implied that the large majority of the EA countries became non-compliant with the European fiscal parameters at the basis of the centralized fiscal rules.

The persistent fragility of the European banking sector and the disequilibria in government balance sheets have been important determinants of the doom loop between the EA sovereign debt crisis and the European banking crisis that resulted in a new and long EA recession from the last quarter of 2011 to mid–2013. However, at the core of this new crisis – and specifically of the near-bankruptcies of Greece, Ireland and Portugal (2009–2011) – has been the sudden stop in the growth path followed by the most fragile EA countries (the so-called peripheral countries) during the period preceding the international financial crisis.⁹

In the years 1999–2006, the peripheral EA countries recorded GDP growth rates that were higher than those of the core EA countries thanks to an amount of national aggregate investment greater than that of national aggregate savings. This imbalance was, obviously, mirrored in a corresponding amount of negative net exports. The consequent negative imbalances in the current accounts of the large majority of peripheral EA countries were compensated by the financial and capital inflows coming from the banking sectors and other investors of the core EA countries that were looking for profitable allocations of their excess national savings. According to the prevailing view (see Blanchard and Giavazzi, 2002), the negative imbalances in the current accounts and the compensating financial inflows signaled the successful and sustainable catching up process performed by peripheral EA member states. Moreover, at first sight, this process offered empirical evidence that European governance, based on market social economy, decentralized fiscal policies, and non-binding market discipline was working efficiently.

Unfortunately, the financial crisis of 2007–2009 revealed the inconsistencies of this view (see Micossi, 2016). The increase in risk aversion of the core countries’ investors led to a quick reallocation of their financial funds to safer havens (the so-called fly to quality). These investors were, then, imitated by a significant part of the wealth owners of the peripheral EA countries. As a consequence, these latter countries recorded financial outflows and were thus unable to reproduce the previous negative imbalances in their current accounts. Their difficulties were worsened by the discovery that a significant part of the previous financial inflows had been allocated in speculative investments or short-term spending without improving the competitiveness of their production systems (see Canofari et al., 2015). The consequent sudden stop required drastic short-term adjustments centered on restrictive fiscal policies that led to severe economic recessions and social disruptions.

As already stated, the unsustainability of the public debt in Greece, Ireland and Portugal, and the subsequent Spanish and Cypriot crises can be ascribed to various combinations of disequilibria in government balance sheets, overly rapid and severe recessionary adjustments of the imbalances in current accounts, and the difficulties of the banking sector. Italy, which has been burdened by excessive public debt since the 1980s and has been in economic stagnation or recession since the beginning of the twenty-first century, was not deeply involved in the sudden stop and the consequent dramatic adjustments of the other peripheral EA countries because the negative imbalances in its current accounts (2005–2011) were not so significant. Nevertheless, Italy has been one of the EA countries that recorded the worst recession in 2011–2013 and the weakest recoveries in 2014–2019; Italy also suffered the deepest difficulties in the banking sector (2015–2017).

2First Steps Toward More Centralized Governance

The Greek sovereign debt crisis at the end of 2009 and the growing difficulties faced by the Irish and Portuguese governments in allocating their new bonds in the financial markets during 2010 convinced the European institutions that the EA needed a centralized mechanism to manage the sovereign debt crises of its member states. However, in compliance with the market social economy approach, European governance had not provided for such a mechanism because the task of solving national fiscal crises and other national economic disequilibria was entrusted to decentralized fiscal policy-makers and possibly to national fiscal repression. Accordingly, European Treaties forbid any type of bailout of government debt, except if the country’s difficulty was due to exceptional reasons beyond its control. Even in such cases, ECB involvement and direct purchases of the concerned country’s government bonds by other EA institutions or member states were not permitted.

