Building a Complete Crisis Management Framework for the EU

This is an excerpt from  Building a Crisis Management Framework for the EU that we wrote for the Crisis Committee of the European Parliament and then presented at the European Commission. Much of the discussion in this paper remains highly relavent and provides a useful guidance to policy makers about what they need to do after stemming the panic in the markets so you would want to read it. 

Despite the fact that the discussion of the euro area crisis has focused primarily on issues in the sovereign debt market, it is instructive to remember at the outset that this crisis is not primarily a sovereign crisis but one that originated in the private financial sector. As often happens in credit crises, private sector debt is taken on to public balance sheets which makes them fragile and can, as in this case, result in serious dislocations of the sovereign debt market.

Though Greece’s problems have (at least partly) had to do with misreporting statistics and a genuinely unsustainable public balance sheet, the problems faced by countries such as Ireland and Spain originated primarily in excessive risk taking and unsustainable levels of activity in the private financial and real estate markets. In fact, Ireland and Spain were the star pupils of the Stability and Growth Pact, hitherto the euro area’s main bulwark against fiscal problems while bigger states such as Germany and France violated the pact at least as often as they respected its provisions. In the decade prior to the crisis, Ireland halved its debt stock to 23% of GDP and Spain reduced its debt burden from 60% to 40%. It is good to remember that Irish sovereign debt problems are a direct result of the Irish government having guaranteed all senior bank debt.

That is why any discussion on the management of the euro area’s fiscal problems cannot be had in isolation from a discussion of crisis management in the financial sector. In fact, as this paper highlights, there are several lessons that can be usefully applied to the management of sovereign debt crisis from measures that have been suggested and used in the management of crises in the financial sector. What makes these lessons particularly useful is that discussions on the management of banking crises are more advanced than the discussions on managing sovereign debt problems. We apply some of these concepts in making suggestions on how sovereign debt problems can be prevented. 

Thus far, the policy discussions on handling problems with sovereign debt

• have ignored the role of problems in the financial sector;

• have assumed unrealistic levels of government control of economic outcomes;

• have focussed primarily on crisis mitigation rather than crisis resolution;

• have ignored the limits and idiosyncrasies of policy making in modern democracies;

• have ignored the difficulties in bringing about structural changes and have forgotten that;

• have not recognised that in order to try and achieve multiple policy objectives, governments need to have a larger portfolio of policy instruments. 

In order to influence policy making on economic governance in the EU, it is important to highlight the assumptions and parameters that are implicit in our approach to improving the crisis management framework in the euro area. At minimum, any such framework must successfully address 1) the problems faced by Greece on the one hand, and 2) Spain and Ireland on the other. It must also address 3) the underlying all-critical question of how best to manage continuing divergences within the euro area in a way that is not destabilizing. Our aim in this contribution is to devise a complete crisis management framework that would tackle these three distinct aspects of the on-going crisis.

In suggesting this framework, we make the following assumptions from which the conclusions and policy proposals put forward in this paper naturally follow:

• No new institution should be established unless really needed – the EU institutional landscape is already too fragmented.

• Political appetite from Member States for ‘an ever closer fiscal union’ is likely to remain particularly low in the near future.

• Substantial changes to the Treaty, at least in the short term, are not really possible.

• Given a choice we have a preference for a pre-planned crisis management system that minimises the role of ad hoc midnight emergency cabinets.

Fiscal transfers to other Member States are against the spirit, if not the letter of the Treaty and should be avoided as far as possible especially since they can backfire and trigger a political backlash. While an ‘ever closer fiscal union’ may be a good idea, the EU does not seem ready for it yet. The worst scenario would be a move towards a ‘shadow fiscal union’ where transfers across Member States are hidden from public view.

While prevention is better than cure, it is never foolproof so we need to always be prepared for contingencies.

Next, we list some observations which form the basis for our analysis:

• In today’s increasingly complex and interconnected world, there are serious limits to the degree of influence that government policies can have on economic decision making.

• Such limits are especially binding in an open free market economy where the room that governments have for manoeuvre is seriously limited.        

• Room for national level policy action in the euro area is especially constricted because of loss of monetary policy autonomy, the confines (at least on paper) of the Stability and Growth Pact, highly interconnected financial markets and an increasingly harmonized regulatory environment.

• Economic outcomes are partly deterministic and partly stochastic so even with the best of intentions there are limits to what governments can do and control in their economies.

Our objectives, assumptions and observations lead us to conclude that the European Economic Governance discussions need to focus on four things in particular.