It is obvious that these legal constraints hindered the initiatives to be taken for the implementation of centralized management of sovereign debt crises in the EA. This can explain the provisional recourse to identical bilateral debt contracts between Greece, on the borrower side, and each of the other EA member states and the International Monetary Fund, on the lender side.¹⁰ This can also explain the following construction of two temporary EU and EA mechanisms, to last three years but ready to supply long-term financing to EA member states entering a European aid program. The first, the European Financial Stability Mechanism (EFSM), was approved by the EU Council in May 2010 and the second, and most important, the European Financial Stability Facility (EFSF), was launched by the EA member states in the form of a Special Purpose Vehicle a few weeks after. In any case, the European institutions were able to immediately give continuity to these temporary mechanisms. In fact, by the end of December 2010 and through a minor change in the treaties, they approved a permanent mechanism (the European Stability Mechanism, or ESM) that was ready to become operative at the end of the EFSM’s and EFSF’s planned terms (June 2013). In parallel (May 2010), the ECB launched its Securities Markets Programme, aimed at purchasing government bonds of the EA countries involved in a European aid program on the secondary financial markets.

The aim of this section is not to analyze the strengths and weaknesses of these new mechanisms and programs in detail.¹¹ I am interested instead in stressing that, at least in principle, the establishment of a centralized mechanism to manage sovereign debt crises and the ECB’s demand for government bonds led to a higher degree of cooperation within the EA: member states that had difficulty accessing or were unable to access financial markets could avoid bankruptcy by benefiting from a temporary transfer of resources indirectly financed by the other countries. This innovation in European economic governance, which marked a discontinuity with the market social economy approach, was however balanced by the conditions of the European aid programs. These conditions were different in the Greek, Irish and Portuguese cases; and in fact, at least in the short and medium term, these programs had a negative impact in Greece, mixed consequences in Portugal and prevailing positive results in Ireland.¹²

Beyond the important specificities of these cases, it is possible to highlight a few common failures of the different European programs (for different perspectives, see Lane, 2012; Sapir et al., 2014; see also Stiglitz et al., 2010). First, all the European aid programs were activated only at the last minute, after long negotiations between representatives of the European lenders (the so-called Troika) and the national governments involved, thus maximizing the economic and social costs of the crisis, and the financial cost of the rescue. Second, these programs were based on standard debt contracts with overly high interest rates and collateral requirements, thus increasing the financial and economic fragility of the borrowing governments. The latter implication was strengthened by a third failure, which was crucial in the Greek case but also characterized the other European aid programs: the macroeconomic adjustments imposed on the countries in difficulty as an entry ticket to these programs neglected the aggregate demand problems and were so severe as to be strongly recessionary and hard to implement.¹³ Fourth, with the possible exception of Ireland, these adjustments focused on short-term wage compression instead of promoting a recovery in long-term competitiveness through innovations (see Esposito and Messori, 2019). Finally, the European aid programs underassessed the interdependence between the EA sovereign debt crisis and the EA banking crisis.

As a provisional conclusion, these changes in EA governance can be read as an attempt to run with the hare of a new cooperation between member states and to hunt with the hounds of the previous market social economy principles. Centralization in the management of the sovereign debt crises implies that the national governments and the related fiscal policy-makers are relieved of the full responsibility of solving the national fiscal crises. However, to compensate this injury to the market social economy approach and – specifically – to safeguard the short-term importance of market discipline, the drastic compression of the aggregate demand and the excessive severity of the European aid programs demonstrate that the main fault for the failures of a given economic system should still be attributed to its government.

The same scheme applies to the changes in EA economic governance determined by the doom loop. The contagion of Italy and Spain during the summer of 2011 led to a vicious circle between the still unsolved sovereign debt crisis and the illiquidity crisis (shifting toward an insolvency crisis) of the EA banking sector during the fall and winter of the same year. To avoid the breakdown of the EA, at the beginning of December 2011 and at the end of February 2012 the ECB launched two extreme open-market operations (called LTRO) in favor of the EA banking sector. These operations were based on a horizontal supply curve of refinancing at a given low policy interest rate and on light collateral requirements. The demand for this refinancing was huge, and its fulfillment allowed to overcome banks’ illiquidity crises. However, the ECB’s initiative was not aimed at preventing the EA economic system from plunging into a new recession or at handling the growing incidence of NPLs in banks’ balance sheet (see Section 1).

To counter the first and to indirectly alleviate the second of these incoming risks, national expansionary fiscal policies would have been allowed. Conversely, by claiming that a large majority of the EA countries were not compliant with the Stability and Growth Pact, the European institutions decided to implement the more binding centralized fiscal constraints partially elaborated in 2010. Hence, when the EA was falling into recession (winter 2011–2012), the Six Pack (three regulations, one directive on fiscal rules and two regulations on the adjustments of macroeconomic imbalances) became operative and the Two Pack was launched. Then, in March 2012, the EU approved the so-called Fiscal Compact and the ESM’s new statute.

Overall, the new Stability and Growth Pact and the European surveillance on national macroeconomic disequilibria, set by the initiatives specified above, strengthened the centralized fiscal constraints. These pro-cyclical fiscal policy initiatives are incongruous from an economic point of view. However, they find a possible explanation in light of the previous provisional conclusion on economic governance. Even though it was a conventional monetary tool aimed at adjusting the banking transmission mechanism, the Long-Term Refinancing Operation (LTRO) threatened one of the pillars of the market social economy approach: the full separation of the ECB from fiscal policy issues (monetary dominance). Thanks to the huge amount of refinancing at low cost, the European banks started, in fact, a carry trade by increasing their purchases of government bonds with higher returns issued by the EA fragile countries, thus easing the centralized constraints on the management of government balance sheets. The response of the European institutions was a compensatory strengthening of the centralized fiscal rules aimed at corroborating the importance of market discipline. According to this logic, it can be stated that the ECB’s intervention to overcome the doom loop and avoid the EA’s breakdown was feasible only because of the rebalancing on the fiscal side.

This rebalancing scheme also applies to the ECB’s second intervention, which avoided another possible breakdown of the EA. Despite the progress made in the European Council and in the Euro Summit meetings at the end of June 2012 (see Section 3), the EA recession worsened mainly because of the more binding fiscal constraints. Combined with the unexpected difficulties in the implementation of a new and lighter European aid program to help the Spanish banking sector, this macroeconomic situation increased the institutional uncertainty and led to a new peak in the EA crisis. In July 2012, the instability in the financial markets became so heavy that Italy and Spain were on the brink of losing access to financial markets for allocating their new government debt. Mario Draghi’s famous statement that the ECB is ready to do whatever it takes to preserve the euro – and believe me, it will be enough, substantiated by the launch of the ECB’s Outright Monetary Transactions (OMT) at the beginning of September 2012, dramatically changed financial investors’ expectations and restored calm to the relative markets (see De Grauwe and Ji, 2013).

The approval of the OMT entitled the ECB to purchase an unlimited amount of short-medium term government bonds (that is, with a residual maturity of between 1 and 3 years), issued by the EA member states already enrolled in a European aid program and – hence – compliant with the centralized fiscal rules. This tool was justified by the ECB’s Governing Council as a way to overcome the dysfunctions in the monetary channel transmission caused by the July surge in financial instability. However, it also resulted in the fading out of clear-cut borders between monetary and fiscal policies. Hence, even if the ECB utilized OMT as an effective threat insofar as it was not activated, the compromise with the other European institutions was the stoppage of liquidity expansion. Empirical evidence shows that, since the second half of 2012, the size of the ECB’s balance sheet (here assumed as a proxy for the liquidity amount pumped into the economic system) diminished dramatically.