1. Better economic policy co-ordination to the extent this is possible under the terms of the current treaty and prevailing political climate. Co-ordination, it is to be remembered, is not the same as uniformity.  

2. A recognition that even with the best of intentions and good co-ordination, euro area economies are structurally, culturally and politically different enough so that substantial economic divergences are likely to continue into the near future. Since these cannot be wished away, policy makers need to focus on devising instruments and approaches that can help mitigate potential negative impacts, such as large imbalances, that might result from these divergences.

3. A recognition that even with better co-ordination and new policy instruments in place, the threat of future crises would remain ever present so any sensible policy making would need to put in place an effective crisis management system for the euro area.

4. Effective crisis management frameworks must be put in place for both sovereigns as well as the financial (banking) sector. Sovereigns provide the final backstop for the banking sector and the banking sector in turn is a significant provider of finance to sovereigns. The high degree of interdependence between the financial sector and sovereigns has become clear in this crisis. Banking crises often lead to sovereign debt problems and sovereign debt problems will almost inevitably increase the likelihood of a banking collapse.

Now that we have stated our assumptions and methodology upfront, the rest of this paper will address the design of an effective crisis management framework for sovereigns in the euro area. The underlying assumption here is that a parallel crisis management framework for the financial sector is already being put in place. 

The design of an effective crisis management framework 

Crisis management is firstly and foremost about minimising the likelihood of occurrence by putting in place effective ex ante risk reducing policies – Crisis prevention. No matter how good such policies look on paper, economic externalities, and endogenous developments in financial markets or stochastic factors can dislocate even the best plans and trigger potentially destabilizing disturbances in the financial markets. These often take the form of liquidity black holes and/or asset prices collapses and/or a collapse in confidence. The challenge at this stage is to contain the crisis, limit damage, stop widespread contagion and restore confidence – Crisis mitigation. Even with the best of efforts to contain a crisis, sometimes it will deepen and spread. Under such a scenario, mitigation gives way to rescue and making a fresh start –Crisis resolution. 

In fire-fighting terms, prevention comes from having a strong fire code, responsible behaviour and taking appropriate precautions. The distinction between crisis mitigation and resolution is somewhat arbitrary but nonetheless critical. Crisis mitigation is about putting out an incipient fire and stopping it from spreading. It will involve the use of smoke alarms, hand-held fire extinguishers, fire blankets and fire doors. Mitigating a crisis or a fire successfully often entails little cost or damage and going back to the ‘normal state of affairs’ is usually easy.

If the crisis or fire is too large or the mitigation tools are inadequate, the problems deepen and spread and cause widespread damage. This is where the big boys, the fire brigade or in the case of financial markets, recapitalizations or bankruptcy are needed to help limit damage and make a fresh start. The degree of collateral damage and the possibility of a healthy fresh start depend on the quality of crisis resolution and rescue measures, or in the case of fire, on the quality and response time of fire brigades and the existence of appropriate insurance policies. 

Crisis prevention depends on 1) responsible fiscal and monetary policies, 2) sound regulation, 3) a countercyclical approach to policy making, 4) moderate to low levels of public and private debt, 5) minimising imbalances and 6) having sufficient room for policy manoeuvre to lean against unfavourable developments. Better co-ordination and surveillance can help too, particularly in the context of the euro area. Prudence and policy space are critical here. 

Crisis mitigation has a lot to do with 1) moving quickly to restore confidence in the financial markets, 2) provision of temporary liquidity and balance of payment support and 3) ring fencing problems so as to minimise contagion. Speed of intervention, minimising conditionality and a credible scale of intervention are critical at this stage. Having a much clearer view of the endgame, in case mitigation fails, can also help calm nerves and restore some semblance of order in the market. 

Crisis resolution often entails substantial costs and involves structural changes, particularly for private sector entities. 1) ex-ante contingency plans, 2) formalized speedy resolution frameworks and 3) the possibility of orderly restructuring are all essential elements of an effective crisis resolution toolkit. A fair burden sharing procedure, predictability and the possibility of redemption are critical at this stage. 

Thus, an effective crisis management framework for the EU will focus on putting crisis prevention, crisis mitigation and crisis resolution tools in place for both the financial sector and sovereigns. In the next section, we discuss some of the main features that such a framework will entail, list what new policy measures have been put on the table and make suggestions on how to improve and strengthen the nascent crisis management apparatus that will need to be a central part of any reform of EU economic governance.