3Risk Reduction Versus Risk Sharing

This unstable compromise between the market social economy principles and the evolution of European economic governance found a possible solution in the initiatives launched by the European Council and Euro Summit at the end of June 2012. The President of the European Council presented a report (Towards a genuine economic and monetary union), prepared in collaboration with the Presidents of three other European institutions,¹⁴ whose main objectives are improvements in the integration of the financial, fiscal and economic policy organization in order to preserve and extend the unity of the European single market and of the institutional framework. A fundamental component of these improvements is represented by a further confirmation of the democratic legitimacy and accountability of the European institutions; and the first step for the implementation of the financial re-organization is the centralization of banking regulation and supervision. The Euro Summit immediately addressed this second issue by starting the so-called Banking Union process.

Part II of this book offers some details on the financial regulatory framework achieved by the EU in 2010 as a response to the international financial crisis, as well as on the Banking Union process. In particular, the Introduction to Part II stresses that the response implemented in 2010 did not centralize banking supervision, banking crisis management and depositors’ protection at the European level. This centralization was pursued two years later by the three pillars characterizing the Banking Union’s original architecture. The latter foresaw the construction of a single supervisory mechanism (first pillar), a single crisis resolution mechanism (second pillar), and a single deposit insurance scheme (third pillar) for the EA’s, and possibly the EU’s, banking sector. The implementation of the first two pillars was unexpectedly rapid. The ECB was appointed as the single responsible entity for banking supervision by the end of 2012 and started its new assignment at the beginning of November 2014. The set of rules for the single resolution mechanism and the single resolution board was fully approved by mid–2014, so that these bodies became partially and fully operative at the beginning of 2015 and of 2016, respectively.

I do not want to anticipate the analysis presented in Part II here. I am instead interested in focusing on those features and open problems of the Banking Union process that are more related to the evolution of European economic governance. Above all, it should be stressed that the centralization of banking supervision and, mainly, of banking resolution and of deposit guarantees implies that the EA member states must share the main risks involved in the various national banking activities with the purpose of unifying the relative European markets. Moreover, such a crucial break in the European economic governance was decided and implemented in a very short period of time (as I just recalled, less than three years). Hence, it is not surprising that the EA core countries, unfavorable to a risk sharing unrelated to a preventive risk reduction, imposed provisions in the three pillars of Banking Union that increased the complexity of its functioning,

The attempt to weaken the risk-sharing component by means of a priority risk reduction explains why the core EA countries required substantial involvement of the private sector through the bail in and a slow and cumbersome construction of the European resolution fund as indispensable conditions to approving the second pillar of the Banking Union. Recourse to the bail-in process possibly involves all the holders of non-guaranteed bonds and deposits of the bank under resolution, must cover at least 8% of the total liabilities of the latter,¹⁵ and comes before the possible utilization of the European resolution fund that cannot exceed 5% of the total liabilities of the same bank. The risk reduction also justifies the national banks’ yearly transfers to the national branches of the European resolution fund, and then the gradual shifting of the accrued resources from these branches to the single centralized fund, instead of providing direct financing of the latter. Moreover, the same goes for explaining the postponement in the approval of the public backstop in the second pillar (see Section 4), the lack of the third pillar and the poor functioning of the resolution process.

It is important to better analyze the impact of this opposition between risk sharing and risk reduction in the Banking Union process. In the international financial crisis, banks’ bankruptcies never affected their creditors; in this respect, the degree of the private sector’s involvement (the 8% minimum threshold) imposed by the European bail in looks excessive. However, the main problem is still another: this bail in is distortionary because it involves financial investors who had purchased bank bonds before the approval of the new mechanism (2013). This injury of the legacy principle is particularly serious in the case of banks’ plain vanilla bonds. Before the introduction of the bail in, this type of financial asset had a high illiquidity risk before expiry, being often exchanged in tiny markets or through bilateral transactions involving the issuer; however, it had very low market and counterparty risks if held at maturity. After the introduction of the bail in, the same financial asset changed its features and became quite risky due to the sharp rise in the two latter risk components.

Let me add that, as a matter of fact, even the guaranteed creditors are not fully protected: a systemic crisis of a national banking sector could affect deposits up to €100,000 due to the lack of a public backstop (see Section 4) and of a European insurance scheme for these deposits (European Deposit Insurance Scheme, or EDIS). In this case too, the incompleteness of the Banking Union must be attributed to the opposition between risk sharing and risk reduction.

In 2015, the European Commission proposed a gradual construction of EDIS, by following the path drawn by the European resolution fund. Despite this compromise solution, the core EA countries refused to approve any form of EDIS and the related risk sharing in favor of the EA’s more fragile banking sectors, if the latter had previously not been ready to reduce their specific risks. As suggested by the Italian case, these risks were represented by the excessive incidence of NPLs on banks’ total loans and of national government bonds on banks’ total assets.¹⁶ The first element interfered with bank lending (see Balgova and Plekhanov, 2016; Huljak, et al., 2020; and, for a different view, see Accornero et al., 2017), while the second increased the probability of a new doom loop (see Section 1). Conversely, Italy and other peripheral member states criticized an acceleration in the market liquidation of NPLs, which would have implied an overly severe market depreciation of large part of these loans and a consequent negative impact on banks’ balance sheets; and they refused the attribution of a positive risk level to the national government bonds held in banks’ balance sheets.

The controversy focused on the second element.¹⁷ Its implementation would have introduced European gold-plating relative to international regulation. Moreover, the adoption of possible criteria of non-diversification risk and, consequently, the banks’ gradual supply of their excessive amount of national government bonds were subordinated by the peripheral countries to the approval of EDIS by the core countries. This opposed sequencing led to a stalemate, which also prejudiced the effective functioning of the resolution process.

According to the European rules, this process would apply to an EA bank failing or likely to fail, only if the centralized resolution was in the public interest. If the latter condition did not apply, the bank’s crisis should be managed through national laws. The problem is that this legal framework presents at least two weak points. First, differently from the definition of significant institution (SI) in the first pillar of the Banking Union,¹⁸ the stalemate in economic governance has prevented careful definition of what public interest means. Second, the national solutions are based on the heterogeneous bankruptcy laws of the various EA countries; and the same stalemate prevented any harmonization of these different laws. The consequence was that each member state had an incentive to pursue opportunistic national behaviors to avoid the stigma of having banks come under European resolution.¹⁹ The subsequent case of two Italian SI banking groups located in the north-eastern part of the country and not considered of public interest, Banca Popolare di Vicenza and Veneto Banca, is emblematic. This event clarified that the definition of public interest does not fully overlap with that of SIs and is left to the assessment of the Single Resolution Board. Moreover, the Italian law is compatible with a form of partial bailout, so the recourse to the national solution undermined the credibility of the single resolution mechanism and increased the mistrust among EA countries (mid–2017).

The negative consequences of the opposition between risk reduction and risk sharing had already become clear in the 2015 Greek crisis, when the national government and the European Commission put forward their incompatible requests to agree on a new European aid program. The Greek government asked for further restructuring of its public debt, which should have been different from the combination of bailout and bail in implemented in 2012; in fact, this new restructuring should have taken the form of risk sharing without heavy conditionality. The European Commission asked for the implementation of the macroeconomic adjustments and microeconomic reforms that Greece should have completed to be compliant with the old aid program; hence, a preliminary further risk reduction was required. After a number of arm-wrestling episodes (the Greek repudiation of the European proposals, the threat of Greece being temporarily expelled from the monetary union, the collapse of the national banking sector), an agreement was finally reached between July and August 2015. Here, it is impossible to assess the final result, which is controversial (see, for instance, Stiglitz, 2016; Lim et al., 2019; Alcidi et al., 2020). It suffices to stress that the 2015 Greek crisis strongly contributed to the negative evolution of European economic governance. The poor management of this crisis determined a loss of reciprocal trust among EA member states, and between the European institutions and the EA’s most fragile countries. This growing mistrust then interfered with the completion of the Banking Union and increased the political-institutional uncertainty (see also Part III, Chapter 1 of this book).

4Monetary Policy and Mechanistic Market Discipline

The sequence between risk reduction and risk